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CDM: OVERVIEW OF FINANCIAL MECHANISMS
Climate Change Information CenterManila ObservatoryAteneo de Manila University
Contents
1. Mechanics of CDM2. Basics of CDM Financing3. Risks in CDM Financing4. State of the Carbon Market
1. Mechanics of CDM
Clean Development Mechanism• Enables developed countries (known as
Annex I countries) to meet their emission reduction commitments in a flexible and cost-effective manner
• Assists developing countries (non-Annex I countries) in meeting their sustainable development objectives
• Investors benefit by obtaining Certificates of Emissions Reductions (CERs)
• Host countries benefit in the form of investment, access to better technology, and local sustainable development
What are the Criteria for CDM Projects?
• Sustainable development– Host country criteria– Environmental Impact Assessment– Stakeholder consultations
• Greenhouse Gas (GHG) emission reductions– Environmental additionality
• Project additionality• Project viability
– Technologically proven– Financially sound
• Host country approval• Project validation and registration
CDM Project
• Achieves Sustainable Development objectives for the host developing country
• Reduces GHG Emissions
Simplistic numerical example
Provide electricity for a barangay• “Business-as-usual” (baseline): Diesel
generator sets– Cost of project $10– Emissions 1 tC
• Cleaner project (CDM-eligible): Micro-hydro– Cost of project $13– Zero Emissions
Simplistic numerical example
• CDM Investor (e.g. Japan)– Invests $3 ($13-$10, difference between
cleaner and business-as-usual project)
– Gains Certificate of Emissions Reduction of 1 tC, which it can meet some of its Kyoto Protocol commitments to reduce emissions
Simplistic numerical example
WIN – WIN – WIN• WIN for the host country
– Sustainable development benefit: Cleaner energy production technology
• WIN for the Annex I country– Credits for emissions reduction
• WIN for the Global Environment– Emissions reduction
Kyoto Protocol:Flexibility Mechanisms
Present day
2012 (BaU)
Assigned Amounts
Domestic Actions
Joint Implementation
Emission TradingAnnex I
Emission Trading
Clean Development Mechanism
Domestic Actions
2012 with KP
- 5%
1990 level
Price of a Unit of Emissions Reductions:
A Competitive MarketCost of Reducing in the Host Country (Developing)
<Price of a Unit of Emissions Reductions by CDM
Cost of Reducing in the Investor Country (Annex I)
<
Preparation and review of the Project
Baseline Study and Monitoring Plan (MP)
Validation process
Negotiation of Project Agreements
Periodic verification & certification
Construction and start up
Project completion
3 months
2 months
2 mon
ths
3 months
1-3 years
Up to 2
1 yea
rs
• Upstream Due Diligence, carbon risk assessment and documentation: $ 50K
• Baseline: $30 K• Monitoring Plan: $25K
• External consultant: $25K• Processing and documentation: $30k
• Consultation and Appraisal: $75K• Negotiations and Legal documentation: $30K
Carbon Asset Creation and Maintenance CostsThe PCF Experience: Transactions Costs
Total through Negotiations• All expenses: $265 K
• Initial verification at start-up: $25K
• Verification: $10-25 K• Supervision: $10-20K
2. Basics of CDM Financing
Starting Point: Viable Project
• A potential CDM Project is a feasible project Technologically feasible Financially sound
• A potential CDM Project is a project which has an Environmental Compliance Certificate (ECC)
Total Project Costs and Sources of Finance Total Project Cost Estimates • Investment costs, including development costs, up to
commissioning of project
Sources of Finance to be Sought or Already Identified
• Critical to identify other debt and/or equity finance• Typical sources of funding: international development
banks, government funding, private financing, supplier credit
• CDM contribution = typically 5-15% of total project costs
Important Distinction
• Project Financing– Equity– Debt
• CDM Finance / CER Revenue
Financing Options in a CDM Project
Equity• Annex I Investor co-finances part of a
CDM project in return for shared financial returns and CERs
• Local investors co-financing CDM projects in a host country may wish to share in CERs so that they have the opportunity to sell the credits at a later time
BanksInvestor
DebtEquity
Power Purchase Agreement
$$Electricity
CDM Equity Financing
CDM Investor Equity $$
CERs
Financing Options in a CDM Project
Loan• Annex I Investor provides loan or lease
financing at concessional rates in return for CERs
BanksInvestor
DebtEquity
CDM Debt Financing
CDM Investor
CERsElectricity
$$Debt $$
Financing Options in a CDM Project
Emission Reductions Purchase Agreement
• Annex I investor agrees to buy CERs as they are produced by the project
BanksInvestor
DebtEquity
Power Purchase Agreement
$$Electricity
Emission Reductions Purchase Agreement
CDM Investor$$
CERs
Emission Reduction Purchase Agreement
Financing Options in a CDM Project
Carbon Funds• Annex I investors contribute to a mutual
fund• Mutual fund agrees to buy CERs as they
are produced by the project• Examples
– WB Prototype Carbon Fund– Netherland’s CERUPT
How Carbon Funds Work..
Industrialized Governments
and Companies
Developing Countries and Communities
Carbon Fund
$Technology
Finance $Technology
Finance
CO EquivalentCO Equivalent22
Emission ReductionsCO EquivalentCO Equivalent22
Emission Reductions
Carbon Fund
$ $
22 22
Emission ReductionPurchase Agreement
BanksInvestor
DebtEquity
Power Purchase Agreement
$$Electricity
$$
CarbonCredits
Nature of Carbon Financing Contract
Emission Reduction Purchase Agreement
• Will improve IRRs• Forward contract
– Payment upon delivery of verified ERs– Upfront payments are rare
• Will provide a hard currency revenue ($, €, £, ¥)• Helps secure financing and reduce project risk
– Future ER payments as collateral for project loans– Can be paid into an escrow account, protecting
lenders from currency convertibility and transfer risks
How CDM can matter
Without CERs
implemented
With CERs not
implemented
No CDM
Without CERs not implemented;
with CERs implemented
CDM
FIRR
CER income
0
Technology IRR
Hydro, Wind, Geothermal 0.8-2.6Methane KickCrop/Forest Residues 3-7Municipal Solid Waste 5-10+
Impact of Carbon Finance on Impact of Carbon Finance on Project Financial Rate of ReturnProject Financial Rate of Return
•Revolution in Solid Waste Management
•Important impact on small-holder crop-processors and animal production
BanksInvestor
DebtEquity
Power Purchase Agreement
$$Electricity
CDM Equity Financing
CDM Investor Equity $$
CERs
ODA
Non-ODA
BanksInvestor
DebtEquity
CDM Debt Financing
CDM Investor
CERsElectricity
$$Debt $$
ODA
Non-ODA
Carbon Fund
$ $
22 22
Emission ReductionPurchase Agreement
BanksInvestor
DebtEquity
Power Purchase Agreement
$$Electricity
$$CarbonCredits
Emission Reduction Purchase AgreementODA
Non-ODA
3. Risks in CDM Financing
Risks in CDM Financing
• Renewable energy projects are considered risky by financing institutions
• Multitude of risks could reduce the value of the project to zero
• Measures are needed to mitigate risks at different stages of the project
“Normal” Project Risks• Political/Country Risks
• Sponsor Risks• Construction Risks
• Technical Risks• Fuel Risks
• Environmental Risks• Financial Risks
• Legal Risks• Operation Risks
CDM-Specific Risks• Market/Price Risk
– Will there be a market for project-based ERs? – Will contract price exceed market price?
• Policy/Compliance Risk– What if no Kyoto Protocol?– What if host country does not ratify or comply?– What if host country does not approve project?
Market and Policy Risk are closely linked
• Baseline Risks– Eligibility--will ERs be Kyoto-compliant?
– Will project be validated and registered?– Will ERs be verified and certified?
– Baseline design--is the baseline robust? Will its assumptions remain valid over time?
– Performance--actual performance will determine level of ERs generated
CDM-Specific Risks
4. Emerging Trends in the Carbon Market
Summary of carbon markets currently in operation
Project-based Emission Reduction purchases
Allowance Trading
Within National trading systems
Intra-Firm tradingRetail
UK
DK
Shell
BP
“Pre-Compliance”
From voluntary
To Kyoto Pre-Compliance
Market Intelligence:“Few Countries Benefiting,
Little Private Sector Buying” • Market: cumulative 200 million tonnes CO2 traded
($500 million) since 1996• Five-fold increase between 2001 and 2002• Only 43% of all carbon transactions made in
CDM/JI (2001-2002), dominated by Dutch and PCF
• Only 13% of the private sector’s purchases were in CDM (2001-2002)
• African countries, smaller countries and small-scale projects are largely bypassed
Carbon Market Volume has increased
Source: Authors’ own calculation, as above, volume projection by PointCarbon
0
10
20
30
40
50
60
70
80
1996 1997 1998 1999 2000 2001 2002(to date)
2002(Proj.)
Estim
ated
vol
umes
tran
sact
ed (M
tCO
2e)
ER TransactionNational MarketsPoint Carbon 02 proj.
Who is buying ER Credits?
Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
1996-2000 2001-2002
Canada
USA
Netherlands
Other WEU
Japan PCFAustralia
Canada
USA
Other WEU
Japan
Australia
PCF
Netherlands
Balance in Asset Classes Emerging
Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
0%
10%
20%
30%
40%
50%
60%
70%
Fuel-Switching EnergyEfficiency
Renewables Industrial Transportation LFG LULUCF GeologicalSequestration
1996-2000
2001-2002
0
2
4
6
8
10
12
14
16
18
Annex II JI Countries CDM Countries
Volu
me
of E
R P
roje
cts
(MtC
o2e)
Carbon Finance flows 2001-2002
Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
USA
Canada
Australia
Latin America
AsiaAfrica
Who’s buying where? (2001-2002)
Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
0
2
4
6
8
10
12
14
16
18
20
Annex II JI CDM
Volu
me
(MtC
o2e)
PrivatePrivate/Public partnershipsPublic
In 2001-2002, private companies acting alone have purchased only 13% of their reductions in developing countries.
World BankCarbon Finance Vehicles
BioCarbon Fund
Netherlands CDM Facility
Italian Carbon Fund
World Bank’s Carbon Finance Business- at a Glance
Carbon Purchases agreed and under negotiation: ~40, ~US$250 million Number/Value of PCF and Netherlands Projects approved for carbon purchase: 64, US$ 440 millionCarbon Asset portfolio: ~50 million tCO2eUnderlying CDM/JI project finance: ~$3.0 bn
Regional Distribution of Active PCF Pipeline ProjectsTotal of Approx. US$ 227 Million
East Asia23%
Eastern Europe17%
Latin America 24%
Africa20%
South and Central Asia
16%
Technological Distribution of Active PCF Pipeline ProjectsTotal of Approx. US$ 227 Million
Bagasse6% Biomass
8%
Energy Efficiency
18%
Geothermal12%
LULUCF4%
Waste Management
21%
N20 Removal5%
Small Hydro12%
Wind14%
Sample Projects• Latvia: $2.5 million PCF Purchase
– anaerobic decomposition of about 20,000 tons of garbage a year– ERs from the existing landfill site gas recovery began June 2002
• Uganda: $3.9 million PCF purchase– a 5.1 MW and 1.5 MW small hydro generating facilities in the
West Nile region– Displaces >200 small and few large public diesel gensets
• Chile: $6 m PCF Purchase– 26MW run-of-river hydro generating 175 GWh to replace
coal/gas• Brazil: $5 mm of PCF Purchase
– Substituting coal/coke by sustainably produced charcoal in pig iron production, plus afforestation and ecosystem restoration, biodiversity and health benefits
Lessons from PCF: Carbon Prices
Uganda small hydro (5&1.5 MW) remote area $3.00
Chile: 25 MW hydro run-of-river $3.50 [ +option]
Brazil sustainable charcoal replacing coal/coke $3.50
Poland District Heating Fuel Switch – Coal to Geothermal and Biomass
$3.50
C. America small wind/hydro $3.50
Romania Afforestation $3.60 [+option]
Colombia wind farm $3.50 + 0.5
South Africa Durban waste management $3.75 + 0.2
Czech small-scale energy efficiency $4.00
Contrasting the New FundsContrasting the New Funds
CF to small-scale energy projects
Generate high-value ERs (contract prices: $4-5t/CO2e)
“Development + Carbon”
CDM countries only: emphasis on smaller, poorer countries and communities
Multiple tranches
Community Development Carbon Fund (CDCF) BioCarbon Fund
CF to agricultural, forestry, and land use
Generate cost-effective ERs (contract prices: $3-4/tCO2e)
Carbon + biodiversity cons., fight against desertification, reduction in rural poverty
CDM and JI
Learn-by-doing prototype
Carbon Funds in Asia
• Asian Development Bank CDM Facility
• Development Bank of JapanCarbon Fund of Japan
• JBIC Carbon Fund
Carbon Prices
0
5
10
15
20
25
30
UKAuction
UKMarket
Denmark Retail--Early
Vintages
JI to 2012 CDM to2012
Annex IIother
Source: PCF estimates, based on database assembled with Natsource,Co2e.com and PointCarbon
Pricing of Emission Reductions• Price range offered depends on the
– Legal jurisdiction of the ER• Kyoto Protocol, EU trading system, domestic trading systems
such as those in UK or Denmark or the voluntary market– Price signal in the market for the jurisdiction– Willingness to pay of the buyers
• Price outcome in a project depends on risk sharing in the contracts including– Regulatory risk (e.g. Kyoto Protocol entry into force,
eligibility of project, verification and certification)– Project performance and delivery risk
Price Differentials b/w CER & AAU
Different Carbon Markets• Legal Status of Asset
AAU has more secure status than CER CER has Kyoto Risks
• Different Trading Regimes AAU: Cap-and-trade CER: Baseline-and-credit
• Each reduction has to be certified – higher transaction costs• Baseline risks
• Compartmentalized Carbon Markets– At present, not allowed to trade CER in EU Trading
Schemes
Estimated and Contracted ERs
Contract default value
5 10Year
Estimated emission reductions
Minimum contracted emission reduction
Additional emission reductions
Actual performance and contract volume
5 10Year
Expected ERs
Actual performance and contract volume
5 10Year
Expected ERs
“Swept” amount
ERs freed due to sweeping
Minimum contracted amount
Emission reduction and revenues
-
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Min ER (TCO2e) Shared ER (TCO2e) PCF revenue ($) Shared ER revenue ($)
Price trends
-
2.00
4.00
6.00
8.00
10.00
12.00
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
$/TC
O2e
Contracted price ($) Market price ($) Average price($) Outcome price ($)
Historical Emissions
Low Surplus (High Demand, Low
Supply)
High Surplus (Low Demand, High
Supply) 1990 2000 % change
2000-2010
CarbonBalanc
e
% change2000-2010
CarbonBalanc
eGROSS DEMAND 220 53
EU Carbon 911.4 895.5 7% 120 -3% 30
Japan Carbon 305.3 313.7 10% 58 -3% 17
Canada Carbon 128.6 158.0 15% 61 0% 37
+ Net other GHGs (+5, -5%) 12 -2
- Managed forest allowance -30 -30
Buyers of Carbon Credits[MtCe/yr]
(Source: Grubb, March 2003)
Historical Emissions
Low Surplus (High Demand, Low
Supply)
High Surplus (Low Demand, High
Supply) 1990 2000 % change
2000-2010
CarbonBalance
% change2000-2010
CarbonBalance
SUPPLY 331 587
Russia Carbon 647 450.7 20% 106 0% 196
Ukraine Carbon 191.9 104.5 20% 67 0% 87
Accession 10 Carbon 245.2 146.6 25% 45 5% 75
Other EITs 87.8 45.4 25% 24 0% 36
Other GHGs (10, 20%) 24 79
+ Managed forest allowance 40 40
CDM
15
50
Sellers of Carbon Credits[MtCeq/yr]
(Grubb, March 2003)
Probable prices for CERs(£/tCO2e)
(Grubb, March 2003)
• Renewable energy and energy efficiency projects under CDM fast-track procedures for small scale projects £10 – 25 per tCO2e
• Land use and other CDM projects £ 5 – 15 per tCO2e
Key Factors in CDM Market Development
• Need 5 years+ for carbon finance to make a difference in a project at current prices;
• Buyers only want ERs delivered by 2012. They heavily discount ERs after 2012
• If value of post 2012 ERs is not assured by 2006, CDM market activity will decline sharply
Lead Time and Uncertainty Constraints on Project-Based
Mechanism (esp. CDM)
2006 20082003 2012
OperatingWind, Efficiency, Waste to Energy
Large Hydro, Geothermal, Coal to Gas PowerCDM Investment Window: 3years
IF NO Decision; No Incentive beyond 2012,
No Investment, Market Development Stalled
Operating
= Start Construction
CDM: Challenges ahead
Roberto C. Yap, S.J., Ph.D.Environmental Economist
Climate Change Information CenterManila Observatory
Ateneo de Manila UniversityTel +63 2 426-6144Fax +63 2 426-6070