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Clean Development Mechanism(CDM)

Session on Finance

Sidharth SinhaIndian Institute of Management, Ahmedabad

The views expressed here are those of the presenter and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they

represent.

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itKyoto Protocol (1 December 1997)

• Parties to the United Nations Framework Convention on Climate Change, New York, May 9, 1992

• The Parties included in Annex I shall, individually or jointly, ensure that

their aggregate anthropogenic carbon dioxide equivalent emissions of the greenhouse gases listed in Annex A do not exceed their assigned amounts,

calculated pursuant to their quantified emission limitation and reduction commitments inscribed in Annex B and in accordance with the provisions of this Article,

with a view to reducing their overall emissions of such gases by at least 5 per cent below 1990 levels in the commitment period 2008 to 2012.

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itKyoto Protocol (continued)

• The Kyoto Protocol broke new ground by defining three innovative “flexibility mechanisms” to lower the overall costs of achieving its emissions targets. 

• These mechanisms enable Parties to access cost-effective opportunities to reduce emissions, or to remove carbon from the atmosphere, in other countries.

The three Kyoto mechanisms are:• Joint implementation (JI) under Article 6 Annex I Parties to

implement projects that reduce emissions, or remove carbon from the atmosphere, in other Annex I Parties, in return for emission reduction units (ERUs).

• Emissions trading, as set out in Article 17, provides for Annex I Parties to acquire units from other Annex I Parties, and,

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itClean Development Mechanism

• The clean development mechanism (CDM) defined in Article 12 provides for non Annex I Parties to implement project activities that reduce emissions resulting in certified emission reductions (CERs). 

• The CERs generated by such project activities can be used by Annex I Parties to help meet their emissions targets under the Kyoto Protocol.

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itClean Development Mechanism (continued)

• CDM project activities must reduce emissions below those emissions that would have occurred in the absence of the CDM project activity (baseline).

• Article 12 also stresses that such project activities are to assist the developing country host Parties in achieving sustainable development and in contributing to the ultimate objective of the Convention.

• The CDM is supervised by the CDM Executive Board.

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itAnnex 12 (5) Kyoto Protocol

• Emission reductions resulting from each project activity shall be certified by operational entities to be designated (DOE) by the conference of the Parties serving as the meeting of the Parties to this Protocol, on the basis of:

Voluntary participation approved by each Party involved;

Real, measurable, and long-term benefits related to the mitigation of climate change; and

Reductions in emissions that are additional to any that would occur in the absence of the certified project activity.

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itTypes of Carbon Projects

• Hydroelectric power offsetting the need for coal- or gas-fired generation

• Extending grid to reach customers currently using diesel or kerosene

• Reducing CO2 and possibly methane (a potent greenhouse gas) by generating energy and bio-fuels from sugar industry by-products -- bagasse and molasses

• Replacing firewood/kerosene/cowdung with biogas from livestock and human wastes

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itTypes of Carbon Projects (continued)

• Extracting methane from landfills or avoiding its generation through composting organic waste in urban dumpsites

• Extracting methane from disposal of sewage sludge

• Capturing N20, a powerful greenhouse gas, from fertilizer production

• Sequestering CO2 by tree planting, small plantations, land restoration

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itCDM Project Participants

• Project developer (sellers)

• CDM investors (buyers)

• Host country designated national authority (DNA) (approver)

• Designated operational entities (DOEs) (auditor)

• CDM executive board (EB) (regulator)

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itCDM Project Stages

• Project design and development• Approval• Validation and registration• Implementation• Monitoring• Verification and certification• Issue of CERs (certified emissions reductions)

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itCDM Project Cycle: Overview

Verification / certification

Approval / Validation / Registration

Implementation / Monitoring

Issuance

Project Design & Development

ER

Project Owner

National Authority

Operational Entity

Executive Board

Project Owner

Operational Entity

Executive Board

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itSteps

1. Project activity design Project participants shall submit information on their proposed CDM project activity using the Project design document.

2. Proposal of a new baseline and/or monitoring methodologyThe new baseline methodology shall be submitted by the designated operational entity to the Executive Board for review, prior to a validation and submission for registration of this project activity, with the draft project design document.

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itSteps (continued)

3. Use of an approved methodologyThe approved methodology is a methodology previously approved by the Executive Board and made publicly available along with any relevant guidance. In case of approved methodologies the designated operational entities may proceed with the validation of the CDM project activity and submit project design document for registration.

4. Validation of the CDM project activityValidation is the process of independent evaluation of a project activity by a designated operational entity against the requirements of the CDM, on the basis of the project design document.

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itSteps (continued)

5. Registration of the CDM project activityRegistration is the formal acceptance by the Executive Board of a validated project as a CDM project activity. Registration is the prerequisite for the verification, certification and issuance of CERs related to that project activity.

6. Verification is the periodic independent review and ex post determination by the designated operational entity of the monitored reductions as a result of a registered CDM project activity during the verification period.

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itSteps (continued)

7. Certification is the written assurance by the designated operational entity that, during a specified time period, a project activity achieved the reductions in emissions by sources of greenhouse gases as verified.

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itRisk in CDM Projects

• Two main types of risk inherent in CDM projects: Carbon specific risks and standard project risks Both give rise to delivery risk

• Carbon asset risks Whether the project, and ultimately the ERs, will be

registered with the CDM Executive Board The most significant component of regulatory risk is

additionality risk, which relates to whether the project will be deemed additional by the CDM Executive Board Approval of registration depends on the weight of

evidence required to be submitted to the Executive Board.

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itRisk in CDM Projects (continued)

This is related to the baseline risk, which relates to the reliability of the baseline (the estimate of emissions that would have occurred without the project) e.g. does a hydro project replace a coal or gas plant

• CDM projects face structural difficulties in obtaining financing- Tend to be highly capital-intensive They are not competitive with fossil fuel technologies in

economic terms Financing generally is not available at low enough interest

rates or for sufficient tenors to permit adequate debt service coverage

Moreover, many banks require additional coverage for country risk

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itCarbon Funds

• The World Bank manages nine carbon funds and facilities comprised of public and private participants.

• These funds are public or public-private partnerships managed by the World Bank as a Trustee. They operate much like a closed-end mutual fund; they purchase greenhouse gas emission reductions from projects and pay on delivery of those emission reductions.

• All the emission reduction credits are purchased on behalf of the public and private sector participants in the funds.

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itCarbon Funds (continued)

• The World Bank is acting as an honest broker to ensure that the benefits of carbon finance make their way also to the developing world and to countries with economies in transition.

• The role of the Bank through its Carbon Finance Unit has been one of market facilitator and catalyst.

• Sale of emission reductions can help secure financing for CDM projects by providing an additional high quality revenue stream -

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itCarbon Funds (continued)

Contracts are denominated in hard currency - usually US dollars or euros - as the known carbon buyers to date are in OECD countries.

Contracts are typically multi-year; for example, the Prototype Carbon Fund’s (PCF) typical ER contracts are for deliveries expected over a 10-year period or longer.

The counter parties are highly-rated: AAA-rated governments accounted for about half of known CDM and JI carbon purchases in 2002-03, with investment-grade multinationals, largely banks and power companies, accounting for most of the rest.

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itCarbon Funds (continued)

• To enable project sponsors to borrow against these revenue streams, the Emission Reduction Purchase Agreement (ERPA) developed by the World Bank’s Carbon Finance Business has the facility to enable ER payments to be placed in escrow.

This has permitted project sponsors to use the ERPA proceeds to service debt.

Placing the escrow account outside the host country mitigates currency convertibility and transfer risk.

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itNova Gerar (“New Generation”)

Landfill Gas Project, Brazil

• SA Paulista, a Brazilian engineering and waste management company, with the concession to manage the Marambaia and Adrianopolis landfills on the outskirts of Rio de Janeiro

• EcoSecurities, a multinational environmental finance company, specializing in greenhouse gas mitigation

Bruce Usher, CEO, EcoSecurities Group Limited, Carbon Finance Risk Mitigation Workshop, PPIAF, 19 November 2003, Paris

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itProject Nova Gerar

• The objective of the Nova Gerar joint venture is to develop the landfill gas collection system on the landfills managed by SA Paulista.

• This involves investing in a gas collection system, leachate drainage system, and a modular electricity generation plant at each landfill site (with expected final total capacity of 12 MW), as well as a generator compound at each site.

• The generators will combust the methane in the landfill gas to produce electricity for export to the grid.

• Excess gas, and all gas collected prior to a grid connection will be flared.

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itProject Nova Gerar (continued)

• Combustion and flaring combined reduce emissions of 11.8 million tons of CO2 equivalent over 21 years.

• Nova Gerar is negotiating an Emission Reduction Purchase Agreement (ERPA) with the World Bank to purchase all of the emissions reductions generated by the project up to 2012, and a right of first refusal for emissions reductions generated beyond that date.

• The World Bank is purchasing the emissions reductions as trustee for the Netherlands Clean Development Facility (NCDF), a CDM project facility.

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itNova Gerar Financing

• Uses• Working capital: $250,000 • Capital investment

Phase 1 - Flaring: $620,000 for flaring equipment and gas plant works

Phase 2 - Electricity generation (8 MW) $ 350,000 for grid connection $ 4,800,000 for power generators

• Sources• Senior loan secured by ERPA: $1,220,000• Leasing: Modular power generators will be leased as

needed.

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itMonetisation of the ERPA

Nova Gerar (Brazil)

Lender

World Bank (US)

Debt Reserve Account$229,000 pa for 9 years

(12% discount rate, declining principal balance)

$1,220,000lent today

$472,000 to$1,701,000 pa

$243,000 to$1,472,000 pa

CERs ($125,000 to 450,000 pa)(9 years)

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CDM Case Study: Jincheng Coalmine Methane Power Project

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itProject Rationale

• The project is at the Sihe coalmine located near the city of Jincheng in Shanxi Province. Shanxi is the largest coal-producing province in China.

• Methane gas in underground coalmines is an extremely explosive gas and a certain portion must be collected and vented to the atmosphere from coal seams to ensure miners’ safety.

• As required by law, JMC has installed a gas collection system in its mines to vent the methane directly to the atmosphere, thereby releasing a highly potent GHG. Methane is approximately 21 times more potent than carbon dioxide (CO2).

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itProject Rationale (continued)

• The proposed project will collect a majority of the mine’s vented methane gas to fuel the proposed 120 MW power plants.

• GHG emission will be reduced when the vented methane (CMM) is captured and used for

power generation, and when the generated electricity displaces electricity

from coal-fired power plant in the grid.

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itRole for CDM

• The revenue from the electricity sales alone will provide a low rate of return for the project because of the low power tariff rate in Shanxi Province.

• The additional revenue stream provided by selling carbon emission credits to the World Bank’s Prototype Carbon Fund (PCF), improves the economics of the project and reduces the investment risk.

• A baseline scenario would be that the recovery and utilization of methane is limited solely to internal mine and household usage, and most of the methane would be vented to the atmosphere for the safety of mine operations. The coal-fired plant would supply the least-cost power production.

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itProject Development Objective & Key Indicators

• The project development objectives are to create and trade GHG emission reduction (ER) credits under the CDM by reducing GHG emissions through

capturing methane for power generation, and replacing grid electricity generated by coal-fired power

plants.

• Project outcomes will be measured by three groups of indicators:

The volume of methane captured annually. The amount of electricity from coal replaced annually. The ER credits created and traded annually.

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itProject Components

The project consists of the following four subcomponents:

• Underground CMM recovery. The use of new equipment and technologies is expected to

increase CMM drainage efficiency by 100 percent and the methane content of the drained CMM by 80 percent

• The 120 MW power plant. A power plant comprising a total of about 32–96 internal

combustion (IC) engines with a total capacity of 120 MW The IC engines are installed during a four-year period.

• The power transmission line.

• Capacity building and consulting services.

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itProject Cost Estimates

ItemTotal cost

(US$ million)

Underground CMM drainage and recovery 14.20

CMM-fired power plant and transmission lines 97.60

Resettlement 1.20

Consulting services 1.18

Staff training 0.60

Institutional strengthening 0.46

Contingency 12.24

Interest during construction 11.21

Total 138.69

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itFinancing Plan (US $ million)

Source Amount %

A. Loans

1. Asian Development Bank 82 59.1

2. Local commercial bank 22 15.9

Subtotal (1) 114 75.0

B. Equity Capital

1. Jincheng Mining Corp 24.69 17.5

Subtotal (2) 24.69 25.0

Total 138.69 100.0

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itFinancing Terms

• The ADB loan will have a 24-year term including a grace period of 4 years. In calculating WACC,

It is assumed that a fixed interest rate of 4.3% will apply.

• The local commercial bank loan is expected to have a 15-year repayment period, including a grace period of 4 years,

Currently the interest rate is fixed at 5.76% per year.

• Foreign exchange costs are estimated at US$ 82 million and local currency costs at US$ 56.69 million equivalent.

This matches the currency of financing

Weighted Average Cost of Capital = 4.96%

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it Institutional & Implementation Arrangements

• The sponsor of the project is JMC, a corporatized entity fully owned by the Shanxi provincial government.

• It has a large operation in developing coalmines, selling coal and generating power.

• The project will be implemented according to the Emission Reduction Purchase Agreement (ERPA) to be signed between JMC and the World Bank, as trustee of the PCF.

• A monitoring plan (MP) will be agreed between parties to the ERPA.

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itImplementation Arrangements (continued)

• ERPA and MP define the quantity, price and other delivery conditions for ERs to be purchased by the PCF, as well as monitoring and verification systems and methods.

• Verification and certification of ERs generated annually by JMC will be coordinated by the PCF, which will ultimately purchase the ERs.

The PCF will retain the services of an internationally recognized, fully independent third party to verify and certify the project ERs.

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itImplementation Arrangements (continued)

The verifier will determine whether the project complies with the design and implementation specifications and meets the requirements.

Annual verification of ERs generated for the previous year will be recorded in a verification report. A certification will allow the ERs to be internationally traded.

• The PCF will purchase only ERs that are verified.

• According to requirements of the Kyoto Protocol, the Government of China will operate a registry to manage the transfer of ERs generated by the project.

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itRisk Mitigation

Risk Risk mitigation measureFrom outputs to objectiveGHG ER credits not created and traded

- Government of China has ratified the Kyoto protocol

- Effective in February 2005.

From components to outputsLow level of electricity generation because of inadequate resources

- Resource assessment has been conducted by JMC and well-known international consultants.

- Additional CMM is available from nearby mines.

Low availability of power units because of new technologies

- Technologies sufficiently proved elsewhere,

- International consultants to assist their applications here.

Delays in finalizing power sale to the grid company and disadvantage power pricing

- Construction of the power plant agreed by the grid company and approved by the government.

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itRisk Mitigation (continued)

Risk Risk mitigation measure

Low level of power generation because of power market saturation

- Shanxi is currently suffering from power shortages, and a high-demand growth is expected for many years.

Social and environmental issues inadequately addressed

- JMC has carried out comprehensive social and environmental impact assessment,

Safety issue inadequately addressed

- Safety is a top consideration during the design of the project,

- Vigorous safety plan is in place

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itSensitivity Analysis

Component 1: CMM Recovery FIRR % NPV million yuan

Total CMM as % of designed output

Without carbon finance

With carbon finance

Without carbon finance

With carbon finance

Base case 100% 5.3 14.8 3.1 211.3 Breakeven point 98% 5.0 14.0 0.0 197.9 CMM level at 95% 4.6 13.1 (3.4) 183.7 CMM level at 90% 3.8 11.4 (9.9) 157.2

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itSensitivity Analysis