clean development mechanism projects and portfolio risks

� Corresponding author. Tel.: +E-mail address: matu@global

0360-5442/$ - see front matter #doi:10.1016/j.energy.2004.03.060

81-3-5841-7055; fax: +81-3-3818-7492.env.t.u-tokyo.ac.jp (R. Matsuhashi).

2004 Elsevier Ltd. All rights reserved.

Energy 29 (2004) 1579–1588

www.elsevier.com/locate/energy

Clean development mechanism projects and portfolio risks

Ryuji Matsuhashi a,�, Sei Fujisawa a, Wataru Mitamura b,Yutaka Momobayashi b, Yoshikuni Yoshida b

a Institute of Environmental Studies, Graduate School of Frontier Sciences, The University of Tokyo,7-3-1 Hongo, Bunkyo-ku, Tokyo 113-8656, Japan

b Department of Geosystem Engineering, Graduate School of Engineering, The University of Tokyo,7-3-1 Hongo, Bunkyo-ku, Tokyo 113-8656, Japan

Abstract

Clean development mechanism (CDM) is expected to facilitate technology transfer from developed todeveloping countries as well as to economically reduce greenhouse gas emissions. In this article, weexplore effective institutions to activate CDM projects. For this purpose, we have estimated internal rateof return (IRR) and other indicators on profitability for 42 CDM or JI projects, taking account of vola-tilities in the price of certified emission reductions (CER). As a result of Monte Carlo simulations,expected values and standard deviations in the IRR of the projects were quantitatively shown. Then weevaluated various risks in CDM, concluding that diversification of investment is an effective way to sup-press these risks. Therefore securitization of CDM finance is proposed as a means of facilitating thediversification of investment. Namely, we present the concept of a CDM bond, which is a project bondwith CER. We also investigated the role of governments to suppress risks in CDM. Referring to CER-UPT, initiated by the Netherlands’ government, the institution of ‘‘insured CERUPT’’ is proposed tosuppress downside risks in the IRR of the projects. We concluded that it is possible to make CDM proj-ects viable by the ‘‘insured CERUPT’’ and CDM bond.# 2004 Elsevier Ltd. All rights reserved.

1. Introduction

Degradation of the global environment and depletion of resources are becoming seriousthreats to the sustainable development of humankind. In particular, there has been a growingconcern about climate change caused by the increase in concentration of greenhouse gases.Although Annex 1 countries in the Kyoto Protocol have to control their greenhouse gas

R. Matsuhashi et al. / Energy 29 (2004) 1579–15881580

emissions according to their assigned amounts, greenhouse gas emissions such as CO2 areincreasing in most countries.Therefore we need to explore efficient and fair ways of internationally reducing greenhouse

gas emissions. Under these circumstances, the clean development mechanism (CDM) is expectedto provide powerful options to suppress the difference between the North and the South, as wellas to economically reduce greenhouse gas emissions.

2. Present situations on CDM projects

2.1. Profitability of CDM projects

The institution of CDM has been the subject of intensive arguments based on the Kyoto Pro-tocol. In particular, issues on ‘‘additionality’’ are significant to certify projects as CDM. Frompast interpretations on investment additionality, operational entities would not certify a projectas CDM, if it were profitable even without revenue from sales of certified emission reductions(CER). Interpretation on the investment additionality changed at the COP7 meeting inMorocco. According to the Marakesh Accord a project could be certified as CDM which isprofitable without CER revenue. Nevertheless, the past interpretation of investment addition-ality seems to be still alive in some developing countries. Under such circumstances, profitabilityof CDM projects must be cautiously evaluated, so that the projects could be carried out.Therefore we investigated the overall profitability of 42 CDM and JI projects, of which feasi-

bility studies were performed under sponsorship of NEDO. Data on initial investment cost,annual running cost, annual production of main commodities, such as electricity, and annualreduction of equivalent CO2 emissions were acquired from NEDO’s reports on each project [1].Table 1 shows the list of the evaluated projects.Evaluated projects include various kinds of CDM and JI, such as fuel switching from coal to

natural gas, efficiency improvement in industrial sectors, recovery of methane from coal mining,energy conservation in commercial and residential sectors. These projects have different charac-teristics especially in revenue structure. If a CDM project is based on high efficiency power gen-eration, revenue is from sale of electricity and CER. Most projects rely on main products, suchas electricity, as well as CER for revenue. However, the value of CER as a share of the totalrevenue is different, depending on the characteristics of each project. For instance, shares ofCER sales are generally high in projects which recover methane from coal mining and utilize thegas for power generation, town gas production or methanol synthesis. In such projects, therecovered methane is converted into equivalent CO2 reduction by multiplying by 21 as globalwarming potential. Thus the amount of equivalent CO2 emissions becomes considerable, so thatrevenue from CER sales often exceeds the sales of the main products. On the other hand, theshare of CER value would be relatively small in projects for efficiency improvement in fossil-fueled power generation. Fig. 1 depicts the distribution of initial shares of CER sales in totalannual revenue in the 42 CDM and JI projects.

2.2. Monte Carlo simulations for estimating risks accompanying CDM projects

Volatility in future CER value is generally higher than the volatility of the value of the mainproduct. Therefore a CDM project which relies heavily on CER value is exposed to higher risk.

1581R. Matsuhashi et al. / Energy 29 (2004) 1579–1588

If the price of CER does not rise as anticipated, the project would not bring about sufficientrevenues to project sponsors. On the other hand, sponsors would receive greater revenues if theprice of CER rose in future. In particular, participation of the USA, even from the second com-mitment period, would promptly escalate the price and increase the revenue of such a project.In order to quantify the above risks, we performed Monte Carlo simulations on the profitabilityof CDM projects. We estimated the internal rate of return (IRR) of 42 projects by Monte Carlosimulations, on which economic data were acquired from NEDO’s reports.Major assumptions for the simulations are as follows.

1. We estimated an implied volatility in CER price from present data as a call option by theBlack–Scholes equation. Based on this estimation, the volatility was assumed to be 23%.

Table 1Examples of feasibility studies on CDM projects sponsored by NEDO

Project H
ost country
1
Project of recovering coal mine methane in China C hina 2 Power generation utilizing waste heat in cement production in China C hina 3 Feasibility study on a project to reduce CO2 emissions through power generation
by residual oil in petroleum refineryC
hina
4
Development of combined cycle power generation systems utilizing blast furnace gas for ironand steel company in China
C
hina
5
Rehabilitation of 300 MW coal fired power generations in China C hina 6 Survey of dissemination situation of various kinds of kilns in cement industry in China C hina 7 Projects of energy savings in the Shengyang iron and steel company in Liaoning Province C hina 8 Evaluation of efficiency improvement in conventional fossil-fueled power plants in China C hina 9 Rationalization of energy consumption in Chinese iron and steel industries C hina 10 Improvement of low-quality limestone to reduce CO2 emissions in Chongqing city in China C hina 11 Energy conservation projects in Bak and Novobak petroleum refinery plants A zerbaijan 12 Energy conservation projects in Khabarovsk petroleum refinery plants R ussia 13 Investigation of improved waste disposal system in factories producing starch from Tapioca I ndonesia 14 Evaluation of energy saving options in a commercial building in Indonesia I ndonesia 15 Rehabilitation of fossil-fueled power stations in Lyazanskaya city R ussia 16 Reduction of losses in electric power generation, transmission and consumption
in MyanmarM
yanmar
17
Replacement of coal fired power stations by combined cycle power generations in Poland P oland 18 Improvement of heating reactors in three petroleum refinery plants in Quivishef,
Shizranniand Novoquibishef in RussiaR
ussia
19
Fuel switch from conventional coal fired power plants to natural gas fired power plants inSakhalin Province
R
ussia
20
Rehabilitation of fossil-fueled power stations in Khabarovsk R ussia 21 Rehabilitation of fossil-fueled power stations in Chekingskaya city R ussia 22 Fuel switch project in the first and ninth combined heat and power plants in Irkutsk R ussia 23 Combined cycle projects in Konakovo power stations in Russia R ussia 24 Fuel switching from Amursk coal fired power plants to natural gas fired power plants
in RussiaR
ussia
25
Fuel switch project in power plants in Ignovaskaya R ussia 26 Repowering of three gas fired power stations R ussia 27 Project of generic rehabilitations in fossil fired power plants in provinces along the oceans R ussia


2. Annual escalation of main products such as electricity was assumed to be 3%. Volatility inprice escalation of main products is assumed to be 1.5%.

3. We estimated the IRR of each CDM project through generating 100,000 random numbersaccording to the above assumptions.

4. The present price of CER is assumed to be 4 US$/t-CO2 based on the current data.5. According to the estimation by the global energy model, DNE [2], the price of emission per-

mits will rise to 22 US$/t-CO2, which corresponds to 21% annual escalation. However, thisis in the case in which USA ratifies the Kyoto Protocol. Under present circumstances, thepossibility of the USA’s participation is very slight. Therefore we set a more conservativeannual escalation of CER price as 10%.

6. We assumed 10 years’ for financing projects, which comprises build, operate and transfer(BOT). This is because an option for the period for generating CER from one project wasdetermined as 10 years in COP7. After 10 years, all the assets concerning the projects will betransferred to the host countries’ governments or companies. Trade-in prices of transferredassets were assumed to be 10% of initial investment.

Fig. 2 shows the computed results of Monte Carlo simulations. Namely it depicts expectedvalues and standard deviations in IRR of the 42 projects with and without CER revenues. Thisfigure indicates how risks and returns in the projects increase by including revenues from CERsales.Although Fig. 1 tempts us to make portfolios of the various projects, it is necessary to inves-

tigate characteristics of risks so as to evaluate the effectiveness of portfolios. Risks accompany-ing CDM projects are generally classified as follows.

1. The risk is certainly significant that volatility in the CER price will change the revenue inCDM projects. This is already taken into consideration in the above Monte Carlo simu-lation. Here the risk is named as ‘CER risk’.

shares of CER sales as proportion of total annual revenue
Fig. 1. Distribution of initial in the CDM projects (legendshows the share of total sales).


2. Another risk which is also crucial is whether a project could be certified as CDM or not? Ifthe project were not certified by operational entities, sponsors of the project could notacquire CER. The risk is named as ‘certification risk’.

3. We should pay attention also to a risk that the amount of CER will change due to modifiedbaselines in future. We call this ‘baseline risk’.

4. We should also be cautious as to whether a CDM project is approved by host countries ornot.

5. A CDM project is also accompanied by country risks due to political or economical insta-bility in host countries. Here we call risks in 4 and 5 as ‘country risks’.

Among the above-mentioned risks, certification risk and baseline risk strongly depend uponproject types. If the technologies could be improved for recovering and combusting methanefrom coal mining in host countries, the baseline in the project for recovering methane would belowered, leading to a reduction of CER units. In the worst case, operational entities might notcertify the project as CDM. In order to suppress these risks, we should invest in different typesof projects, rather than in similar projects.On the other hand, risks in 4 and 5 depend upon political and economic stability in the host

countries. In order to lower these risks, we should invest in projects in different countries, ratherthan in a single country.CER risk itself is difficult to avoid by portfolios of CDM projects, since it is similar to sys-

tematic risks in the market for securities. However, we could control certification risk, baselinerisk and country risks by diversification of investment. In sum, further investigation is requiredto make effective portfolios of CDM projects to lower the above-mentioned risks.

and standard deviations in IRR of the 42 projects with and w
Fig. 2. Expected values ithout CER revenues.


3. Schemes to make CDM projects viable

3.1. The concept of CDM bond

From the observations in the last section, it is desirable for sponsors to diversify investmentinto various projects in various countries so as to reduce baseline risk, certification risk andcountry risks.One such measure is a partial securitization of financing for CDM. Here we propose the con-

cept of a CDM bond as a kind of securitization. Fig. 3 shows the scheme of the CDM bond. Inthis scheme investment banks or securities companies would evaluate the total risks in CDMprojects, structure them and make CDM bonds, which are project bonds with CER units. Thenthey can sell them to individual investors, general companies and to qualified institutional buy-ers (QIB). In some cases, they can make portfolios of CDM bonds to sell them as a ‘CDMFund’ such as the present ‘Eco Fund’. Possible investors or QIB would be companies whichwant to supplement their own efforts to reduce CO2 emissions by the CER, which want to raisetheir environmental ranking, or which undertake it just as an investment business.From the standpoint of investors, the projects in which they prefer to invest will depend on

their attitudes toward the risk. It will also depend on the need for CER in each company. Somecompanies will take the investment imperative to comply with the voluntary action programexpressed by, for example, the Nihon Keidanren, while others will take it just as an environ-mental business or advertisement. If there are wide varieties of securities to be sold in the

Fig. 3. Financial flow accompanying partial securitization of CDM projects.


market, individual investors, companies or QIB are able to buy them according to their ownattitude toward the risk and necessity of CER. Thus the concept of securitization of CDMdeserves further investigation. We will establish the institution more concretely and evaluate itin our future work.

3.2. The concept of insured CERUPT

So as to reduce risks in CDM, governments of donor countries could also play an importantrole. In this respect, CER units procurement tender (CERUPT) which was initiated by theNetherlands’s government deserves attention. In CERUPT, the government will purchase CERunits acquired from CDM projects, where host countries and donor countries ratify the KyotoProtocol. In future, other governments may also take the establishment of such systems intoconsideration, including Japan. If a donor country’s government could offer a lower price for aCER unit in such a system, it could contribute to suppressing downside risk in the IRR ofCDM, resulting from volatilities in the CER price. Here we call the concept ‘Insured CERUPT’as this could suppress the downside risks in CDM by determining a minimum price for CER.We compared the IRR of a CDM project with and without the Insured CERUPT, for a projectwhich recovers coal-mine methane to utilize it for power generation in a developing country.Fig. 4 shows the estimated profile of IRR of the project, with and without the Insured CER-

UPT, in which the government shows the lowest price of CER at US$ 4/t-CO2, the present

abilistic distribution of IRR estimated by Monte Carlo simulations with and without the Ins
Fig. 4. Prob ured CER-UPT.


price in emission trading. Fig. 4 makes us recognize the effect of the Insured CERUPT to sup-press downside risks in the project.The index of value at risk, VaR, is often used to estimate risks in financial engineering. When

we sort data on IRR from the lowest to the highest, VaR is in the order of 1000th (1%) among100,000 data points. We estimated VaR in IRR to be 10% with the Insured CERUPT and 6%without the Insured CERUPT, respectively. Thus its institution by government could also helpto make CDM and JI projects viable.

3.3. The effect of the proposed institutions

Then we evaluated the b value as defined in Eq. (1). Here the value of b is utilized to assesssensitivity of IRR to increasing rate of CER price.

IRR ¼ bðRCERÞ þ c (1)

where RCER is the rate of increase in CER price.Based on the concept of the securitization and the evaluated value of b, we can evaluate risks

and returns in portfolios which admit diversified investments. In this analysis, we took the com-bination of the portfolios and the insured CERUPT to activate JI and CDM projects. Based onthe following assumptions, we determined the most possible combinations in 42 projects asshown in Fig. 5. This figure indicates the effects of the securitization and the Insured CERUPT.

1. In a scenario of business as usual, we picked projects as marketable, in which IRR exceeds15% even without revenue from CER. We calculated the sum of equivalent CO2 reductionsby adopted JI and CDM projects. This is the criterion which ordinary trading companies relyon for carrying out projects.

Fig. 5. Equivalent CO2 reductions by adopted JI and CDM.


2. In scenario of the Insured CERUPT, we picked projects as marketable in which IRR exceeds15% including CER revenues with the institution. Then we calculated the sum of equivalentCO2 reductions by adopted JI and CDM projects in the same way as above. This is the cri-terion in which the government establish the institution of the Insured CERUPT.

3. In this scenario, we picked the most possible projects by making portfolios which insure thefollowing risk/return formulas. Investors could easily prepare their portfolios by the securiti-zation of JI and CDM. We maximized the number of adopted projects, under constraints ofEq. (2). Eq. 2 implies a basic relationship between risks and returns observed in securitiesmarket. Rf and a were determined from present data on the market.

l � Rf þ ar (2)

where l is the return of a portfolio; Rf the risk free rate; r the risk of a portfolio; and a is theconstant.

4. In this scenario, we picked the most possible projects by making a portfolio which insuresthe same risk/return constraints as above. In this scenario, we also took the Insured CER-UPT into consideration. Namely, we evaluated the total effects of controlling risks by portfo-lios and the Insured CERUPT.

4. Conclusion

In this paper, we explored efficient institutions to make CDM projects viable. For this pur-pose, we estimated IRR and other indicators on profitability for 42 projects, taking account ofvolatilities in CER price and other costs. As a result of Monte Carlo simulations, expected val-ues and their standard deviations in IRR were quantitatively shown. Risks accompanying CDMprojects were identified as CER risk, certification risk, baseline risk, and country risk. Althoughit is difficult to suppress CER risk by diversifying investment into various CDM projects, wecould effectively control certification risk, baseline risk or country risks by portfolios of varioustypes of projects in various countries.Therefore securitization of CDM finance was proposed to facilitate the diversification of

investment. Namely, we presented the concept of the CDM bond, which is a project bond withCER. We also investigated the role of governments to suppress risks in CDM. The institutionof the Insured CERUPT was proposed to suppress downside risks in the IRR of the projects.Then we evaluated the b value to assess the sensitivity of IRR to increasing rate of CER price.Based on the evaluated value of b, we explored the most possible combinations in 42 projectswith and without proposed institutions. The evaluated results indicated that the Insured CER-UPT and CDM bond could activate CDM projects.

Acknowledgements

The authors are grateful to Shunsuke Mori, Tetsuo Tezuka, Tsuyoshi Iwama and JunichiMurakami for their useful comments during frequent discussions on CDM.


References

[1] Matsuhashi R. Investigation of effective institution to make CDM projects viable. Paper presented at UNIDO/MRI Forum on CDM and Kyoto Protocol: Opportunities for Japan in Asia, Tokyo; 2002.

[2] Akimoto K, Matsunaga A, Fujii Y, Yamaji K. Game theoretic analysis for carbon emission permits tradingamong multiple world regions with an optimizing global energy model. Transactions of Japan Institute of Electri-cal Engineers 1998;118C(10):1424–9.

clean development mechanism projects and portfolio risks

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