overview of cdm financial mechanisms

CDM: OVERVIEW OF FINANCIAL MECHANISMS

Climate Change Information CenterManila ObservatoryAteneo de Manila University

Contents

1. Mechanics of CDM

2. Basics of CDM Financing

3. Risks in CDM Financing

4. 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


• 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


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 Market

Cost 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 m

onth

s

3 months

1-3 years

Up

to 2

1 ye

ars

• 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 InvestorEquity $$

CERs


Loan

• Annex I Investor provides loan or lease financing at concessional rates in return for CERs

BanksInvestor

DebtEquity

CDM Debt Financing

CDM Investor

CERsElectricity

$$Debt $$


Emission Reductions Purchase Agreement

• Annex I investor agrees to buy CERs as they are produced by the project

BanksInvestor

DebtEquity


$$

Electricity

Emission Reductions Purchase Agreement

CDM Investor$$

CERs

Emission Reduction Purchase Agreement


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 FundCarbon Fund

$$Technology

Finance $$Technology

Finance

CO EquivalentCO Equivalent22

Emission Reductions

CO EquivalentCO Equivalent22

Emission Reductions

Carbon Fund

Carbon Fund

$$ $$

22 22

Emission ReductionPurchase Agreement

BanksInvestor

DebtEquity


$$

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 0.8-2.6

Methane Kick

Crop/Forest Residues 3-7

Municipal 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


$$

Electricity

CDM Equity Financing

CDM InvestorEquity $$

CERs

ODA

Non-ODA

BanksInvestor

DebtEquity

CDM Debt Financing

CDM Investor

CERsElectricity

$$Debt $$

ODA

Non-ODA

Carbon Fund

Carbon Fund

$$ $$

22 22

Emission ReductionPurchase Agreement

BanksInvestor

DebtEquity


$$

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.)

Est

imat

ed v

olu

mes

tra

nsa

cted

(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 PCF

Australia

Canada

USA

Other WEU

Japan

Australia

PCF

Netherlands

Balance in Asset Classes Emerging


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

ER

Pro

ject

s (M

tCo

2e)

Carbon Finance flows 2001-2002


USA

Canada

Australia

Latin America

AsiaAfrica

Who’s buying where? (2001-2002)


0

2

4

6

8

10

12

14

16

18

20

Annex II JI CDM

Volu

me

(MtC

o2e

)

Private

Private/Public partnerships

Public

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

http://www.communitycarbonfund.org/

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 tCO2e

Underlying 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 % change2000-2010

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 % change2000-2010

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

Operating

Wind, 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 Center

Manila Observatory

Ateneo de Manila University

Tel +63 2 426-6144

Fax +63 2 426-6070

[email protected]

mailto:[email protected]

mailto:[email protected]

overview of cdm financial mechanisms

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