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					CDM: OVERVIEW OF
FINANCIAL MECHANISMS

Climate Change Information Center
Manila Observatory
Ateneo 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
  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
             Annex I
                                Emission Trading
                                Emission Trading


                               Clean Development
                                   Mechanism

                  1990 level
                               Joint Implementation
                       - 5%

                                Domestic Actions
                                Domestic Actions



                               Assigned Amounts
Present    2012    2012 with
  day     (BaU)       KP
      Price of a Unit of Emissions
              Reductions:
         A Competitive Market
Cost of            Price of a       Cost of
Reducing in                         Reducing in
the Host
               <   Unit of      <   the Investor
                   Emissions
Country            Reductions       Country
(Developing)       by CDM           (Annex I)
         Carbon Asset Creation and Maintenance Costs
         The PCF Experience: Transactions Costs
                                                Preparation and review of the Project
           Project completion                       • Upstream Due Diligence, carbon risk
                                                    assessment and documentation: $ 50K


                                                                 Baseline Study and Monitoring
                                                                 Plan (MP)
                                                                    • Baseline: $30 K
Periodic verification &                                             • Monitoring Plan: $25K
certification
  • Verification: $10-25 K
  • Supervision: $10-20K
                                                                 Validation process
                                                                  • External consultant: $25K
                                                                  • Processing and documentation: $30k



  Construction and start up                           Negotiation of Project Agreements
    • Initial verification at start-up: $25K        • Consultation and Appraisal: $75K
                                                    • Negotiations and Legal documentation: $30K

                                  Total through Negotiations
                                   • All expenses: $265 K
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
                  CDM Equity Financing


                           Investor   Banks


                     Equity                   Debt


               Equity $$                        Power Purchase Agreement
CDM Investor
                                                $$
                CERs                                     Electricity
    Financing Options in a CDM
              Project
Loan
• Annex I Investor provides loan or lease
  financing at concessional rates in return
  for CERs
              CDM Debt Financing


                     Investor   Banks


               Equity                   Debt



                                        Debt $$
                $$                                CDM Investor
Electricity                              CERs
    Financing Options in a CDM
              Project
Emission Reductions Purchase
  Agreement
• Annex I investor agrees to buy CERs as
  they are produced by the project
        Emission Reductions Purchase Agreement


                          Investor   Banks


                      Equity                 Debt

                                               Power Purchase Agreement
                     $$
CDM Investor                                   $$
                                                        Electricity
                 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..

            Technology                          Technology

             $    Finance
                                                 $    Finance




Industrialized                                           Developing
Governments                  Carbon Fund                Countries and
    and                                                 Communities
 Companies



        CO2 Equivalent                      CO2 Equivalent
       Emission Reductions                 Emission Reductions
             Nature of Carbon Financing Contract
                             Investor              Banks


                         Equity                              Debt

                                                               Power Purchase Agreement
                                                               $$
                                                                        Electricity




                                             $$
    $                $
                              Carbon
        Carbon                Credits
         Fund                           Emission Reduction
                                        Purchase Agreement
2                2
    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
FIRR
       Without CERs    With CERs      Without CERs not implemented;
       implemented        not            with CERs implemented
                      implemented

                                    CER income

  0




              No CDM                              CDM
  Impact of Carbon Finance on
 Project Financial Rate of Return


 Technology                 DIRR

 Hydro, Wind, Geothermal    0.8-2.6
 Methane Kick
 Crop/Forest Residues         3-7
 Municipal Solid Waste       5-10+

•Revolution in Solid Waste Management
•Important impact on small-holder crop-
processors and animal production
                  CDM Equity Financing
                                                     ODA
Non-ODA

                           Investor   Banks


                     Equity                   Debt


               Equity $$                        Power Purchase Agreement
CDM Investor
                                                $$
                CERs                                     Electricity
              CDM Debt Financing
                                               ODA

                                                        Non-ODA
                     Investor   Banks


               Equity                   Debt



                                        Debt $$
                $$                                   CDM Investor
Electricity                              CERs
 Emission Reduction Purchase Agreement
                                                                  ODA




                               Investor              Banks


Non-ODA                    Equity                              Debt

                                                                 Power Purchase Agreement
                                                                 $$
                                                                          Electricity

      $                $
                                               $$
                                Carbon
          Carbon                Credits
           Fund
                                          Emission Reduction
                                          Purchase Agreement
  2                2
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
           CDM-Specific Risks
• 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
4. Emerging Trends in the
     Carbon Market
 Summary of carbon markets currently in
              operation
Project-based
                                                        Allowance
Emission
                  “Pre-Compliance”
                                                           Trading
Reduction
purchases                                 Within National trading systems
                   From voluntary
                                                           UK

                                                                    DK




                                                     Intra-Firm trading
  Retail        To Kyoto Pre-Compliance
                                                                   BP

                                                           Shell
               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
                                         80
 Estimated volumes transacted (MtCO2e)




                                         70
                                                      ER Transaction
                                         60           National Markets
                                                      Point Carbon 02 proj.
                                         50


                                         40


                                         30


                                         20


                                         10


                                          0
                                              1996   1997      1998       1999   2000   2001     2002       2002
                                                                                               (to date)   (Proj.)

Source: Authors’ own calculation, as above, volume projection by PointCarbon
        Who is buying ER Credits?                   Buyers (# of projects)


                      1996-2000                                                             2001-2002
                 Australia
              Japan          PCF
                                                                                                        Canada
     Other WEU                                                                PCF

   Netherlands


                                                                 Australia
        USA


                                                                   Japan
                                                                                                                     USA


                                                  Canada

                                                                       Other WEU
                                                                                                   Netherlands




Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
                 Balance in Asset Classes Emerging
  70%


  60%


  50%                                       1996-2000
                                            2001-2002
  40%


  30%


  20%


  10%


    0%
           Fuel-Switching    Energy      Renewables   Industrial   Transportation   LFG      LULUCF      Geological
                            Efficiency                                                                  Sequestration



Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
                                        Carbon Finance flows 2001-2002
                                   18

                                   16
                                                     Australia
  Volume of ER Projects (MtCo2e)




                                   14

                                   12

                                   10
                                                     Canada
                                    8                                                                            Asia
                                                                                                                 Africa
                                    6

                                    4

                                    2
                                                     USA                                                         Latin America
                                    0
                                          Annex II               JI Countries                  CDM Countries


Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
                        Who’s buying where? (2001-2002)
                        20

                        18

                        16                          Private
                                                    Private/Public partnerships
                        14
                                                    Public
      Volume (MtCo2e)




                        12

                        10

                         8

                         6

                         4

                         2

                         0
                             Annex II                           JI                             CDM

In 2001-2002, private companies acting alone have purchased only 13% of their reductions in
                                   developing countries.
  Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon
     World Bank
Carbon Finance Vehicles
               Netherlands
               CDM Facility
               Italian Carbon
                     Fund




             BioCarbon 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 million
Carbon Asset portfolio: ~50 million tCO2e
Underlying CDM/JI project finance:
   ~$3.0 bn
      Regional Distribution of Active PCF Pipeline Projects
                Total of Approx. US$ 227 Million

                                           Africa
     Latin America                         20%
          24%




                                                     South and
                                                    Central Asia
                                                       16%
Eastern Europe
     17%



                               East Asia
                                 23%
     Technological Distribution of Active PCF Pipeline Projects
                 Total of Approx. US$ 227 Million
                                Bagasse
                 Wind
                                  6%    Biomass
                 14%
                                           8%



 Small Hydro
   12%                                              Energy
                                                   Efficiency
                                                      18%
N20 Removal
    5%



                                            Geothermal
         Waste                                12%
       Management                 LULUCF
          21%                       4%
                   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     $3.50
Geothermal and Biomass
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 Funds
 Community Development
   Carbon Fund (CDCF)
                                        BioCarbon Fund

 CF to small-scale energy         CF to agricultural, forestry,
  projects                           and land use
 Generate high-value ERs          Generate cost-effective ERs
  (contract prices: $4-5t/CO2e)      (contract prices: $3-4/tCO2e)
 “Development + Carbon”           Carbon + biodiversity cons.,
                                     fight against desertification,
                                     reduction in rural poverty
 CDM countries only:              CDM and JI
  emphasis on smaller, poorer
  countries and communities
 Multiple tranches                Learn-by-doing prototype
       Carbon Funds in Asia
• Asian Development Bank CDM Facility



• Development Bank of Japan
    Carbon Fund of Japan



• JBIC Carbon Fund
                          Carbon Prices
      30

      25

      20

      15

      10

       5

       0
              UK        UK    Denmark       Retail-- JI to 2012 CDM to       Annex II
            Auction    Market                Early               2012         other
                                            Vintages

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

                        Estimated emission
                            reductions
  Additional emission
      reductions


                                             Minimum contracted
                                             emission reduction



                                             Contract default value




                   5                  10
                        Year
Actual performance and
    contract volume


                     Expected ERs




     5          10
         Year
Actual performance and
    contract volume
         “Swept”   Minimum contracted
         amount         amount


                                        Expected ERs




                                   ERs freed due to
                                     sweeping




     5              10
            Year
                                       Emission reduction and revenues

1,600,000



1,400,000



1,200,000



1,000,000



 800,000



 600,000



 400,000



 200,000



      -
            2003   2004     2005           2006        2007       2008          2009           2010            2011   2012

                          Min ER (TCO2e)      Shared ER (TCO2e)   PCF revenue ($)      Shared ER revenue ($)
                                                       Price trends

          12.00




          10.00




           8.00
$/TCO2e




           6.00




           4.00




           2.00




            -
                  2003   2004   2005           2006          2007          2008           2009           2010        2011   2012

                                Contracted price ($)    Market price ($)   Average price($)      Outcome price ($)
                   Buyers of Carbon Credits
                                         [MtCe/yr]
                               (Source: Grubb, March 2003)

                                Historical       Low Surplus (High     High Surplus (Low
                                Emissions       Demand, Low Supply)   Demand, High Supply)

                             1990       2000    % change    Carbon    % change    Carbon
                                                2000-2010             2000-2010
                                                            Balance               Balance
GROSS 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
                   Sellers of Carbon Credits
                                        [MtCeq/yr]
                                    (Grubb, March 2003)
                             Historical Emissions     Low Surplus (High     High Surplus (Low
                                                    Demand, Low Supply)   Demand, High Supply)

                             1990         2000      % change    Carbon    % change     Carbon
                                                    2000-2010   Balance   2000-2010    Balance


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
        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)
                         Wind, Efficiency, Waste to Energy
                                        Operating
CDM Investment
Window: 3years         Large Hydro, Geothermal, Coal to Gas Power
                                                              Operating




  2003               2006           2008                          2012
                                                         = Start
                                                         Construction
      IF NO Decision; No Incentive beyond 2012,
      No Investment, Market Development Stalled
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
           rcyapsj@observatory.ph

				
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