The upturn in energy prices since 2004 changed energy market dynamics. Significant capital was attracted to the field, and there was a knock-on effect on renewable energy.
Biofuels mania led to overcapacity and a bust. Wind and solar began to scale but were hurt by lack of credit support in project finance during 2008 and 2009. Traditional oil and gas project finance and production were impacted by the fact that many indepen- dent producers were overleveraged and much acreage is not viable for production with oil under $50 per barrel. But the economic engine of growth will require both fossil fuels and clean energy particularly as the developing world continues to industrialize.
The question is how do energy and environmental issues seek balance in this changing global market.
The goal of creating a low-carbon economy is decades away but the impact of cli- mate change legislation and national renewable energy portfolio standards will begin to impact the energy industry today. Most importantly, they will impact how capital is deployed and how project finance goes forward. It will be fascinating to watch how the world financial markets transition from funding conventional energy to the new sources of renewable energy and its impact on the global carbon footprint.
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Creating and Financing the Next-Generation Carbon Offset Project
An Application to Carbon Capture and Storage
Robin Cantor , Praveen Gunaseelan , James Vopelius , and Alexander Bandza *
I. BACKGROUND ON CARBON CREDIT AND OFFSET MARKETS
Scientists have reached a general consensus that global climate change is leading to adverse effects, including extreme weather and heat, and that the pace of climate change is accelerating. In 2007, the Intergovernmental Panel on Climate Change, a science panel established by the United Nations in 1988, determined with at least 90 percent certainty that human activities have already caused climate change and that more dangerous changes are yet to come. 1 As to the future, climate change is predicted
* Dr. Robin Cantor is a principal in Exponent, Inc.’s Alexandria offi ce. She specializes in environ- mental and energy economics, applied economics, statistics, risk management, product liability, and insurance claims analysis. She can be reached at rcantor@exponent.com. Dr. Gunaseelan is the founder and principal consultant at Vantage Point Energy Consulting. He specializes in assess- ing the techno-economic feasibility, market viability, and lifecycle environmental impacts of large projects and process technologies in the oil and gas, chemicals, power, and renewable fuels and energy sectors. He can be reached at praveen@vantagepoint-energy.com. Mr. James J. Vopelius is vice president and CFO of Trident Risk Management, LLC. He specializes in the technical and commercial aspects of the energy sector in the United States and abroad, including fi nancial mod- eling and risk analysis, feasibility studies, asset and product pricing, and market analyses. He can be reached at jim.vopelius@tridentrmllc.com. Mr. Bandza is an associate in Exponent’s Alexandria offi ce. He specializes in environmental and energy economics, energy policy analysis, and carbon capture and storage regulatory analysis. He can be reached at abandza@exponent.com.
1 Richard Alley et al., Climate Change 2007: The Physical Science Basis — Summary for Policymakers, Intergovernmental Panel on Climate Change, Fourth Assessment Report (Feb. 2007), http://
ipcc-wg1.ucar.edu/wg1/docs/WG1AR4_SPM_PlenaryApproved.pdf (last visited May 21, 2009).
BACKGROUND ON CARBON CREDIT AND OFFSET MARKETS
to lead to substantial human health effects from heat stress, diseases, and allergies;
reductions in species diversity, agricultural productivity, and availability of clean water; and changes in the frequency, intensity, and duration of extreme weather events, including floods, droughts, and hurricanes.
Governing institutions at all levels are responding to the climate change threat by implementing far-reaching and diverse new policies and regulations. Internationally, the Kyoto Protocol, 2 which has not been ratified by the United States, is affecting many multinational corporations and international investments. In the United States, a recent Supreme Court decision makes it more likely that greenhouse gas (GHG) emissions will be regulated under the Clean Air Act. 3 Examples of more localized developments include the Regional Greenhouse Gas Initiative (RGGI), which is an agreement by ten Northeast and Mid-Atlantic states to implement a regional cap-and-trade program; 4 the Global Warming Solutions Act enacted by California, which requires reductions in California’s global warming emissions to 1990 levels by the year 2020; 5 and New Jersey’s Global Warming Response Act, mandating cuts of GHG emissions by about 16 percent by 2020 and 80 percent by 2050. 6 All of the major bills proposed by various congressional sponsors include similar large-scale reductions in GHG emissions. 7
Many believe that carbon emission caps, trading, and carbon markets must be the central policy mechanisms of global responses to mitigate climate change, with a mar- ket-based approach favored for reasons of efficiency and practicality. In fact, world- wide growth in the number of countries participating in some aspect of carbon trading has been nothing less than remarkable. This growth is certainly one factor supporting continuing and expanded use of a market-based approach, as large groups of stake- holders profit from the income-generating benefits of trading. Moreover, trading is an approach being considered not only for carbon dioxide (CO 2 ) emissions, but also for other gases with global warming potential greater than that of CO 2 .
Nonetheless, the changes in energy sources and global development trends implied by the proposed policy goals represent a brave new world for emissions trading. Long-term planning horizons, active technological change, international players, and regulatory uncertainty characterize this unprecedented trading environment. The scale of change that would be required to meet the stabilization goals for GHG atmospheric concentra- tions is also extraordinary. As a result, an equally important consideration — and the focus of this chapter — for carbon market development is the potential of large-scale (e.g., next-generation) carbon capture and storage (CCS) technologies to offset CO 2 emissions and thereby “earn” value through carbon credits. In a world in which project
2 United Nations Framework Convention on Climate Change, Kyoto Protocol to the United Nations Framework Convention on Climate Change (1998), http://unfccc.int/resource/docs/
convkp/kpeng.pdf (last visited May 21, 2009).
3 Mass. et al. v. Envtl. Prot. Agency et al. , 127 S. Ct. 1438 (2007), Opinion by Justice Stevens, Apr. 2, 2007.
4 Regional Greenhouse Gas Initiative, http://www.rggi.org/ (last visited Feb. 8, 2009).
5 Global Warming Solutions Act of 2006, Cal. AB 32 (Sept. 2006).
6 New Jersey Global Warming Response Act (2008), N.J. Stat. § 26:2C-37.
7 Pew Center on Global Climate Change, Climate Action in Congress, http://www.pewclimate.
org/what_s_being_done/in_the_congress (last visited May 18, 2009).
success depends on emissions trading, such value would be a necessary ingredient to create the investment incentives for CCS to play the bridging role envisioned by many analytical models of various low-carbon futures. 8
II. DUE DILIGENCE AND TRANSACTIONAL ISSUES
A. The Carbon Offset Value Proposition
The United States is effectively the birthplace of emissions trading for controlling pol- lution, especially air emissions. Trading programs have existed in the United States since 1979 for stationary sources regulated by the Clean Air Act. 9 Results from emis- sions trading programs have been regarded as largely positive. Economic studies rou- tinely find, on a theoretical or an empirical basis, that well-designed emissions trading programs achieve their pollution reduction and mitigation policy goals at the lowest cost to society. 10 Trading programs achieve these goals more quickly and with more positive spin-off effects than other regulatory mechanisms that rely on controlling behaviors or technological options. Not surprisingly, when global warming and cli- mate change became a policy priority in the United States and elsewhere, emissions trading was quickly identified as a key policy tool to reduce GHGs. Mandatory carbon trading programs have been met with greater enthusiasm outside the United States.
Carbon markets are basically emissions trading markets with various allowance and credit features. Allowances are generally associated with cap-and-trade programs, where a number of allowances or permits to emit a unit of the regulated emission are awarded up to an aggregate cap. Participants emitting beyond their allowances are sub- ject to sanctions set out in the trading program. With pure cap-and-trade programs, there is at least theoretical certainty that the level of polluting emissions will be capped.
Credit markets are generally associated with baseline-credit programs, where cred- its are issued for reductions in emissions beyond an established baseline. Similarly, credits for offsets can be issued for activities that capture, avoid, sequester, or remove emissions beyond an established baseline. Pure credit-based systems promote effi- ciency by meeting objectives for emission intensity or average performance, but noth- ing in the design of these programs ensures lower emissions on a programwide basis.
For example, programs designed to lower GHG emissions could nevertheless result in higher actual emissions in those regions with growing economies. To address these issues, some hybrid trading schemes rely on both allowances and credits to meet the emissions control requirements.
8 Mike Fowler, Clean Air Task Force, The Role of Carbon Capture and Storage Technology in Attaining Global Climate Stability Targets: A Literature Review (Feb. 2008), http://www.catf.
us/projects/power_sector/advanced_coal/CATF_CCS_Review.pdf .
9 Denny Ellerman and David Harrison, Jr., Pew Center on Global Climate Change, Emissions Trading in the U.S.: Experience, Lessons and Considerations for Greenhouse Gases (May 2003), http://www.pewclimate.org/docUploads/emissions_trading.pdf .
10 Id.
DUE DILIGENCE AND TRANSACTIONAL ISSUES
Allowances are essentially finite and controllable by the regulatory authorities.
Although credits are limited, in theory, by many factors, including nature, physics, available technology, and economics, their supply is not controlled directly by the regulatory authorities. With that theoretical point acknowledged, experience with the flexible mechanisms of the Kyoto Protocol discussed below has produced new insights and concerns about the potential international participation in these markets and the actual size of the credit supply. To meet their environmental objectives, trading pro- grams that combine allowances and credits must carefully set the rules governing how participants can substitute these currencies. In the extreme, a participant might be able to meet its emission requirements with credits only while never reducing its own emis- sions. More realistically, there is the potential for sources of credits to oversupply nascent trading markets and, as a result, to depress the price of the allowances.
Three fundamentals make emission trading markets work effectively. First, emission limits must be established that require binding emission reductions. Without a need for an explicit reduction of current and projected emissions, there is no demand to trade (beyond altruistic or public relations benefits). Second, there must be measurable vari- ability in the cost of reducing emissions for the regulated activities, because variability promotes trading between high- and low-cost sources of reductions. Third, the require- ments must be enforceable and enforced. If there is no penalty for failing to meet con- trol obligations, the first fundamental — to set binding reductions — will be negated.
Enforceability requires accurate accounting of emissions and verification that reduc- tion targets have, in fact, been met. In selecting sectors or activities that are likely to be most amenable to a cap-and-trade program, costs to administer emissions inventories and the existence of consistent accounting rules are important. Attempts to address all emission sources might render a cap-and-trade program unworkable. In some sec- tors — for example, transportation — there might be large number of sources that are difficult to monitor, which would make an end-use trading program expensive to administer and enforce.
Compliance with an emission trading program can be designed at the local, regional, or national level. Flexible compliance is provided by various schemes and mechanisms available to the parties that are compelled to meet the targets (Compliance Group) and typically include:
• Bubbles — where a group of trading parties aggregates their emissions allowance tar- gets (e.g., assigned amount units [AAUs]) and redistributes them internally. The European Union (EU) member states under the Kyoto Protocol, for example, have a collective 8 percent reduction target, but have redistributed AAUs among members, creating targets that range from –28 percent (Luxembourg) to + 27 percent (Portugal).
• Credits generated within the Compliance Group: such as Joint Implementation (JI) — projects in countries with emission targets that reduce, avoid, or sequester GHG emissions and create emission reduction units (ERUs).
• Credits outside of the Compliance Group: such as Clean Development Mechanism (CDM) — projects in countries without emission targets (non–Annex I countries) that reduce, avoid, or sequester GHG emissions and create certified emission reductions (CERs).
Each party with targets in the Compliance Group should be issued a number of allowances reflecting its reduction target. To reduce compliance costs to meet the tar- gets, trading programs might develop rules for trading and transferring compliance units. Each party can then meet its emission requirements through a combination of (1) allowances, initially acquired and transferred from trading; (2) credits from land- use activities, such as removal units (RMUs) that reflect approved land use, land-use change and forestry (LUCF) activities (that is, “sinks”); (3) internal credits, such as ERUs generated by JI projects; and (4) outside credits, such as CERs generated by CDM projects.
Different types of projects and activities can generate emission offsets and therefore are potential sources of internal and outside carbon credits. Typical offset activities include improvements in energy efficiency; fuel switching; methane avoidance or cap- ture; GHG recovery and avoided venting; afforestation, reforestation, and avoided deforestation; investments in renewable energy; and carbon capture and storage.
Offset projects have received various levels of encouragement across trading sys- tems. In the European Union Emission Trading Scheme (EU-ETS), the use of offset credits is determined by the national allocation plans. Regulated installations are gen- erally allowed to use JI and CDM credits to supplement their allowance allocations by 10 percent. 11
In the United States, the Regional Greenhouse Gas Initiative (RGGI) limits offset credits to 3.3 percent of a power plant’s total compliance obligation, but leaves open the possibility for a larger share when CO 2 allowance prices exceed threshold levels. 12 Moreover, RGGI’s compliance rules limit the type of projects that qualify as offset- based credits, as noted on its Web site:
RGGI has developed prescriptive standards for specific project categories, to ensure that offsets are real, additional, verifiable, enforceable, and permanent. At this time, five project categories for CO 2 offset allowances are eligible under the participating states’ regulations.
• Landfill methane capture and destruction
• Reduction in emissions of sulfur hexafluoride (SF6) in the electric power sector • Sequestration of carbon due to afforestation
• Reduction or avoidance of CO 2 emissions from natural gas, oil, or propane end-use combustion due to end-use energy efficiency in the building sector
• Avoided methane emissions from agricultural manure management operations RGGI also allows for emissions credit retirements from a mandatory program outside the United States (e.g., Clean Development Mechanism CERs) to be used as an offset under limited circumstances. 13
11 See National Allocation Plans: Second Phase (2008–2012), http://ec.europa.eu/environment/
climat/emission/2nd_phase_ep.htm (last visited on Feb. 8, 2009).
12 See http://www.rggi.org/offsets (last visited Feb. 8, 2009).
13 Id.
DUE DILIGENCE AND TRANSACTIONAL ISSUES
The carbon credit market is dominated by the CDM. Of the 2007 project-based activity in carbon credits, CDM project share was 87 percent of the volume and 91 percent of the value. Moreover, these investments are regionally concentrated in a small number of developing countries. In 2007, for example, China hosted 73 percent, India 6 percent, and Brazil 6 percent of the CDM projects. 14
B. The Carbon Capture and Storage Value Proposition
Not all offset programs will be equal in the brave new world of carbon trading. The quality of any particular carbon offset — and its potential value in the voluntary and compliance credit markets — will depend on a number of factors. The simplified credit trading “value chain” has four basic steps:
• Carbon credit creation : Regional/national/international rules that define projects to reduce carbon emissions beyond a specific level and create excess credits for banking or sale.
• Certification : Independent bodies that record and verify the creation of carbon cred- its for both compliance and voluntary markets.
• Carbon credit brokering, marketing, and trading : Direct sale of credits, aggrega- tion of credits created by others, and trading in secondary markets.
• Carbon credit purchasing : Credit purchases by entities subject to carbon caps or entities pursuing voluntary reductions.
An important quality issue at the certification stage is additionality; that is, the con- dition that the carbon credits reflect GHG emission reductions over and above what they would have been under baseline conditions or in the absence of the trading pro- gram. Additionality is particularly relevant for the value of carbon credits, because these investments might have ancillary benefits that would drive their implementation in the absence of the trading program. For example, consider whether renewable energy investments necessitated by regulatory requirements under a Renewable Energy Portfolio standard should also be eligible to generate carbon credits in the voluntary markets. Other factors giving rise to quality and reliability concerns include the techni- cal feasibility of the project to reduce or remove emissions, the permanence of the reduction or removal, and verification of the project’s performance.
With respect to CCS, additionality, technical feasibility, and permanence are all critically important challenges to its potential as an investment that is eligible for carbon credits. With large-scale CCS, additionality is less likely to be a challenge to its credit eligibility. This presumes that the captured CO 2 is not used in profitable applications, such as enhanced oil recovery (EOR). Leakage and long-term storage issues, however, pose significant barriers to the future commercial viability of CCS investments that depend on generating value from carbon credit. As we discuss below, storage integrity — whereby captured CO 2 remains in the storage application for
14 World Bank, State and Trends of the Carbon Market 2008 (Washington, D.C., 2008), at 19.
hundreds or thousands of years — is clearly a significant technical, legal, and verifica- tion challenge. Nonetheless, CCS demands attention not only due to its potential and (perhaps) necessity as a bridging technology to any realistic low-carbon future, but also due to the close proximity of sinks to areas currently dependent on coal-fired gen- eration. Not surprisingly, the world’s current and proposed demonstration projects are largely located in North America, Europe, and Australia. 15
III. SECOND-GENERATION CARBON CAPTURE AND STORAGE PROJECTS
Carbon capture and storage is one of several approaches being considered for abate- ment of atmospheric GHG levels to reduce global warming. “Carbon capture and stor- age” refers to the recovery of CO 2 from a gas stream that is routinely emitted into the atmosphere, followed by its transportation to a sink for permanent storage or disposal.
While other GHGs (such as methane) may have a greater global warming potential, CO 2 accounts for approximately 75 percent of global GHG emissions. 16 As the most abundant GHG emitted by human activity, CO 2 is arguably the most important GHG.
Of the 2004 global CO 2 emission footprint of approximately 38 gigatonnes (GtCO 2 ), more than 70 percent (or about 28 GtCO 2 ) is attributable to fossil-fuel combustion. 1781
15 American Coalition for Clean Coal Electricity, ACCCE CCS Database (Dec. 19, 2008), http://
www.americaspower.org/Media/Files/ACCCE-CCS-Database (last visited Feb. 16, 2009).
16 U.S. Environmental Protection Agency, Climate Change — Greenhouse Gas Emissions, Global Greenhouse Gas Emissions 2000, http://www.epa.gov/climatechange/emissions/globalghg.
html (last visited Feb. 2009).
17 Manfred Fischedick et al., CO 2 -Capture and Geologic Storage as a Climate Policy Option (Wuppertal, Germany: Wuppertal Institute, 2007), 7, http://www.wupperinst.org/uploads/
tx_wibeitrag/ws35e.pdf . Data from this source are used to create Figure 2.1 .
18 Id.
CFCs, etc.
1 Gt (1%)
N2O 4.5 Gt (9%)
Methane 7.5 Gt (15%)
Total CO2 38 Gt (75%)
CO2unrelated to Fossil Fuel Combustion
10 Gt (20%) CO2from Fossil Fuel Combustion 28 Gt (55%)
Figure 2.1 2004 Global GHG emissions by type, highlighting CO 2 emissions from fossil-fuel combustion 18