Chapter 4 Carbon Credits as a Currency for Project Finance
C. How Carbon Transaction Agreements Address Risk
There are many ways to partially mitigate some of the risks mentioned in Section IV.B., above. Apportioning the risk to the party best able to deal with it, via an ERPA or other contract between project stakeholders is the primary way. In addition, there are a number of ways in which CDM-specific regulatory risk can be reduced at the international level.
1. Allocation of Risks in the ERPA Contracts between CER buyers and sellers can be structured in many different ways as described in Section IV.A, above. CER pricing terms in an ERPA will be determined, in part, by the structure of the transaction and the allocation of risk between the buyer and seller in negotiating the terms and condi- tions of the ERPA. 87 For example, CER pricing will depend, in part, on whether the seller guarantees delivery of a specified volume of CERs. Generally, pricing will be higher where the seller guarantees delivery, particularly if the seller is obligated to provide replacement CERs if the project fails to generate the guaranteed volume.
Similarly, CER pricing terms will be influenced by the extent to which the buyer’s obligation to purchase is subject to preconditions. 88
Buyers in the primary market (especially those entering into nonfirm contracts) use different techniques to mitigate their risks, including, for example: (1) call options;
(2) paying a premium for the first-generated (most likely to be generated) assets of a project; (3) buying a fraction of the assets expected to be produced by the project;
(4) avoiding up-front payments, thereby reducing the likelihood of having to seek reimbursement from the seller if the buyer does not receive the credits it has already paid for; (5) build “retiring” provisions into the contracts, so that the obligation to purchase assets is reduced if certain project-related milestones or criteria are not met;
and (6) diversifying their carbon portfolios, by buying pools of assets from several projects, thereby reducing the impact of a single project failure. 89
2. Risk Mitigation by Investors in the U.S. Market 90 Unless a cap-and-trade pro- gram is implemented at a federal level, the U.S. government will not have defined the carbon commodity that will be traded. Some have referred to current conditions as a “buy- er-beware” market; however, strategies are available to mitigate the risks of operating
86 Id.
87 For a CDM ERPA template which includes standardized wording, see the IETA publications, available at http://www.ieta.org .
88 UNEP CD4CDM, supra note 33.
89 Id.
90 Stanford A. Renas, Negotiating Carbon Trading Contracts in the United States , FUT. & DERIV. L. REP. (Sept. 2008).
outside an established legislative market. Currently, participants in the small U.S.
carbon market rely on standards ranging from those used under Kyoto to those created within the industry, or allowances unique to regional initiatives such as RGGI (Regional Greenhouse Gas Allowances, or RGAs). Given the many existing voluntary standards and the possibility of a preemptive national standard, a buyer of carbon credits might choose to only purchase carbon credits created under standards (voluntary or legisla- tive) no less strict than those contained in the Waxman-Markey American Climate and Energy Security Act 2009 or the Kerry-Boxer Clean Energy, Jobs and American Power Act. In addition to restricting purchases of carbon credits to those created under strin- gent standards, investors might time carbon credit purchases so that the acquired cred- its can be used or sold in the near future, thereby reducing the risk of interference from preemptive federal law.
In addition, investors can use contractual techniques, including indemnities, so that the buyer is entitled to full reimbursement of all damages and expenses arising out of or related to the cancellation or devaluation of the carbon offset resulting from federal preemption (including consequential damages and lost profits). Further, investors may employ assurance clauses to require the seller to perform all acts as may be necessary or desirable to affect the purpose of the contract and carry out its provisions. Assurance clauses may also be used to require an act by the seller that prevents cancellation of the carbon credit due to preemption, or otherwise preserve the value of the carbon credit.
Buyers may also mitigate risks by diversifying their portfolios to include credits created under several emissions programs, instead of relying only on one regime that might be preempted. If federal preemption were to occur with respect to some, but not all emissions regimes, a buyer would experience lower losses than if it had relied entirely on one regime that was preempted. 91
V. CASE STUDIES: ENERGY EFFICIENCY, RENEWABLE ENERGY, AND METHANE
A. Renewable Energy Case Study
1. 15 MW Grid-Connected Wind Energy Project at Sankaneri Village in Tamil Nadu, India
A. DETAILS OF PROJECT
The project involves the implementation of a wind farm with 15 megawatt (MW) of installed capacity through the installation of twelve state-of-art 1.25 MW wind-energy generators developed by Suzlon Energy Limited. It generates electrical energy through sustainable means using wind-power resources, utilizing, in part, the generated output while selling the remaining electricity, approximately 45 million units per year, to the grid. Taking into account energy shortages and current trends of investment in fossil fuel–based energy generation in the region, in absence of the project, an equivalent
91 Stanford A. Renas, supra note 91.
CASE STUDIES: ENERGY EFFICIENCY, RENEWABLE ENERGY, AND METHANE
amount of electricity would have been generated using fossil fuel–based power plants.
Thus, generation from this project displaces the fossil fuel–based energy generation and leads to an emission reduction of [approximately] 37,144.5 tCO2e annually over the ten-year crediting period. 92 The project was registered with UNFCCC on the June 4, 2007. Because the capacity of the project is 15 MW or below, the project is consid- ered as a small-scale CDM project activity and UNFCCC indicative simplified modal- ities and procedures are applied.
B. DETAILS OF FINANCING
The project cost was Rs. 67.5 crores (US$ 13.8 million) and was financed with a debt equity ratio of 3:7. Interest rate on debt is 13.5 percent compounded quarterly and is to be repaid in ten years. The project lifetime is estimated to be twenty years, with the crediting period for the CDM project taken as ten years. The effects from carbon finance were that on the basis of the cash flows, the IRR of the project without CDM funds was found to be 13 percent, and IRR is 15 percent with CDM funds. This means that the incremental IRR is 2 percent. 93
C. DEVELOPER AND INVESTOR
Senergy Global Private Limited was the developer and the Netherlands (CERUPT) agreed to purchase all of the CERs as the sole investor.
B. Energy Effi ciency Case Study
1. Kuyasa Low-Cost Urban Housing Energy Upgrade Project, Khayelitsha, Cape Town, South Africa
A. DETAILS OF PROJECT
The project is an intervention in an existing low-income housing development with households in Kuyasa and Khayelitsha, as well as in future housing developments (100 hectare [ha]) in this area. The project aims to improve the thermal performance of the existing and future housing units and improve lighting and water heating effi- ciency, which will result in reduced current and future electricity consumption per household, with significant avoided CO 2 emissions per unit. Other co-benefits of the project include a reduction in local air pollution, with subsequent decreases in pulmo- nary pneumonia, carbon monoxide poisoning, and other respiratory illnesses. In addi- tion, decreased fire accidents and property damage is also anticipated.
The project utilizes the following three interventions to alleviate “energy poverty”
per household unit: (1) insulated ceilings; (2) solar water heater installation; and (3) energy-efficient lighting. Improved end-use energy efficiency combined with the
92 Clean Development Mechanism PDD for 15 MW Grid Connected Wind Energy Project at Sankaneri Village in Tamil Nadu, available at http://cdm.unfccc.int/UserManagement/
FileStorage/LTQ7B5EU4GADFVVT66P4NJZEIJRWP8 .
93 Gaurav Raizada et al., Indian Institute of Management Lucknow, Carbon Credits — Project Financing the “Green” Way (2006).
use of solar energy for water heating will measurably avoid pollutant emissions and measurably save energy consumption. By increasing the use of renewable energy and improving thermal performance energy, services provided are cleaner and cheaper than in the baseline situation. Improvements in thermal performance will moderate indoor air temperature with associated comfort and health benefits. The project was registered with UNFCCC on August 27, 2005. The project won the Gold Standard Award in 2004 and Point Carbon’s Best CDM Project at the Carbon Market Insights Conference in Amsterdam 2004. 94
B. DETAILS OF FINANCING
The project was financed through a hybrid of methods presented in Chapter 3: a a local government research grant from the PAWC of EUR 1.95 M (US$ 2.5 M); a National Government Poverty Alleviation Grant from the DEAT of EUR 1.6 M (US$ 2 M); an EDF Grant of EUR 57,692 (US$ 73,647); and the revenue from the sale of the Gold Standard registered CERs of EUR 320,513 (US$ 409,150) (at EUR 8 per credit or US$ 10.2 per credit). The net present value of the income from the emissions reduc- tions was estimated to cover 20 percent to 30 percent of the capital costs of the instal- lation of these technologies, based on the nature of the carbon market at the time of construction. 95
C. DEVELOPER AND INVESTOR
The project was developed by South South North, and was validated as a Gold Standard CDM project, generating 130,000 credits over a twenty-one-year crediting lifetime.
The first 10,000 credits have been sold to the UK government to offset the G8 Presidency.
C. Methane Capture Case Study
1. Durban Landfi ll-Gas-to-Electricity Project — Mariannhill and La Mercy Landfi lls, South Africa
A. DETAILS OF PROJECT
The project was registered with the UNFCCC on the December 15, 2006. The project consists of an enhanced collection of landfill gas at two landfill sites of the municipal- ity of Durban and the use of the recovered gas to produce electricity. The produced electricity will be fed into the municipal grid to replace electricity currently purchased from other suppliers. The project will be implemented on the Mariannhill and the
94 Clean Development Mechanism PDD for Kuyasa low-cost urban housing energy upgrade project, Khayelitsha, Cape Town, South Africa, available at http://cdm.unfccc.int/
UserManagement/FileStorage/FS_292989657 .
95 South South North Case Study, Kuyasa, Lessons from the Developing World, (2008), avail- able at http://climateanddevelopment.nri.org/background_papers/presentation_arendse.pdf .
CASE STUDIES: ENERGY EFFICIENCY, RENEWABLE ENERGY, AND METHANE
La Mercy landfill sites. The Mariannhill landfill is an active landfill site where waste will be deposited until 2024. It extends over 49 ha and receives 550 to 700 tonnes of waste per day.
This is the first CDM-registered landfill gas project in Africa, comprising the extrac- tion of landfill gas (comprising 40–60 percent methane) through gas wells and inter- linking pipe work installed into the Mariannhill and La Mercy landfill sites and the generation of electricity by purpose-built spark ignition engines of 1,000 kilowatt (kW) and 500 kW capacity respectively. The project will reduce harmful GHG emis- sions of approximately 700,000 tons of C02e over a period of ten years. Reductions will be attributed to the destruction of methane gas and the displacement of coal- derived electrical power to the Durban municipal grid. 96
B. DETAILS OF FINANCING
The CERs generated by this project are crucial in making the utilization of the landfill viable, and successful development of this project is expected to provide an internal rate of return in excess of 25 percent. The project agreement will be for the sale of 3.8 million tons of carbon dioxide equivalents at the rate of $3.95 per ton over the maxi- mum period of twenty-one years. The total project cost of R150 M (US$ 15 M) con- sists of the capital expenditure of R64 M (US$ 6.37 M) and operating costs of R86 M (US$ 8.57). Anticipated revenue from the project is R205 M (US$ 20.42 M), which consists of a carbon credit sale to the PCF totaling R114 M (US$ 11.36 M) and R91 M (US$ 9.06 M) from the sale of electricity to the grid. This would realize a net profit of R55 M (US$ 5.48 M) over the expected agreement period of twelve years. The project is also expected to produce significant profits through additional sales of CERs on the global market. 97
C. DEVELOPER AND INVESTOR
The project development was a team made up of CDM project consultant Bob Chronowski, Durban Solid Waste engineering, project manager Lindsay Stachan, and eThekwini City manager Dr. Michael Sutcliffe. The World Bank’s Prototype Carbon Fund (PCF) has agreed to purchase all of the CERs generated by the project. 98 Of this amount, $0.20 per ton must be credited to a social benefit. In this regard the PCF has agreed that the total amount of CERS that the project will generate for the social benefit project may be payable up-front.
96 Civil Engineering Magazine (Nov./Dec. 2007), Africa’s First CDM Project , available at http://
www.resource-india.net/CivilEngNov2007.pdf (last visited Feb. 12, 2009).
97 L.J. Strachan et al., Harnessing Landfi ll Methane to Address Global Warming and Renewable Energy: An Overview of the Durban Cdm Landfi ll Gas to Electricity Project , Proceedings of the Biennial Congress of the Institute of Waste Management of Southern Africa, WasteCon2004 (2004), at 351.
98 World Bank Prototype Carbon Fund, available at http://wbcarbonfi nance.org/Router.cfm?
Page=PCF&FID=9707&ItemID=9707&ft=Projects&ProjID=9615 .
VI. ADDRESSING UNCERTAINTY AND MANAGING RISK IN CARBON CREDIT MARKETS
A. The Future of the Kyoto Protocol
Although there are differing views with regard to the Kyoto Protocol’s effectiveness, there is near-uniform agreement on the need for a post-2012 climate control accord to succeed Kyoto. 99 Negotiations for an agreement are ongoing , and a number of propos- als have appeared in both academic and policy literature. 100
The 2009 Harvard Project on International Climate Agreements (Harvard Project) presents one of the most comprehensive studies available at the time of this writing: it leverages leading thinkers from academia, private industry, government, and non-gov- ernmental organizations (NGOs), and includes twenty-eight research teams in differ- ent parts of the world. 101 The Harvard Project’s key findings and suggestions acknowledge that climate change is a global commons problem, and, therefore, a cooperative approach involving many nations is necessary to address it successfully. It states, first and foremost, that a credible global climate change agreement must be equitable, in that the industrialized world should accept responsibility for historic emissions of GHGs, but developing countries with rapidly growing economies must also take on increasingly meaningful roles, discussed further in Section VI.D., below. In addition, a climate change agreement should be cost-effective; able to bring about significant technological change and technology transfer; and must be consistent with the interna- tional trade regime. It should also be practical, in the sense that it builds on existing institutions and practices (where possible); attentive to short-term achievements as well as medium-term consequences and long-term goals; and realistic. The Harvard Project concludes that no single approach guarantees a sure path to ultimate success, and the best strategy may be to pursue a variety of approaches simultaneously. 102 1. Post-Kyoto Frameworks Implementation of the different emission trading schemes throughout the international community described in Section II, above, signals the support for cap-and-trade programs beyond 2012, but the financial crisis and ensuing recession have proven to be formidable roadblocks. Climate change concerns have been relegated behind economic recovery efforts and made the introduction of climate change regulation- politically unpalatable, at least temporarily, in some countries. While the climate change summit Conference of the Parties at its fifteenth session (COP 15) in Copenhagen in December 2009 produced no international agreement, many would argue that it was also not a failure. Copenhagen did serve to raise awareness of climate change globally, which has resulted in governments focusing on the issue. The compound effect has been to cata- lyze a host of new policy announcements and government initiatives. An important result
99 Joseph Aldy and Robert Stavins, Harvard University, Designing the Post-Kyoto Climate Regime: Lessons from the Harvard Project on International Climate Agreements (Nov. 2008).
100 See, e.g. , IEA (2002), Aldy and Stavins, supra note 100; Stern (2008).
101 Aldy and Stavins, supra note 100, at 1.
102 Id.
ADDRESSING UNCERTAINTY AND MANAGING RISK IN CARBON CREDIT MARKETS
of COP 15 was that the group of countries who want to take action expanded to the key emerging markets (Brazil, China, India, and South Africa), and the senior leaders of these four countries and the President of the United States drafted the Copenhagen Accord. This constituted an unprecedented outcome in international negotiations and provides an important foundation toward a more ambitious international agreement based on this political understanding. In terms of emissions trading and carbon finance, no agreement was reached on how to scale up carbon markets, while modalities were defined to allow developers to appeal against UN panel rejections of CDM projects.
In terms of global emissions trading, the EU continues to advocate for a well- functioning carbon market, as it is essential for driving low-carbon investments and achiev- ing global mitigation objectives in a cost-efficient manner while generating important financial flows to developing countries. The EU has continued to pursue the creation of an international carbon market by linking compatible domestic cap-and-trade systems. Their announced goal at the time of this writing is to develop an OECD-wide market by 2015 and an even broader market by 2020. The EU aims to use the provisions of the current EU ETS legislation to incentivize the development of sectoral carbon market mechanisms and to promote the reform of the CDM. Conceivable future steps would involve working together with interested developed and developing countries to develop sectoral mechanisms, whose credits could then be recognized for use in the EU ETS, and dependent on progress in the development of sector-wide mechanisms, developing and proposing strict measures for improving the quality requirements for credits from project-based mechanisms. 103
As described in Section II, above, the United States may soon have a carbon market.
President Barack Obama has expressed his support for a cap-and-trade system, targeting a reduction in CO2 emissions to 1990 levels by 2020 and reducing them an additional 80 percent by 2050. The Waxman-Markey bill, the “American Clean Energy and Security Act,” passed by the House of Representatives in June 2009, aims to reduce U.S. emissions 20 percent from 2005 levels by 2020, and the Kerry-Boxer Clean Energy, Jobs and American Power Act passed out of the Senate Environment and Public Works Committee in November 2009, aims to reduce US emissions by 20 percent by 2020, and by 83 percent from 2005 levels by 2050. Legislation for establishment of a cap-and-trade system for carbon has, however, been advanced before and failed, and no one can be sure a bill will pass anytime soon, especially given the current economic downturn.
B. Regulatory Uncertainty and How This Impacts Markets for Carbon Credits
Post-Kyoto risk is the uncertain international demand and recognition for CERs beyond 2012, even though the EU has stated that the EU-ETS will remain active even after the 2012 end of the Kyoto commitment period. 104 Post-Kyoto risk relates to CDM projects
103 European Commission, “International climate policy post-Copenhagen: Acting now to rein- vigorate global action on climate change”, (March 2010), available: http://ec.europa.eu/
environment/climat/pdf/com_2010_86.pdf
104 European Commission, DG Environment, available at http://ec.europa.eu/environment/climat/
emission.htm .