Chapter 4 Carbon Credits as a Currency for Project Finance
B. How Risk Is Factored into the Price of Carbon
As discussed in Section II.A.1.a., above, CERs are typically sold through forward contracts entered into at an early stage in a project’s development, when it is exposed to a wide range of risks. CDM projects may also be developed without a forward con- tract in place, in which case the CERs can be sold on the spot market once actually issued. The vast difference in risk between these two options results in a wide range of prices for CERs sold under different contractual arrangements and at different stages of the CDM project cycle. 76
1. Types of Project Risk Conventional project risks can be divided into three phases:
planning, construction, and operation risks. Planning Pphase risks include feasibility study failure and the denial of permit/licenses. Construction phase risks include the risk that the project is not commissioned on schedule and the possibility that costs involved in implementing the project are higher than expected. 77 Operation phase risks
72 World Bank, supra note 12.
73 Id.
74 Clifford Chance, Developing carbon structured products (2008) .
75 UNEP CD4CDM, supra note 33, at 24.
76 UNEP CD4CDM, supra note 33.
77 Id.
CARBON FINANCE AS AN OPTION FOR PROJECT FINANCE
can be divided into supply risk, operating risk, political, legal and regulatory risks, financial risk, and counterparty risk. 78
2. Types of CDM Project Risk A variety of CDM-specific risks need to be taken into account for a CDM project, many of which are related to certain parts of the larger categories of CDM cycle risk, CDM performance risk, and CER price risk.
A. METHODOLOGY RISK
Developing a new methodology is costly, time consuming, and risky. Therefore, using an existing, approved methodology will considerably reduce a project’s overall risk profile. However, using an approved methodology does not eliminate the risk that the CDM Executive Board (Executive Board) may withdraw, or put on hold, the previ- ously approved methodology, or make amendments to the methodology that may have a material impact. 79
B. HOST COUNTRY APPROVAL RISK
A CDM project must receive approval from the host country’s Designated National Authority (DNA) in order to be registered. In addition, project participants must also be authorized by a Kyoto Party (whether the host country or an Annex I Party). There are three kinds of risk associated with obtaining DNA approval: (1) approval risk;
(2) time lag risk; and (3) market interference risk. 80
C. VALIDATION RISK
Projects are required to be validated by an accredited, third-party Designated Operational Entity (DOE). Risks related to this are that the project will not be approved or will face delays in approval.
D. REGISTRATION RISK
Once validated by a DOE and approved by the host country, a project must be submit- ted for registration with the Executive Board. Although the approval and validation processes may be rigorous, they do not ensure that a project will be registered. The Executive Board may reject the application for registration or various delays in the registration process may occur. 81
E. MONITORING AND VERIFICATION RISK
Monitoring of GHG reductions achieved by a project must be carried out accurately and in accordance with the methodology and procedures set out in the monitoring plan in the Project Design Document (PDD). Issues result if the monitoring data is not being recorded accurately (or quality controlled to a sufficient level). Verification is a highly skilled activity, requiring a combination of process engineering, quality assur- ance, and financial auditing skills. Not surprisingly, skilled verifiers are hard to find, leading to a shortage of DOEs available to undertake verifications. This risk can be
78 Id. , at 44.
79 UNEP CD4CDM, supra note 33.
80 Id.
81 Id.
compounded when a DOE faces legal issues or other unrelated difficulties, as illus- trated by the Executive Board’s temporary suspension of Norwegian consulting firm DNV’s ability to accredit CDM projects in December of 2008, prompting potential delays for project developers’ issuance of CERs. 82
F. PERFORMANCE RISK
Project performance is affected by a number of factors, including performance of the equipment, the skill of the operating team, availability of feedstock for fuel for certain types of projects, counterparty performance and weather. The risks associated with project performance are higher for some technologies and sectors, and operating con- ditions may have significant, and sometimes unpredictable, effects on performance. 83 Managing these risks is critical for project performance and has a direct impact on CER delivery.
G. MARKET RISK
CER value is determined by market supply and demand. At present, the largest CER market is the EU-ETS where demand is determined by the aggregate decisions of twenty-seven sovereign nations, each pursuing its own national interest as it sets the level of free allocation of allowances in advance of each phase of the scheme. While well-informed guesses can be made about the outcomes of these decisions, there remains an irreducible element of unpredictability to this market. Different allocation decisions in the two phases of the scheme (2005 through 2007 and 2008 through 2012) have already led to pricing irregularities. 84
H. POST-KYOTO RISK
The post-2012 fate of the CER market is uncertain. While it is clear that the emission reductions required under Kyoto are insufficient to “prevent dangerous human inter- ference with the global climate” (the stated objective of the UNFCCC and Kyoto Protocol), it remains to be seen whether the international community will be capable of translating this need into further action. It appears increasingly likely that there will be a multiplicity of schemes, which may include voluntary agreements in Japan; self- imposed efficiency targets in the largest developing countries; mandatory caps in Europe and certain U.S. states and/or sectors; and a range of voluntary schemes.
Multiple schemes could create differing regulatory requirements, informational barri- ers and, ultimately, price signals that reduce the size and liquidity of the overall market. 85 From a developer’s perspective, this uncertainty implies a rapidly approach- ing point beyond which it will be virtually impossible to raise finance for new CDM projects. Project development requires six months at a minimum and often up to three years or longer. As a result, the window of opportunity for a project to recover its costs before December 2012 is narrowing rapidly. In practice, this cut-off point will be reached at different times for different project types, depending on project rates of
82 Id.
83 Id .
84 Id.
85 Id.
CARBON FINANCE AS AN OPTION FOR PROJECT FINANCE
return. The cut-off point may already have been reached for some project types. 86 (See Figure 4.10 .).