Chapter 4 Carbon Credits as a Currency for Project Finance
A. Regulatory and Voluntary Frameworks for
1. The Kyoto Protocol The global carbon market is the most visible result of early regulatory efforts to mitigate climate change. The United Nations Framework Convention on Climate Change (UNFCCC), an international environmental treaty that entered into force in 1994, adopted as its goal the stabilization of GHG concentrations in the atmosphere at a level that will prevent dangerous anthropogenic interference with the climate system, according to predominant scientific thinking. 1 The Kyoto Protocol was negotiated in 1997 to accomplish this goal. The Kyoto Protocol estab- lished binding caps on GHG emissions for developed nation parties and parties with economies in transition for 2008 through 2012. 2 The EU, Japan, and Canada are the largest participants subject to Kyoto targets. Through the Kyoto Protocol, most devel- oped countries, excluding the United States, have collectively begun to counteract trends toward climate change, while at the same time providing developing nations with additional resources and economic development through the Kyoto Protocol’s flexible mechanisms for compliance.
The Kyoto Protocol stipulates three flexible mechanisms by which countries with caps can reach their compliance targets: (1) Emissions Trading, (2) Clean Development Mechanism (CDM) and (3) Joint Implementation (JI).
To comply with Kyoto targets, cap-and-trade schemes have been established, which involve a central regulatory agency allocating or auctioning allowances, each equal to one metric tonne of carbon dioxide equivalent (CO 2 e) to emitter entities regulated under the scheme.
The CDM is a mechanism whereby public and/or private entities in developed coun- tries can participate in GHG-reducing projects in countries without emission caps under Kyoto. Each tonne of CO 2 e reduced beyond a “business as usual” scenario can be imported into the cap-and-trade scheme and used by a regulated emitter entity as a
1 Nicholas Stern, Review on the Economics of Climate Change , H.M. Treasury, UK (Oct.
2006).
2 United Nations Framework Convention on Climate Change, New York, U.S., May 9, 1992, art.
2, U.N. Doc. FCCC/Informal/84, available at http://unfccc.int/resource/docs/convkp/conveng.
pdf (last visited Dec. 22, 2008).
means of offsetting its emissions that are in excess of its cap. Emission reductions accomplished by projects that take place outside the regulated area are referred to as project-based carbon credits 3 or offsets. (See Figure 4.1 .).
A. OFFSETS
Certified Emission Reductions (CERs) are the currency of the CDM — and are the measure of the quantity of emissions that has been avoided or offset by CDM projects.
One CER represents one metric tonne of carbon dioxide equivalent (MtCO2e). 4 There are 148 developing countries eligible for hosting CDM projects. Operational since the beginning of 2006, the mechanism has registered more than 2,119 projects and current projects in the pipeline are expected to produce CERs amounting to more than 2.9 billion tonnes of CO2e in the first commitment period of the Kyoto Protocol, 2008–2012. 5 JI projects follow a similar objective, however, consist of projects imple- mented in countries with economies in transition; the corresponding unit being an Emission Reduction Unit (ERU). CDM and JI projects are discussed in more detail in Section 2.
3 Carbon credit, in common parlance is a generic term for a carbon asset which covers Certifi ed Emission Reductions (CERs), Emission Reduction Units (ERUs) and other emissions-reduc- tion credits such as Verifi ed or Voluntary Emission Reductions (VERs). However, in the con- text of the EU-ETS, this term refers to all credits other than European Union Allowances (EUAs) (which are referred to as “allowances”).
4 Clean Development Mechanism, available at http://cdm.unfccc.int/about/index.html (last visited Dec. 29, 2008).
5 UNFCCC CDM Statistics, http://cdm.unfccc.int/Statistics/index.html.
Actual emissions Country without emissions cap (Brazil) Country with emissions cap (UK)
Emissions quota under Kyoto Project “carbon credits” transfer annually to offset a portion of purchaser’s emissions
Carbon credit payment CO2
Emissions offset through carbon credits
Figure 4.1 Carbon credits can also be sold by entities in countries without emissions caps to entities in countries subject to emissions caps
MARKET FRAMEWORKS FOR CARBON CREDITS
2. Compliance Markets
A. THE EU-ETS
The EU-ETS, a tributary scheme of the Kyoto Protocol, is the major compliance market for allowances and offsets and is the main driver in terms of transaction volume and monetary value of the global carbon market. It covers all twenty-five of the EU coun- tries. Allowances trade in the EU-ETS as European Union Allowances (EUAs), and under certain circumstances, CERs or ERUs may trade within the ETS as EUAs. One fundamental achievement of the EU-ETS is that it helps to discover the cost of emit- ting GHGs in Europe, and this price signal, in turn, encourages project developers to reduce emissions globally through the CDM and JI projects that generate carbon cred- its for sale into the EU-ETS. The current Phase II of the EU-ETS is for the period 2008 through 2012, coinciding with the commitment period for the Kyoto Protocol. The EU has made a commitment to extend the EU-ETS to 2020, regardless of whether there is a second compliance period for the Kyoto Protocol. 6 (See Figure 4.2 .).
B. NON-KYOTO COMPLIANCE SCHEMES
In the absence of U.S. federal cap-and-trade legislation, important regulatory develop- ments have occurred since late 2006 in North America, with several initiatives to manage GHG emissions at regional levels emerging.
(I) REGIONAL GREENHOUSE GAS INITIATIVE (RGGI)
In late 2005, a group of Northeastern and Mid-Atlantic states announced their agreement on the basic structure for a regional cap-and-trade program to reduce CO 2 emissions from power plants in the region. The effort, called the Regional Greenhouse Gas Initiative (RGGI), covers power generation larger than 25 megawatts (MW) in ten Northeastern states. The first compliance period began in January 2009. 7
6 Pew Center on Climate Change, The EU ETS in Perspective , (May 2008).
7 Regional Greenhouse Gas Initiative, http://www.rggi.org/home (last visited Dec. 23 2008).
Kyoto framework
EU ETS (domestic) Kyoto signatories outside EU ETS Annex I countries with economies in transition.
Potential JI countries Non Annex I countries.
Potential CDM host countries
Figure 4.2 Kyoto Framework Map
(II) CALIFORNIA AB 32
California’s Air Resources Board released a draft plan to reduce California’s GHG emissions by 25 percent by 2020. Assembly Bill 32, the Global Warming Solutions Act of 2006, calls on California to reduce its GHG emissions to 1990 levels by 2020. 8
(III) THE WESTERN CLIMATE INITIATIVE
The Western Climate Initiative (WCI) announced in 2007, builds on California’s plan and will create a comprehensive regional effort by the governors and premiers of six U.S.
states and four Canadian provinces to promote environmental sustainability and eco- nomic growth. The WCI will reduce GHG emissions by 15 percent below 2005 levels by 2020 through a multisectoral cap-and-trade system scheduled to launch in 2012. 9
(IV) MIDWESTERN REGIONAL GREENHOUSE GAS REDUCTION ACCORD
In November 2007, six Midwestern states and one Canadian province established the Midwestern Regional Greenhouse Gas Reduction Accord (Accord). Under the Accord, members agree to establish regional GHG reduction targets and develop a multisector cap-and-trade system to help meet the targets. 1011
8 California Assembly Bill 32, http://www.arb.ca.gov/cc/docs/ab32text.pdf (last visited Dec. 23 2008).
9 Western Climate Initiative, http://www.westernclimateinitiative.org/ (last visited Dec. 28, 2008).
10 Midwestern Regional Greenhouse Gas Reduction Accord, http://www.midwesternaccord.org/
(last visited Dec. 28, 2008).
11 Pew Center on Climate Change.
Regional Initiatives
Regional Greenhouse Gas Initiative Midwestern Regional GHG Reduction Accord Western Climate Intiative
Individual State Cap-and-Trade Program
Figure 4.3 North American Regional Initiatives 11
Source: Pew Center on Global Climate Change
MARKET FRAMEWORKS FOR CARBON CREDITS
(V) OTHER COMPLIANCE SCHEMES
Other regulated non-Kyoto markets currently include the New South Wales system in Australia, and New Zealand’s ETS covering all GHGs and progressively including all sectors, starting with forestry in 2008. A number of existing (or proposed) cap- and-trade schemes in Australia, Japan, Switzerland, Norway, and Canada are all currently formulating post-2012 actions. (See Figure 4.3 .).
3. Voluntary Markets A voluntary carbon market, with demand not motivated by compliance requirements, has been growing robustly, with most of its growth since 2005. The voluntary market encompasses all the purchases of carbon assets by entities not subject to any mandatory emissions caps. The voluntary market remains small in volume and value, especially in comparison to the broad Kyoto compliance market. 12
The key drivers of demand for offsets in the voluntary market are corporate social responsibility and precompliance, with a particular focus on offsets from projects that demonstrate community benefits or strong sustainability components. The regulatory void in some countries, and the anticipation of imminent legislation on GHG emis- sions, is central to the growth in the activity of the voluntary market. This is especially true in the United States and Australia, where buyers have been looking to secure precompliance and early action offsets.
A. CHICAGO CLIMATE EXCHANGE
The Chicago Climate Exchange (CCX) is a structured and closely monitored cap- and-trade system that organizations join voluntarily. Its members make voluntary, but firm commitments to reduce GHG emissions 6 percent below a baseline period of 1998–2001 by 2010 and trade carbon credits as Carbon Financial Instruments (CFIs). 13
B. THE OVER-THE-COUNTER (OTC) MARKET
Outside of CCX, a range of transactions that are not driven by an emissions cap exist and involve voluntary carbon credits and assets that do not tend to trade on a formal exchange. These transactions take place as Over-the-Counter (OTC) transactions between buyers and sellers. 14 Credits sourced specifically for the OTC market are often referred to as Verified/Voluntary Emission Reductions (VERs). There are a number of standards for voluntary carbon credit projects that have been developed and broadly adopted in order to ensure the integrity of the projects. The prospect of U.S. engage- ment in climate policy also attracted a new exchange, the New York–based Green Exchange, launched by NYMEX. 15
4. Market Size The Kyoto Protocol and other regulations intended to constrain GHG emissions, along with voluntary efforts to reduce GHG emissions, have created a
12 World Bank, State and Trends of the Carbon Markets (May 2008).
13 Chicago Climate Exchange, http://www.chicagoclimatex.com/ (last visited Dec. 29, 2008).
14 New Carbon Finance, State of the Voluntary Carbon Markets (May 2008).
15 The Green Exchange, http://nymex.greenfutures.com/ (last visited March 2010).
burgeoning carbon market with a valuation of $136 billion in 2009, 16 despite the ongoing economic difficulties. The valuation is expected to grow to $1.4 trillion per year by 2020. 17 Thus far, the market has been successful in sending signals for the price of mitigating carbon emissions, which has, in some cases, stimulated innovation and carbon abatement worldwide, as motivated individuals, communities, companies, and governments have cooperated to reduce emissions. (See Table 4.1 and Figure 4.4 18 .). 19
16 Point Carbon, Carbon Market Monitor, 2009: Year in Review (January 2010).
17 Bloomberg New Energy Finance, Press Release, “The Global Carbon Market Increases by 5 % in 2009,”(Jan. 18, 2010).
18 World Bank, supra note 12.
19 New Carbon Finance, Sate of the voluntary Carbon Markets (May 2009).
Table 4.1 Growth of the carbon markets 19 2007 Volume (MiCO2e)
Value (MUSS)
Volume (MtCO2e)
Value (MUSS)
Project-based Transactions
Secondary CDM Primary CDM
JI
Voluntary market
EU ETS
New South Wales Chicago Climate Exchange RGGI AAUs Sub total
Sub total
TOTAL 2,984 63,007 4,811 126,345
92,859 3,276
49,361 2,108
240 5,451 1,072 26,277
7,210 463
8,195 636
552 41 43
2,060 25 23 na na
49,065 224 72 na na
3,093 31 69 65 18
91,910 183 309 246 211 7,433
499 263
6,519 294 397 389
20 54
Sub total
Allowances Markets
2008
MARKET FRAMEWORKS FOR CARBON CREDITS
B. Buyers and Sellers of Carbon Credits
1. Buyers According to the 2009 World Bank State and Trends of the Carbon Markets Report , 20 European buyers continue to dominate the CDM and JI market for compliance. At the close of 2008 the European market share stood at 80 percent.
Private companies have been the most active buyers, with approximately 90 percent of volume transacted in 2008. 21 The most active buyers include large European compli- ance buyers with installations in several countries, project developers, and aggrega- tors, and financial institutions have returned to the market with an eye to the booming secondary markets. The most active buyers largely operate out of London, which, at 59 percent, is considered the global carbon finance center. Japan represented 11 percent of the market in 2007, with both public and private sector intensifying their activity, but this had declined to 5 percent by the end of 2008. 22
Other participants are intermediaries, such as aggregators, trading houses, compli- ance funds, and banks (with banks entering the carbon market en masse in 2007, then departing during the recent financial crisis of 2008); asset managers (investors carbon funds, hedge funds) investing in a new commodity market; U.S. multinationals operat- ing in Europe or Japan or preparing for the Regional Greenhouse Gas Initiative (RGGI) in the Northeastern United States, or anticipating California Assembly Bill 32 or the Western Climate Initiative; power retailers and large consumers regulated by the New South Wales (NSW) market in Australia; and North American companies with volun- tary but legally binding compliance objectives under the CCX. 23 (See Figure 4.5 .).
20 World Bank, supra note 12.
21 Id.
22 Id.
23 World Bank, supra note 12.
Historic Values for the Voluntary Carbon Markets
800 700 600 500 MtCOe2 400
300
$171M
$43M $23M $37M $42M
$99M
$335M
$705M
200 100
pre-2002 2002 2003 2004 2005 2006 2007 2008
OTC CCX Other exchanges
171
43 23 3
35 3
39
38 1 72
262
397 307 1
61 0
Figure 4.5 OTC Transaction Volumes
Source: Ecosystem Marketplace, New Carbon Finance
2. Sellers China has been the world leader in CER supply for four consecutive years with an 84 percent market share in terms of 2008 transacted volume. With a leading 66 percent of primary CER supply so far under contract, China is still the destination of choice for buyers of credits, who cite its large size, economies of scale in origina- tion, and its favorable investment climate for reasons of interest. China is well ahead of other countries in the CDM pipeline with 53 percent of potential CER supply until 2012. In 2008, India and Brazil — with 4 percent and 3 percent of the market share respectively — transacted the highest volumes behind China, while the rest of Asia followed with 4 percent. 24
For JI projects, the market’s focus has moved from Eastern Europe to Russia and Ukraine, with 68 percent and 18 percent respectively. 25
In terms of voluntary market supply, Asia held in 2008 the largest share of credits transacted by any single region in the OTC market at 45 percent; the United States (largest single country supplier) had the second highest origination of VER credits at 28 percent. The Middle East, while still not a major source of credits, increased production of VERs dramatically between 2007 and 2008 from near 4 percent to 15 percent of the market. New Carbon Finance describes a clear trend in 2007 and 2008 in that an increasing number of OTC customers, especially those in the United States and Australia, prefer to buy offsets from projects close to home. 26
C. Price Drivers of Compliance Carbon Credits
The price of an EUA is driven by a number of supply-and-demand factors. Supply factors include the number of EUAs allocated to annual emissions of GHGs and the number of CERs or ERUs imported as additional EUAs into the EU-ETS.
Demand factors are elements that increase demand for energy and electricity, includ- ing unusually warm summers or cold winters. Energy markets in Europe have a large effect on EUA price because power sector emissions cover 60 percent of total EU-ETS emissions. Also factored into the demand for EUAs is the relative cost of fuels with high carbon content (such as coal) to those with lower carbon content (such as oil or natural gas). It is assumed that when oil or natural gas is much more expensive than coal, electricity suppliers will use coal, increasing their need for EUAs. The “dark spread” represents the theoretical profit that a coal-fired power plant makes from sell- ing a unit of electricity having purchased the fuel required to produce that unit of electricity. The “spark spread” refers to the equivalent for natural gas-fired power plants. Within the EU ETS, the value of emission allowances can affect the cash flows of a power plant during its entire lifetime, thus with the introduction of carbon costs, these spreads need to be adjusted for allowance prices, called the “clean dark spread”
and the “clean spark spread.” In theory the difference between spark (and dark) spread
24 Id.
25 Id.
26 New Carbon Finance, supra note 14.
MARKET FRAMEWORKS FOR CARBON CREDITS
and the clean spark (and clean dark) spreads should be the cost of carbon in the open market and a main driver of the price.
In addition to the factors that affect the price of EUAs, the price of CERs is influ- enced by other factors. This is evidence by the price disparity between EUAs and CERs.
Forward CERs are purchased on a forward basis, that is, they are purchased before the CERs have actually been generated from a project. Spot CERs have been historically priced at a discount to EUAs. With respect to forward purchased CERs, pricing factors in various risks, such as the risk that the CERs will not in fact be generated. The price is further affected by the stage of project development at which the forward contract put in place. In 2009, CERs from projects at an early stage of regulatory and operational preparation transacted at around EUR 8.50 to 9.75, while registered projects with streamlined technology attracted prices between EUR 10 to 12.25. 27
Spot-traded CERs trade at a discount to EUAs because of discrepancies between the potential utility of CERs and EUAs. For example, there are limits on the portion of an EU country’s compliance obligation that can be met through the use of CERs. At the time of this writing, the price of a spot CER is approximately 88 percent of the price of a EUA. 28 (See Figure 4.6 .).29
27 Point Carbon, Carbon Market Monitor, 2009: Year in Review (January 2010).
28 Point Carbon.
29 Point Carbon.
Transaction Volume by Project Type, OTC 2008
Not Specified
2% 13%
3%
15% 16%
32%
Other types 2%
Fugitive Emissions
2%
Avoided Deforest 1%
3%
RE: Hydro Landfill RE: Wind
Aff/Ref Conservation Geological Seg Energy efficiency RE: Biomass Ag Methane Other 4%
5%
7%
Coal Mine 1%
Aff/Ref Plantation 1%
Fuel Switching 1%
Ind. Gas 1%
AgSoil 1%
Forest Management 1%
Figure 4.6 Volumes and Prices in the EU-ETS, 2004–09 29
Source: Ecosystem Marketplace, New Carbon Finance
Prices of CERs may also depend on the underlying project demonstrating strong sustainability attributes and community benefits (such as those certified under the Gold Standard), which have been reported to fetch a $7.34/tCO 2 e above-average premium. 30
D. Pricing Voluntary Carbon Credits
In the voluntary market, prices differ based on which standard is used in the verifica- tion of VER projects. For instance, emission reductions that have been verified to stringent standards such as the Gold Standard or pre-CDM VERs tend to command the highest prices. Conversely, emissions reductions verified to the CCX standard brought comparatively much lower prices in the VER market, trading in the US$1–4 range for much of 2008. 31 Projects with attractive sustainable development attributes attract healthy price premiums for resulting VERs as compared to projects that use the Gold Standard or similar standards certifying strong development attributes. If the Climate, Community, and Biodiversity Alliance Standard (CCBS) (a project design standard) joins the Gold Standard, this might help forestry projects to obtain a premium for resulting VERs. (See Figure 4.7 32.).
30 Id.
31 New Carbon Finance, supra note 18.
32 Ecosystem Marketplace, New Carbon Finance.
35 30 25 20
€ / tonne 15 10 5
1/12/04 6/9/05
Volume EUA 2007 EUA 2009 EUA 2008 sCER09
14/6/06 21/3/07 28/12/07
0 10 20 30 40 50
Million EUAs traded
0
Figure 4.7 Credit Prices by Standard 32 Source: Point Carbon’s Market Trader