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Understanding the Carbon Credits Business

Amit Gopal Chauhan28th March 2008

SIBER, KOLHAPUR

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I will Talk About• Governance• Global Warming• IPCC, UNFCCC, Kyoto Protocol• Carbon Trading• Requirements for a CDM project• Examples• Discussion on price factors• Market strategy one should adopt• CDM market failure• Conclusion

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Governance

• Three pillars – Governments– Institutions– Markets

• When one fails other compensates• When one fails it either self corrects and

evolves with new attributes. Or depends on the other pillars for a change.

• The cycle should repeat it self.

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Global Warming

• Its responsible for life on Earth• Water Vapor, CO2, Methane, N2O caused

natural GW Historically• Industrialization has magnified the emissions

of GHGs exponentially• Increase in temperature, increase in sea water

level, extreme movements of draught/ hurricanes/ floods expected

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IPCC, UNFCCC, Kyoto Protocol• Intergovernmental Panel on Climate Change• United Nations Framework Convention on Climate

Change• North & South agree to mitigate climate change

before “it is too late”• Agree that they have “Common but Differentiated

responsibilities”. • Kyoto Protocol which in details describe how the

GHGs can be reduced entered into force on 16th February 2005.

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The Kyoto protocol

Annex INon-Annex INot ratified

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Kyoto Protocol

• It relies on market based flexible mechanisms to reduce GHGs emissions to mitigate GW.– Emission trading (trading of allowances between

Annex I governments)– Clean Development Mechanism (CDM) (projects

in Non-Annex I countries with participation of Annex I countries)

– Joint Implementation (JI) (projects between Annex I countries)

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GHGs With GWPs under Kyoto

Carbon dioxideGWP: 1

HydrofluorocarbonsGWP: 11,700

MethaneGWP: 21

Sulphur hexafluorideGWP: 23,900

Nitrous oxide

GWP: 310

PerfluorocarbonsGWP: 9,200

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Formula Name Global warming Potential

CO2 Carbon dioxide 1

CH4 Methane 21

N2O Nitrous oxide 310

PFCs Perfluorocarbons 9200

HFCs Hydrofluorocarbons 11700

SF6 Sulphur hexafluoride 23900

GWP & Carbon Credits

If one tonne of GHG emission is reduced then number of carbon credits issued will be equivalent to the GWP.

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Carbon Credits are also Known as…

• Emission reduction unit (ERUs), • Certified emission reduction (CERs),• Assigned amount unit (AAUs)• Removal unit (RMUs)• Voluntary emission reduction (VERs)

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Generating Carbon Credits G

HG

em

issi

ons

TimeProject commissioned

“With project” emission level

“Without project” emission level Carbon

credits

Project based emission reductions need to be calculated and verified 1 reduced Ton of Carbon Dioxide equivalent = 1 Carbon Credithereafter they can be sold on the open market.

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Supposed benefits of the market mechanisms

• Help identify lowest-cost opportunities for reducing emissions and attract private sector participation in emission reduction efforts.

• Cost of limiting emissions varies considerably from region to region, the benefit for the atmosphere is the same, wherever the action is taken.

• Developing nations benefit in terms of technology transfer and investment brought about through collaboration with industrialized nations under the CDM.

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The Carbon market (1)

International agreements to reduce greenhouse gases:• EU Emissions Trading System (EU-ETS) requires

EU countries to reduce emissions of greenhouse gases by 6% during 2005-2007

• Kyoto Protocol requires Annex I countries (West and Eastern Europe, North America, Japan, New Zealand, Australia) to reduce emissions of greenhouse gases by 5.2% during 2008 – 2012

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The Carbon market (2)

• Voluntary participation of Non-Annex 1 countries (Brazil, China, India, South Africa, etc.)

• The Linking Directive allows credits from Clean Development Mechanisms (CDM) and Joint Implementation (JI) projects to help companies comply with their obligations

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Registry systems under Kyoto (1)

• National Registries: containing accounts within which units are held in the name of the government or in the name of legal entities authorized by the government to hold and trade units

• CDM registry: for issuing CDM credits and distributing them to national registries. Accounts in the CDM registry are held only by CDM project participants, as the registry does not accept emissions trading between accounts.

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Registry systems under Kyoto (2)

• In addition to recording the holdings of Kyoto units, these registries “settle” emissions trades by delivering units from the accounts of sellers to those of buyers, thus forming the backbone infrastructure for the carbon market

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Registry systems under Kyoto (3)

• Each registry will operate through a link established with the International transaction log put in place and administered by the UNFCCC secretariat. The ITL verifies registry transactions, in real time, to ensure they are consistent with rules agreed under the Kyoto Protocol. The ITL requires registries to terminate transactions they propose that are found to infringe upon the Kyoto rules

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Registry systems under Kyoto (4)

• In verifying registry transactions, the ITL provides an independent check that unit holdings are being recorded accurately in registries. After the Kyoto commitment period is finished, the end status of the unit holdings for each Annex B Party will be compared with the Party’s emissions over the commitment period in order to assess whether it has complied with its emission target under the Kyoto Protocol

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Registry systems under Kyoto

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Requirements for South for participating in CDM

• The host country where the project is executed is a Kyoto signatory.

• The project meets the sustainable development criteria framed by the country.

• The projects results in real, measurable, long-term GHG reduction.

• The projects must be Additional (i.e. must face some financial, technical, common practice barriers. It should be proved that the project must not have been commissioned without the CDM)

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Basic data needed for CDM!• Evidence of CDM consideration

• Start & commissioning dates

• Financial analysis (IRR calculation)

• Electricity saving data

• Barrier analysis information

• EIA report, if required by law

• Contractual agreement between each individual sub-project and the bundling agency

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CDM Sectors All types of Renewable energy

Energy Efficiency in Industry (demand & supply)

Energy Distribution loss prevention

Construction

Transport Mining & Mineral Production

Fugitive emissions from fuels

Fugitive emissions from production and consumption of halocarbons and Sulphur hexafluoride

Solvent use Waste Handling and disposal

Afforestration and reforestation

Agriculture

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Outline of the CDM project process (1)

• An industrialized country that wishes to get credits from a CDM project must obtain the consent of the developing country hosting the project that it will contribute to sustainable development.

• Then, using methodologies approved by the CDM Executive Board (EB), the applicant (the industrialized country) must make the case that the carbon project would not have happened anyway (establishing additionality),

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Outline of the CDM project process (2)

• Must establish a baseline estimating the future emissions in absence of the registered project.

• The case is then validated by a third party agency, called a Designated Operational Entity (DOE), to ensure the project results in real, measurable, and long-term emission reductions.

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Outline of the CDM project process (3)

• The EB then decides whether or not to register (approve) the project.

• If a project is registered and implemented, the EB issues credits, called Certified Emission Reductions to project participants based on the monitored difference between the baseline and the actual emissions, verified by the DOE.

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Steps is CDM

PIN / PCN & PDD Development

Host Country Approval

Validation

Verification

Monitoring

Implementation

Registration

Certification

Project Developers / Consultant

GOI / MOEF i.e. DNA

DOE

CDM EB

Project Developers

Project Developer + DOE

DOE

CDM EB

Issuance of CERs CDM EB

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CDM Project Activity Cycle (1)• Project Activity Design:

The Project design document (CDM-PDD) and the Guidelines for completing CDM-PDD including a glossary of terms (Approval, authorization, project participants etc.) have been developed by the Executive Board on the basis of Appendix B of the CDM modalities and procedures. Project participants shall submit information on their proposed CDM project activity using the Project design document (CDM-PDD).

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CDM Project Activity Cycle (2)• Proposal of a New Baseline and/ or

Monitoring Methodology: The new baseline methodology shall be submitted by the designated operational entity to the Executive Board for review, prior to a validation and submission for registration of this project activity, with the draft project design document (CDM-PDD), including a description of the project and identification of the project participants.

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CDM Project Activity Cycle (3)• Use of an Approved Methodology: The

approved methodology is a methodology previously approved by the Executive Board and made publicly available along with any relevant guidance. In case of approved methodologies the designated operational entities may proceed with the validation of the CDM project activity and submit project design document (CDM-PDD) for registration.

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CDM Project Activity Cycle (4)• Validation of the CDM project activity:

Validation is the process of independent evaluation of a project activity by a designated operational entity against the requirements of the CDM as set out in decision 17/CP.7, the present annex and relevant decisions of the COP/MOP, on the basis of the project design document, as outlined in Appendix B.

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CDM Project Activity Cycle (5)• Registration of the CDM project activity:

Registration is the formal acceptance by the Executive Board of a validated project as a CDM project activity. Registration is the prerequisite for the verification, certification and issuance of CERs related to that project activity

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CDM Project Activity Cycle (6)• Certification/ Verification of the CDM project

activity: Verification is the periodic independent review and ex post determination by the designated operational entity of the monitored reductions in anthropogenic emissions by sources of greenhouse gases that have occurred as a result of a registered CDM project activity during the verification period. Certification is the written assurance by the designated operational entity that, during a specified time period, a project activity achieved the reductions in anthropogenic emissions by sources of greenhouse gases as verified.

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Possible CDM projects in Energy Sector for example

• Renewable Energy (wind, solar, biomass, hydro, geothermal etc.)

• Energy Efficiency• Combined Cycle Gas Turbines (CCGT)• Super Critical Technology for Power Generation• Renovations & modernization of Power plants• Reduction in T&D loss• Fossil fuel switch - Coal to Gas, Oil to Gas • Waste gas: heat, pressure, electricity• SF6 abatement• Biomethanation • Coal Mine Methane (CMM)

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Possible CDM projects in Oil & Gas Sector for example

• Gas flaring reduction,• Re-injection, • Associated gas recovery, • prevent pipeline leakage, • Geological storage of GHGs

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Possible CDM projects in Iron & Steel Sector for example

• Cleaner and more efficient coke production• Furnace efficiencies and upgrades • Heat Recovery from Direct Reduction Kiln• Energy Capture from Waste Gas• Fuel switch to natural gas / biomass, for

various ovens and kilns• Green Belt Development & Afforestration to

act as a sink for CO2

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Possible CDM projects in Chemical Industry

• Energy Efficiency • Wastewater/ Methane Avoidance • Biodiesel and Biofuels• Biomass Energy• Fossil fuel switch - Coal to Gas, Oil to Gas• Gas pipeline leakage• HFCs abatement• Renewable Energy: Biomass, Geothermal, Hydro, Solar, and

Wind• Waste gas: heat, pressure, electricity• Process modification• Forestry - Afforestation and Reforestation etc.

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How is CDM relevant for Businesses?

By selling the emission reductions from a project to a Annex I party additional cash flows can be realised.

Emission cap Actual

emissions

Buyer

Carbon Credits

Carbon value (€)

Annex I party Emission reduction project

The CDM project reduces the carbon emissions

in the CDM country

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Impact on the IRR of The Project

IRR BenchmarkProjectreturn

excludingCDM revenue

Projectreturn

includingCDM revenue

CDM cash flowThe gap betweenthe project return and the required

return oninvestment threshold

The CDM cash flow increases the IRR of the project making it more interesting for investors. (2%-100%, diversification, offshore revenue stream)

12 %

15 %

16 %

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Project Example

Waste heat Power Generation

50 MW combined cycle gas-steam turbine (CCGT)

12 MW condensing steam generator (CSG)

85% load factor Displaces 500 GWh / a of fossil

grid electricity CERs: 400,000/p. a = Rs. 660

million up to 2012

Biomass Power Plant

10 MW Rice Husk plant supply and grid export

70% load factor Displaces 70 GWh / a of fossil

grid electricity CER: 55,000 p a = Rs. 90

million up to 2012

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Energy Efficiency Projects for Example

• Doing the same with less• Potential & Opportunities

– Cogeneration– waste Heat/ gas Recovery– Energy Management System– Combustion Control– Fuel Switching– High efficient Refractory– Industrial Process Modifications/Fuel Savings

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Types of project• Measures/technologies

– Diffuse/small scale energy efficiency:• Energy efficient devices (bulbs, motor controller, appliances)

– Distribution– Labelling/government programme

• Buildings’ energy efficiency (insulation, SSC renewable, etc)

– Large scale (industrial) energy efficiency (demand/supply side)

• ‘Pure’ energy efficiency• Waste heat/gas recovery• Fuel switch

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Methodologies– Pure EE:

• AM0018 – Steam optimization• AM0020 – Water pumping efficiency improvement• AM0038 – Improved electrical efficiency in SiMnmetal production• ACM0007 – Single cycle to combined cycle power generation

– Fuel switch:• AM0017 – Natural gas cogeneration (BSL=gas-heat + grid-elec)• AM0029 – Construction of new natural gas power plants• AM0036 – Fuel switch Fossil fuel to biomass for heat generation• ACM0003 – Fuel switch in cement plants• ACM0009 – Fuel switch coal or petroleum to Natural gas

– Waste heat/gas recovery:• AM0024 – Waste heat recovery in cement plants• AM0032 – Cogen from waste gas/heat• AM0037 – Flare reduction and gas utilisation at oil & gas facilities• ACM0004 – Waste gas/heat for power generation

Applicability conditions!

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Regulatory and

political risks

Operational risk

Technical risk

Social acceptability

Market risk

Financial risk

Completion risk

Threats to project

Not enough financing to

complete project

Project does not pass completion tests

Project does not operate reliably

Project does not

meet regulatory commitments

Community protests

lead to permit denial or

revocation

Project boycotts

Bankers reluctant to lend

Source: Miller and Lessard, 2000

Traditional project risks

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Additional CDM project risks

• Institutional and regulatory risk• Methodology risk• Host country risk• Validation risk• Registration risk• Monitoring and verification risks

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Time frame and uncertaintyStep Propose

methodologyValidatio

nLOA Annex 1

approval

Registration Request for review

Consult. 3 weeks 30 days Variable

Not requested

Up to 8 weeks LS Up to 2.5 months

Time frame

Up to 2 years 2-6 months

1 month – 3 years

1-3 weeks

Up to 6 mo, if reviewed Up to 3 months

Rejection Level

~50% Not known

Variable

Not known

Up to 70% request for review

~33% formal review

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Time frame and uncertainty

StepFormal

reviewVerificati

on IssuanceRequest for

reviewFormal

review

Consult N/A N/A 15 daysUp to 1.5

Month N/A

Time FrameUp to 4

Months

2-4 Months

Up to 5 Weeks Up to 2 Months

Up to 4 Months

Rejection Level 26% rejected

Not Known

Up to 75% request for review

Up to 66% formal review None Yet

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Project Risks

Apparent costs- Equipment- O&M- Management

Hidden costs

- Opportunity costs (late start)- Overrun budgets

Operational risks:- Reduced CER generation- Equipment failure

- Administrative expenses and other transaction costs (lawyers, consultants)

Total real costs

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The CER Price Structure

CER Price

Counterparty & Default Risk

Commissioning Risk

Late Delivery Risk

Underperformance Risk

Asset Transfer Risk

Baseline & CER Calculation risk

Registration Risks

Volatility risk

International Transaction Log & Cap risk

Hot Air & Supply Risk

UNFCCC Policy Risk, Political Risks

EU ETS market price

EURO 5 15

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The Myth of the Carbon CreditEUAEuropean Union Allowance

ERUEmission Reduction Unit

CERCertified Emission Reduction

Existence Allocated by Annex I countries: Real Commodity

Created by JI projects

Created by CDM projects

Ownership AAA rated companies

Medium and large scale companies

Small, medium & large sized companies

Country- and project risk

No risk Medium risk High risk

Delivery risk No risk Medium risk High riskPrice high Medium Low

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Key Price determinants for CDM projects

• Risk allocation• Creditworthiness & experience of project sponsor• Viability of underlying project• Contract structure (e.g. upfront payments incur

discount, penalties for non-delivery, ability to pay penalties)

• ER vintage & seniority• Cost of validation & potential certification• Host country support & willingness to cooperate• Additional environment and social benefits

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Contract Types1) Seller does its utmost to deliver a flexible/non-firm volume, buyer

guarantees to buy- Few preconditions

2) Seller does its utmost to deliver a flexible/non-firm volume, buyer guarantees to buy- The contract is only valid on a set of preconditions

3) Seller guarantees to deliver a firm volume, buyer guarantees to buy- The contract is only valid on a set of preconditions

4) Seller guarantees to deliver a firm volume, buyer guarantees to buy- Non-delivery: seller pays mark-to-market/liquidated damages CERs or cash

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Cost of developing a CDM Project• Apart from the project development, implementation cost. The

developer has to pay for– The consultant fees– Registration with the Designated National Authority (MOEF)

• Public hearing– Validation fees (to Designated Operational entity)– Registration fees at the UNFCCC– Monitoring & Verification fees (to third party DOE)– CERs Issuance fees– Contribute to the UNFCCC adaptation fund

• Then bargain for the price of the CERs with the Buyers

• A picture of Market Failure!!

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CDM Market in India is • Consultant driven• Buyers are there but few and offer low price• Brokers promise good price but reliability record is

poor• Size of the projects is very small though the quantity

is large… hampers bargaining capacity of the project developer

• Most project developers hoard( do not sell) CERs in expectation of higher price

• Most projects face problems in implementation.

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Why CDM is a market failure? (1)

• Too sophisticated/complex a market• Too expensive to enter• The future beyond 2012 is yet uncertain• Does not survive the Cost Benefit analysis• Huge Markets like agriculture untouched• Forestry projects are too complex• The project developer doesn’t get a fair price• The ultimate buyer doesn’t get a fair price

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Why CDM is a market failure? (2)• Profits go in the pocket of middlemen • CDM popular only in developing countries not in

Lower developed countries• Technology transfer which CDM promises already

exist with South in some cases• Little initiative by government entities to take up

CDM projects• Proving additionality is very difficult in most of the

cases• Carbon exchanges have played limited role till yet

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Critiques & Concerns (1)

• Some emission reductions under the CDM are false or exaggerated

• In 2007 the CDM was accused of paying €4.6 billion for projects that would have cost only €100 million if funded by development agencies

• Where as the project developers feel they did not get a fair price

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Critiques & Concerns (2)

• The first commitment period of the Kyoto Protocol excluded forest conservation/avoided deforestation - carbon emissions from deforestation represent 18-25% of all emissions, and will account for more carbon emissions in the next five years than all emissions from all aircraft since the Wright Brothers until at least 2025.

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Market strategy one should adopt (1)

• Enter as early as possible….project conceptual stage• Educate oneself and staff thorough…before going to

consultant• Invite a buyer as a project participant at an early stage• Appoint a consultant for CDM PDD writing and

handling UNFCCC matters…note your job is to execute the project

• Option of in-house PDD development can also work for you…delegate the job

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Market strategy one should adopt (2)

• Sell some CERs in advance and hold some portion for expectation of higher price…don’t hold all the CERs

• Carbon market will stay in some way or the other….the market will correct itself or be get corrected

• Expect local carbon markets in the future….say in next 7-12 years

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Conclusion

• The market need a major makeup• Simplify• Active role from institutions to take up

programme of activities CDM• Efficient, transparent, carbon exchanges• More information and education• Considering other than market approach to

mitigate climate change