Carbon Finance

MEMAE Master in Economics and Management of Environment and Energy

Ricardo Scacchetti Tutor Bocconi: Stefano Gatti Tutor First Climate: Nikolaus Schultze

Universit Luigi Bocconi

December 2009

Preface

This thesis was written during my internship at the Project Finance department of First Climate, which is a carbon asset management company, covering the entire carbon credit value chain. The Project Finance department is responsible for securing funds for projects, either through dedicated funds or partner institutions. The internship gave me the opportunity to understand the Carbon Market by inside. In addition, working in the Project Finance department I could know the main mechanisms by which an emission reduction project can be financed and also understand the project success drivers by assessing a number of projects in Europe, Africa and Latin America within a wide variety of technologies. However, the development of this thesis includes not only First Climates experie nces, but also a research on Project Finance, Carbon Market and Carbon Finance concepts.

Acknowledgements

I wish to thank First Climate, for giving me this tremendous opportunity to know Carbon Market in such a wonderful work environment, and specially Nikolaus Shultze, Linda Manieram and Stephanie La Hoz Theuer. I also wish to thank Stefano Pogutz, Masters Director, for motivating me to enroll the course, and Stefano Gatti for being my tutor in this thesis. On a personal level, I want to thank Louise Ferr for her affection, constant good mood and patience, to all my colleagues from Bocconi for their friendship and my family for their support.

Index

Acronyms ........................................................................................................................5 1 2 Introduction ...........................................................................................................6 Carbon Market background ....................................................................................7 2.1 2.2 2.3 3 Kyoto Protocol................................................................................................7 CER the new commodity.................................................................................8 Barriers for the CDM project development ................................................... 15

Carbon Financing .................................................................................................. 16 3.1 3.2 3.3 3.4 Carbon Finance concept ............................................................................... 16 Early assessment .......................................................................................... 20 Carbon Finance models ................................................................................ 24 Risk identification and sharing ...................................................................... 28

Conclusions .......................................................................................................... 33

References .................................................................................................................... 35 Annexes ........................................................................................................................ 37

Figures

Figure 1: CER commercialization in different Emission Trading Schemes..........................9 Figure 2: Carbon Market values ..................................................................................... 11 Figure 3: Types of CDM project with CERs issued (% number of projects) ...................... 13 Figure 4: Expected growth of accumulated CERs by project type ................................... 14 Figure 5: Registered projects by host region (% number of projects) ............................. 14 Figure 6: Project Finance documentation ...................................................................... 18 Figure 7: Carbon Finance concept ................................................................................. 20 Figure 8: Ratio of investment to ERPA value .................................................................. 22 Figure 9: Emission reduction success rates (by technology) ........................................... 23 Figure 10: Carbon payments escrowed as debt service .................................................. 26 Figure 11: Pooling model............................................................................................... 27 Figure 12: Local Bank guarantee model ......................................................................... 27 Figure 13: Project Risks profile per stage ....................................................................... 29 Figure 14: CDM project risk profile and its impact on Carbon Credit price ..................... 30 Figure 15: General project risks groups ......................................................................... 31 Figure 16 - Participants to the Kyoto Protocol ............................................................... 37

Acronyms

CER CDM ERPA GHG IRR JI LDC LFG LoA NPV PDD PIN UNEP UNFCCC

Certified Emission Reduction Clean Development Mechanism Emission Reduction Purchase Agreement Greenhouse gas Internal Return Rate Joint Implementation Least Developed Country Landfill Gas Recovery and Flaring project Letter of Approval Net Present Value Project Design Document Project Idea Note United Nations Environment Programme United Nations Framework Convention on Climate Change

1 Introduction
According to UNFCCC1, additional investment and financial flows of USD 200 210 billion will be necessary in 2030 to develop an effective and appropriate International response to climate change. The largest share (86%) of this investment and financial flow is constituted by private-sector investments. In this light, the Carbon Market plays an important role in shifting private investment flows to reach the necessary investments to mitigate climate change issues. In order to do so, the Kyoto Protocol has developed mechanisms able to leverage the necessary capital such as the Clean Development Mechanism (CDM). Despite the success of the CDM Market with more than 500 fully developed projects since 2004, the progress of CDM projects has been limited by some barriers. According to UNEP 2, the lack of access to financing is one of the key reasons why numerous CDM projects have never materialized. In this sense, Carbon Finance plays a significant role in the Carbon Market, acting as facilitator for project financing. Nevertheless, access to financing is not the only factor that will improve the CDM performance. This dissertation explores the main activities carried out by Project Finance in the Carbon Market such as the project assessment and the arrangement of financial mechanisms related to Carbon Credits, giving the necessary background to the reader. By way of background, the first Chapter introduces the Carbon Market and the transformation of Carbon Credits in a valuable and liquid commodity. Chapter 2 explains the mechanism of Carbon Finance, its different instruments and how it influences Project Finance. Lastly, Chapter 3 summarises the main concepts and concludes with lessons learned from real experiences.

United Nations Framework Convention on Climate Change (UNFCCC), Investment and financial flows to address climate change, (2007).
2

United Nations Environment Programme (UNEP), Guidebook to Financing CDM projects

2 Carbon Market background

This section provides a brief overview of the Carbon Market. Firstly, it addresses the origin of the Kyoto Protocol and its Flexible Mechanisms, including Carbon Credits. Secondly, it briefly describes the main Carbon Credit trading schemes in existence, and the resulting adoption of the Carbon Credit as a new commodity. Finally, it describes the CDM, its process in generating Carbon Credits and its barriers for further development.

2.1 Kyoto Protocol

At the Rio 92 conference, there was a broad international recognition of the need for a common effort to mitigate climate change. This resulted in an unprecedented international legally binding agreement, aiming to curb greenhouse gas emissions the United Nations Framework Convention on Climate Change (UNFCCC). The need to establish concrete measures and targets for action on the UNFCCCs framework provisions resulted in the Kyoto Protocol, signed in 1997. Under the Kyoto Protocol, industrialized countries and some developing countries agreed to specific emission reduction targets. Based on the principle that effect on the global environment is the same regardless of where GHG (Greenhouse gases) emissions reductions are achieved, countries may meet their targets through a combination of domestic activities and use of Kyoto Protocol Flexibility Mechanisms, which are designed to allow industrialized countries to meet their targets in a cost-effective manner and to assist developing countries in particular to achieve sustainable development. There are three Kyoto Protocol Flexibility Mechanisms: Joint implementation - JI Clean Development Mechanism - CDM

 International Emission Trading Both JI and CDM are project-based mechanisms which involve developing and implementing projects that reduce GHG emissions, by generating Carbon Credits that can be sold on the Carbon Market. JI is a mechanism that allows the generation of credits (known as Emission Reduction Units or ERUs) from projects within Annex I countries, whereas the CDM allows the generation of credits known as Certified Emission Reductions (CERs) from projects within non-Annex I countries(i.e. developing countries). Finally, International Emissions Trading allows trading directly between Annex I Parties in the units in which each countrys target is denominated, known as Assigned Amount Units (AAUs). All of these different units (ERUs, CERs and AAUs) are effectively permits allowing an Annex I Party to emit one tonne of carbon dioxide equivalent. The various categories of participants on the Kyoto Protocol are illustrated on Annex 1.

2.2 CER the new commodity

As mentioned above, project-based mechanisms, namely CDM and JI can generate different types of Carbon Credits, as CERs or ERUs respectively. The CDM is the most important mechanism, representing 90% of the project-based transactions. Thus, this mechanism will be further explored to show the current barriers and challenges faced by CDM projects. The CERs can be commercialised in different markets resulting in different prices. The main current trading markets are illustrated below:

Figure 1: CER commercialization in different Emission Trading Schemes.

Emission Trading Schemes The Carbon Market has doubled in value each year reaching about EUR 86 billion in 2008. The existing Carbon Markets can be divided between compliance and voluntary markets. The terms compliance and voluntary Carbon Markets refer to whether or not industries are obligated to hand in carbon allowances and Carbon Credits to governmental institutions. The existing emission trading schemes, are briefly described below: European Union Emission Trading Scheme (EU ETS) is the largest compliance market, representing three-quarters of market volume and value, and it is the most significant in terms of generating demand for CERs. The start-up: on January 2005, with the participation of the 27 EU Member States. The scheme covers five sectors, whose emissions represent 45% of the EUs emissions, namely power and heat generation, iron and steel, mineral oil refineries, mineral industry and the pulp and paper sectors. The system: the Kyoto Protocol emission target is shared out between EU Member State and each country is responsible for allocating their individual emission allowances to the sectors covered by the EU ETS. The EU ETS allows companies to trade surplus EUAs between themselves. In
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addition, companies are able to purchase CER from CDM projects in order to achieve their target. Keidanren voluntary action plan is a voluntary emission trading scheme established in 1996 by the Japanese business federation. This scheme involves 85% of the industrial emissions and these companies have the option of using CERs. A compliance market is under development in Japan. Chicago Climate Exchange (CCX) is a voluntary scheme based in Chicago, USA. Although the CCX allows the use of CERs, the volumes and prices traded on the CCX market were comparatively low. Regional Greenhouse Gases Initiative (RGGI) is a coordinated effort between seven USA States (Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York and Vermont) to implement a cap and trade program to limit GHG emissions in the region. It is currently of limited interest to CER vendors as it will only allow the use of CERs when the price of emissions reductions rises above US$10 per tonne. Canadian Large Final Emitters (LFE) is currently on hold by the Canadian government on its way forward. It is supposed that LFE will allow access to CERs. Australian Carbon Pollution Reduction Scheme (CPRS) the Australian trading scheme is moving rapidly forward. This scheme involves 80% of the Australian emissions and it is currently being decided which conditions the use of CER for abatement would be permitted.

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Figure 2: Carbon Market values

Source: World Bank

The Carbon Market rapidly reached an improved level of maturity, due to the healthy exchange of in-depth information and know-how, reinforced by a transparent regulatory system. The achieved market maturity resulted in reduced margins and spreads as well as in a less volatile market. CDM processes The carbon credit generated by a CDM project is the CER; one unit of CER means 1 tonne of CO2 equivalent (tCO2-e). The Kyoto Protocol recognises six main greenhouse gases with different Global Warming Potentials (GWP). The equivalences per tonne of each recognized gas are described below: Carbon dioxide (1t CO2) = 1 tCO2-e Methane (1t CH4) = 21 tCO2-e Nitrous oxide (1t N20) = 310 tCO2-e Hydro-fluorocarbons (1t HFCs) = 15011,700 tCO2-e Perfluorocarbons (1t PFCs) = 6,5009,200 tCO2-e Sulphur hexafluoride (1t SF6) = 23,900 tCO2-e
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CDM projects must overcome a rigorous process of documentation and approval, called CDM project cycle, in order to generate CERs. This process is regulated by UNFCCC and the main steps are: initial feasibility assessment, development of a Project Design Document (PDD), host country approval, project validation, registration, emission reduction verification and credit issuance. Throughout, this process involves national and international stakeholders. In order to receive approval of the entities responsible for validation and verification, CDM projects must meet the requirements described below: Contribute to the host countrys sustainable development; Provide real, measurable carbon emission reductions using an approved baseline and monitoring methodology. The fact that the project must quantify the emissions reduction potential before submitting for validation is particularly important for project developers also, since this information allow them to know the carbon revenue potential. Reductions in emissions must be additional to any that would occur in the absence of the certified project activity. In other words, a CDM project should be something that would not have happened, in the absence of the CDM. For instance, a CDM project with a high IRR does not meet this additionality criteria, since it is commercially attractive without the CER revenues. Projects should not result in significant negative environmental impacts and undertake public consultation. Projects should not result in the diversion of official development assistance (ODA). CDM overview There are more than 160 approved baseline and monitoring methodologies available, however most of the completed projects have concentrated only on a
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relative few. Around 87% of the CDM projects are related to renewable energy, methane reduction and energy efficiency, as illustrated on figure 3.
Figure 3: Types of CDM project with CERs issued (% number of projects)
CERs issued in each sector
3% 8% 4% 0% 6% HFCs, PFCs & N2O reduction Renewables CH4 reduction & Cement & Coal mine/bed Supply-side EE 19% Fuel switch Demand-side EE 60% Afforestation & Reforestation Transport

Source: UNFCCC

CDM has boosted renewable energy projects since last few years. According to State of the Carbon Market in 2009 of Word Bank:
CDM leverage clean energy investments in 2008 through projects in renewable energy, fuel switching and energy efficiency. Hydro, wind, biomass energy and energy efficiency of power generation at large industrial facilities led the growth of the CDM pipeline and accounted for 70% of the number of projects and 65% of the volumes that entered the pipeline from January 2008 to March 2009. Hydro projects alone accounted for over a quarter of all projects and volumes entering the pipeline in this period.

Renewable energy projects are expected to continue growing supported by two main factors: First, a high opportunity for emission reduction in the energy sector. Second, the energy sector, even in Developing Countries, is well structured and presents a technical know-how, which facilitates the implementation of such a sophisticated mechanism as the CDM. The market is dominated by projects reducing hydroflurocarbons (HFCs), nitrous oxide (N2O) and methane (CH4), which in total account for about two thirds of all expected CERs. This is due to the high global warming potential of these gases (around 11.700 x CO2-e). By contrast, the large number of renewable
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energy projects accounts for only 22% of all expected CERs (Figure 4). The reasons are that renewable energy projects typically reduce emissions of CO2, which has a global warming potential of 1, and are often small-scale applications.
Growth of total expected accumulated 2012 CERs

Figure 4: Expected growth of accumulated CERs by project type (Million of CERs on pipeline)
3.000 2.500

Afforestation & Reforestation Fuel switch Energy Efficiency

Million CERs

2.000 1.500 1.000 500 0

CH4 reduction & Cement & Coal mine/bed Renewables

Jun 04 Jun 05 Jun 06 Jun 07 Jun 08 Dez 03 Dez 04 Dez 05 Dez 06 Dez 07 Dez 08 Jun 09

HFC & N2O reduction

Source: UNFCCC

China hosted around 84% of the CDM projects in 2008, followed by India with 4% and Brazil with 3%. Furthermore, there is a broad recognition that the CDM must be spread farther afield to lesser developed countries, especially in Africa. Changes on the CDM rules for the Post Kyoto period (2012-2020) are being discussed, in order to facilitate CDM development in Least Developed Countries.
Figure 5: Registered projects by host region (% number of projects)
Latin America 23.89%

Africa 1.85% Other 0.54% Asia / Pacific 73.72%

Source: UNFCCC

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2.3 Barriers for the CDM project development

Although, CDM gives projects the opportunity to receive CER revenue, it does changes the risk profile of the project, since CDM subjects the project to CDM requirements and associated high transaction costs. Moreover, projects in Developing Countries have an additional challenge related to the country risk profile. The main barriers for the CDM projects development are: CDM project cycle - inefficiencies and bottlenecks in the CDM regulatory system. According to World Bank:
Only one-third of the projects in the pipeline have been registered and by some projections, only about half of the potential CDM supply is expected to materialize by 2012. There is continuing frustration regarding the regulatory process, not just from private project developers but also from state-owned developers and developing country governments who have been waiting for their expected revenue streams to flow. Delays and inefficiencies along the project cycle have continued, leading to higher transaction costs, losses in CER volumes and lower market values.

Developing countries risks - CDM projects must be undertaken in Developing Countries, as a result of that they generally face additional challenges related to: political instability, high tax, weak regulatory systems, lack of infrastructure, local know-how and access to financing. As mentioned earlier, Post Kyoto agreement probably will facilitate and promote the development of CDM projects in Least Developed Countries; this will significantly increase the challenge. Uncertainty about the future CER price and regulatory rules post Kyoto.

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3 Carbon Financing
This chapter describes how Carbon Credits can be used to finance CDM projects. Firstly, it explains the Carbon Finance concepts. Secondly, it describes the investor Project Finance approach of a CDM project, beginning with the assessment of projects and illustrating the most common financial structures of Carbon Finance. Lastly, it describes the identification and management of project risks.

3.1 Carbon Finance concept

Carbon finance is based on the ability to monetise the sale of Carbon Credits to finance project investment costs. Carbon Finance involves few specific parties and documents that go beyond conventional Project Finance documentation. Parties involved in Carbon Financing Carbon Finance transactions normally involves Project owners, Carbon Credit sellers, government and sources of finance. These parties and their respective role in Carbon Finance are briefly described below: Project owner The entity which promotes a project, brings together the various parties and obtains the necessary permits and consents in order to get the project underway. Often they are involved in some particular aspect of the project such as construction and/or operation. They are invariably investors in the equity of the project company and may be debt providers or guarantors of specific aspects of the project companys performance. Carbon Credit buyer The entities which purchases Carbon Credits normally are Carbon Credit investment funds, Carbon intermediaries or compliance companies.

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 Banks Generally banks involved in Carbon Finance are International banks with experience in Carbon Market, often having dedicated departments of specialists, or local banks (Developing Countries) with no experience or knowledge in Carbon Market. Host government The host country is likely to be involved in the issuance of consents, permits and licences. This party can also act in sharing risks with the sponsor company. Multilateral agencies Multilateral agencies are able to enhance the bankability of a project by covering risk levels that the project cannot cover. Third-party equity These are investors in a project who invest alongside the sponsors. Unlike the sponsors, however, these investors are looking at the project purely in terms of a return on their investments for the benefit of their own shareholders. Project documentation Contracts between the various project parties assume a huge significance in project/ carbon finance and it is these documents that are the instruments by which many of the project risks are shared amongst the project parties. Figure 6 below illustrates the most common documents for a project.

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Figure 6: Project Finance documentation (Source: A guide to project finance)

In addition to these documents usually found in Project Finance, CDM projects also incorporate specific documents generated during the CDM cycle (2.2.2 CDM processes) and Carbon Credit sales. These documents are described below. Project Idea Note (PIN) - Preliminary CDM feasibility study; not a statutory part of the CDM process but often produced to facilitate host country approval and/or financing of a project. Project Design Document (PDD) Document contents include project description, estimation of ex ante net anthropogenic GHG removals, monitoring plan, environmental and social impacts. This document needs to be prepared and submitted by the project developer in order to register a CDM project. Validation Report Document that reports the result of the validation process, which determines that the project is eligible to be registered as a CDM project, confirming that the project meets the requirements of the

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CDM. This process is carried out by independent private entities, called designated operational entities (DOE). Letter of Approval (LoA) The letter by which the designated national authority (DNA) confirms that it approves the participation of the project proponents in the project activity, and in the case of the host Party letter of approval, that the project will contribute to sustainable development in that country. Monitoring Report Reports the result of the measuring of emission reductions. This report determines the amount of Carbon Credits to be issued. Emission Reduction Purchase Agreement (ERPA) Contractual agreement for the purchase of CERs. The ERPA is crucial to reduce uncertainties about project future revenues, by determining the price and ensuring the acquisition of the future Carbon Credits generated. The price may be fixed or indexed on the current Carbon Credit market prices. Function of Carbon Finance The main purpose that leads to Carbon Finance is the emissions reduction potential of the project. This projected emissions reduction is translated into future cash flow by an ERPA signed between a Project Owner and a Carbon Credit buyer. The ERPA may support the project financing in the following manners: Up-front payment for future delivery of Carbon Credits Increase of collateral for debt Improvement of the project attractiveness by ensuring future revenues Figure 7 below illustrates the ERPAs effect over Project Financing. D uring the project development, from the planning phase until the financial closure, different sources of finance must be sought in order to fulfil the necessary capital

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for the construction. The ERPA can attract finance sources due to the improvement of the project cash flow or the collateralization of debt. The mechanisms by which the ERPA can be used to boost Project Finance will be further explored on 3.3 Carbon Financing Models.

Figure 7: Carbon Finance concept

3.2 Early assessment

The Early assessment is the first step conducted by an investor in order to identify the main characteristics of a project. This analysis also permits investors to check the projects robustness, verifying some aspects where CDM projects normally fail. Risks identification and mitigation instruments will be explored in 3.4 Risk identification and sharing. Counterparty check The counterparty check aims to identify the parties involved in the project, to assess their experience and financial situation as well as to determine whether there is any associated reputational risk. The variety of variables analysed in a counterparty check are listed below: Experience - projects realized, years acting in the market, clients portfolio and partners;
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 Financial situation or creditworthiness - Ratio Debt/Equity; liquidity (current asset - current liability); operating profit; rating agencies (Moodys, Standard & Poors, Fitch Ratings) Reputational risk - is widely defined as any negative comments with respect to a companys activities. The issue that is addressed here is public perception. In order to assess public perception, an internet research is done, testing associations between the counterparty name and different issues such as corruption, environmental problems, insolvency and social scandals. Project development status A CDM project can be thought as a conventional project with an additional CDM-specific component. As the project status evolves, the uncertainty related to the project outcomes decreases, and consequently the project risk profile also diminishes. Since, financiers appetite for risk may not match the project risk profile, different sources of finance must be sought according to each phase the project is in. These finances are accumulated until the necessary capital for the total investment is completed. (Figure 7) Therefore, is important to identify the current development phase of the project in order to identify sources of finance which match with the project risk profile. The assessment of the CDM project development can be made by the UNFCCC website, verifying the published documents of the specific project, if the project is already registered. Otherwise the assessment can be done based on the PIN sent by Project Owner. Carbon Finances capacity of attracting finance sources Depending on the ratio between Carbon Credit value and project total investment, the capacity of leveraging finance sources by Carbon Finance can be more or less significant. This ratio can change mostly based on the project technology, for instance a Landfill Gas Recovery and Flaring project (LFG), has all
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its revenue generated by Carbon Credits, so Carbon Finance will be essential important in attracting finance. On the contrary, Carbon Finance will be less important in the case of a Wind energy project, where the Carbon Credit revenue represents a slight part of the total project investment. Figure 8 below shows the ratio of investment to ERPA value for different projects technologies (for instance, Hydro projects investment are 12 times bigger than the ERPA value).
Figure 8: Ratio of investment to ERPA value
ERPA value = Investment

Hydro
Wind Biomass energy LULUCF

Landfill Gas
Energy Efficiency HFC
0 2 4 6 8 10 12 14

Source: World Bank

In addition, an important factor that determines the carbon finances capacity of attracting finance sources is the effectiveness of certain project in issuing CERs, in particular the issuance rate (Figure 9). In the case of non operating projects, this factor depends basically on the precision of emission reduction projections. The success rate can be analysed by type of technology, since projects of the same technology use the same methodology to foresee emission reductions. In the case of operating projects, the success rate can be assessed by the Monitoring report, which shows the real emission reductions generated over a given period.

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Figure 9: Emission reduction success rates (by technology)

Hydro Wind
Biomass energy

Transport Landfill Gas Energy Efficiency

HFC
0% 20% 40% 60% 80% 100% 120%

Source: UNEP RIS Issuance success

Therefore, the assessment of the capacity of Carbon Finance in leveraging finance sources must take into account two factors: the ratio between value of Carbon Credits and the sought capital; and the normal success rate of Carbon Credit generation for the analysed project technology. A further analysis to identify the real success rate of the project can be done during a Due Diligence; however, at the Early assessment, the most important thing is to have a indicative perception of risks. Scale: Capital Investment and CER available Although large scale projects are preferred by banks and funds due to their economies of scale and reduced transaction costs, small scale projects represent 44% of all CDM projects3. One of the main reasons for such a result is that there are several small-scale methane (CH4) reduction projects, where global warming potential is 21 times bigger than CO2. Moreover, there are two additional reasons for that: the lack of large-scale approved methodologies; emission reduction success ratio does not depend statistically on the project scale. Therefore, the assessment of project scale is important to match the project scale with potential investor interest. Generally, small scale projects can be

Data of UNEP RISO - 2008

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interesting for the voluntary market or they can be packaged into a big project that is interesting for carbon funds or banks.

3.3

Carbon Finance models

As mentioned before, CDM projects have faced some barriers in accessing finance due to some intrinsic aspects such as small size; clean technologies are usually more capital intensive than conventional ones; lenders ask for higher interest rates in Developing Countries; and local financial institutions do not accept Carbon Credits as a valuable asset (security) or do not understand the risks involved in the CDM cycle processes. Therefore, in front of these challenges the Carbon Market has developed mechanisms to overcome these barriers. The most common models are described below: Advanced payment mechanism Carbon Credit buyers may be willing to invest in CDM projects, since they are also interested in the materialization of the project. This investment is usually done as a form of upfront payment, applying a high discount rate to the future value of the Carbon Credits. In this circumstance, the advanced payment mechanism acts much like a loan provided by the Carbon Credit buyer. This mechanism is simple and relatively quick to arrange, comparable to a conventional loan, because Carbon Credit buyers are usually well informed about CDM-specific risks and are able to conduct the necessary Due Diligence at a low cost. However, this mechanism suggests a risk allocation toward Carbon Credit buyer, since they are exposed to all risks associated with the future delivery of Carbon Credits. As a result of that, in order to mitigate risks, Carbon Credit buyers usually offer a low price per carbon Credit and a high interest rate.

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Another disadvantage is that buyers are willing to provide upfront payments usually only at advanced stages (after registration on UNFCCC and completion of construction). As result, this mechanism usually does not solve the financial problem for early stage projects. Carbon payments escrowed as debt service World Bank has pioneered this mechanism that capture the high quality of Carbon Credit revenues, and that is not only based on the additional revenues that can be generated (Bishop, 2004). These extra values brought by the quality of revenue are: Carbon contracts are denominated in hard currency, usually dollar or Euro; Long-term contracts, for example, the Post 2012 carbon Credit Fund of First Climate is able to buy Carbon Credits generated until 2020. Counterparties are generally highly-rated, for example, the Post 2012 Carbon Credit Fund with 125 million Euro from Aaa credit rating banks. The mechanism consists on using the backed ERPA to collateralize debt made by a bank (Figure 10). An escrow account outside the host country is set up, in order to safeguard the revenue stream for debt service and mitigate currency risks, since the debt and revenues are usually from an OECD country. Once the service debt payment is finished, the residual Carbon Credit revenue is directed to Project Owner.

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CER revenues

Escrow account

CER Buyer (ERPA)

Debt service

CER revenues remaining

CERs

Partner Bank
Debt

Project

Figure 10: Carbon payments escrowed as debt service

This mechanism is normally used by First Climate in partnership with a Bank, who accepts Carbon Credits as collateral. Generally, Partner Banks require an overcollateralization of around 50% of the Carbon Credit present value. The Carbon payments escrowed as debt service model has a significant potential in attracting financial sources and is growing its importance since the recognition of Carbon Credit as a commodity is being established.

Less common practices are the Pooling model and the Local bank guarantee model, described briefly below: Pooling model A successful structure pioneered by Standard Bank and Camco, capable to capitalize 15 million upfront by a pool of 5.8 million CERs from nine CDM projects in China. The model follows the structure of mezzanine finance, which is basically debt capital that gives the lender the rights to convert it to an ownership or equity interest in the company if the loan is not paid back in time and in full. This mechanism aims to package a pool of projects and monetize their emission reductions (or the whole cash flow) by tranches with different risk
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profiles. The tranche are auctioned in tranches and the first one gets the first credits, wherever they come from, the second a bit more risk, and so on (Figure 11). An advantage of this model is that it is able to secure upfront money without tying it to CER delivery; however it has a low demand for this kind of investment since the Subprime Mortgage crisis in USA.

Investors
Senior lender Subordinated lenders

Debt

Project pool

CERs CER revenues

SPV
Figure 11: Pooling model

ERPA

CER Buyer

Local Bank guarantee model Similar to the Pooling mechanism, however instead of providing debt the Investors provide a Letter of Guarantee for a Local Bank, which does not accept Carbon Credits as collateral. With the Guarantee letter the Project owner is able to access finance from a Local Bank. In case of a Project Owner defaults debt service payment the Investors can access the Carbon Credits of the Project pool (Figure 12).
Guarantee

Investors
Senior lender Subordinated lenders
Financial Agreement
Debt

Local Bank
Debt Service

Project individual or Project pool

CER revenues

CERs
ERPA

SPV

CER Buyer

Figure 12: Local Bank guarantee model

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CDM project values beyond the cash flow Beyond the valuation of the project cash flow, financial institutions have been recognizing environmental and social aspects as a requirement for investment. Since these aspects are an intrinsic part of CDM projects, the concern with sustainability of the financial sector has indirectly favoured CDM projects financing.

3.4 Risk identification and sharing

Project participants are particularly concerned with ensuring that they have identified and understood all risks that they will be assuming in connection with the project. The main risks of a CDM project can be divided between CDMspecific risks and Generic project risks; both can affect the project causing basically: Failure, Delay or Under-performance, depending on the project stage (Figure 13). The project risk profile affects the ability of a CDM project to attract finance in two different ways: directly, by affecting the lenders willingness to invest; indirectly, by changing the Carbon Credit buyer perception of risk. This last will impact the project financing when the Carbon Credit Buyer compensates its risk on the Carbon Credit Price (as shown in Figure 14), offering a lower price for the acquisition. Therefore, the lower value of Carbon Credits will affect the debt collateral and the project cash flow.

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CDM

PA start

Validation Registration Issuance

Implement

Financial close

Construction Purchase

Commissioning Working mode

Failure Perform Delay

Figure 13: Project Risks profile per stage (Source: First Climate analysis)

As figure 13 shows, after financial closure the risk of project failure falls. This confirms that financial closure is an important challenge for CDM projects. Moreover, the fact that the risk of under-performance persists high until the Registration explains why advanced payment by Carbon Credit buyers is done just after this phase. This section shows briefly the most common CDM-specific risks and Generic project risks, and lists instruments of management and mitigation that can be used. CDM-specific risks The perception of risk by the Carbon Credit Buyer is transmitted on the offered price for an ERPA, affecting the financial performance of the project as a whole. The most common CDM-specific risks are illustrated in the figure 15 below.

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Figure 14: CDM project risk profile and its impact on Carbon Credit price (Source: UNEP FI)

Sharing project risks The key project risks encountered in different types of projects can be grouped as: Financial Risks; Market risks; Legal and Regulatory Risks; Construction and Operation Risks. After the decision to implement a CDM project is taken, the CDM-specific risks and Generic project risks are integrated into the project risk profile. For instance, in the case of an energy project, its financial performance depends on the projected energy and Carbon Credit revenues. In this sense, CDM-specific parties may assume part of the project risks. For instance, part of Financial risks are assumed by Carbon Finance mechanism, Market risks by Carbon Credit buyers and so on. (Figure 15) It is likely that most participants in projects will need to consider one or more of these risks and decide by whom these risks are to be assumed and how. Once these risks have been identified, it is through the various contractual

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arrangements between the parties, and insurance, that these risks are, for the most part, apportioned and assumed.
Financial Risks Market Risks

Suppliers

Banks Supply Agreements

Of f take Agreements (PPA) ERPA

Of f takers

Sponsors

Credit Agreement/ Security Documents/ Carbon Finance Shareholder Agreements

Carbon buyer

Special Purpose Vehicle

Consents /Permits
Local Laws Concession Agreements CDM cycle

O&M Agreements EPC Operator Contractor

Host Government

Consulting

Legal & Regulatory Risks

Construction & Operation Risks

Figure 15: General project risks groups (Source: Guide to Project Finance)

Existing instruments to address risks There are some instruments currently available that help CDM projects to avoid market and technical threats. The existing instruments are listed below: Country risk guarantee Emission Reduction Purchase Agreement Escrow accounts outside the host country - It permits deposit of payments for Carbon Credits from a buyer outside the host country, thereby safeguarding the revenue stream for debt service while also mitigating currency risk;

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 Partial risk guarantees to insure against host country non-compliance - It assurances that the government will not seek to nationalise CERs or attempt to re-negotiate prices agreed in ERPAs. Alternatively, a lender might require a commitment from the government as to the price or availability of key inputs to the project (e.g. waste to a landfill site), or future electricity or heat tariff increases that are required to make the project financially viable; Carbon Delivery Guarantee - It is a credit enhancement product, which guarantees delivery of Carbon Credits from quality projects in developing countries to buyers in developed countries.

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4 Conclusions
Carbon Markets play an important role in shifting private investment flows toward climate change issues. This dissertation concludes reviewing the most successful Project Carbon Finance instruments and giving recommendations for the private sector development. Best-practice in project financing Intrinsic CDM related barriers 4 to finance, must be overcome by the quality of Carbon Credit revenues (Bishop, 2004): Carbon contracts are denominated in hard currency - Dollar or Euro; Long-term contracts, generally until 2020; Counterparties are generally highly-rated. The current Financial Models able to enhance the values above successfully are: Carbon payments escrowed as debt service - model which consists on using the ERPA to collateralize debt to be issued by a bank. While, an escrow account outside the host country is set up, in order to safeguard the revenue stream for debt service and mitigate currency risks. Advanced payment mechanism - upfront payment from Carbon Credit Buyers, applying a high discount rate to the future value of the Carbon Credits. This mechanism is simple and relatively rapid to arrange, relative to a conventional loan, because Carbon Credit buyers are usually well informed about CDM-specific risks and are able to conduct the necessary Due Diligence at a low cost.

CDM project characteristics that difficult access of finance: small size; clean technologies are usually more capital intensive than conventional ones; lenders ask for higher interest rates in Developing Countries; and local financial institutions do not accept Carbon Credits as a valuable asset or do not understand the risks involved in the CDM cycle processes.

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Carbon Market know-how CDM risks and underlying project risks are not disconnected. Since part of companys revenue and risks derives from CDM projects, the carbon aspect must be a part integrated in the companys core-business, developing internal knowhow on Carbon Market or constructing partnership with liable Carbon companies. Limited knowledge on the business has resulted in project failure or in losses of opportunities.

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References
Books and papers: Andrew, J. (2004) Climate Change Strategy: The Business Logic behind Voluntary Greenhouse Gas Reductions. Bishop, V. (2004) Catalysing climate-friendly investment. Carbon Finance, March: 16-17. Business for Social Responsibility (2008) Offsetting emissions: A Business Brief on the Voluntary Market. Denton Wilde Sapte (2004) A guide to project finance. London: Denton Wilde Sapte. Deodhar, V., Michaelowa, A. & Krey, M. (2005) Financing structures for CDM projects in India and capacity building options for EU-Indo collaboration. Ecosecurities Ltd, UNEP (2007) Guidebook to Financing CDM Projects. Environmental Finance Report (2009) Confronting Climate Risk. Federal Environmental Agency from Germany (2007) Promoting Renewable Energy Technologies in Developing Countries through the CDM. Available at: http://www.umweltbundesamt.de Green, Gavin A. (2008) Cost-effectiveness of CDM projects types. UNEP. IETA, The World Bank (2009) State and Trends of the Carbon Market 2009. Lash, J., Wellington, F. (2007) Competitive Advantage on a Warming Planet. KPMG (2008) Climate Changes your Business Review of the business risks and economic impacts at sector level. McKinsey & Company (2009) Pathways to a Low-Carbon Economy. New Energy Finance (2006) Global Clean Energy Investment Overview. Swiss Re (1999) Project finance: The added value of insurance. Zurich: Swiss Re Publishing. The UNEP FI African Task Force (2009) And yet it moves. United Nations Framework Convention on Climate Change - UNFCCC (2008) Investment and financial flows to address climate change, Technical Paper.

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United Nations Framework Convention on Climate Change - UNFCCC (2004) The First Ten Years. UNEP (2008) Public Finance Mechanisms to Mobilise Investment in Climate Change Mitigation. Websites: http://cdmpipeline.org http://carbon.newenergyfinance.com/ http://www.pointcarbon.com/ http://www.carbonfinanceinternational.com/ http://www.carbon-financeonline.com/

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Annexes
1. Categories of participants on the Kyoto Protocol - (Source: Point carbon) The various categories of participants on the Kyoto Protocol are illustrated bellow distinguished by colour:

Figure 16 - Participants to the Kyoto Protocol (Source: Point Carbon)

Blue, the European Union (EU-15): All EU members are Annex I countries, and the EU-15 has taken on a common commitment to reduce their average greenhouse gas emissions by 8 % in the first Kyoto commitment period (2008-2012) compared to 1990 level. Yellow: Countries undergoing the process of transition to a market economy: countries that have emission caps and are usually net sellers in the Carbon Market. JI projects are hosted mostly in these countries. Red: Annex II non-EU countries that ratified the Kyoto Protocol: these countries have ratified the Kyoto Protocol, have compliance targets, but are not part of the EU or are not economies in transition. White: Annex I parties not ratified: a mong the Annex 1 countries that signed the Kyoto Protocol in 1997, only the USA has not ratified it. In 1990, the USA emitted 36.4 % of the total GHGs in the world.

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 Green: Non-Annex I countries having ratified the Kyoto Protocol: the nonAnnex countries do not have emission caps and are potential host countries of CDM projects.

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