CDM Projects:

The Financial Perspective

Robert Kelly
Regional Coordinator, CDM Capacity Development,
Southern & Eastern Africa
robert.kelly@undp.org

March 27th, 2008

Agenda

The big picture

Why bother with financial analysis?

Conducting financial analysis

A practical example

2 2
The bewildering range of potential CDM projects

Forestry
Hydro power
Wind power
Heavy Industry

Bio-fuels
Transport
Animal waste

Sewage / Landfill
wastewater
Bagasse

3 3
Not all carbon projects are born equal…
Average Annual CER Production by CDM Project-Type
4.5m
970,000

520,000

318,000
206,000
170,000
83,000 79,000 74,000 54,000
26,000 18,000
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5 5
Carbon revenues also vary on a project-by-project basis
7,934
7,934

Standard
Standarddeviation
deviation
(kCERs
(kCERs by2012)
by 2012) 4,128
4,128
1,811
1,811 Markers
3,039
3,039 indicate
maximum,
mean and
minimum
1,711
1,711 project
928
928 size within
each
543
543
technology
1,228
1,228 661
661 1,101
1,101
379
379 330 827
827
330
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762 1,179
1,179
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6 6
For some projects, the ‘carbon layer’ is the only layer

– True for some industrial projects:

– e.g. thermal decomposition of HFCs
– e.g. flaring of methane from urban waste dumps
– e.g. capture of N2O from nitric acid manufacturing process

There is no reason why a project developer would carry

out these activities if it weren’t for the carbon revenue

7 7
But many carbon projects combine revenue streams
Most carbon projects rely upon a number of revenue flows. The
‘carbon layer’ typically represents just one financial layer

Multiple Carbon Layers

– e.g. an animal waste management project that claims CERs

for captured methane and claims CERs for ‘clean energy’
generation

– e.g. a palm oil plantation that claims tCERs for carbon

sequestration and CERs for ‘fuel switching’ (the
displacement of mineral diesel by bio-diesel)

8 8
But many carbon projects combine revenue streams
Most carbon projects rely upon a number of revenue flows. The
‘carbon layer’ typically represents just one financial layer

Carbon & Non-Carbon Layers

– e.g. an urban landfill project that claims credits for
captured methane and uses the methane to generate
electricity

– e.g. a forestry project that claims credits for carbon

sequestration during the project crediting period, and then
logs the trees for timber revenues

9 9
But many carbon projects combine revenue streams
Most carbon projects rely upon a number of revenue flows. The
‘carbon layer’ typically represents just one financial layer

Carbon & Non-Carbon Layers

revenue streams
Complementary

– e.g. an urban landfill project that claims credits for

captured methane and uses the methane to generate
electricity
revenue streams
Contradictory

– e.g. a forestry project that claims credits for carbon

sequestration during the project crediting period, and then
logs the trees for timber revenues

1010
So, to summarise…
– Different project-types (and different projects) generate
different volumes of carbon credits

– Some projects rely solely on carbon revenues

– Many projects combine carbon revenues with non-carbon

sources of revenue

Financial analysis is vital to understanding a CDM

project, both in advance and during the project’s
lifetime

1111
Agenda

The big picture

Why bother with financial analysis?

Conducting financial analysis

A practical example

1212
Three uses for financial analysis…

1 Is the project going to make money?

1313
A CDM project costs money. Is it worth the effort?
Pre-Registration Post-Registration
CDM Costs CDM Costs

53,000 Indicative CDM Cost Profile For

US$ 164,500
A ‘Typical’ CDM Project

Assumes
Assumes aa 10-year
10-year
project.
project.
34,000
111,500
Ongoing Recurrent
Recurrent costs
costs
Verification discounted
discounted at at 3%
3%
By annual
annual rate
rate to
to express
express
10,000
77,500 DOE in present-value
in present-value
16,500 terms.
67,500 terms.
Initial
38,000
51,000 Monitoring Registration
Registration costs,
costs,
Validation Ongoing Administration
Administration Fee
Fee
Annual and Adaptation Fund
and Adaptation Fund
Monitoring Levy
Levy not
not included.
included.
13,000
PDD
PIN

1414
Three uses for financial analysis…

1 Is the project going to make money?

2 Demonstrating additionality

1515
Demonstrating additionality – investment comparison analysis

Choose an appropriate financial indicator, such as IRR, NPV or benefit-

cost ratio, to demonstrate additionality

Carbon
Carbon revenue
revenue
makes
makes the
Revenue / NPV / IRR

the
project
project
worthwhile
worthwhile
Break-even point

Project
Project without
without
carbon
carbon revenue
revenue
is
is unprofitable
unprofitable

Project without Project with

carbon element carbon element

1616
Demonstrating additionality – benchmark analysis
Choose an appropriate financial indicator and compare it with a relevant
benchmark value: e.g. required return on capital or internal company
benchmark
Carbon
Carbon revenue
revenue
makes
makes the
the
project
project attractive
attractive
Revenue / NPV / IRR

relative
relative to
to
investment
investment
Investment
threshold
alternatives
alternatives
Project
Project without
without
carbon
carbon revenue
revenue
is
is profitable
profitable ––
but
but not
not
sufficiently
sufficiently
profitable
profitable
Project without Project with
compared
compared with with
carbon element carbon element
alternatives
alternatives

1717
Three uses for financial analysis…

1 Is the project going to make money?

2 Demonstrating additionality

3 Structuring the project

1818
Revenue flows determine more than just profits…

Future carbon revenue flows can be used as collateral for

obtaining loans from financial institutions

Future carbon revenue flows can be used to negotiate

forward payment from the carbon buyer. This up-front
payment can then be used to pay for project
establishment costs

The distribution of carbon revenues in time determines

how frequently the project should be verified

1919
Agenda

The big picture

Why bother with financial analysis?

Conducting financial analysis

A practical example

2020
Investment appraisal techniques

• Payback period

• Net present value (NPV)

• Internal rate of return (IRR)

• Benefit-cost ratio (BCR)

2121
Payback period
The payback period is the length of time taken for the
inflows of cash (i.e. revenue) to equal the original cost of
investment

Measures the length of time it takes for a project to repay

its initial capital cost:
– E.g. a piece of machinery costs $10,000 and it earns a
cashflow of $10,000 over a 12-month period. The
payback period is 1 year

Acts as a proxy for risk: the shorter the payback period,

the lower the risk

Informal thresholds are typically employed: e.g. 3-5 years

in Britain, 6 months in Iraq?

2222
Payback period - example

Year Year 0 Year 1 Year 2 Year 3 Year 4

$1,000
Project A (400) 300 110 67 0
Cumulative (400) (100) 10 77
Project B (400) 100 100 125 235
Cumulative (400) (300) (200) (75) 160

2323
Net present value (NPV)
The weakness of the payback period is that it does not
consider the time value of money

More immediate cashflows are more valuable than more

distant cashflows
– E.g. if a company puts $1,000 into a bank account earning
5% interest per year, in one year’s time the bank will pay
$1,050. The future value of $1,000 today is $1,050 in one
year’s time
– The present value of $1,050 at 5% interest rate in one year’s
time is $1,000

In effect, a dollar is worth more now than a dollar in one

year’s time
– Why? Because there is an opportunity cost associated with
investing money in a bank account. The company has to be
rewarded for investing – in the form of interest
2424
Generating interest on an investment
Year
Year15:
15:
Total savings
Total savings
$ 450 are
are$420
$420
(4.2
(4.2times
times
400 greater
greaterthan
than
350 the
theinitial
initial
investment)
investment)
300

250

200

150

100

50

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

2525
Discounting future revenue flows

$ 120

100

80

60
Year
Year15:
15:
Annual
Annualrevenue
revenue
40 of
of$100
$100isisworth
worth
$24
$24
in
in presentvalue
present value
20
terms
terms
(4.2
(4.2times
timesless
less
0 than
than$100
$100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 today)
today)

2626
Net present value (NPV) - example

Year Year 0 Year 1 Year 2 Year 3 Year 4

$1,000
Project A (400) 300 110 67 0
Discount Factor 10% 1.00 0.909 0.826 0.751 0.683
Present Value (400) 272.2 90.9 50.3
NPV= 13.4
Project B (400) 100 100 125 235
Discount Factor 10% 1.00 0.909 0.826 0.751 0.683
Present Value (400) 90.9 82.6 93.9 160.5
NPV= 27.9

A project with a positive NPV is profitable; a project with a

negative NPV should not be undertaken

2727
Internal rate of return (IRR)

The internal rate of return is the discount rate that

produces a net present value (NPV) of zero

The IRR is the break-even discount rate. It represents the

maximum cost of finance at which the project remains
viable

How to calculate the IRR…Use a computer!

– The IRR is determined through an iteration process,
using different discount rates until an NPV of zero is
produced

2828
Internal rate of return (IRR)
Once the IRR is found, it is compared with the company’s
pre-set threshold investment rate (the ‘hurdle rate’)

The hurdle rate is usually the company’s opportunity cost

of capital – e.g. the interest it could make on money saved
in a bank account

The IRR decision rule:

IRR > hurdle rate  accept
IRR < hurdle rate  reject

The IRR provides a simple investment decision framework

for managers

2929
The IRR uplift typically provided by carbon revenues

Impact of CER Revenue on the Internal Rate

of Return of CDM Projects

Technology IRR
Hydro 0.8-2.6
Wind 1.0-1.3
Bagasse 0.4-3.6
Biomass 2-7
Municipal Solid Waste >5
Forestry 2-7

3030
Benefit-cost ratio (BCR)

According to finance theory, any project offering a

positive NPV should be undertaken

However, investment capital is often scarce – when

confronted with 2 NPV-positive projects, a company may
not have sufficient money to undertake both projects

The IRR represents one way of distinguishing between

profitable projects. However, the IRR measures % returns
– not absolute financial returns

3131
Benefit-cost ratio (BCR)

The benefit-cost ratio (BCR) provides a means of

distinguishing between profitable projects in an absolute
sense

Present value of future cashflow

BCR =
Value of initial capital invested

The project with the highest BCR represents the most

attractive investment

The minimum ‘typical’ BCR of an attractive project is

approximately 1.3

3232
Project comparison

Project A Project B
Initial Investment 400 400
Nominal Revenue 477 560
Payback in: 2nd year 4th year
NPV ($1,000) 13.4 27.9
IRR 12.6% 12.9%
BCR 1.03 1.07

3333
 Financial Indicator Strengths
Payback period • Easy to calculate and to understand
• Acts as a proxy for risk and is
suitable for a company whose
objective is survival or which is
operating in high risk environment
Net Present value • NPV method overcomes the problem • The choice of discount rate is
of changing value of money over time.
• It looks at projects over their whole
lifetime, unlike payback
Internal rate of Return • IRR takes into account the value of
time and is easily understood by
managers
Benefit Cost Ratio • Enables a ranking of projects when
capital is rationed
Weaknesses
• Cash flows beyond the payback
period are ignored
• It does not reflect inflation and
opportunity costs of money as it
ignores the timing of the flows
• The determination of the required
payback period is highly subjective
problematic
• It makes the assumptions that there
is a single market rate of interest for
both borrowing and lending
• Does not take into account the effect
of taxation or other policy measures
• As it measures % returns, it fails to
measure wealth changes in terms of
absolute amounts
• IRR is problematic if the cash flows
are unconventional.
• Does not take into account the effect
of taxation and other policy measures
• Same as for NPV
3434
Agenda

The big picture

Why bother with financial analysis?

Conducting financial analysis

A practical example

3535
Animal waste management

3636
 Theory
Animal waste management Theory
Methane
Methaneisisproduced
producedasaspart
part
of the normal digestive
of the normal digestive
process
processin inanimals
animals(‘enteric
(‘enteric
fermentation’).
fermentation’).The
TheCHCH4 4isis
exhaled
exhaledor oreructated
eructatedbybythe
the
animal.
animal.

Revenue
RevenueOpportunity
Opportunity
Credits
Creditsfor
forreduced
reducedCH CH4 4
emissions;
emissions;utilise
utilisecaptured
captured
CH
CH4 4for
forenergy
energygeneration
generation(and
(and
further
furthercarbon
carboncrediting)
crediting)

Method
Method
Covered Lagoon 22potential
potentialapproaches:
approaches:
•• Modify
Modifyanimal
animalfeed
feedintake
intake
Capture CH emissions
•• Capture CH4 emissions
Complete Mix Digester 4

3737
Methane flaring from a swine farm in Brazil: costs and revenues
US$ Year Year Year Year Year Year Year Year Year Year
0 1 2 3 4 5 6 7 8 9
Equipment (61,363)
costs (cover,
PVC, meter,
flare, etc.)
Installation (92,000)
costs
(ground
excavation,
etc.)
Maintenance (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600)
costs
Other costs (9,200)
(operation,
engineering)
Revenues 0 0 0 0 0 0 0 0 0 0
from the sale
of electricity
Number of 25,000 69,500 69,500 69,500 69,500 69,500 69,500 69,500 64,000 60,000
CERs
generated

3838
Calculating the Net Present Value (NPV)
$US Total costs Total revenue Cashflow Discounted cashflow
Year 0 -167,163 250,000 82,837 82,837
Year 1 -4,600 695,000 690,400 627,580
Year 2 -4,600 695,000 690,400 570,533
Year 3 -4,600 695,000 690,400 518,672
Year 4 -4,600 695,000 690,400 471,525
Year 5 -4,600 695,000 690,400 428,663
Year 6 -4,600 695,000 690,400 389,698
Year 7 -4,600 695,000 690,400 354,274
Year 8 -4,600 640,000 635,400 296,413
Year 9 -4,600 600,000 595,400 252,506

NPV 3,992,700

(Assuming a 10-year project crediting period, 10% discount rate and $10 per CER)

This project is NPV-positive: it makes financial sense to undertake the project

CERs represent the only revenue stream: demonstrating additionality is

straightforward

3939
Adding an electricity generation component
$US Total costs Total revenue Cashflow Discounted cashflow
Year 0 -237,163 280,000 42,837 42,837
Year 1 -9,600 765,000 755,400 686,666
Year 2 -9,600 765,000 755,400 624,248
Year 3 -9,600 765,000 755,400 567,504
Year 4 -9,600 765,000 755,400 515,918
Year 5 -9,600 765,000 755,400 469,021
Year 6 -9,600 765,000 755,400 426,387
Year 7 -9,600 765,000 755,400 387,628
Year 8 -9,600 700,000 690,400 322,071
Year 9 -9,600 660,000 650,400 275,831

NPV 4,318,110

(The annual revenue from this electricity generation component of the project is
$US30,000 in Year 0, $70,000 in Years 1-7, and $60,000 in each of Years 8 and 9.
The cost of installing the required electrical equipment is $70,000 in Year 0 and
$5,000 in each subsequent year)

The NPV of the project has increased: it makes financial sense to add an
electricity generation component to the project

4040
Electricity generation without carbon revenues from the CDM
$US Total costs Total revenue Cashflow Discounted cashflow
Year 0 -237,163 30,000 - 207,163 - 207,163
Year 1 -9,600 70,000 60,400 54,904
Year 2 -9,600 70,000 60,400 49,913
Year 3 -9,600 70,000 60,400 45,376
Year 4 -9,600 70,000 60,400 41,252
Year 5 -9,600 70,000 60,400 37,502
Year 6 -9,600 70,000 60,400 34,093
Year 7 -9,600 70,000 60,400 30,994
Year 8 -9,600 60,000 50,400 23,512
Year 9 -9,600 60,000 50,400 21,374

NPV 131,757

This project is NPV-positive: it makes financial sense to undertake the project

But the argument for CDM additionality has become a lot more difficult. The project
developer would have to demonstrate either that there are more attractive projects to
invest in (i.e. that the NPV, though positive, isn’t sufficiently large) or that there are non-
financial barriers to investment that the CDM helps to overcome

4141
 End

Robert Kelly
Regional Coordinator, CDM Capacity Development,
Southern & Eastern Africa

robert.kelly@undp.org

4242