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Understanding Carbon Credits Business

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  • Understanding the Carbon Credits BusinessAmit Gopal Chauhan28th March 2008SIBER, KOLHAPUR

  • I will Talk AboutGovernanceGlobal WarmingIPCC, UNFCCC, Kyoto ProtocolCarbon TradingRequirements for a CDM projectExamplesDiscussion on price factorsMarket strategy one should adoptCDM market failureConclusion

  • GovernanceThree pillars GovernmentsInstitutionsMarketsWhen one fails other compensatesWhen 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.

  • Global WarmingIts responsible for life on EarthWater Vapor, CO2, Methane, N2O caused natural GW HistoricallyIndustrialization has magnified the emissions of GHGs exponentiallyIncrease in temperature, increase in sea water level, extreme movements of draught/ hurricanes/ floods expected

  • IPCC, UNFCCC, Kyoto ProtocolIntergovernmental Panel on Climate ChangeUnited Nations Framework Convention on Climate ChangeNorth & South agree to mitigate climate change before it is too lateAgree 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.

  • The Kyoto protocol

    Annex I

    Non-Annex INot ratified

  • Kyoto ProtocolIt 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)

  • GHGs With GWPs under Kyoto

    Carbon dioxideGWP: 1HydrofluorocarbonsGWP: 11,700MethaneGWP: 21Sulphur hexafluorideGWP: 23,900Nitrous oxideGWP: 310PerfluorocarbonsGWP: 9,200

  • GWP & Carbon CreditsIf one tonne of GHG emission is reduced then number of carbon credits issued will be equivalent to the GWP.

    FormulaNameGlobal warming PotentialCO2Carbon dioxide1CH4Methane21N2ONitrous oxide310PFCsPerfluorocarbons9200HFCsHydrofluorocarbons11700SF6Sulphur hexafluoride23900

  • Carbon Credits are also Known asEmission reduction unit (ERUs), Certified emission reduction (CERs),Assigned amount unit (AAUs)Removal unit (RMUs)Voluntary emission reduction (VERs)

  • Generating Carbon Credits

    GHG emissionsTimeProject commissionedWith project emission levelWithout project emission levelCarbon creditsProject 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.

  • Supposed benefits of the market mechanismsHelp identify lowest-cost opportunities forreducing emissionsand attract private sector participation in emission reduction efforts. Cost of limiting emissions varies considerably from region to region, thebenefit 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.

  • 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 2005-2007Kyoto 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

  • 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

  • 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.

  • 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

  • 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

  • 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 Partys emissions over the commitment period in order to assess whether it has complied with its emission target under the Kyoto Protocol

  • Registry systems under Kyoto

  • Requirements for South for participating in CDMThe 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)

  • 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

  • CDM Sectors

    All types of Renewable energyEnergy Efficiency in Industry (demand & supply)Energy Distribution loss preventionConstructionTransportMining & Mineral ProductionFugitive emissions from fuelsFugitive emissions from production and consumption of halocarbons and Sulphur hexafluorideSolvent useWaste Handling and disposalAfforestration and reforestationAgriculture

  • 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),

  • 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.

  • 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.

  • Steps is CDM

    PIN / PCN & PDD DevelopmentHost Country ApprovalValidationVerificationMonitoringImplementationRegistrationCertification

    Project Developers / ConsultantGOI / MOEF i.e. DNADOECDM EBProject DevelopersProject Developer + DOEDOECDM EBIssuance of CERsCDM EB

  • 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).

  • 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.

  • 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.

  • 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.

  • 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

  • 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.

  • Possible CDM projects in Energy Sector for exampleRenewable Energy (wind, solar, biomass, hydro, geothermal etc.)Energy EfficiencyCombined Cycle Gas Turbines (CCGT)Super Critical Technology for Power GenerationRenovations & modernization of Power plantsReduction in T&D lossFossil fuel switch - Coal to Gas, Oil to Gas Waste gas: heat, pressure, electricitySF6 abatementBiomethanation Coal Mine Methane (CMM)

  • Possible CDM projects in Oil & Gas Sector for exampleGas flaring reduction, Re-injection, Associated gas recovery, prevent pipeline leakage, Geological storage of GHGs

  • Possible CDM projects in Iron & Steel Sector for example Cleaner and more efficient coke productionFurnace efficiencies and upgrades Heat Recovery from Direct Reduction KilnEnergy Capture from Waste GasFuel switch to natural gas / biomass, for various ovens and kilnsGreen Belt Development & Afforestration to act as a sink for CO2

  • Possible CDM projects in Chemical IndustryEnergy Efficiency Wastewater/ Methane Avoidance Biodiesel and BiofuelsBiomass EnergyFossil fuel switch - Coal to Gas, Oil to GasGas pipeline leakageHFCs abatementRenewable Energy: Biomass, Geothermal, Hydro, Solar, and WindWaste gas: heat, pressure, electricityProcess modificationForestry - Afforestation and Reforestation etc.

  • 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.

  • Impact on the IRR of The Project

    IRR BenchmarkProjectreturnexcludingCDM revenueProjectreturnincludingCDM revenueCDM cash flowThe gap betweenthe project return and the requiredreturn oninvestment thresholdThe CDM cash flow increases the IRR of the project making it more interesting for investors. (2%-100%, diversification, offshore revenue stream)12 %15 %16 %

  • Project Example

    Waste heat Power Generation

    50 MW combined cycle gas-steam turbine (CCGT)12 MW condensing steam generator (CSG) 85% load factorDisplaces 500 GWh / a of fossil grid electricity CERs: 400,000/p. a = Rs. 660 million up to 2012Biomass Power Plant

    10 MW Rice Husk plant supply and grid export70% load factorDisplaces 70 GWh / a of fossil grid electricityCER: 55,000 p a = Rs. 90 million up to 2012

  • Energy Efficiency Projects for ExampleDoing the same with lessPotential & OpportunitiesCogenerationwaste Heat/ gas RecoveryEnergy Management SystemCombustion ControlFuel SwitchingHigh efficient RefractoryIndustrial Process Modifications/Fuel Savings

  • Types of projectMeasures/technologiesDiffuse/small scale energy efficiency:Energy efficient devices (bulbs, motor controller, appliances)DistributionLabelling/government programmeBuildings energy efficiency (insulation, SSC renewable, etc)

    Large scale (industrial) energy efficiency (demand/supply side)Pure energy efficiencyWaste heat/gas recoveryFuel switch

  • MethodologiesPure EE:AM0018 Steam optimizationAM0020 Water pumping efficiency improvementAM0038 Improved electrical efficiency in SiMnmetal productionACM0007 Single cycle to combined cycle power generationFuel switch:AM0017 Natural gas cogeneration (BSL=gas-heat + grid-elec)AM0029 Construction of new natural gas power plantsAM0036 Fuel switch Fossil fuel to biomass for heat generationACM0003 Fuel switch in cement plantsACM0009 Fuel switch coal or petroleum to Natural gasWaste heat/gas recovery:AM0024 Waste heat recovery in cement plantsAM0032 Cogen from waste gas/heatAM0037 Flare reduction and gas utilisation at oil & gas facilitiesACM0004 Waste gas/heat for power generation

    Applicability conditions!

  • Traditional project risks

    Threats to projectSource: Miller and Lessard, 2000

  • Additional CDM project risks

    Institutional and regulatory riskMethodology riskHost country riskValidation riskRegistration riskMonitoring and verification risks

  • Time frame and uncertainty

    StepPropose methodologyValidationLOAAnnex 1 approvalRegistrationRequest for reviewConsult.3 weeks30 daysVariableNot requestedUp to 8 weeks LSUp to 2.5 monthsTime frameUp to 2 years2-6 months1 month 3 years1-3 weeksUp to 6 mo, if reviewedUp to 3 monthsRejection Level~50%Not knownVariableNot knownUp to 70% request for review~33% formal review

  • Time frame and uncertainty

    StepFormal reviewVerificationIssuanceRequest for reviewFormal reviewConsultN/AN/A15 daysUp to 1.5 MonthN/ATime FrameUp to 4 Months2-4 MonthsUp to 5 WeeksUp to 2 MonthsUp to 4 MonthsRejection Level26% rejectedNot KnownUp to 75% request for reviewUp to 66% formal reviewNone Yet

  • Project Risks

  • The CER Price StructureEURO 515

  • The Myth of the Carbon Credit

    EUAEuropean Union AllowanceERUEmission Reduction UnitCERCertified Emission ReductionExistenceAllocated by Annex I countries: Real CommodityCreated by JI projectsCreated by CDM projectsOwnershipAAA rated companiesMedium and large scale companiesSmall, medium & large sized companiesCountry- and project riskNo riskMedium riskHigh riskDelivery riskNo riskMedium riskHigh riskPricehighMedium Low

  • Key Price determinants for CDM projectsRisk allocationCreditworthiness & experience of project sponsorViability of underlying projectContract structure (e.g. upfront payments incur discount, penalties for non-delivery, ability to pay penalties)ER vintage & seniorityCost of validation & potential certificationHost country support & willingness to cooperateAdditional environment and social benefits

  • 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

  • Cost of developing a CDM ProjectApart from the project development, implementation cost. The developer has to pay forThe consultant feesRegistration with the Designated National Authority (MOEF)Public hearingValidation fees (to Designated Operational entity)Registration fees at the UNFCCCMonitoring & Verification fees (to third party DOE)CERs Issuance feesContribute to the UNFCCC adaptation fundThen bargain for the price of the CERs with the Buyers

    A picture of Market Failure!!

  • CDM Market in India is Consultant drivenBuyers are there but few and offer low priceBrokers promise good price but reliability record is poorSize of the projects is very small though the quantity is large hampers bargaining capacity of the project developerMost project developers hoard( do not sell) CERs in expectation of higher priceMost projects face problems in implementation.

  • Why CDM is a market failure? (1)Too sophisticated/complex a marketToo expensive to enterThe future beyond 2012 is yet uncertainDoes not survive the Cost Benefit analysisHuge Markets like agriculture untouchedForestry projects are too complexThe project developer doesnt get a fair priceThe ultimate buyer doesnt get a fair price

  • Why CDM is a market failure? (2)Profits go in the pocket of middlemen CDM popular only in developing countries not in Lower developed countriesTechnology transfer which CDM promises already exist with South in some casesLittle initiative by government entities to take up CDM projectsProving additionality is very difficult in most of the casesCarbon exchanges have played limited role till yet

  • 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

  • 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.

  • Market strategy one should adopt (1)Enter as early as possible.project conceptual stageEducate oneself and staff thoroughbefore going to consultantInvite a buyer as a project participant at an early stageAppoint a consultant for CDM PDD writing and handling UNFCCC mattersnote your job is to execute the projectOption of in-house PDD development can also work for youdelegate the job

  • Market strategy one should adopt (2)Sell some CERs in advance and hold some portion for expectation of higher pricedont hold all the CERsCarbon market will stay in some way or the other.the market will correct itself or be get correctedExpect local carbon markets in the future.say in next 7-12 years

  • ConclusionThe market need a major makeupSimplifyActive role from institutions to take up programme of activities CDMEfficient, transparent, carbon exchangesMore information and educationConsidering other than market approach to mitigate climate change