CDM Projects: The Financial Perspective

CDM Projects: The Financial Perspective December, 2010 United Nations

Topic The big picture Why bother with financial analysis? Conducting financial analysis A practical example Carbon Markets

Not all carbon projects are born equal…

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 N2O Wind Solar HFCs Hydro Biogas Transport Landfill gas Reforestation Energy efficiency(power) Energy efficiency(households) Fugitive emissions

Carbon revenues also vary on a project-by-project basis 7,934 Standard deviation(kCERs by 2012) Markers indicate maximum, mean and minimum project size within each technology 1,811 4,128 3,039 1,711 928 543 661 1,228 1,101 379 827 330 1,179 762 0 234 0 13 0 91 Tidal Wind Solar PFCs Hydro Biogas Cement Fugitive Transport Agriculture Landfill gas Geothermal EE industry Reforestation EE supply side EE households Biomass energy Fossil fuel switch EE service sector Coal mine methane Energy distribution

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

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

Contradictoryrevenue streams Complementary revenue streams 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

So, to summarize…. • 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

Three uses for financial analysis… 1 Is the project going to make money?

Pre-RegistrationCDM Costs Post-RegistrationCDM Costs 53,000 US$ 164,500 34,000 111,500 OngoingVerificationByDOE 10,000 77,500 16,500 67,500 InitialMonitoring 38,000 51,000 Validation Ongoing Annual Monitoring 13,000 PDD PIN A CDM project costs money. Is it worth the effort? Indicative CDM Cost Profile For A ‘Typical’ CDM Project Assumes a 10-year project. Recurrent costs discounted at 3% annual rate to express in present-value terms. Registration costs, Administration Fee and Adaptation Fund Levy not included.

Three uses for financial analysis… 1 Is the project going to make money? 2 Demonstrating additionality

Carbon revenue makes the project worthwhile Break-even point Revenue / NPV / IRR Project without carbon revenue is unprofitable Project without carbon element Project with carbon element Demonstrating additionality – investment comparison analysis Choose an appropriate financial indicator, such as IRR, NPV or benefit-cost ratio, to demonstrate additionality

Carbon revenue makes the project attractive relative to investment alternatives Investmentthreshold Revenue / NPV / IRR Project without carbon revenue is profitable – but not sufficiently profitable compared with alternatives Project without carbon element Project with carbon element 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

Three uses for financial analysis… 1 Is the project going to make money? 2 Demonstrating additionality 3 Structuring the project

Revenue flows determine more than just profits… 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 Future carbon revenue flows can be used as collateral for obtaining loans from financial institutions The distribution of carbon revenues in time determines how frequently the project should be verified

Investment appraisal techniques • Payback period • Net present value (NPV) • Internal rate of return (IRR) • Benefit-cost ratio (BCR)

The IRR uplift typically provided by carbon revenues Impact of CER Revenue on the Internal Rate of Return of CDM Projects

Animal waste management =

Revenue Opportunity Credits for reduced CH4 emissions; utilize captured CH4 for energy generation (and further carbon crediting) • Method • 2 potential approaches: • Modify animal feed intake • Capture CH4 emissions Covered Lagoon Complete Mix Digester Animal waste management Theory Methane is produced as part of the normal digestive process in animals (‘enteric fermentation’). The CH4 is exhaled or eructated by the animal.

Methane flaring from a swine farm: costs and revenues

Calculating the Net Present Value CER Only (NPV) (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

Electricity generation without carbon revenues from the CDM 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

Both electricity generation & CER component (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 the most financial sense to add an electricity generation component to the project

Carbon Market • The Carbon Market refers the market-based approach of controlling pollution by providing economic incentives for achieving reductions in the emissions of pollutants • A central authority (usually a governmental body) sets a limit or cap on the amount of a pollutant that can be emitted under a Cap & Trade Scheme or Carbon Tax System. • The limit or cap is allocated to firms in the form of emissions permits/Carbon Credits which are CFI’S (carbon financial instruments) and represent the right to emit or discharge a specific volume of the specified pollutant.

Carbon Market • Under a Cap & Trade Scheme • At a price set by the respective market place, firms can purchase the required Carbon Credits to meet the level of emissions they emit. • Subsequently firms can sell excess Carbon Credits that they hold over & above their capped emission levels • Under a Carbon Tax System • Firms pay a government the set price for Carbon Credits if they exceed their emission levels • Tax benefits can be obtained by firms that have emissions lower than their allowed limits

Carbon Market • Mandatory Carbon Market • The European Union Emissions Trading Scheme (EU ETS). Is the largest multi-national legal binding emissions trading scheme in the world • The Voluntary Carbon Market • In this market there are no caps or legal binding responsibilities to fulfill as there are in the mandatory compliance market. • This market usually involves buyers such as companies, individuals or organizations seeking to offset emissions for ethical reasons, branding or Public Relations.

Tradable CFI’s (Carbon Financial Instruments) • Carbon Financial Instruments • EUAs - European Emission Allowances; • CERs - Certified Emission Reduction Credits; • VERs - Voluntary Emissions (country specific);

Carbon Exchanges • Europe • European Climate Exchange • OMX Nordic Exchange • EEX – European Energy Exchange (Eurex) • EXAA – Energy Exchange Austria • Bluenext – (formerly Powernext) (NYSE Euronext and Caisse des Depots) • Climex (Amsterdam) • Climate Spot Exchange (London) • North America • CCX – Chicago Climate Exchange • The Green Exchange (NYMEX) • CCE – Canadian Climate Exchange (Winnipeg Commodities Exchange) • MCeX – Montreal Climate Exchange • Toronto Stock Exchange

Carbon Exchanges • Asia • MCX – Multi Commodity Exchange of India • HKEx – Honk Kong Stock Exchange • ACX – Asia Carbon Exchange (Singapore) • Beijing and UNDP Exchange • Tokyo Stock Exchange Group and the Tokyo Commodity Exchange • Australia • Australian Climate Exchange

Regulatory Frameworks

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CDM Projects: The Financial Perspective