A Kyoto windfall

Investing in hydropower in Guatemalia, geothermal in El Salvador or landfill gas projects in Bangladesh may not seem the obvious way for a European company to meet its new EU-allocated carbon emissions targets – but projects of this sort in the developing world are set to do just that, via emissions trading under the Kyoto Protocol’s Clean Development Mechanism (CDM).

The CDM opens up a potentially enormous market between Europe and the developing world, where heavy polluters in EU member states can invest in emissions reduction projects in developing countries, buying themselves credits that can be used in the EU Emissions Trading Scheme (ETS).

The projects are assessed and awarded certified emissions reductions credits (CERs), which are a valid carbon currency in the EU ETS. Like EU allowances, a CER is worth one metric tonne of CO2 equivalent.

“CERs are another source of supply in the ETS market,” says Garth Edward, head of Shell’s environmental trading desk in London. “Companies that have a compliance requirement under the EU ETS have a choice: to buy compliance instruments or make physical emission reductions. If they decide to buy compliance instruments they have a further choice: to buy EU allowances or to buy CERs.”

The CDM applies to projects in developing (‘non-Annex 1’) countries that have ratified the Kyoto Protocol, such as India, China and Brazil, which do not have targets under the Protocol. Projects in Annex 1 countries, such as Russia, can be linked into the EU ETS by the Joint Implementation (JI) mechanism from 2008, in which both countries must have a reduction commitment under the Kyoto Protocol. The first 2005–2007 phase of the EU ETS however, allows only CDM projects.

The EU Linking Directive, under which CDM and JI operate, has come under fire from environmental groups who fear it will dampen progress on emissions reduction in Europe.

But Alexander de Roo, former member of the European Parliament and rapporteur of the Linking Directive, believes the problem of emissions reduction should be viewed globally.

“The Linking Directive will reduce emissions in developing countries who won’t sign up to Kyoto,” he said at a recent conference in London. Moreover, the developing world is where most focus should be, as its emissions are rising the most rapidly.

“It will stimulate competition between governments and companies for CDM projects. It offers enormous possibilities,” he says.

So far the CDM market is embryonic. A CDM executive board has been set up to approve the projects and lay the building blocks of regulatory approval.

Identifying and registering a project is a highly complex and time-consuming process comprising up to 15 different stages, and, at the end of 2004, only one project had made it through to final registration.

A project’s initial design document is typically 60–100 pages long and has to prove that the project will result in overall carbon emissions reductions compared with a ‘business-as-usual’ scenario.

The project needs to meet the criteria of ‘additionality’ – emissions reductions achieved by the project must be additional to any that might occur in the absence of the project activity, says Greg Dunne, director of Icecap, a London-based specialist purchaser of CERs that sources projects in the developing world.“The carbon finance coming from the developed world should make a material difference to the project,” he says.

For a project to be accepted, the United Nations must first approve its methodology. So far, fewer than 20 methodologies have been approved, but around 70 are expected to be approved in 2005, which should speed through a lot more projects, experts say.

So the market in CERs to date is a forward market, with first CER delivery taking place some time in 2005. A typical transaction would yield around 200,000 CERs, says Steve Drummond, managing director of CO2e.com, a unit of Cantor Fitzgerald based in London. “A project can consist of several transactions. It’s hard to sell anything less than 50,000 CERs,” he says.

CO2e is one of the leading brokers in greenhouse gas credits, and brokered the first public purchase of CDM CERs by a European company in October 2004, under which a seven-figure volume of CERs was bundled together from three sugarcane waste-fired electricity generators in Brazil and sold to a European company. The deal was facilitated by Brazilian advisory firm Ecoinvest.

Another recent transaction brokered by CO2e under the CDM involved capturing and combusting the methane in pig manure at a large Chilean pork producer. The CERs awarded to this project were sold to Canadian power company TransAlta and Japanese electricity firm Tepco.

Shell is also involved in the CDM market.

“Shell has wind, solar, energy efficiency and a developing hydrogen business,” Edward says. “In the developing world these are eligible as CDM projects,” he says.

As the CDM market is entirely over-the-counter rather than exchange-traded, there is little transparency. And with so many projects potentially eligible, keeping track of them all will be a difficult job. But the information will be highly sought after, as CERs are a supply fundamental in the EU ETS.

A registry of CERs is being built for implementation in 2005, which will aid the market’s development, says Icecap’s Dunne. But eventually there is likely to be a need for independent data providers to track projects and prices.

A company’s decision whether or not to enter the CDM market will depend on many things, including appetite for risk, but there are several reasons the market may appeal, experts say.

“Companies in the EU emissions trading scheme will find CDMs attractive for two reasons,” says Dirk Forrister, managing director of Natsource Europe, an environmental brokerage and asset management firm in London that is active in developing a greenhouse gas buyers’ pool to purchase emissions credits. “First, the prices are lower than EU allowance prices. This reflects the greater complexity and risks of CDM projects, along with the degree of riskmitigation in each individual transaction structure.”

CERs typically cost between E3 to E5.50, compared with a current EU allowance price of E8 to E9.

“Second, CDM credits can be used any time between 2005 and 2012, unlike EU allowances, which cannot be carried over from phase to phase,” Forrister says. “Because companies’ emissions will vary each year, having a supply of CERs will give companies much better flexibility to deal with compliance needs that may arise over the long term,” he says.

At the end of the first 2005–2007 session of the EU ETS, companies must surrender all their credits, and will be issued with a new allocation for the second 2008–2012 phase.

Another advantage of CERs is that they are available in larger volumes than European allowances, says CO2e’s Drummond. The market is also likely to be stimulated by demand from governments, he says.

As the EU ETS covers only around 40% of emissions produced in Europe, governments will have reduction responsibilities as well, so some EU states will be in the market for EU allowances or CERs.

And, so that the market doesn’t become flooded with cheap CERs that could effectively curtail physical abatement in Europe, there is likely to be a limit put on projects. This will be assessed in 2006. De Roo says a limit of 50 % investment at home and 50% abroad is likely to be imposed.

For companies who decide that entering the CDM market could be for them but do not want to deal with the bureaucracy involved, a whole new market is opening up offering facilities in this area and bringing buyers and sellers together.

“Some of the very biggest sellers of CERs might be visible, but many won’t be,” says Icecap’s Dunne. “Similarly, if you’re a biomass producer on the Argentine plains, are you going to know about the CDM? Probably not,” he says. “A lot of companies will have carbon assets and won’t know what to do with them.”

As well as brokers such as CO2e and Evolution Markets, there are also intermediary firms such as MGM International and Ecoinvest in Brazil, and Ernst & Young and PricewaterhouseCoopers in India, who source or develop projects and then sell CERs in Europe, Japan and elsewhere.

There are also specialist purchasers of CERs such as Icecap and the World Bank who invest, bilaterally or via carbon funds, in cleaner energy projects and can buy and sell CERs.

In December the World Bank facilitated several ‘firsts’ in CDM trading, including buying CERs from a project in China where coalmine methane will be captured and used for power generation; buying CERs from a hydropower project in Peru on behalf of the Dutch government; and buying CERs from a wind farm in the Philippines and a landfill gas recovery project in Argentina.

“I think this is an area that will really open up in future,” Dunne says. “I would expect more financial institutions to enter the market and start trading CERs.”

Once a company has decided that it wants CDMs in its carbon portfolio, it then needs to assess the overall risks, and specialist companies are also growing up to advise on this.

Natsource Europe has a computerised risk assessment model that assesses the range of risks of a particular project, such as counter party, country, regulatory, technical and baseline risks, but it also looks at the risks of the overall portfolio.

“Our computer model assesses these risks in a bundle, so we can guide and advise our contacts and make sure their portfolios are truly diverse,” Forrister says. A portfolio containing several different types of energy projects in different countries may look extremely diversified, but the projects could all hinge on the same fundamentals. A particularly dry year, for example, could negatively affect lots of different projects.

The presence of the CDM market also opens up opportunities in financial engineering, such as allowing companies to sell coal with emissions credits tagged to it, thereby assisting big buyers of coal such as electricity generators who are already constrained by emissions caps. This way the burden of emissions constraints is spread throughout the supply chain.

For the time being, until more projects are approved, it’s difficult to predict how liquid the CDM market will become, but its presence is certainly likely to add to liquidity in the EU ETS market, and it could eventually facilitate truly global emissions trading.