Discussion Forum

January 2003 Number 4

Monetizing Carbon Credits

Washington-area professionals gathered at IRGs Washington, DC, headquarters in January for the fourth session of the IRG Discussion Forum, Monetizing Carbon Credits. Kenneth Newcombe, fund manager of the Prototype Carbon Fund, Richard Rosenzweig, managing director of NatSource, and Matthew Mendis, IRG vice president, addressed attendees and participated in a discussion on the topic. Henri-Claude Bailly, chairman of the IRG Advisory Board, moderated the session.

developed nations can negotiate with the host developing country for a portion of the resulting emission reductions created by the project. The revenue generated from such mechanisms is intended to provide an incremental increase in a projects cash flow, thereby enabling marginal projectsfor example, renewable energy or energy efficiency projects that are often more costly than conventional fossil fuel projects.

Market-based mechanisms for trading emissions have become a popular approach to abating pollution. The Kyoto Protocol, created as part of the UN Framework Convention on Climate Change, establishes a system for global trading of the six primary greenhouse gases that cause climate change. Originating primarily from energy generation, waste, and agricultural practices, greenhouse gas emissions are dominated by carbon dioxide and methane. The principle means of reducing these emissions is through the use of low- or no-carbonemitting technologies, such as renewable energy (wind, biomass, solar), the reduction of fugitive methane, or the sequestration of carbon in soil or geological formations. The Kyoto Protocol establishes commitments from developed nations to reduce their greenhouse gas emissions, and it set up three flexible mechanisms that can be used to help developed nations meet their reduction targets. The Clean Development Mechanism (CDM, Article 12 of the Kyoto Protocol) is one of the systems established to provide a framework for developed nations to reduce their emissions through the transfer of environmentally sustainable technologies, capital, and services in specific, approved projects. In exchange, Richard Rosenzweig, HenriClaude Bailly, Kenneth Newcombe, and Matthew Mendis (from left) spoke at the fourth session of the IRG Discussion Forum, Monetizing Carbon Credits.

Kyoto Programs
In anticipation of the Kyoto Protocols coming into force, several funds have been established as risk management tools for countries that wish to jumpstart the carbon market. The most notable of these is the World Banks Prototype Carbon Fund (PCF). Created to pioneer Kyoto-based rules, the PCF is moving toward a role as catalyzer of private sector investment in carbon trade. Based on the PCFs success, the World Bank has expanded its carbon business by buying for the Dutch government and others, and is marketing two new fundsthe BioCarbon Fund and the Community Development Carbon Fundto ensure that the CDM benefits smaller, poorer countries and rural communities. The World Banks carbon finance business expects to have $150 million in projects booked by the summer of 2003, with $300 million more in the pipeline. The voluntary efforts of participating companies and countries have created a market for carbon trades, which are often transacted through brokerage firms or existing CDM funds. Along with the World Bank, the energy and environmental broker Natsource has noted a marked increase in trading recently, with 2002 exchanges of 6070 million metric tons (tonnes) accounting for a third of the total from 1996 through 2002 (200 million tonnes).

INTERNATIONAL RESOURCES GROUP

Although the Kyoto Protocol has been ratified by countries producing 44 percent of developed-country emissions, to come into force, it must be ratified by countries c that represent 55 percent of 1990 emissions. This threshold would be met if the protocol is ratified by Russia, which has indicated that it will do so in 2003.
Three significant issues have been confronted in the short history of the carbon trade.
!

What counts as compliance or as a real carbon credit? There are three flexibility mechanisms in the Kyoto Protocol, each resulting in different types of carbon emissions reductions, or commodities. In addition, several countries and regions are establishing their own trading systems, which do not yet recognize other tradable units for compliance. This will result in different markets until the systems converge under the Kyoto Protocol. Projects lag, on average, five years from pre-feasibility study to the first certification of emission reductions after a year of operations. This creates several problems. First, risk is higher and overall investment lower due to the downturn in the global economy, resulting in fewer direct, bilateral, private-sector deals and, to date, only 16-percent private-sector direct carbon purchase in the CDM. Second, investors are focused on 2012the end of the Kyoto Protocols first commitment periodso they heavily discount credits earned beyond 2012 since there is no agreement on the value of such CDM credits in the second commitment period. Third, as time passes there are fewer credits to be earned before 2012, decreasing the value of carbon to renewable energy project finance. Small projects must have commercial value. Despite streamlined procedures for approving small-scale

renewable energy and energy efficiency projects, currently the revenue resulting from monetized carbon credits only significantly benefits projects that are already near financial viability. Hence, smaller projects in risky business environments are difficult and need special assistance with grant resources, intermediation, and capacity building to get done.

Other Programs
!

Denmark and the United Kingdom are the only countries with trading programs in place. The Danish pilot system will end in 2003. The European Union is in the process of developing a continent-wide system designed to come into force in 2005. Canada, Japan, and Norway each have carbontrading plans under development. Several state and provincial emission reduction programs exist, including systems in Alberta, California, Massachusetts, New Hampshire, and Oregon. Several US firms have begun voluntary efforts to reduce their emissions to a specified target.

Profitability
What is carbon trading worth? For projects that may be Kyoto-compliant under the CDM, reductions of carbon dioxide equivalents (CO2e)

Richard Rosenzweig, managing director of NatSource, provides consulting services to private firms, governments, and international financial institutions on climate change. From 1993 to 1996, he was chief of staff to the secretary of the U.S. Department of Energy, where he was responsible for developing and coordinating strategy in global climate change and other areas. Kenneth Newcombe is the fund manager of the Prototype Carbon Fund, launched by the World Bank to ensure that poor countries can benefit from international responses to climate change and to pioneer the market for project-based emission reductions. Dr. Newcombe has also served as a research scientist at the Australian National University and general manager of the Papua New Guinea power utility, and he helped to establish the Energy Planning Administration in Papua New Guinea. Matthew Mendis, corporate vice president and managing director of energy and environmental management at IRG, is internationally recognized for promoting the development, financing, and implementation of alternative energy and greenhouse gas mitigation projects in developing countries. He advises the World Bank, Asian Development Bank, UN Development Programme, USAID, and other bilateral development agencies on climate change policy.

INTERNATIONAL RESOURCES GROUP

trade at $3$5 per tonne. Under other projects or special programs or funds, CO2e may trade from $1 to $10 per tonne or higher. Many of these emission reductions come from projects that displace energy from coal or other fossil fuels, which, as a rule-of-thumb, result in reductions averaging 1 kilogram per kilowatt-hour. At $4 per tonne of CO2e, this yields an additional 0.4 cents per kilowatthouror, for most projects, a 13 percent increase to their internal rate of return. The most cost effective abatement opportunities are those that capture methane and use it to generate energy. Methane has a global warming potential that is 23 times greater than CO2resulting in a much higher value per abated ton. Capturing fugitive methane from landfills or gas pipelines directly reduces emissions into the atmosphere, and harnessing the methane for energy then displaces emissions that might otherwise may have resulted from coal combustion. Thus, for methane projects, the internal rate of return can be increased by 515 percent. Unlike most avenues for reducing pollution, trading emissions capitalizes on market-driven mechanisms that are attractive to businesses and entrepreneurs. However, unless carbon credits originate from high-yield projects such as methane abatement, the impact on the bottom line may not be sufficient to overcome significant financial shortfalls. But credits do provide a guaranteed cash flow to projects, whicheven at low levelsmay be sufficient to reduce perceived risk and enable project loans.

Emission Trading and the Environment

Emission trading can dramatically reduce the cost of reaching environmental objectives. Environmental laws or agreements generally set a limit on the amount of emissions a source is allowed to emit. Should that source achieve reductions below its regulated level, it may trade those reductions to entities that exceed their limits. Entities who can achieve reductions at less than market price will realize additional revenue, while companies that can only achieve reductions above market price will have a lower-cost option to meet their regulatory requirements. The provisions incorporated into the 1990 clean air act amendments requiring reductions of precursors of acid deposition Environmental Protection Agency's acid rain program in the 1990 U.S. Federal Clean Air Act is a successful example of a trading program.

Forum Feedback
!

The capacity of governments is the biggest constraint to project success. Often, required reductions don't fit into the client's design criteria, or environmental or social issues interfere with the deal. On the demand side reductions cost less than on the supply side, but transaction costs are also higher. Demand-led projects are rare in the developed world because ownership is indirect. Markets, countries, technology, production, and risks are the predominant factors in salvaging CO2. There may be an opportunity for increasing CO2 gains through increased use of wood in building projects. The BioCarbon Fund hopes to look into production projects like these in the future. Is the World Bank crowding out the private sector? Or is it taking risks the private sector wouldn't by building capacity while a commercial market develops? Requirements call for 6080 percent reductions in emissions during 20302100. Compared to what will be needed, current investment is meager.

For More Information...

World Bank carbon finance programs: www.carbonfinance.org Prototype Carbon Fund: www.prototypecarbonfund.org UN Framework Convention on Climate Change: www.unfccc.org International Emissions Trading Association: www.ieta.org Natsource: www.natsource.com Chicago Climate Exchange: www.chicagoclimatex.com
! ! !

INTERNATIONAL RESOURCES GROUP

About the IRG Discussion Forum

The IRG Discussion Forum is a monthly roundtable for the Washington-area policy community. Building on the Central Asia Speaker Series held at IRG in spring 2002, the Discussion Forum focuses on public and private sector issues affecting international developmentagriculture, energy, sustainability. Each session is informal, and off the record; guest speakers and attendees are participating in a personal capacity. With the Discussion Forum, IRG hopes to foster an environment for sharing experiences, exchanging ideas, and creating new approaches to development. Henri-Claude Bailly, chairman of the IRG Advisory Board and senior advisor to the president, moderates the IRG Discussion Forum. Mr. Bailly is the former chairman and CEO of Hagler Bailly, an international management and consulting firm to the energy and utility industries. He is a director of the Alliance to Save Energy and a member of the Advisory Council of the Energy Future Coalition.

Schedule
Thursday, January 23 Thursday, March 20 Monetizing Carbon Credits Business-Driven Sustainable Development

For more information, email discussionforum@irgltd.com or call International Resources Group at 202-289-0100.

International Resources Group (IRG) is an international professional services firm headquartered in Washington, DC, that provides practical solutions to complex problems for public and private sector clients worldwide. Since 1978, IRG has completed more than 600 contracts in 120 countries. Our state-of-the-art services help governments, institutions, and communities understand and better manage resources, address emergencies, and capitalize on new opportunities. IRGs professional staff includes world-renowned specialists who have pioneered analytical techniques employed in their fields. Our ability to provide management, economic, and technical advice is enhanced by the diversity, cross-cultural experience, foreign language skills, and management capabilities of these experts, working from 20 offices around the world.

INTERNATIONAL RESOURCES GROUP

1211 CONNECTICUT AVENUE, NW ! SUITE 700 ! WASHINGTON, DC 20036 ! UNITED STATES TEL: 202-289-0100 ! FAX: 202-289-7601 ! WEB: WWW.IRGLTD.COM