Using Kyoto mechanisms for funding oil and gas sector projects

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NOT AN OFFICIAL UNCTAD RECORD
Using Kyoto mechanisms for funding oil and gas
sector projects Lamon Rutten, Chief, Finance and
Energy United Nations Conference on Trade and
Development (UNCTAD)
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Overview
The Kyoto Protocols Clean Development Mechanism
(CDM) How to generate Certified Emission
Reductions (CERs) What are CERs worth? Using CERs
to leverage access to finance Concluding remarks
NOTE RATIFICATION OF THE KYOTO PROTOCOL WILL
INFLUENCE CER PRICING, BUT EVEN WITHOUT
RATIFICATION, THERE IS A MARKET FOR CERs
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The Kyoto Protocol and CDM The Kyoto Protocol,
once ratified, commits developed country
signatories to reduce greenhouse gas emissions by
5.2 (compared to their 1990 levels) by
2008-2012. Article 12 of the Protocol allows
developed countries and countries with economies
in transition, so-called Annex I countries, to
meet their greenhouse gas reduction commitments
by engaging in what is called Clean Development
Mechanism (CDM) projects. Annex I countries
receive certified emission reduction (CERs)
credits for investing in projects that result in
additional reductions in the emission of
greenhouse gases in developing countries. For
this, the reductions must be approved and
certified.
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As of 15 April 2004, countries representing 44.2
of Annex I emissions had ratified the Kyoto
Protocol. Russian ratification would bring the
Kyoto Protocol into force. But Russia continues
dithering... But even if the Kyoto Protocol is
not ratified, a new EU Directive on Greenhouse
Gases Emission Trading will also provide for
international trading in CERs. Moreover, a number
of NGOs and corporates are buying CERs on a
voluntary basis, and there are also a number of
government and investors programmes in place. So
in any case, the market will be there, even
though prices are far from certain.
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The greenhouse gases covered by the Kyoto
Protocol
The market is largest for CO2. But there are
also markets for the other greenhouse gases.
Payments are a function of the contribution of
the gas to the greenhouse effect. E.g., for each
ton of methane emissions reduction, the price
would be 21 times as high as that for the
reduction of CO2 emissions.
CO2 carbon dioxide CH4 methane N2O nitrous
oxide HFCs hydrofluorocarbons PFCs
perfluorocarbons SF6 sulphur hexafluoride
Emission measures are commonly expressed as  CO2
equivalent .
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Eligible sectors
E.g., reducing gas flaring making energy
generation more efficient reducing emissions in
energy generation improving transport.
Energy Industrial processes Solvent
use Waste Land-use change, and forestry
Improving efficiency of energy use reduce
emissions from industrial production.
Improving agricultural techniques (e.g., less
fertilizer), reducing emissions (e.g., different
irrigation techniques for rice production).
Better handling of waste water improve
efficiency of waste incarneration.
Afforestation and reforestation (e.g., new timber
plantations) selective harvesting
In practice, many of these possibilities have not
yet been tested.
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For a further discussion on the Clean Development
Mechanism, see UNCTAD, 2000.
http//r0.unctad.org/ghg/publications
/cdm-report.pdf
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And on the implementation mechanisms, UNCTAD,
20003
http//r0.unctad.org/ghg/sitecurrent/download_c/pu
blications.html
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How to generate Certified Emission Reductions
(CERs)
The obligations under the Kyoto Protocol are
obligations of countries. Governments
 repackage  these obligations, e.g. in
developed countries by forcing specific emission
limits onto individual companies. If these
companies produce less emissions than they are
allowed to, they can sell the difference (if they
produce more, they pay fines). Also, companies
in both developed and developing countries can
develop  autonomous  projects that reduce
emissions, or that sequestrate greenhouse gases
if they meet the requirements of a specific
procedure, they then get CERs.
CERs resulting from CDM investment become assets
that can be traded in emerging carbon markets.
But whether CERs (or unused emission permits) can
be sold outside of the country is a sovereign
decision states retain the rights for
international trade.
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• In principle, there are good possibilities in the
  oil and gas sector. E.g.,
• reduce gas flaring (in different ways
  re-injection, more efficient flaring, using the
  gas for local or international markets)
• replace a fuel by a cleaner one
• improve energy efficiency in the oil and gas
  sector (including in transport)
• reduce emissions (e.g., of sulphur in
  refineries)
• Both direct contributions (e.g., using gas
  instead of coal) and indirect ones (bringing the
  gas to a place where it will be used to replace a
  dirtier fuel) could generate CERs.

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An African gas project that generated carbon
credits
The AMPCO methanol project, Equatorial Guinea
Noble
CMS
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Guarantee of payment of interest on the notes
Private placements in two US 125 million issues
Institutional investors
AMCCO
90 of equity (US 244.4 million)
US 200 million political risk insurance
Government of Equatorial Guinea
OPIC
US 173 million loan
10 of equity (valued at US 27 million)
Raytheon
AMPCO
US 322.5 million turnkey contract
20-year contract for supply of gas
Alba field operators
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The US Initiative on Joint Implementation
(USIJI), which administers the U.S. Government's
process for reviewing and accepting carbon
dioxide emissions reductions, has determined that
the AMPCO project will lead to a reduction of a
total of 71.27 million metric tons of carbon
dioxide equivalent during the project's 25-year
life span
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In its projects, the World Bank has found
significant improvements in internal rate of
return when including CER sales
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Procedure to get CERs
The project design originates from the host
country, and could be in cooperation with some
other entity. Feasibility studies based on the
project's potential and local conditions should
be assessed as well as receiving approval from
the host government. Validation by the
operational entity can take place where the
operational entity resides. Operational entities
can be located anywhere as long as they qualify.
The operational entity passes the validation
report on to the Executive Board of the CDM for
registration. The project participants monitor
the project according to the approved monitoring
plan, which is approved in the validation and
registration stages. The operational entity
reviews and audits, including on-site visits, to
verify the GHG reductions. The operational entity
then delivers a report to the Executive Board of
the CDM certifying the reduction. Based on the
certification report, the Executive Board will
issue the CERs.
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Some operational bottlenecks Determining the
size of the emission reductions. Reductions are
measured as the difference between emissions with
the project, and a baseline of emissions. The
baseline can be difficult to establish. This
quantification must be clear, conservative, and
based on sound science. Then, this number is
reduced by a certain percentage to account for
uncertainties. Proving additionality. Article
12 of the Kyoto Protocol provides that, in order
to be creditable, emissions reductions must be
additional to any that would occur in the
absence of the certified project activity. It
was agreed that the CDM authorities implementing
this provision should not adopt any rigid test of
additionality, and thus, additionality should not
mean that the project would not be undertaken
without the CER payments. However,
additionality criteria have become more
stringent, and this part of the process is in
flux.
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Implementation can be difficult, time-consuming
and costly
A major problem the high costs of the
procedures. For large energy projects, these can
approach a million . For smaller projects,
there are simpler rules but even then, the
average cost that the World Bank has had were, as
of mid-2003, US 250,000 per project (a
transaction cost of some 7). Part of the reason
for the high costs limited capacity in
developing countries, and ill-prepared
governments. But certain investors (e.g., the
World Bank) are willing to cover these costs, to
be reimbursed only if the project is successful,
through part of the CERs generated in the
project.
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• Transaction Cost Estimates (source
  EcoSecurities), (US )
• A) Up-front (pre-operational) Costs
• ER Feasibility Assessment 12,000 - 20,000
• Monitoring Verification Plan 5,000 - 20,000
• Registration 10,000
• Validation 10,000 -15,000
• Legal Work 20,000 25,000
• Total Up-front Costs 57,000 90,000
• B) Operational Phase Costs
• Sale of CERs Success fee in region of 5 -10 of
  CER value. Higher for a small project than a
  large project.
• Risk Mitigation 1-3 of CER value yearly.
  Mitigation against loss of incremental ER value
  as a consequence of project risk.
• Monitoring and Verification 3,000 15,000 per
  year

See UNCTAD 2003 (rubber)
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How much are CERs worth?
Current market prices are volatile and depend to
a considerable extent on the quality of the
certificates. Markets are segmented. 2002
prices per ton of CO2 - Dutch tenders (to buy
from developing countries) 4.5-4.6 per ton -
UK spot trading 7-9 per ton - Prototype Carbon
Fund buys at 3-4 per ton, sells to investors
for 5.5 per ton.
US per ton of CO2
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Why arent CERs worth more? In the EU, an
internal price of US 15 per ton of CO2 is
expected. Companies have to pay 40 per ton in
fines if they exceed their quota (and after 2007,
this will be US 100 per ton). In Japan, the
costs of reducing emissions can be as much as 100
US a ton. So, youd expect firms to scramble to
buy CERs, driving up prices to worldwide
equilibrium levels. But this is not happening,
nor will it happen soon. The reason market
distortions. Markets will remain segmented
Western governments allow only limited purchases
of CERs outside of the country.
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How are prices for CERs determined? The market
is still very segmented, and fungibility of CERs
is limited. Efforts are underway to create
trading platforms e.g., the Chicago Climate
Exchange is starting this month to trade
(auction)CERs, mostly targeting voluntary
purchases by US companies, municipalities etc.
But most of the trade is bilateral with only a
limited part passing through brokers. Its
Governments that determine where CERs can come
from and decisions can be politically-driven.
Thus, there are many segmented markets. Moreover,
NGOs and corporates are often willing to pay more
for CERs that come from attractive projects.
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• Major buyers are
• international public/private funds (World Banks
  Prototype Carbon Fund, Community Development
  Carbon Fund,  BioCarbon Fund, Netherlands Clean
  Development Facility)
• Private investment funds )- e.g., a 200 mln
  fund managed by Natsource.
• NGOs (to take them off the market)
• Corporates who want to  warehouse  CERs for
  future use. ( banking )

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Using CERs to leverage access to finance
When CERs are sold to an investor, this is
generally under a 7- or 10-year contract. This
contract sets out the price to be paid, and the
quantity to be bought. Normally, payment is only
on delivery. However, such contracts are a good
underlying for financings backed by the 7- or
10-year receivables. This can take the form of
prepayments (the financier prepays the CERs to be
delivered, and sells them on to the investor) or
pre-finance (the contract is assigned, and
payments are made through an escrow account).
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Standard mechanism
Agreement with host government
Host government
Investor
Under Kyoto Protocol, contracts are for 7 (with 2
possible renewals) or 10 years (no renewal).
Sales contract for CERs sponsor has to deliver
certified CERs
Project sponsor
Fînanciers
Financing agreement
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In principle, the investor could make a
prepayment for the CERs to be produced over the
time of the contract. However, major investors
such as the World Bank currently dont like these
risks, and do not pay CERs before actual delivery
(they already take the risk that CERs are not
accepted by the Executive Board of the CDM and
feel this is enough). Structured finance banks
should feel more comfortable with a prepayment
arrangement - or a secured pre-financeand it can
represent 5-15 of the total investment in a
project.
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One structured finance mechanism
Agreement with host government
Host government
Investor
Payment
Escrow account
Sales contract for CERs
Assignment
Project sponsor
Financiers
Financing agreement
Reimbursement
Assignment of titles, rights etc.
Project
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Note that CERs are paid in hard currency, which
could allow an investor hard currency revenue for
a project that otherwise would generate only
local currency. CERs could also be used to pay
suppliers - e.g., an equipment supplier, who
would use the CERs to meet his own CO2 reduction
obligations. Again, this could be a way to
overcome hard currency problems.
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Mitigating the risks in the structured finance
mechanism
Agreement with host government
Host government
Investor
Assignment (step-in rights)
Political risk insurance
Agreement with national government
Insurance company
Project sponsor
Due diligence insistence on consultation
procedures legal opinions
Political risk insurance (non-ratification Kyoto
Protocol)
Insurance company
Project
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Mitigating the risks in the structured finance
mechanism

• This agreement will set out the commitments of
  the host governments towards the project sponsor.
  This is similar to the undertakings governments
  give for, say, a power project. It will
• specify when the project sponsor is entitled to
  receive the CERs
• allocate some of the risks e.g., what if
  because of government intervention, the project
  does not meet its emission reduction targets?
• when will measurement start?
• what if there is a technical problem in the
  measurement process?
• how is force majeure defined?
• what if the Kyoto Protocol does not come into
  force?

Host government
Agreement with national government
Project sponsor
Project
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The securitization mechanism
Hedge counterparty
Special Purpose Vehicle
Futures, options, swaps
Buyers
Sale of CERs on market
Sale of notes
Buyers of notes
Financing agreements
Sales contracts for CERs
Possibility of risk tranches
Project sponsors
This type of aggregation may be crucial for some
countries
Assignment of titles, rights etc.
Projects
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See for a discussion on how CERs can help project
finance, and the risks involved, UNCTAD 2003
http//r0.unctad.org/ghg/sitecurrent/download_c/pu
blications.html
Structuring and Contracting CDM Transactions
Structuring Transactions 1. Upfront Payment
for Future Stream of CERs 2. Forward Contract
for Delivery of CERs at Fixed Prices 3. Forward
Contract for Delivery of CERs at Floating Prices
4. Option Payment for Future Delivery of CERs
5. Spot Market Issues around Contracting
Transactions Delivery Risk Timing Risk
Counter-Party Credit Risk Country Risk
Currency Risk
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One risk future CERs do not have the same
legal status as current ones. Once the CERs
have been actually generated and certified, they
are irrevocably valid, protecting the buyer and
freeing the seller from any liabilityr. The
stream of possible future CERs would be
non-certified. But after the project has been
registered with the CDM authority, the future
CERs would be sellable as promissory notes in
the forward/futures/options market, with a market
discount based on the risks that anticipated
future credits would not be earned and certified.
These promissory notes will only become CERs if
the emission reduction is indeed delivered.
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Concluding remarks

• The possibility of getting CERs may well
  influence the choice of optimal technology
  (e.g., for energy generation)
• CERs can have a considerable positive impact on
  project economics
• There are many (possible) projects in the African
  energy sector which lead to reduced greenhouse
  gas emissions
• But to translate this into CERs which can
  generate finance is difficult
• Once a project has started, its too late to try
  to be paid for any resulting CO2 reduction (there
  is no additionality). So, the earlier one
  starts looking at CER possibilities, the better.

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For more information http//www.unctad.org/ghg