ESRI International Collaboration Projects 2005

Contribution of Government Support for

Developing CDM Projects with Social Benefits

February 2006

Nomura Research Institute

Executive Summary

According to the Kyoto Protocol that came into effect in February 2005, Japan has the burden of reducing its CO2 emissions by 6% compared to its emission level in 1990, and by 14% compared to its level in 2004. However, it is believed that Japan cannot reduce this gap of CO2 emissions by implementing only domestic measures. This means that Japan must cooperate with Non-Annex I countries, Russia, and other nations.

Existing CDM/JI projects now appear disproportional in terms of particular

categories. The present situation of CDM/JI feasibility studies funded by the Japanese government also reflects such a situation. Those feasibility studies are limited to only a few selected sectors. This is partly due to the Global Warming Potential (GWP) values. The GWP values indicate the rates for converting the amount of GHG (greenhouse gas) to its CO2 equivalent in terms of greenhouse effect. It is absolutely necessary to use GWP values since they reflect the harm and benefits brought about by reducing the emissions of harmful gases. However, these conversion rates only reflect the greenhouse effect and do not consider other factors that affect other social benefits, such as an improved standard of life in urban areas, a stabilized supply of electricity, and technology transfer. This is the basic problem facing implementation of the Kyoto Protocol.

Even if there are external benefits in potential CDM projects, such benefits are

not precisely evaluated. Under the Kyoto Protocol, the implementation of projects is based on profitability. Since projects offering external benefits are good for the host country from the standpoint of social benefits, said projects must be implemented even if financial support of the project by the host country is required.

There are some projects that offer external benefits in addition to GHG reduction effects. We can examine the economic effects of FDI, technology transfer, and reducing poverty through the implementation of such projects as examples. As one concrete example, we can consider a rural electrification project using renewable energy. This facility substitutes the use of fossil fuels and thus effects global warming. Moreover, generating electricity within rural areas will improve the supply of electricity there. As a result, the living standard in rural areas will improve. Reducing poverty, improving the quality of life, and environmental policy are major issues in developing countries. Therefore, we should pay attention to external benefits in addition to the environmental effects of CDM projects.

The types of renewable energy used in CDM projects offer many external benefits, but are often inferior in terms of profitability to projects that conserve energy or fluorinated gases, and projects that reduce methane gas. Consequently, even if some projects offer useful external benefits to the host countries, they are not necessarily implemented under the existing Kyoto Mechanism. Since CDM projects require approval by the host country’s government, that government can manage CDM investments by setting conditions regarding prioritized issues. If the host country offers incentives for specific sectors, private companies may be willing to undertake projects in such sectors. However, even though such CDM projects may have positive effects, low or unstable profitability may prevent private companies from investing in these projects. Therefore, despite the host government’s hopes to develop such kinds of CDM projects, private companies will not get involved. As a result, the Kyoto Mechanism has a major flaw in that it is an imperfect system to internalize external benefits.

If a government sector (either that of donor countries or host countries) prepares

support mechanisms to compensate for this institutional flaw of the Kyoto Mechanism, some potential projects will be implemented. We can assume that there are various kinds of government support (e.g., subsidies, tax exemptions), a commitment for purchasing the electricity generated from CDM projects involving renewable energy, and other types of measures to eliminate project risk. Considering the goals of the global community or those of the Indian government, promoting CDM projects to develop renewable sources of energy has significant value. The United Nations has targeted sustainable development in its Millennium Development Goals. The government of India also agrees with these MDGs through its planning vision, as reflected in its tenth five-year plan for sustainable development. As we mentioned in last year’s report, the Indian government fully intends to reduce poverty while promoting economic development and environmental policy at the same time. For the Indian government, promoting CDM projects for the development of renewable sources of energy is significant in terms of the MDGs and energy security.

As evident through the above-mentioned discussion, it is useful for developing countries to directly support potential projects that offer external benefits, even though unprofitable or risky. There is no difference between a host country’s funding obtained through subsidies, commitments, etc. and a donor country’s funding such as ODA, for private companies to develop CDM projects. One thing is clear: government funding attracts private funding, thus has a leveraging effect.

Today, the government of India insists on abiding by the Marrakech Accord, but

also approves the use of Indian government subsidies for CDM projects under the condition of technology transfer. Thus, the Indian government is no doubt aware of the external benefits of CDM projects.

Therefore, host countries should approve the diversion of ODA to CDM for projects

under the following basic conditions: 1. The host government can participate in determining how ODA is used. 2. The host government recognizes that it must lend political support to promoting

CDM projects involving private companies. 3. The host government agrees that the diversion of ODA to projects and schemes that

support CDM projects can bring more benefit than that from wasted ODA spending.

As a result, host countries will receive more benefits under the Kyoto Mechanism. A flexible interpretation of the Marrakech Accord will also have a better impact on the Kyoto Mechanism.

Table of contents

1. Introduction...................................................................... 1

2. Benefits of the CDM beyond GHG reductions................ 4

2-1 Sustainable development and the CDM ........................................................................ 4 2-2. Sustainable development criteria.................................................................................. 6

3. Current status of CDM projects ...................................... 9

3-1. Distribution of CDM types............................................................................................. 9 3-2. Progress of Feasibility Studies on CDM/JI in Japan.................................................. 13

4. Case study in India’s Gujarat state............................... 19

4-1. Overview of the case study in India’s Gujarat state................................................... 19 4-1-1. Background information of this project................................................................ 20 4-1-2. Small wind power generator................................................................................. 21 4-1-3. Village scale and electricity demand in rural areas of India............................... 22

4-2. Social Benefits by the CDM project............................................................................. 23 4-3. Wind power policy ........................................................................................................ 25

4-3-1. Wind power policy in Indian states ...................................................................... 25 4-3-2. Wind power policy in Gujarat state...................................................................... 26

4-4. Simulation of proposed CDM project in Gujarat state............................................... 28 4-4-1. Conditions of simulation ....................................................................................... 28 4-4-2. Simulation results ................................................................................................. 32

5. Adequacy of utilizing Japanese ODA in projects/schemes that support CDM.............................................................. 34

5-1. Profitability issue of CDM projects with external benefits ........................................ 34 5-1-1. External benefits of CDM projects........................................................................ 34 5-1-2. Issue of realizing CDM projects with external benefits....................................... 35

5-2. Meaning of public support for CDM projects .............................................................. 37 5-2-1. Role of public support for CDM projects............................................................... 37 5-2-2. Incentive for host governments to support CDM projects................................... 39

5-2-3. Analysis of host government behavior using the consumer choice theory.......... 40 5-3. Utilization of ODA in supporting CDM projects......................................................... 42

5-3-1. Host country’s incentive to utilize ODA ............................................................... 42 5-3-2. Regulation of ODA utilization............................................................................... 43 5-3-3. Possible rules for financial additionality and diversion ...................................... 44 5-3-4. Possibility of Japanese ODA in CDM................................................................... 45

6. Conclusion ...................................................................... 47

References........................................................................... 49

Interview lists..................................................................... 50

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1. Introduction Background

According to the Kyoto Protocol, Japan has the burden of reducing its CO2 emissions by 6% compared to its emission level in 1990. However, it will be very difficult for Japan to achieve said CO2 emission target by implementing only domestic measures. Japan must make good use of the Kyoto Mechanism such as implementing CDM/JI projects in cooperation with Non-Annex I countries, Russia, and other nations.

To create more CDM projects, donor countries must not only focus on the CER

amount from said projects, but also pay attention to the needs of host countries. CDM projects offer some potential for providing social benefits in addition to preventing global warming, which are major social issues for host countries. It is expected that an efficient approach to their needs will prove a fast path toward establishing a win-win relationship regarding the implementation of CDM projects.

However, existing CDM/JI projects and current feasibility studies appear

disproportional in particular categories. This is partly due to the fact that the Kyoto Mechanism does not consider other factors that affect social benefits, that is, “external benefits” such as a better standard of life in urban areas, a stabilized supply of electricity, and technology transfer.

Last year, our research on Japan’s relationship with India’s climate change policy

concluded the following: - The government of India is not implementing policy under the pretext of

preventing global warming, but is taking action towards sustainable development (social benefits).

- India lacks the financial resources to obtain sufficient technology and personnel, and support from developed countries such as Japan is needed.

- The development of infrastructure through existing ODA should be carried forward to launch projects to prevent global warming such as those through the CDM.

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Objectives 1. To clarify external benefits for host countries through potential CDM projects

under the Kyoto Mechanism 2. To discuss the role of public investment, especially ODA to promote CDM projects

that contribute to external benefits for host countries Approach

First, we survey existing research documents on CDM projects and their benefits to host countries, then analyze the disproportion between existing CDM projects and external benefits.

Secondly, we conduct a case study on a rural electrification project using renewable energy that is expected to provide some external benefits to the host country. In this case study, we analyzed the need for government financial support quantitatively.

Moreover, we analyze the role of public investment in CDM projects, especially ODA as it pertains to microeconomic theory. Structure

This report consists of six chapters as described below. Chapter 2 reviews the discussion regarding the benefits of CDM projects beyond

reducing GHG levels. The dual purposes of the CDM include assistance for developing countries in achieving sustainable development. Developing countries expect to receive such development benefits and set criteria for the approval of CDM projects.

Chapter 3 examines the current situation of CDM projects. Sectors where GHG

reduction is efficient with modest development benefits are expected to produce the most CERs. For example, just two HFC 23 destruction projects are expected to generate 30% of CERs. Conversely, projects that apparently offer abundant development benefits, such as solar power and wind power generation projects, are strikingly few in terms of the number of projects or CERs. A similar situation is observed in feasibility studies conducted in Japan. It is pointed out that this situation is caused by the decision-making approach taken by private companies under given conditions.

Chapter 4 introduces our case study project in India. As background information

for this case study project, it introduces the location and key players involved. As for details,

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this chapter also describes the situation at the site, the policies of Indian state governments, and the technology to be adopted. Moreover, the possible benefits to stakeholders are also analyzed. Based on the information given, possible patterns of projects are elaborated with profit performance simulated for each pattern.

Chapter 5 discusses the role of public funding for the CDM by using the simple

model of microeconomic theory, and considers the eligibility of Japanese ODA for the CDM. It also discusses how CDM projects are promoted by diverting public funds to projects and schemes that support the CDM, and how the total benefits from such projects can exceed the benefits lost that would have been otherwise generated by said diversion of public funds. It is also pointed out that developing countries might have the incentive to use ODA to fund such projects and schemes. In such cases, this chapter discusses whether Japanese-style ODA may be eligible for use since developing countries control the use of ODA.

Chapter 6 concludes our report by listing the conditions under which host

countries should approve the diversion of ODA to the CDM.

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2. Benefits of the CDM beyond GHG reductions

The Clean Development Mechanism (CDM) is designed to contribute to the sustainable development priorities of developing countries, as well as to assist governments and private sector entities to reach their GHG reduction targets in a cost-effective manner. Host countries set up sustainable development criteria including economic, social, and environmental considerations for the approval of CDM projects.

2-1 Sustainable development and the CDM

Cosbey et al. (2005) insist on the potential of the CDM to make important contributions: delivering benefits to developing countries beyond those strictly related to climate change, in the areas of economic growth through investment, technological evolution, the alleviation of poverty; and environmental and human health improvements. Such benefits are collectively referred to as the “development dividend.”

Article 12 of the Kyoto Protocol clearly states the goals of the CDM that include achieving sustainable development in developing countries.

The purpose of the clean development mechanism shall be to assist Parties not included in Annex I in achieving sustainable development and in contributing to the ultimate objective of the Convention, and to assist Parties included in Annex I in achieving compliance with their quantified emission limitation and reduction commitments under Article 3. (UNFCCC Kyoto Protocol Article 12.2)

Cosbey et al. (2005) explain that a key achievement of the Kyoto Protocol is the

establishment of three market mechanisms designed to help industrialized countries achieve their Kyoto commitments. One such mechanism is the Clean Development Mechanism (CDM), which was created as a way of assisting governments and private sector entities to reach their GHG reduction targets in a cost-effective manner, while contributing to the sustainable development priorities of developing countries.

There are several reasons for considering the CDM an important engine of sustainable development:

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- Unlike most FDI and much ODA, CDM flows are focused on sustainable

development as an outcome, and even offer the possibility of a subsidy (Certified Emission Reduction (CER) revenues). As such, CDM investments are in areas that clearly demonstrate that environment and development can be mutually supportive – a lesson that bears promoting in most countries. And it can direct investment to new environmentally preferable technologies, thereby helping to bring them closer to the mainstream, with environmental benefits that last long after the crediting period.

- CDM investment has the potential to create tangible and important side

benefits that will increase quality of life in developing countries, for example through improved air quality, provision of energy and so on.

- CDM has the potential to funnel funds into small, community-based

initiatives that may be unattractive to traditional investors, but which may have significant beneficial impacts. Depending on the value of CERs, pursuing such projects through the CDM may be more financially attractive than traditional investment.

- CDM is a way to involve both the private sector and developing countries in

achieving the goals of the UNFCCC. The energies and support of both groups are critical to the long-term success of the Convention.

(Cosbey et al., 2005)

Cosbey et al. (2005) summarize why the CDM is worth improving and considering, even though it pales in comparison to the traditional flow of investment. Specifically, the CDM offers the potential to pay a development dividend to developing countries, and at the same time help achieve the objectives of the UNFCCC.

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2-2. Sustainable development criteria

For a more concrete description of “sustainable development” or the “development dividend,” several criteria can be listed regarding economic considerations, social considerations, and others.

India, for example, sets up the following “sustainable development indicators” as

part of its “eligibility criteria” that proposed projects should meet in order to qualify for consideration as a CDM project activity:

1. Social well being: The CDM project activity should lead to alleviation of poverty by

generating additional employment, removal of social disparities and contribution to provision of basic amenities to people leading to improvement in quality of life of people.

2. Economic well being: The CDM project activity should bring in additional

investment consistent with the needs of the people. 3. Environmental well being: This should include a discussion of impact of the project

activity on resource sustainability and resource degradation, if any, due to proposed activity; bio-diversity friendliness; impact on human health; reduction of levels of pollution in general;

4. Technological well being: The CDM project activity should lead to transfer of

environmentally safe and sound technologies that are comparable to best practices in order to assist in upgradation of the technological base. The transfer of technology can be within the country as well from other developing countries also.

It is also stated “The CDM projects should also be oriented towards improving the

quality of life of the poor from the environmental standpoint.” (CDM India, 2006)

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Korea, as another example, sets the following approval criteria for CDM projects by Designated National Authority1:

1. A CDM project shall contribute to sustainable national development; 2. Emission reductions attributable to a CDM project shall be additional to any that

would otherwise be achieved in the absence of the proposed project; 3. A CDM project shall assess its impact on the environment, if applicable; 4. Environmentally sound technologies and know-how shall be transferred; and 5. A CDM project shall comply with relevant policies and regulatory regimes.

Here again, the standpoint of sustainable development is included and reference is

made to more concrete points, such as environmental friendliness or technology transfer. Cosbey et al. (2005) summarize such a “sustainable development criteria” of host countries as one typical suggested list (Table. 2-1). Possible items of economic dimension, social dimension, and environmental dimension are listed.

1 Interviews conducted by the authors. Korea Energy Management Corporation (2006), Korea Energy Management Corporation (2006)

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Table 2-1 Suggested CDM Sustainable Development Criteria

Economic Dimension Generate employment Reduce economic burden of energy imports Provide financial return to local entities Positive impact on balance of payment Technological change Cost effectiveness

Social Dimension Increase equity Increase energy access Gender Issues Education and training Health Alleviation of poverty Legal framework Governance Information sharing

Environmental Dimension GHG emission reductions Local Environmental benefits (e.g., air quality) Pollution, water, soil, waste Use of exhaustible resource Use of renewable resources Biodiversity

(Source) Cosbey et al. (2005)

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3. Current status of CDM projects

Upon reviewing the current status of the CDM, those projects that have efficient GHG reduction opportunities and less development benefit are apparently being promoted. Conversely, projects that are less efficient in terms of reducing GHG levels but provide more development benefit face issues that must be addressed. A similar situation is observed regarding feasibility studies conducted in Japan.

3-1. Distribution of CDM types

According to Cosbey et al. (2005), the early crop of CDM projects may not contribute as much as expected to the environmental, social, and economic development priorities of host countries. As the first series of projects move through the approval process, the trend is toward projects that offer clear reductions and simple additionality. However, some observers perceive that projects that easily meet these criteria, such as those that reduce the release of HFCs and methane, only provide modest development benefits for their host countries. During the tenth Conference of the Parties (COP) at the UNFCCC, Ambassador Raúl Estrada insisted that the emerging CDM is not what negotiators had in mind when he presided over development of the Kyoto Protocol. He specifically pointed out that many projects being developed do little to promote renewable sources of energy or technology transfer2.

As of April 2005, 88 projects were in the process of being validated, and another four had been registered (two HFC23 decomposition projects: a landfill gas-to-energy project, and a small-scale hydro project). As shown in Figure 3-1, hydropower the sectors of biomass power and landfill gas capture accounted for a large portion.

2 Valente, Marcela (2004) Climate Change: A disappointing start for Clean Development http://www.ipsnews.net/interna.asp?idnews=26604 Accessed February 2006

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Figure 3-1 Types of CDM Projects

Other5%

EE Industry2%

Geothermal2%

HFCs2%Wind3%

Landfill24%

Biogas power4%

Biomass power27%

Hydro31%

100%=92 projects

As of Apr. 6, 2005

Other5%

EE Industry2%

Geothermal2%

HFCs2%Wind3%

Landfill24%

Biogas power4%

Biomass power27%

Hydro31%

100%=92 projects

As of Apr. 6, 2005

(Source) UNEP-Riso cited in Cosbey et al. (2005)

However, when viewed from the standpoint of CERs projected to be earned by the end of the first commitment period by project type, the situation looks different (see Figure 3-2). The share of landfill gas capture and HFC 23 decomposition projects accounts for 74%. In both sectors this share reflects the high global warming potential (GWP) value of the gases involved. In the fluorinated gas sector, the two projects in this sector account for 30% of all expected CERs in the project pipeline (Cosbey et al., 2005).

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Figure 3-2 CERs by Type of Project

Other0% EE Industry

0%Geothermal4%

HFCs30%

Wind2%

Landfill44%

Biogas power3%

Biomasspower11%

Hydro6%

100%=131.6 Mt CO2e

As of Apr. 6, 2005Other0% EE Industry

0%Geothermal4%

HFCs30%

Wind2%

Landfill44%

Biogas power3%

Biomasspower11%

Hydro6%

100%=131.6 Mt CO2e

As of Apr. 6, 2005

(Source) UNEP-Riso cited in Cosbey et al. (2005)

Cosbey et al. (2005) argue that fluorinated gas decomposition is an end-of-pipe technological fix that has no apparent side benefits in terms of local air quality, local quality of life, employment, transformation of the energy supply regime, or any of the other indicators proposed by host countries (see Table 2-1). Evaluated from the standpoint of such lists, it is doubtful that projects involving HFC 23 decomposition would score highly.

In contrast to the landfill and HFCs sectors that account for a significant share, it

is remarkable that there are no solar energy projects, and only a single residential energy efficiency project in the mix. Both sectors offer potentially large development benefits, in effect providing more distributed power to poor rural populations, generating employment, and reducing non-climate-related environmental degradation. Renewable sources of energy are generally not well represented in the project mix, though the totals in terms of shares of

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CERs are rather low (Cosbey et al. 2005). Therefore, the CDM faces a potential issue regarding the achievement of both efficient GHG reductions and the sustainable development of developing countries. Cosbey et al. (2005) quote the following argument:

“Even in the initial stages of CDM project preparation, it is evident that there are trade-offs between profit maximisation by investors and the sustainable development objectives of the CDM. The latter are most likely to be achieved through projects such as renewable energy schemes and such schemes would also contribute to the financing of necessary energy infrastructure investments in developing countries … . In contrast, large potential generators of CERs, such as fluorinated gases reduction projects, have no broader developmental impact, but these projects provide the lowest-cost means of generating Kyoto units. 3”

Cosbey et al. explain that the implicit breakdown offered here between the CDM for renewable sources of energy and a clean energy infrastructure as sustainable development on one hand, and the example of fluorinated gas projects on the other as being no such thing, a view that is commonly shared by many analysts.

3 Cited in Cosbey (2005), p7

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3-2. Progress of Feasibility Studies on CDM/JI in Japan

We also see the present situation of CDM/JI project development in Japan by using the data of the Global Environment Centre Foundation (GEC) and New Energy and Industrial Technology Development Organization (NEDO). The situation observed has something in common with that of the CDM globally.

Currently in Japan, NEDO (an organization related to the Ministry of Economy,

Industry and Trade) and GEC (related to the Ministry of the Environment) have been granting subsidies to private companies to conduct CDM feasibility studies. From the viewpoint of private companies, it is rational to use those subsidies for CDM/JI projects. Therefore, since 1999, many companies have developed potential CDM projects by using such funds. Today, the database of subsidized feasibility studies provides a broad base of information concerning CDM/JI feasibility studies in Japan. In this section, we use the NEDO and GEC databases to analyze the sectors in which Japanese companies have conducted CDM/JI feasibility studies.

In this analysis, we have classified CDM/JI projects into four major sectors:

“Renewable Energy,” “Forestation,” “Energy Saving,” and “Methane, Fluorinated Gases, and other GHG Reductions.” The “Renewable Energy” sector has five subsectors: “Wind power,” “Solar power,” “Geothermal,” “Hydro,” and “Biomass.” The “Methane, Fluorinated Gases, and other GHG Reductions” sector has two subsectors: “Waste management or mining methane” and “Fluorinated gases, etc.” Table 3-1 below lists the above-mentioned classification.

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Table 3-1 Classification of CDM/JI Feasibility Studies

Major sector Subsector

Wind power

Solar power

Geothermal

Hydropower

Renewable Energy

Biomass

Forestation Afforestation/Reforestation

Energy Saving Energy conservation

Waste management or mining methane

Methane, Fluorinated Gases and other GHG Reductions

Fluorinated gases, etc.

The published reports of previous subsidized studies can be found on the web sites

of the GEC and NEDO. We analyzed that information regarding CDM/JI feasibility studies.

Both NEDO and GEC are strictly supervised by the Ministries under which each

covers different CDM/JI projects. For example, NEDO has interests in sectors regarding new technologies, and traditionally concentrates on energy conservation technology. Therefore, it focuses on the sectors of renewable energy and energy conservation. Conversely, the Ministry of the Environment supervises GEC, which is concerned with natural conservation, waste management, and sustainable development. Therefore, GEC focuses on biomass projects, forestation, and waste management (methane) projects. Both organizations cover different sectors of the CDM/JI projects. However, both share information about determining which feasibility studies to subsidize4.

The distribution of feasibility studies is analyzed from the standpoint of sectors. Figure 3-3 shows the cumulative distribution by sector from FY1999 to FY2004. We have used the data from GEC and NEDO subsidized feasibility studies. Figure 3-4 shows the cumulative distribution by region from FY1999 to FY2004.

4 We have interviewed GEC officials.

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As shown in Figure 3-3, most feasibility studies in FY2004 were conducted in the energy conservation sector. The second largest sector is biomass, followed by methane reduction. From FY1999 to FY2000, many feasibility studies were conducted on forestation projects. However, only a few studies have been conducted during the past three years. The projects for renewable sources of energy like solar power, wind power, and geothermal power generation were rarely studied from FY1999 to FY2004. Figure 3-3. Cumulative distribution of GEC & NEDO Feasibility Studies from FY1999 to FY2004

0

10

20

30

40

50

FY1999 FY2000 FY2001 FY2002 FY2003 FY2004

Proj

ect N

umbe

rs

Methan Reduction Fluorinated gas destructionEnergy-saving Biomass (incl. Biomass & Forestation)Forestation Wind PowerSolar Energy GeothermalOthers

(Source) GEC and NEDO

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As shown in Figure 3-4, 40% of CDM/JI feasibility studies conducted in Japan dealt with Southeast Asia. The total reaches 60% when including East Asia, South Asia, and Southeast Asia. Apparently, feasibility studies conducted in Japan reflect a very strong regional preference.

Figure 3-4. Regional distribution of feasibility studies on CDM/JI

0% 20% 40% 60% 80% 100%

Cumulative numberFrom F Y1999-2004

East Asia Southeast Asia South AsiaRussia Central/East Europe Middle EastAfrica Central/South America Pacific area

(Source) GEC and NEDO

The inclination by sector as shown in Figure 3-3 is due to the decision-making

approach taken by private companies. Concerning CO2 reduction projects (e.g., for energy conservation, renewable energy), private companies cannot expect CER revenue as major income from such projects because they perceive the CER price as risky. . In such cases, companies try to compensate for the capital investment required with project revenue without any CER revenue5. Many energy conservation projects cover capital investments with their amount of cost reduction, and are implemented as CDM projects. However, whether renewable energy type projects can cover their capital investments with project revenue depends on their situations. This explains the reason for the inclination between projects intended for saving energy and those for renewable sources of energy.

Conversely, when private companies consider a GHG reduction project other than

CO2 reduction projects, the Global Warming Potential (GWP) value of the gas reduced will

5 Interview with officials of Chugoku Electric Power Co., Inc.

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create another situation. (The GWP values indicate the rates of converting the GHG amount to the CO2 equivalent in terms of greenhouse effect). In such cases, even if the reduced amount of GHG is the same, the CER produced by a GHG reduction project will be larger than that produced by CO2 reduction type projects. Hence, the revenue expected with CER revenue in will increase even in worst cases. As a result, companies will promote investment for a GHG reduction project other than for CO2 (e.g., fluorinated gas destruction, methane emission reduction by waste management).

As such, projects that offer huge social benefits may be ignored if they require a large initial project cost or have unstable revenue.

As already mentioned, private companies make decisions based on the size of GHG reduction per project. This is important from the standpoint of efficient project development. Figure 3-5 plots each project along the axis of reduction cost per unit and reduction volume per project. The unit cost is converted to Japanese yen based on the exchange rate on the same date. The term of estimation is basically completed within ten years. Moreover, because the variances of the numbers are large, we use a common logarithm on axes.

Figure 3-5 Reduction cost and reduction volume of each project

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

3.0 4.0 5.0 6.0 7.0 8.0

log10(GHG reduction per project)

log1

0(th

e re

duct

ion

cost

per

CO

2t

Wind power Methane from Waste Fluorinated gas reductionForestation Biomass Others

(Source) GEC.

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The lower the reduction cost, the greater the possibility that a business can survive, even if the CER price or business profit is low. As shown in Figure 3-5, regardless of the project sector, the reduction cost per CO2 tonnage varies. The reduction cost for forestation, however, shows comparatively small variance. Moreover, the reduction cost decreases slightly depending on the amount of reduction. . Thus, we can observe the economy of scale.

Methane-related projects are generally considered cost-effective. However, the reduction cost is comparatively higher for a project of small size. Wind power projects have much a higher reduction cost, but sufficient samples and related information are not available for such projects. Therefore, from the standpoint of economic rationale, large methane reduction projects, fluorinated gas destruction projects, and forestation will be implemented.

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4. Case study in India’s Gujarat state This chapter discusses the implementation of a small-scale windmill project in

India’s Gujarat state as a CDM project, and examines the implications of this small-scale CDM project in terms of cost structure, social benefits, and government support.

4-1. Overview of the case study in India’s Gujarat state Gujarat state is located in western India along the border with Pakistan. We

have collaborated with a local NGO, VIKSAT (VIKRAM SARABHAI CENTRE FOR DEVELOPMENT INTERACTION), to demonstrate the possibility of a small-scale windmill project in a non-electrified area of Gujarat state. VIKSAT was established by Vikram Sarabhai, a famous scientist, and is mainly involved in rural/agriculture matters, such as the education of women and solutions to water-related problems. Gujarat state is an appropriate area for windmill generation in India. The project site was selected given its proximity to the VIKSAT rural office, because we plan for VIKSAT to operate windmill generation. The map (in Figure 4-1) shows the location of the project site.

Figure 4-1 Location of project site in Gujarat State

The Location in India The Location in Gujarat State

Ahmedabad

Pilot Project Site

Gujarat State

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4-1-1. Background information of this project Basically, India lacks sufficient systems to supply electric power . Many Indian

people do not make good use of electric home appliances in their daily life. There are many non- electrified areas in India and electric power failure frequently occurs in electrified areas

The Indian government is implementing the development of electric power

generation in the country. The government has liberalized the scheme and social systems related to the generation of electric power. The electricity supply system in each state has been divided into power generation, transmission, and distribution. As a result, , there has been a stable supply of electricity without any power failure in states like Maharashtra over the past few years due to increased competition in power generation between TATA and other companies. Gujarat state has a policy to build up an electric infrastructure like thermal power plants in order to supply sufficient electric power throughout the state.

Under present circumstances, the supply of electricity to rural areas is limited, at

most about 6 hours a day. Over the past two to three years, the Indian government has been developing a transmission network for rural areas. This project site is linked to the transmission lines under the “Rural Electrification Program of Gujarat State” that is intended to solve the problem posed by the insufficient supply of electricity.

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4-1-2. Small wind power generator

The small-scale power generator that we proposed in this case study is outlined below. The power generation capacity is only 10 KW, but is expected to accommodate the demand for electricity in the village being supplied. Since the plant will be connected to the local grid, the power generated will be effectively supplied to the village.

Figure 4-2 Small wind power generator in this case study

(Source) Mayekawa Mfg. Co., Ltd.

Item Unit 10.0 KW

Standard output(12 m/sec) kW 10

Cut in wind speed m/s 2

Cut out wind speed m/s 15

Darrieus diameter mm 6500

Number of blades pcs. 3

Blade material Aluminum

Frequency Hz 50/60

Tolerance against wind speed m/s 60 or more

Standard revolutions per minute rpm 200

Estimated weight kg 1000

Brake Equipped

22

4-1-3. Village scale and electricity demand in rural areas of India Let’s examine the power demand in rural areas of India. Table 4-1 lists the scale of

various rural villages and their electricity needs. The figures are based on a survey conducted by VIKSAT.

The population in neighboring villages ranges from a minimum of 640 people to a maximum of 3290 people. The number of households ranges from 129 to and 651. The average consumption of electricity per household ranges from 48 kWh to 156 kWh. At present, the electrical home appliances owned by villagers in this area are limited to lighting, radios, fans, and other small appliances. There are very few televisions or refrigerators. As a result, the consumption of electricity is very low here.

Table 4-1 Village scale and electricity demand

Sr. No.

Village name Area (ha)Village

PopulationNo. of

Households

Estimated Monthly domestic energy requirement Units* per village

1 Chhanasara 2,910 1,205 363 87,120 2 Barara 1,255 1,057 277 66,480 3 Daldi 1,699 1,033 190 45,600 4 Boamroli 6,376 2,523 636 152,640 5 Jamwala 1,457 1,035 149 35,760 6 Jajam 3,049 2,250 328 78,720 7 Rajushra 1,102 885 129 30,960 8 Garamdi 1,690 1,309 300 72,000 9 Patanka 3,736 856 251 60,240 10 Babra 2,953 1,354 227 54,480 11 Bavarda 1,355 970 200 48,000 12 Ranmalpura 721 848 162 38,880 13 Roju 1,281 640 200 48,000 14 Vauva 3,054 3,208 651 156,240 15 Fangli 3,027 694 253 60,720 16 Sidhada 1,807 2,367 593 142,320 17 Madhutra 4,375 3,290 621 149,040

note: - 1 unit = 1000 W- hr

- Santalpur is located 250 km from Ahmedabad via the National Highway.

- Few villages are within the BSNL mobile network.

- The average monthly domestic consumption of electricity is approx. 240 units per household.

- Electric Supply; Approx. 6- 8 hrs. per day

(Source) VIKSAT

23

4-2. Social Benefits by the CDM project

Let’s examine some social benefits that CDM projects can offer to society. Figure 4-3 shows a spread image of direct effects and repercussion effects in India and Japan by a CDM project involving the small-scale generation of electric power.

Figure 4-3 Benefits by the CDM project for small-scale wind power generation

Electricity supply by small windmill in Rural Areas

Improvement of agricultural productivity

Industrial raising

Improvement of “Quality of life” in rural areas

Creation of employment opportunities

Stabilization of the electric supply to urban

areas

Industrial activation Improvement of “Quality of life” in urban areas

Reduction of electricity distribution loss

Improvement of energy security by saving of

fossil fuel

Investment reduction for conventional energy

sources

Attraction to more FDI

Economic Growth

Contribution to Global warming repression

CO2 emission reduction achievement of Japanese

corporation

Defact-standardization of Japanese technologies

Strengthening of the industry competitiveness with technology transfer

Turnover increase of Japanese corporation

Improvement of Japan’s position in international

society regarding the climate change framework

JapanJapan IndiaIndia

Contribution to Global warming

Direct Effect Repercussion Effect

In rural areas, implementing a small wind power CDM project will contribute to

reducing CO2 emissions in India and will benefit Japanese corporations in earning CERs. Moreover, this kind of project will create employment opportunities. The energy generated will improve productivity and income in the agricultural sector. This will result in a better standard of life in rural areas. The generation of electric power in rural areas will reduce transmission loss and improve energy self-sufficiency.

The implementation of such projects in rural areas will also affect urban areas.

It will help stabilize the supply of electric power in urban areas, which will benefit the industrial sector and thus attract more FDI.

24

Therefore, CDM projects have the potential of increasing private funds for public

development. The Indian government invests 30% of its planned budget for such rural development as irrigation and energy supply. However, such government funding is not sufficient to meet the large requirements of rural areas. Consequently, the Indian government promotes a public-private partnership in rural development to increase funding. This kind of partnership in CDM projects will attract funds from foreign corporations. This will also ensure more investments by the private sector as well.

The benefits for Japan will be CERs, the export of Japanese technologies and

products, and a larger India market. Japanese corporations playing a significant role in implementing Indian electrification policy through CDM projects will improve Japan’s position in international society regarding the climate change framework.

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4-3. Wind power policy

4-3-1. Wind power policy in Indian states Each state in India has an incentive policy for promoting renewable sources of

energy. The Gujarat state government is also promoting the use of renewable energy under the electric power law.

Table 4-2 below shows the present situation involving wind power generation

policy. Since the possibility of wind power generation depends on wind conditions, all states do not have a wind power generation policy. Specifically, 12 of India’s 27 states have wind power policies.

Table 4-2 Incentive policy for wind power generation in India

State Programme Wheeling Banking Third Party

Sale

Buy-Back

(Rs./kWh)

Annual Tariff

Escalation

Recommended

Level By

MNES

2% 12 Months Recommended Rs.2.25 5%

(1994-95 as base year)

Andhra

Pradesh Wind Available Available Not Available Available Available (94' basis)

Chattisgarh Wind Available Available Available Available Not Available

Gujarat Wind 4% 6 months Not Available 2.6 5 paise 2002-2003

Haryana Wind Available Available Available Available Available (94' basis)

Karnataka Wind Available 2% on monthly

basis Available

3.10 for new

projects 2% on base tariff

Kerala Wind 5% June-Feb Not Available 2.8 2000-01 for five years

Madhya

Pradesh Wind Available Not Available Available Available Not Available

Maharashtra Wind Available Available Available 3.5

@15 paise per year

from the year of

commissioning for 13

years

Rajastan Wind 10% Calendar Year

Basis Available 3.32 in 2003-4 -

Tamil Nadu Wind 5% 5% Not Available 2.7 No escalation

Uttar Pradesh Wind 12% Available 0.50% Available 95' basis

West Bengal Wind Available 6 months Not Available Not Available

26

(Source) MNES web site. 4-3-2. Wind power policy in Gujarat state

In Gujarat state, a wind power policy was introduced in the year 2002 (Table 4-3).

The state government has a social system in place for power generation by using large-scale windmills. This system is effective until the year 2007, which also coincides with India’s current 5-year plan.

Under the liberalization policy of the power sector, there are also some benefits in the case of windmill power generation, such as exemption of the power generation tax, a guaranteed buyback by the state, free land, and connection with the local power grid. The regulated purchase price is normally Rs. 2.6/kWh. However, the negotiated rate was recently changed from Rs. 3.2 to Rs. 3.8/kWh. The rate will be fixed upon discussions with the Gujarat Electricity Regulation Council (GERC). The Ministry of Non-conventional Energy Sources (MNES) must approve the specifications of the wind power generator. MNES evaluates such generators for certain aspects of new technology.

For implementation of this CDM project, we must arrange the following: (1) Negotiation of purchase price with GERC, (2) Decision of connectivity method by the Gujarat Electricity Board (GEB), and (3) Support and model approval by the Gujarat Energy Development Agency (GEDA).

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Table 4-3 Outline of the Gujarat Wind Power Policy 2002

Items Contents

Validity period - The validity period is from year 2002 till 5 years. - The subjects of the policy are those that have established wind mill

power generation facility in last 5 years or the ones that are established with the objective of wind mill power generation.

- The validity period is 20 years or the life of wind mill, whichever is shorter.

Objects - The industries manufacturing in Gujarat State. - Non-Industry or developers ( But the transmission of power the 3rd

party is not approved. Gujarat Electricity Board: GEB has monopoly over purchase))

The Sale of Power - GEB buys power at Rs. 2.6/ kWh. - Every 10 years there is an increase of 5 Paisa ( 100 paisa = Rs. 1) - The purchasing rate is negotiated/revised after 10 years. - The selling to 3rd party is not approved.

Equipment. Model - The wind mill model needs to be approved by the MNES. Land - In case land is not prepared, it can be allocated or supported by

Gujarat Energy Development Agency:GEDA The power storage - The surplus power can be stored by obtaining the 6 months license

from GEB. Electricity tax exemption

- The payment of the electricity tax is exempted.

Measurement of the Power Generation

- It is measured by GEB, GEDA at 66 kV wind mill power generation sub station in 1 month unit

Source: Gujarat Wind Power Policy 2002.

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4-4. Simulation of proposed CDM project in Gujarat state

4-4-1. Conditions of simulation We conducted a simulation study on the cost and profit for implementing this

CDM project in Gujarat state. At first, we assumed four system options for supplying electricity from a wind power generator, in terms of the generator’s concentration / dispersion and need for a storage battery (see Figure 4-4 and Table 4-4).

(1) Local Power Generator type (2) Well type (3) Independent generator type (4) Grid connection type For simulation, we considered the “Gujarat Wind Power Policy 2002” and income

level of the targeted rural area, and then selected two types: (2) Well type and (4) Grid connection type. The project has one small-scale windmill in the rural area and an evaluation term of 10 years. Table 4-5 lists the other preconditions.

With regard to government funding, we assumed four types of financial government support: commitment, ODA, no funds, and subsidies from the government (see Table 4-6).

Figure 4-4 Types of wind power generation projects assumed in rural areas

Concentration Dispersion

Con

cent

ratio

nD

ispe

rsio

n

Necessary

Pow

er G

ener

atio

n

(1)

Local Power Generator type

(2)

Well type

(3)

Independent generator type

Unnecessary

(4)

Grid connection type

Storage battery

29

Table 4-4 Definition of types of wind power generation projects

Type Classification Concentration/DispersionStorage battery

Definition

(1)

Local Power Generator type

Concentration Necessity - Using substations as connection points of electricity generated by a solar power or wind power facility.

- Using a storage battery, thus achieving stable supply.

(2) Well type (i.e., with villagers co-managing the facility)

Concentration Necessity - Installing a power generator as a regional public asset.

- Providing a battery (including controller) for each household

- Each household charging the battery during the day and using the required quantity at night.

(3) Independent generator type

Dispersion Necessity - Solar panel (e.g., of 100 W) Each household to own controller and battery

- Each household to handle generation, storage, and use.

(4) Grid connection type

Concentration/Dispersion Unnecessary - Using the windmill and solar-type generation via connection to the grid to receive insufficient power, with the supplied to the grid.

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Table 4-5 Preconditions for simulation

Items (2) Well Type (4) Grid Connection Note

The cost of power generation equipment (Small- scale windmill of 10 kWh)

3 million yen -

Purchase rate of power

3.8Rs/kWh 3.8 Rs/kWh

Actually, people who live in rural areas in India don’t have to pay utility costs. However, this time, we assume that the NGO concerned will collect electricity charges from the villagers to maintain the windmill. Moreover, the rate is not regulated but the actual rate.

Quantity of power sold

156.24 kW/month @ “Vouba” village

Amount of power generated

-

Selling Power to 3rd party

To residences - Power Act 2003 The average income of villages in this region is approximately 50Rs/day (i.e., 15000Rs/year).

Cost/charge of Transmission Network

-

4% of sales amount of electricity

Gujarat Wind Power Policy 2002 Since the cost of an independent transmission network is not clear, we assume the fee given for use of the existing system)

Battery charger 300,000 yen - -

Battery (Car battery)

1000 Rs/each household - -

Maintenance Cost 10,000 yen -

CER Exchange rate

0.371 CO2 kg/kWh

We use the baseline I.A.(1) (Electricity generated by users) for the well type and the baseline I.D. of renewable energy for the grid connection type. However, we cannot obtain the average emission coefficient. Therefore, we examined the total electricity as the reduction volume of CO2.

CER price $10/CO2t - Yen$ Exchange rate

$1=¥115.58 -

Yen- R Exchange rate

1R.=¥2.7 -

31

Table 4-6. Simulation cases by financial support

Financial Support

from Government

(2) Well

type

(4) Grid

Connection typeNote

Commitment - Case 1

2.6 Rs/kWh,The initial capital is to be

borrowed from financial institutions

under Indian policy at an annual

interest rate of 8%.

ODA - Case 2

Initial capital borrowed for 10 years at

an annual interest rate of 5%. This is

based on the assumption that the

current interest rate for loans from

financial institutions under Indian

policy is 8%.

No support Case 3 - Benchmark

Subsidy Case 4 -

The cost of equipment (with 90% of the

cost of the windmill and battery

charger being subsidized, and with the

cost of the battery to be borne by each

household)

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4-4-2. Simulation results We calculated the “amount of reduced CO2 emissions,” “revenue of CER,” and

“amount of government support” to estimate “IRR (Internal Rate of Return) before government support” and “IRR after government support” as project feasibility factors. Table 4-7 below lists the simulation results.

Table 4-7 Simulation results

Types of government support (4) Grid Connecting type (2) Well type

CommitmentCommitment

+ODA No Support

Subsidy to facility

For 10 years/one unit

Case1 Case2 Case3 Case4

unit

Amount of reduced CO2 emissions

179.5 179.5 7.0 7.0 CO2t

Revenue of CER 207,471 207,471 8,040 8,040 yen

Amount of government support (Nominal value)

0 900 0 3,270 thousand

yen

IRR before government support

- -4.0% -42.2% -42.2% %

IRR after government support

-4.0% 2.8% - -19.4% %

In cases 3 and 4, there is small electric demand due to low project feasibility, even

if we consider the CER revenue and revenue obtained from electricity fees charged to village residences. Especially in case 3, which has no government support, the projected IRR is -42.2%. In case 4, even though the government subsidizes 90% of the initial cost of the project, the IRR increases to -19.4% at most. This reduces the project feasibility much lower that when each household procures a battery charger for electrification.

Conversely, in case 1, where the government approves both connection to the grid

and the purchase of electricity generated by the windmill, the IRR after government support is still negative. In case 2, funding the initial cost by using ODA (e.g., government loan from Japan) increases the IRR to plus (2.8%) due to the reduced interest burden. Although the IRR is not of a high level, there is a room to actualize the CDM project.

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The amount of support from a foreign government in case 2 is less than that from

the domestic government in case 3. Both the approval of grid connection and the commitment to purchase electricity by the state government makes a difference in IRR between cases 2 and 3. Furthermore, in case 2 of the grid connection type, the state government (e.g., the Gujarat Electricity Board or GEB) can sell surplus electricity generated by the windmill in the rural area to residences and factories in urban areas. Thus, there is no possibility of the Gujarat state government suffering a loss from this project.

In this way, should CDM projects obtain a good combination of host country and donor country support, we can expect the implementation of CDM projects for renewable sources of energy that would otherwise be very difficult.

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5. Adequacy of utilizing Japanese ODA in projects/schemes that support CDM

There are potential CDM projects that are not profitable enough to attract private investment but beneficial to the host countries. Host countries can have the opportunity and incentive to obtain such benefits by investing in projects/schemes that support CDM projects. Host countries may also have an incentive to use ODA to finance such projects/schemes, while adhering to the issue of financial additionality that prohibits the diversion of ODA to CER acquisition. Even some possible rules governing the issue of financial additionality that are compatible with the idea of public projects/schemes that support CDM projects involve problems including the risk of such diversion. However, as far as Japanese ODA that maintains the “collaborative shaping principle” is concerned, such problems are avoided.

5-1. Profitability issue of CDM projects with external benefits Some potential CDM projects have “external benefits” other than the mitigation of

global warming, such as poverty alleviation and technology transfer6. Under the Kyoto Mechanism, CDM projects offering such benefits are not necessarily appreciated or properly realized. Since CDM projects must be profitable though said benefits do not contribute to profitability, insufficiently profitable projects are not implemented, even though the host countries set the criteria regarding those benefits. 5-1-1. External benefits of CDM projects

There are potential CDM projects that offer benefits other than the mitigation of

global warming. CDM has an impact on mitigating global warming by reducing the emissions of greenhouse gases. The external benefits are other benefits brought about to host countries. These include the economic effects brought about by project investments, technology transfer of the technology used or training involved, and an improved quality of

6 The term “external benefits” means the same as the benefits that are already discussed in “2. Benefit of CDM beyond GHG reductions” and thereafter. In this chapter, to emphasis the externality, the term “external benefits” is used.

35

life for the residents of local communities. One such example is the electrification project of rural villages by using renewable sources of energy. In rural villages without a sufficient energy supply where potential energy resources are diesel or electricity produced by fossil fuels, introducing sources of renewable energy to such villages is beneficial in terms of reducing greenhouse gas emissions. Moreover, a supply of energy using renewable energy sources can improve the quality of life for villagers. Improving the quality of life in rural villages may be one of the most important policy issues in developing countries. Thus, CDM projects can have other benefits than reducing greenhouse gases emissions.

Figure 5-1 Profitability issue: example of our case study project

Insufficient income of villagers to pay for electricity

Incomplete local grid

Uncertain CER acquisition and the price

Initial situation of our case study project

Insufficient/uncertain income from electric power selling

Necessity to invest for local electric grid

Insufficient/uncertain income from CER

Bottle neck for private investment

Project realization with private investment seemed impossible

Insufficient income of villagers to pay for electricity

Incomplete local grid

Uncertain CER acquisition and the price

Initial situation of our case study project

Insufficient/uncertain income from electric power selling

Necessity to invest for local electric grid

Insufficient/uncertain income from CER

Bottle neck for private investment

Project realization with private investment seemed impossible

5-1-2. Issue of realizing CDM projects with external benefits

However, these CDM projects offering external benefits are not necessarily

profitable enough to attract private investment. Our case study project in India is one concrete example. Since the income level of villagers is insufficient to pay for electricity, there is uncertainty regarding the revenue obtained from selling electricity to villagers. The electric power grid to individual households is incomplete and new investment in the grid is needed. This investment is costly and adversely affects the profitability of the project. Given the uncertainties of CDM approval and CER price, the income from CER is also uncertain. Thus, our case study project in India appears difficult to realize with only private investment.

36

Thus, even if a project offers valuable benefits to developing countries, such a

project may not necessarily be realized under the existing Kyoto Mechanism. Since CDM projects require the approval of host countries, the host countries can establish rules to give affirmative approval to projects that offer external benefits that the countries value. Consequently, private companies may propose projects that offer even greater external benefits. At the same time, a project must be sufficiently profitable in order to even be listed for approval. Thus, under the Kyoto Mechanism, internalization of these external benefits remains incomplete and projects offering external benefits can be simply forgotten.

5-2 External benefits of CDM project and their relation to Kyoto Mechanism

Possible benefit of CDM project

Mitigation of global warming

External benefit(Other benefit than above)

• Reduction of green house gas emission

• Economic effect

• Technology transfer

• Quality of life

Relation to Kyoto Mechanism

• Allocate the emission reduction obligations to developed countries and the reduction from CDM projects can be traded…thus this benefit is internalized into the market mechanism

• Not enough mechanism for internalization

Example in our case study project

• Reduction of the potential green house gas emission with the introduction of renewable energy sources

• Improvement of quality of life in villages by introducing electricity supply

Possible benefit of CDM project

Mitigation of global warming

External benefit(Other benefit than above)

• Reduction of green house gas emission

• Economic effect

• Technology transfer

• Quality of life

Relation to Kyoto Mechanism

• Allocate the emission reduction obligations to developed countries and the reduction from CDM projects can be traded…thus this benefit is internalized into the market mechanism

• Not enough mechanism for internalization

Example in our case study project

• Reduction of the potential green house gas emission with the introduction of renewable energy sources

• Improvement of quality of life in villages by introducing electricity supply

37

5-2. Meaning of public support for CDM projects Host governments can obtain external benefits by investing in projects/schemes to

support CDM projects. These governments may have enough incentive to do so because such support can promote private investment in CDM projects and the external benefits obtained may exceed lost benefits due to the diverting of other public investment for such support. 5-2-1. Role of public support for CDM projects

Host governments can obtain the external benefits of unprofitable projects by

making such projects profitable by sharing the burden. The ways of sharing this burden may vary. Governments can not only subsidize the projects themselves, but may invest in the infrastructures that make CDM investment easier, and make a commitment to purchase the electricity generated from renewable energy projects. In our case study project, which was apparently unprofitable, government support has made it profitable. The local government devised an affirmative plan to purchase electricity generated by using renewable energy sources7. This commitment raised the expected level of revenue from the project and alleviated uncertainty about said revenue. As for the electric power grid, the local government plans to develop a local grid, thus eliminating the otherwise huge investment needed, which would adversely affect the profitability of the project.

7 According to the Gujarat Electricity Regulatory Commission (2005), the Gujarat Electricity Board was purchasing the electricity generated by using renewable energy sources for more than Rs.3/kWh in December of 2005.

38

Figure 5-3 Cost/revenue structure of our case study project(NPV basis, dummy value)

39

5-2-2. Incentive for host governments to support CDM projects

A host government may have the incentive of obtaining external benefits by somehow sharing the burden of a given project. Even if a certain amount of existing public spending is reduced to support a CDM project offering external benefits, more benefits may be obtained by attracting private investment. Figure 5-4 below graphically illustrates such a situation.

Figure 5-4 Increase in benefit by diverting public investment

to projects/schemes that support CDM

B(PI) B(DIV) B{C(DIV)} B(PI-DIV)+ B{C(DIV)}

B(PI-DIV)B(PI) B(DIV) B{C(DIV)} B(PI-DIV)+ B{C(DIV)}

B(PI-DIV)

B( ) indicates the benefit the country and is a function of investment including public and CDM investment. C( ) indicates the amount of CDM investment and is a function of government support for CDM projects. PI stands for public investment and represents the existing public investment by the host government, including the investment in projects to alleviate poverty and address other problems. DIV stands for diversion and indicates a portion of existing public investment diverted to support CDM projects. At the beginning, suppose that a host government enjoys the benefit of B(PI) from its own public investment. When the amount of DIV is reduced, the benefit of B(DIV) is lost and B(PI-DIV) remains. However, with DIV of CDM support, C(DIV) of CDM investment is obtained with the resulting benefit of B(C(DIV)). When this benefit is larger than B(DIV), the host country benefits by supporting CDM projects offering external benefits.

40

5-2-3. Analysis of host government behavior using the consumer choice theory Such a situation is explained by using the analogy of the “consumer choice theory”

in the micro economic theory (Figure 5-5). Assume that a host government chooses to allocate budget to either existing public investment or “CDM investment.” Here, “CDM” includes projects that have the potential of becoming CDM projects. Therefore, renewable energy projects are included, for example, even though not approved to be CDM projects. “CDM investment” includes investment in the projects/schemes that support CDM.

Figure 5-5 Allocation of public budget by a host country

b1

Existingpublic investment

CDM investment

e0

e1

More benefit

Indifference curves(benefit)b0

B0 B1

Public investment

PrivateInvestment

B2

b2

e2

b1

Existingpublic investment

CDM investment

e0

e1

More benefit

Indifference curves(benefit)b0

B0 B1

Public investment

PrivateInvestment

B2

b2

e2

Without the Kyoto Mechanism and given existing budget constraints, suppose

that budget line B0 and investment plan e0 are obtained. This is a corner solution when the convex indifference curve is b0. This means that all of the budget will be allocated for existing public investment, and that the government will not invest in any “CDM” projects. There is a possible interior solution whereby e0 may be on B0 depending on the shape of indifference curves. In such case, some public investment will be allocated to “CDM” projects, such as renewable energy projects, to obtain the benefits of those projects.

41

Given the option to invest in projects/schemes to support “CDM” projects, the

government may make a “CDM investment.” In real life, governments not only invest in projects but also support projects. For renewable energy projects, such support includes a subsidy, a commitment to purchase electricity, the development of infrastructure, and other actions. With this support, private investment is attracted to “CDM investment.” In the diagram, this situation can be seen to depict a loosening of budget constraints since a larger total amount of CDM investment can be obtained with some public investment. Therefore, new budget line B1 may be assumed. If the convex indifference curve is like b1, for example, or a new investment plan is not the corner solution, a certain amount of investment supporting “CDM” projects will be made to achieve better benefits and “CDM investment” indicated by e1 will be achieved. This analysis explains the subsidy made by the Indian government or the commitment to purchase energy generated from renewable energy.

The Kyoto Mechanism can give more incentives to governments for making “CDM

investment.” With the Kyoto Mechanism, private companies can expect revenue from CER. Therefore, more private “CDM investment” can be expected with than without the Kyoto Mechanism. This situation is seen as a further loosening of budget constraints in the diagram. Thus, assume budget line B2. If “CDM investment” does not have the characteristics of Giffen goods in consumer choice theory, that is, the income effect does not setoff positive substitution effect, the government increases its “CDM investment” to obtain more external benefits from “CDM” projects by allocating and gaining more “CDM investment.” This analysis is compatible with the situation where the Indian government is raising the purchase price of electricity generated by renewable energy8. The Indian government thus believes that this scheme is working as a governmental measure to support and promote private CDM investment regardless of whether that is the intent9.

8 In September of 2005, the Gujarat Electricity Board (2005) explained that the purchase price of electricity generated by renewable energy was Rs 2.75-3.50/kWh. In December of 2005, according to the Gujarat Electricity Regulatory Commission (2005), the Gujarat Electricity Board was purchasing it for more than Rs.3.15-3.87/kWh. 9 The Ministry of Non-Conventional Energy Sources (2005) agreed with this view.

42

5-3. Utilization of ODA in supporting CDM projects Given existing financial constraints, developing countries may have an incentive

to use ODA to finance projects/schemes that support private CDM investment, while adhering to the issue of financial additionality that prohibits the diverting of ODA to CER acquisition. Even some possible rules governing financial additionality that are compatible with the idea of public projects/schemes that support CDM projects involve problems including the risk of such diversion. However, as far as Japanese ODA that maintains the “collaborative shaping principle” is concerned, such problems are avoided. 5-3-1. Host country’s incentive to utilize ODA

ODA can be a possible source of funding projects/schemes that support private

CDM investment. Given the financial difficulties faced by host countries, there may be an incentive to use ODA to fund such projects/schemes.

Figure 5-6 is a diagram similar to Figure 3-2. The vertical axis is replaced by

existing ODA. B0 is a budget line depicting the amount of ODA provided to the country.

Figure 5-6 Allocation of ODA by a host country

More benefit

Indifference curves (benefit)

ODA PrivateInvestment

Existing ODA

B0 B1

b1

b0

e0

e1

CDM investment

More benefit

Indifference curves (benefit)

ODA PrivateInvestment

Existing ODA

B0 B1

b1

b0

e0

e1

CDM investment

43

Here, e0 will be chosen if the host government does not want ODA to be used for “CDM” projects. This may be a rational choice when the indifference curve is given as b0. This situation explains the current situation where developing countries are refusing to use ODA for CDM or to acquire CER.

However, when considering the option to invest in the projects/schemes to support

“CDM” projects, the rational choice made by the host country may change. As already discussed, governmental support of CDM projects can attract private CDM investment, thus assuming a new budget line such as B1. If the convex indifference curve is like b1, for example, or a new investment plan is not the corner solution, better benefits will be achieved by investing ODA in CDM projects. There is also the possibility of a corner solution even after shifting the budget line. If enough public investment has already been made by budget components other than ODA and the marginal rate of substitution of existing ODA for CDM investment is greater than the slope of B1, there is no need to divert ODA to CDM investment. However, given the financial difficulties in developing countries, a host government may require ODA to be diverted to projects/schemes that support CDM. 5-3-2. Regulation of ODA utilization

Regardless the possible benefits of diverting ODA to CDM investment, as already

mentioned, developing countries are refusing such diversion. The Marrakech Accords state that “public funding for clean development mechanism projects from Parties in Annex I is not to result in the diversion of official development assistance and is to be separate from and not counted towards the financial obligations of Parties included in Annex I (UNFCCC 2001, p.20).” Although there are some different interpretations, some developing countries maintain a strict attitude toward this financial additionality issue. For example, China, India, Korea, South Africa, the African group, Senegal, and Venezuela once proposed the following interpretation: “Financial additionality is achieved if the project funding does not include any contribution from ODA (Aska, 2000, p8).”

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5-3-3. Possible rules for financial additionality and diversion There are some arguments that define the possible domain in which ODA is

utilized under the rules of financial additionality. However, regarding those arguments, problems including the possibility of diversion are pointed out.

Dutschke et al. (2003) introduced “Distinction between baseline project and CDM ‘add on’ (Dutschke, 2003, p11)” as a possible manner of operation for financial additionality. Here it is assumed that a baseline project and the CDM portion can be distinguished. Baseline projects are projects that would have been funded through ODA anyway. The CDM portion is a CDM project added on to the baseline project. A coal-fired power plant may be a baseline project and improving efficiency with more advanced technology may be the CDM portion. To ensure financial additionality, ODA may not be used for the CDM portion. Regarding ODA applicability to greenhouse gas abatement, there are also arguments insisting that ODA funds should at most be used for capacity building in developing countries (Asuka 2000). For example, Kete (2001) concludes that in developing countries that make CDM a priority, aid should be used for human and institutional capacity development in both the public and private sectors, focusing on the creation of circumstances conducive to attracting CDM projects.

Figure 5-7 “Distinction between baseline project and CDM add-on” rule

• This project would have been funded through ODA anyway

• This portion can be defined

Assumption

• The improvement of efficiency due to use of a more advanced technology

Coal power plant

Similar project to our case study

Examples

• Power plant with renewable source

• Coal power plant • Infrastructure for electricity supply

• (Fund for purchasing and reselling of electricity)

CDM portion

Baseline project

• This project would have been funded through ODA anyway

• This portion can be defined

Assumption

• The improvement of efficiency due to use of a more advanced technology

Coal power plant

Similar project to our case study

Examples

• Power plant with renewable source

• Coal power plant • Infrastructure for electricity supply

• (Fund for purchasing and reselling of electricity)

CDM portion

Baseline project

CDM portion

Baseline project

These arguments are compatible with the idea of public projects/schemes that

support CDM projects. Both arguments assume that private CDM projects are possible under the conditions created by public investment or ODA investment. In the “Distinction

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between baseline project and CDM ‘add on,’” the CDM portion considered to be only possible when investment is made in a baseline project. As for the argument of capacity building, it is thought that some CDM projects are only possible when capacity building is achieved through ODA.

However, regarding those rules, problems including the possibility of diversion are

pointed out. Dutschke (2003) points out the problems of “Distinction between baseline project and CDM ‘add on’ (Dutschke, 2003, p11).” With this rule, diversion is likely toward projects that are suitable to “piggyback” CDM. He also argues that defining a baseline project is not so simple. As for capacity building, Asuka (2000) points out the possibility of crowding out the regular flow of ODA. That occurs because public funds that are used for capacity building can serve as a quasi-subsidy to reduce the transaction costs of individual CDM projects. 5-3-4. Possibility of Japanese ODA in CDM

The risk of diverting Japanese ODA is smaller than that of ODA in general. The

Japanese government maintains the “collaborative shaping principle” in its ODA project development, and developing countries have control over diverting ODA to projects/schemes that support CDM. Moreover, developing countries can define the manner of supporting CDM projects.

To obtain “development dividend” or “external benefits”, Cosbey et al. (2005)

proposes, engagement of ODA is one of possible options. They discuss that it seems a natural fit to engage ODA in supporting CDM projects that have high development benefit.

Cosbey et al. (2005) also insists on the necessity of assessment regarding the way

ODA is used in supporting CDM. They argue that “any decision on how to spend existing ODA to support the CDM should be strategically assessed, always subject to the test; could this money be used elsewhere? (Cosbey et al., 2005, p.52)”

As for Japanese ODA, developing countries have an opportunity to express their

intentions regarding the utilization of ODA in projects/schemes to support and promote private CDM investment. Japan used to follow a “request principle” whereby aid projects were developed only when developing countries requested the projects. In 1997, Japan

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introduced the “collaborative shaping principle” whereby the donor countries also present their vision and both parties collaboratively develop the aid program or project. Still, developing countries can influence the way that ODA is used.

In a similar way, developing countries can influence how CDM projects are

supported and promoted with ODA. Thus, “baseline projects” or “capacity building projects” can be flexibly defined by developing countries.

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6. Conclusion

In order to achieve the targeted reduction in GHG emissions in Japan, Japan must not only implement domestic measures, but also cooperate with India to improve CDM projects in India. However, currently existing CDM/JI projects and related feasibility studies are apparently disproportional in particular categories.

This is partly due to the Global Warming Potential (GWP) values. The GWP

values //only reflect the greenhouse effect and do not consider other factors that affect social benefits, such as a better standard of life in urban areas, a stabilized supply of electricity, and technology transfer. Even if there are external benefits offered by potential CDM projects, such benefits are not precisely evaluated. This is the basic problem of the Kyoto Protocol.

Governmental support mechanisms to compensate for said institutional flaw of the Kyoto Mechanism will be useful to implement some potential CDM projects that offer external benefits, but which are unprofitable or risky. There is no difference in terms of incentives to promote CDM projects between host country funding (e.g., subsidies, commitment) and donor country funding, such as ODA, for private companies to develop CDM projects.

Today, the government of India insists on abiding by the Marrakech Accord, but

also approves the use of Indian government subsidies for CDM projects under the condition of technology transfer. Thus, the Indian government is no doubt aware of the external benefits of CDM projects.

Therefore, host countries should approve the diversion of ODA to CDM for projects

under the following basic conditions: 1. The host government can participate in determining how ODA is used. 2. The host government recognizes that it must lend political support to promoting

CDM projects involving private companies. 3. The host government agrees that the diversion of ODA to projects and schemes

that support CDM projects can bring more benefit than that from wasted ODA spending.

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As a result, host countries will receive more benefits under the Kyoto Mechanism. A flexible interpretation of the Marrakech Accord will also have a better impact on the Kyoto Mechanism.

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References Asuka, Jusen (2000) “ODA Baseline as a Criterion for Financial Additionality” Joint Implementation Quarterly 6 (3), p.8. Cosbey, Aaron; Parry, Jo-Ellen; Browne, Jodi; Babu, Yuvaraj Dinesh; Bhandari, Preety; Drexhage, John; Murphy, Deborah (2005) “Realizing the Development Dividend: Making the CDM Work for Developing Countries, Phase 1 Report – Prepublication Version ”, International Institute for Sustainable Development (IISD) CDM India (2006) http://www.envfor.nic.in/cdm/host_approval_criteria.htm Dutchke, Michael; Michaelowa, Axel (2003) “Development Aid and the CDM - How to interpret ‘Financial Additionality’”, HWWA discussion Paper 228, Hamburg Institute of International Economics, Hamburg Kete, Nancy; Bhandari, Ruchi; Baumert, Kevin (2001) “Should Development Aid Be Used to Finance The Clean Development Mechanism?” World Resources Institute, Washington D.C. UNFCCC (2001): Report of the Conference of the Parties on its seventh session, held at Marrakech Oct 29 – Nov 10, Part two: action taken by the Conference of the Parties, Vol. II, FCCC/CP/2001/13/Add.2, Marrakech Valente, Marcela (2004) Climate Change: A disappointing start for the Clean Development http://www.ipsnews.net/interna.asp?idnews=26604 Accessed February 2006

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Interview lists GEB; Gujarat Electricity Board (2005) Interview conducted by authors in September and December GERC; Gujarat Electricity Regulatory Commission (2005) Interview conducted by authors in September and December GEDA; Gujarat Energy Development Agency (2005) Interview conducted by authors in September and December The Ministry of Non-Conventional Energy Sources (2005) Interview conducted by authors in December Torrent Power (2005) Interview conducted by authors in September Chugoku Electric Power Co.,Inc. (2005) Interview conducted by author Korea Energy Management Corporation (2006) Interview conducted by authors in February