Carbon Finance for Beginners

Part 1: Kyoto Protocol and its mechanisms

Wednesday 28 March, 2007Bratislava, Slovakia

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Overview

• Part I: Kyoto and its mechanisms

• Climate change and its causes

• International Response: UNFCCC and Kyoto Protocol

• Part II: Current state of carbon market

• Micro level

• Macro level

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Climate change: history

• Intergovernmental Panel on Climate Change (IPCC) - 1988 (www.ipcc.ch)

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Direct Observations of Recent Climate Change

Gobal mean temperature

Global averagesea level

Northern hemisphereSnow cover

Source: WG I Contribution to the IPCC Fourth Assessment Report, February 2007

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Climate change: how it works

Source: Department of Environment and Heritage. Government of South Australia

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Carbon dioxide (CO2)• Source: fossil fuel combustion and land-use changes,

particularly deforestation • the most important GHG, but • lowest global warming potential (GWP) - 1

Methane (CH4)• Source: coal mining, landfill operations, livestock raising and

natural gas/oil exploitation and transportation• GWP - 21 ( 1t CH4 = 21 tCO2 in terms of global warming effect)

Nitrous oxide (N2O)• Source: fertilizer manufacturing, fossil fuel combustion (mainly in

transport sector) • GWP – 310

Climate change causes: ”natural” greenhouse gases (GHG)

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Annual greenhouse gas emission by sector

Source: Global Warming Art

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Hydrofluorocarbons (HFCs) and Perfluorocarbons (PFCs)

• Alternative to ozone depleting CFCs and HCFCs • Source: manufacturing processes (e.g. refrigeration and air

conditioning equipment)• GWP: HFCs range from 140 to 11,700 (HFC23), CxFx range

from 6.500 (CF4) to 9,200 (C2F6) Sulphur hexofluoride (SF)

• Used as a dielectric fluid (e.g. in power grids)• GWP - 23,900• Atmospheric lifetime of one molecule - 3,200 years• Most dangerous anthropogenic-induced GHGs

Climate change causes: ”engineered” greenhouse gases (GHG)

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Climate change: General UN Message

Science is clear: warming of climate system is

unequivocal and attributable to human activities

Severe impacts of climate change are already being

felt, particularly in developing countries, and demand

an urgent response

Economic assessments indicate that cost of

inaction will exceed the cost of taking action now by

several orders of magnitude.

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• Objective: stabilize global GHG concentrations in atmosphere

• Universally agreed: 189 countries have ratified/accepted UNFCCC

• Principle of common but differentiated responsibilities:

• Industrialized countries (Annex I) aim to restore GHG emissions to 1990 levels (no mandatory commitments thus legally non-binding)

• Developed countries (Annex II) commit to build capacity of and facilitate technology transfer to developing countries

• Identifies two options to address climate change:

• mitigation of climate change by reducing GHG emissions and enhancing sinks, and

• adaptation to the impacts of climate change

Both mitigation and adaptation are essential in reducing the risks of climate change!!!

International Response: UN Framework Convention on Climate Change (UNFCCC) 1992

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• Kyoto Protocol amended UNFCCC with 2 principal provisions:

I. Assigns mandatory (legally-binding) GHG emission reduction targets to Annex I parties:

• Individual targets for each industrialized country: on average by 5% below 1990 levels

• Establish time-frame (Kyoto commitment period): 2008-12

• Developing countries and some economies in transition (non-Annex I) countries do not have reduction targets

II. Introduce market mechanisms to allow industrialized countries to meet their commitment in most cost-effective way by purchasing GHG emission reductions from elsewhere:

• from financial exchanges (Emission Trading)

• from projects which reduce emissions (Clean Development Mechanism (CDM) or Joint Implementation (JI))

International Response: Kyoto Protocol, 1997

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Emission trading (cap-and-trade) Kyoto Protocol sets a limit or cap on the amount of GHG that can

be emitted Each country is given credits or allowances (assigned Amount

Units or AAU), i.e. the right to emit a specific amount which corresponds to the cap

Countries that emit beyond their allowances must buy credits from those who emit less than their allowances

This transfer is referred to as a trade

Emissions in reporting year

Allocated allowances (AAU)

Surplus of certificates

Deficit of certificatesCountry A Country B

CAPTrade in AAUs

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Project-based mechanisms: JI and CDM

JI: allows one Annex I country to meet part of its target by investing in and carrying out a project to reduce greenhouse gas (GHG) emissions in another Annex I country.

CDM: allows one Annex I country to meet part of its target by carrying out a project to reduce greenhouse gas (GHG) emissions in non-Annex I country (host country).

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Kyoto Mechanisms: economic rational behind

Developed countries:

• Kyoto allows Annex I countries to purchase “GHG emission

reductions” instead of reducing emission domestically

• Costs of complying with Kyoto targets is prohibitive for Annex I

countries (most EU members with highly efficient, low GHG

polluting industries, and high environmental standards)

Developing countries:

• Kyoto encourages non-Annex I developing economies to

reduce GHG emissions since doing so is now economically

viable because of the sale of GHG emission reductions

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Kyoto Architecture: Cap&trade, JI & CDM

Bulgaria Denmark

CAP

Trade in AAUs

Italy

CDM projects

Trade in CER (Certificates from CDM projects)

Emissions in reporting year

Allocated allowances (AAU)

Surplus of allowances

Deficit of allowance

JI projects

Trade in ERUs (Certificates from JI projects)

Ukraine

?

Difference between trade in AAUs, ERUs & CERs - PRICE

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Kyoto Protocol in RBEC: chaotic picture

Annex I EU Member States • Members of EU ETS – can trade in allowances• JI projects – for GHG sources not covered by EU ETS (e.g. land use change)

Belarus, Russia, Ukraine

• JI projects• Trade in allowances – very difficult

Croatia • Accepted, but not ratified KP• Very tight cap• Most likely need to buy AAUs

Turkey • Not ratified KP and will not likely do• Voluntary market

Non-Annex I

South Caucasus, Moldova, Western Balkan, Central Asia

• CDM projects• Voluntary market

Kazakhstan • not ratified KP, would like to be included in the list of Annex I• unless legal status resolved – voluntary market

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• End of Part I

• Questions?

• Thank you

• 30 minutes break

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Carbon market: Project (micro) - level

• CDM Eligibility Criteria

• Project Examples

• CDM Project Development Cycle

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CDM Eligibility Requirements

Country-level

Ratification of Kyoto Protocol

Establishment of DNA for host country approval of CDM project

Project-level Project should result in real and measurable GHG emission reductions Project should be additional to what would have occurred under

business-as usual scenario Project must help the host country to achieve its national sustainable

development goals Other criteria set-up by a host country “CDM project should not result in diversion of ODA”

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CERs = Baseline emissions – (Project emissions + Leakage)

The baseline is the amount of GHG that would be emitted in the absence of the CDM project. It is not necessarily the current amount of emissions.

KEY:– ability of a project developer to identify and prove the selection of baseline scenario;– CDM projects must follow official Baseline Methodologies (provide clear guidance on how to establish baseline for each project category)

CDM Eligibility Requirements: Measuring emission reductions

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Selection of

project baseline

Source: GTZ

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Project description

a) Grid-connected wind power plant

b) 20MW (net) in capacity

c) US$30 million in investment

Sources of reduction (CERs)

a) Displacement of fossil-fuel based power b) Amount of emission reductions depends on carbon intensity of

the grid

CER calculation: an example

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(Illustrative Calculations)

・ Emission-free power generation by the project 20MW x 24h x 365d x 80% 140,000MWh/year

・ Carbon intensity of replaced electricity (Example)

- 50% combined-cycle (0.40tCO2e/MWh) - 50% fuel oil (0.72 tCO2e/MWh) - 50% x 0.40 tCO2e/MWh + 50% x

0.72tCO2e/MWh = 0.56 tCO2e/MWh

・ 140,000MWh/year x 0.56tCO2e/MWh 75,000tCO2e/year

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a) CDM projects must be “additional”. This concept requires careful

attention.

b) Official language

・ (A CDM project must achieve) Reductions in emissions that are additional to any that would occur in the absence of the certified project activity. 　　　　　　　　　　　　　　　　　　

・ A CDM project activity is additional if anthropogenic emissions of greenhouse gases by sources are reduced below those that would have occurred in the absence of the registered CDM project activity

CDM Eligibility Requirements: Additionality

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c) Interpretation・ CDM status will be given only to those projects

that cannot be implemented without it. ・ Those projects that can/will be carried out in the

course of regular business (Business-As-Usual - BAU - projects) are disqualified.

d) Paraphrase ・　 CERs are offered as an incentive to encourage developers to undertake GHG mitigation projects that do not normally happen.　　　

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CDM Eligibility Requirements: Additionality tool

Step 1. Identify legal alternative scenarios to the project

Step 2. Investment analysis Step 3. Barrier analysis

Step 4. Common practice analysis

Step 5. Impact of CDM

The proposed CDM project activity is additional

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a) Rigorous process led by CDM Executive Board.

b) Project Design Document (PDD) as the centerpiece of the CDM process. The PDD includes: ・ project description　　・ additionality argumentation ・ CER calculation

c) The PDD will be subject to 　　 ・ public comments ・ scrutiny by an independent third party

called the Designated Operational Entity (DOE)

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CDM Project Cycle

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CDM Project Cycle

(1) Identifying CDM

project (PIN) PPs

(2) Preparing Project Design Document (PDD)

- PPs

(3) Getting approval from each Party involved - DNA

(4) Validation - DOE (5) Registration – CDM EB

(6) Monitoring - PPs

(7) Verification and Certification - DOE

(8) Issuance of CERs – CDM EB

(9) Distribution of CERs - PPs

PPs – project participants; DNA – Designated National Authority

DOE – Designated Operational Entity, CDM EB – CDM Executive Board

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Project Participants

•CDM Project owner (CER seller): - Any legal entity officially registered in host country that can

develop and operate CDM projects (business, municipalities, NGOs)

- Each host country may establish additional criteria for project owners (e.g. financial sustainability or share of foreign capital)

- Others: CDM broker, project financier, technology provider, project operator, etc… Who and How to define CER ownership?

•CDM Project Investor (CER buyer):- An entity that purchases CERs from a CDM project. The investor

is usually from an Annex I country and can be a corporation, a government body or non-governmental organization, or an international carbon fund (e.g. World Bank PCF)

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Designated National Authority (DNA)

• Project participants shall get written approvals of CDM project from the DNA of each Party involved

• PPs may get written approvals in step (1), (2) or even (4), but before a request for registration

• The written approval from CDM host Party must confirm:- The fact of Kyoto Protocol ratification;- Voluntary participation in CDM project activity;- Contribution to sustainable development of the host Party

• Additionally, the letter may contain:- Authorization of project participants (official confirmation of CER

ownership)- No objection or assistance to current and/or future allocation of CERs

(especially important for unilateral CDM)

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Designated Operational Entity (DOE)

• DOE is domestic or international legal entities that have been

accredited by the CDM Executive Board (Info in UNFCCC data base http://cdm.unfccc.int/DOE)

• It has two key functions:1) To validate and subsequently request registration of a proposed CDM project

activity (Step 4)2) To verify emission reduction of a registered CDM project activity, certify as

appropriate and request the CDM Executive Board to issue CERs (Step 7) – verification is done periodically at the request of PPs

• 12 DOEs officially accredited by CDM EB; only two from non-Annex I Parties (South Korea and South Africa)

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CDM Executive Board (CDM EB)

• CDM EB – is an international CDM governing body

• It consists of 10 members (& 10 alternates): 2- from Annex I , 2 - from non-Annex I, 1 from each UN region, 1 from small island developing states

• Its key functions:− to register CDM projects (Step 5) and issue CERs (Step 8)− to approve baseline and monitoring methodologies− to accredit DOEs− to any others tasks according to the decision of COP/MOP

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CDM Vs GEF Project Cycle

• Both GEF and CDM project aims at GHG emission reduction, but• CDM focuses only on activities that lead to real and measurable GHG

emission reduction, while GEF has a broader focus (capacity building,

institutional development)

• CDM produces a market commodity, hence calculation and monitoring of

GHG emissions is much more stringent

• Similar development pathway: from project idea (PIN/PID) to

implementation and monitoring, BUT:• In CDM the existence of robust underlying project is crucial (feasibility

study, business plan, investors identified)

• Different nature of transaction costs

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CDM Project Cycle Vs GEF Project Cycle

Step CDM GEF

Project identification and development

PIN/PDD PDGs/FSPs

BUT: for CDM the existence of an “underlying project” is crucial (feasibility study, business plan, investors identified) before PIN/PDD

Getting National approval

Designated National Authority

GEF Operational Focal Point

Independent review DOE STAP

Registration CDM EB GEF

Monitoring PPs based on PDD and approved Monitoring Methodology

IAs based on IAs’ rules and approved prodoc

Evaluation DOE Independent evaluators

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Carbon market: Macro - level

• Market capitalization

• Market structure by project type and geography

• Price

• Future perspective

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Overview of carbon markets: volume (tCO2) and value ($)

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Overview of carbon markets: volume (tCO2) and value ($)

EU-ETS Takes All: Shares of Volume (left) and Value (right) Transacted in the Carbon Market (2006 until September 30)

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Project-based Transactions – Location of CDM & JI Projects

• China continued to have a dominant CDM market-share with 60%• Ukraine supplies one third of Joint Implementation (JI) volumes

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Type of technology in emission reduction projects (as a share of volume contracted)

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Project-based Transactions – Who is buying @ what price level…..?

Price levels vary according to (assumed) risk levels:(current – March 2007 – price levels for CERs: €8-10)

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Market outlook to 2012

The countries with shortfalls in their Kyoto emission allowances are likely to need 4.0-5.0 billion Kyoto compliant units by 2012 to meet their commitments.

Based on current trends the CDM is probably capable of supplying an average of 100-200 million CERs per year during the commitment period or, in aggregate, around 800 million CERs by 2012.

JI is estimated to be able to supply an additional 40-50 million ERUs per year during 2008-2012, or in total 200-250 million by 2012.

Combined CER and ERU supply to 2012 could be around 1,000 million units, which would meet about 15-25% of Kyoto market demand for compliance units.

Source: UNDP-EEG, March 2006

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THANK YOU FOR YOUR KIND ATTENTION