Carbon Credits - India

- Implications as a financing instrument

Authors: Akash Gehani Gopal Kapoor Kalyan Teja Nimushakavi Neha Goyal Sumit thawrani Adwitiya Sarkar (Students of MDI, Gurgaon)

Carbon Credits - Implications in India as financing instrument

Table of Contents
EXECUTIVE SUMMARY: ....................................................................................................................................3 1. INTRODUCTION ......................................................................................................................................4 1.1 CONCEPT OF CARBON CREDITS ................................................................................................................ 4 2. BIRTH OF CARBON CREDITS ...............................................................................................................5 2.1 KYOTO PROTOCOL .................................................................................................................................. 5 2.2 IMPLEMENTATION ROADMAP ................................................................................................................... 6 2.2.1 JI (Joint Implementation)................................................................................................................. 6 2.2.2 CDM (Clean Development Mechanism) ........................................................................................... 6 2.2.3 Emissions Trading ........................................................................................................................... 7 2.3 CDM MECHANISM IN INDIA .................................................................................................................... 7 3. CDM PROCESS .........................................................................................................................................8 3.1 INDIA CDM METHODOLOGY ................................................................................................................... 8 3.2 ADDITIONALITY ...................................................................................................................................... 9 3.3. MAJOR PHASES ...................................................................................................................................... 9 3.3.1 Project Identification ..................................................................................................................... 10 3.3.2 Project Design............................................................................................................................... 11 3.3.3 Host Country Approval .................................................................................................................. 11 3.3.4 Validation ..................................................................................................................................... 12 3.3.5 Registration................................................................................................................................... 13 3.3.6 Monitoring .................................................................................................................................... 14 3.3.7 Verification and Certification ........................................................................................................ 14 3.3.8 Issuance of CERs........................................................................................................................... 14 4. ELIGIBILITY .......................................................................................................................................... 15 5. CARBON FINANCING ........................................................................................................................... 16 5.1 CDM PROJECTS .................................................................................................................................... 16 5.1 BILATERAL PROJECTS ............................................................................................................................ 16 5.2 UNILATERAL PROJECTS ......................................................................................................................... 17 5.3 FINANCING SOURCES ............................................................................................................................. 17 5.4 CER PURCHASERS................................................................................................................................. 18 5.5 FINANCING TRANSACTION COSTS ........................................................................................................... 18 5.6 PRICING OF CER’S ................................................................................................................................ 19 6. RISKS WITH CDM PROJECTS AND MITIGANTS............................................................................ 20 7. ARGUMENTS ABOUT CDM PROCESS ............................................................................................... 21 7.1 ADVANTAGES ....................................................................................................................................... 21 7.2 DISADVANTAGES .................................................................................................................................. 21 9. EXAMPLE OF A COMPANY:................................................................................................................ 22 9.1 SRF LIMITED ........................................................................................................................................ 22 10. CONCLUSION ....................................................................................................................................... 23 REFERENCES ............................................................................................................................................. 24

2

Carbon Credits - Implications in India as financing instrument

Executive Summary:
In 1997, Kyoto Protocol, a voluntary treaty was signed by 141 countries to reduce the emissions of Global House Gases by 5.2% below 1990 levels by 2012. Certified Emissions Reductions (CER) or Carbon credits are certificates issued certifying reduction in emissions. The developing countries have been exempted from any such restrictions. These certificates can be traded in the market and purchased by firms which find purchasing emission credits to offset its emissions lower in cost. Thus an opportunity has emerged for firms in developing countries like India, Brazil and China to boost their earnings by complying with norms. However not all projects are eligible for registration under the Clean Development Mechanism under the Kyoto Protocol. As a result a large number of advisory firms have spawned. In addition an entire market has been developed around the same. The key participants apart from the project developers are, including not limited to, verification, certification and financing institutions. In India this opportunity has manifold implications affecting not only industry but also government, financial institutions and civil society at large. Most importantly this has opened up a new source of cash flow in project financing making unviable projects viable by exceeding the hurdle rate for investment returns. Industry will need to adapt to the changing opportunity that it brings along i.e. higher return on investments along with risks that are inherent in carbon credit project financing. In my opinion, it will be pragmatic on part of firms to consider this mode of cash flows in project financing. Further this provides a strategic role for the countries to benefit from the cash flows that can be invested in cleaner technologies for sustainable development.

3

Carbon Credits - Implications in India as financing instrument

1. Introduction

Carbon credits have emerged as an important instrument in the financial markets. The primary goal is to reduce emission of green house gases. By permitting allowances to be bought and sold, an operator can seek out the most cost-effective way of reducing its emissions, either by investing in cleaner machinery and practices or by purchasing emissions from another operator who already has excess capacity.

1.1 Concept of Carbon Credits

Carbon credits are a key component of national and international emissions trading schemes that have been implemented to mitigate global warming. They provide a way to reduce greenhouse effect emissions on an industrial scale by capping total annual emissions and letting the market assign a monetary value to any shortfall through trading. Credits can be exchanged between businesses or bought and sold in international markets at the prevailing market price. Credits can be used to finance carbon reduction schemes between trading partners and around the world. There are also many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint on a voluntary basis. These carbon offsetters purchase the credits from an investment fund or a carbon development company that has aggregated the credits from individual projects. The quality of the credits is based in part on the validation process and sophistication of the fund or development company that acted as the sponsor to the carbon project. This is reflected in their price; voluntary units typically have less value than the units sold through the rigorously-validated Clean Development Mechanism.

4

Carbon Credits - Implications in India as financing instrument

2. Birth of Carbon credits

2.1 Kyoto Protocol

The issue of climate change and global warming became the topic of International concern in the 1980s and since then has been subject to debate and several agreements on scientific issues, voluntary actions, legally binding greenhouse gas emission targets, rules for implementation and mechanisms. At the 1997 Climate Change Convention in Kyoto, the primary topic of discussion was the reduction of greenhouse gases (GHG), which are believed to be the principal cause of global warming. Kyoto Protocol is a voluntary treaty signed by 141 countries, including the European Union, Japan and Canada for reducing GHG emission by 5.2% below 1990 levels by 2012. However, US which accounts for one-third of the total GHG emission, is yet to sign the treaty. The preliminary phase of the Kyoto Protocol ends in 2007 while the second phase starts from 2008. The penalty for non-compliance in the first phase is Euro 40 per ton of carbon dioxide (CO2) equivalent. In the second phase, the penalty is hiked to Euro 100 per ton of CO2. Carbon credits are certificates issued to countries that reduce their emission of GHG (greenhouse gases) which causes global warming. Carbon credits or Certified Emissions Reductions (CER) are a "certificate" just like a stock. A CER is given by the CDM Executive Board to projects in developing countries to certify they have reduced green house gas emissions by one ton of carbon dioxide per year. For example, if a project generates energy using wind power instead of burning coal, it can save 50 tons of carbon dioxide per year. There it can claim 50 CERs (one CER is equivalent to one ton of carbon dioxide reduced). Ideally, Carbon credits can essentially be viewed as a means of empowering the market to care for the environment. The legislations can set inflexible environmental targets for the industry with the flexibility to meet the objectives in any manner, it chooses to. The industry must find the lowest cost solutions to meet these objectives with all the flexibility at their disposal. The emissions cap is decided under the Kyoto Protocol and the level of reductions by time frames has been specified. The emissions are easily tradable and thus results in lower abatement costs. All this allows permanent reduction in emissions from a certain decided baseline. However, a certain industry can purchase emission credits to offset its emissions from somewhere else at a lower cost.
5

Carbon Credits - Implications in India as financing instrument

2.2 Implementation Roadmap

In 1990 UNO (United Nations Organization) feeling an immediate need to decrease the emission of greenhouse gases into the atmosphere released the Kyoto Protocol. As a result under the UNFCC (United Nations Framework Convention on Climatic Change) industrialized nations entered into a legally binding agreement to reduce the collective emissions of greenhouse gases (GHG) by 5.2% compared to the 1990 level; calculated at an average over the five year period of 2008-12. Separate national targets have been given to US (7%), European Union (8%), Japan (6%) and Russia (0%). The reduction is to be done on six greenhouse gases – carbon dioxide, methane, nitrous oxide, sulphur hexafluoride, HFCs and PFCs. Further the protocol reaffirms the principle that industrialized countries have to pay and supply technology to other countries for climate related studies and projects. The Protocol came into force in February 2005 giving GHG emission limits for each developed (Annex I) country included in the protocol. In order to facilitate reaching emission limits, three additional mechanisms were agreed upon in the Marrakesh Accords in 2001. These are the Clean Development Mechanism (CDM), Joint Implementation (JI) and Emission Trading (ET). 2.2.1 JI (Joint Implementation) Developed countries can implement projects that reduce emissions or remove carbon from the atmosphere in other developed countries in lieu of ERUs (Emission Reduction Units). These ERUs can be used to meet the emission reduction targets. JI projects must have the approval of all parties involved and must lead to emission reductions or removals that are additional to any that would have occurred without the project. ERUs can only be issued from periods onwards of year 2008 although JI projects can be started from year 2000 onwards. 2.2.2 CDM (Clean Development Mechanism) Developed countries can implement projects that reduce emissions or remove carbon from the atmosphere in other developing countries in lieu of CERs (Certified Emission Reductions). These CERs can be used to meet the emission targets. The protocol stresses that such projects are to assist the developing countries host parties in achieving sustainable development. Further the protocol refrains developed countries from using CERs generated out of nuclear facilities to meet the targets.
6

Carbon Credits - Implications in India as financing instrument

2.2.3 Emissions Trading The protocol provides that developed countries can acquire units from other developing parties and use them towards meeting their emissions targets, but must be prepared to transfer the units when they do not require them for compliance. This enables developed countries to make use of low cost opportunities to reduce emissions. Only some developed countries with emission limitation and reduction commitments specified in the protocol can engage in such an activity.

2.3 CDM Mechanism in India

The CDM was created to give a cost effective option for developed (Annex I) countries to achieve their emission reduction targets. In the CDM, an organization from a developed country (Annex I country) can obtain Certified Emission Reductions (CERs) by reducing emissions in a developing (non-Annex I) country where a comparable reduction requires substantially smaller investments. The country and the organization receiving the CERs from the CDM project are allowed to add the corresponding amount of CO2 emissions to its emission quota. India qualifies to be a host country for the CDM projects only. India is considered as one of the most potential countries in the world for CDM projects. This is due to its large power sector that depends on fossil fuels, and to the proactive policies of the Indian government towards CDM. The power sector alone is estimated to emit 433 million tonnes of CO2 per annum. The total CO2 reduction potential through CDM projects in India is estimated to be around 300 million tonnes. The largest potential is in the renewable energy sector with 90 million tonnes CO2 equivalents. The total expected average annual CER’s from registered projects by India are about 22 million having a 15% world share.

7

Carbon Credits - Implications in India as financing instrument

Expected CER’s from Registered Projects

3. CDM Process

3.1 India CDM Methodology

In India the Designated National Authority (DNA) is hosted by the Ministry of Environment and Forests (MoEF). In addition to the DNA, India has many state-level nodal agencies promoting and facilitating CDM-projects in their area. These organizations can be of assistance in setting up contacts with public organizations to arrange CDM projects, or in approaching a larger number of small-scale possible project proponents. They can act also as bundling agencies, i.e. combine a number of small-scale CDM projects and handle financial management for bundled projects. The CDM also allows an industrial actor in the non-Annex I country to reduce its Green House Gas emissions and to sell the reduction units to a party in the Annex I countries. The GHG reductions and the way to reduce them have to be approved by the CDM EB. The GHG reduction achieved though a CDM project is quantified as a Certified Emission Reduction (CER), one CER corresponding to one tonne of CO2 equivalent. An industrial actor in a non-Annex I country can execute the project activity all by itself, in which case the project activity is called unilateral. If a party from an Annex I country takes part in the project through funding, a project is called bilateral.
8

Carbon Credits - Implications in India as financing instrument

The technical way to reduce Green House Gas emissions is called a methodology. A methodology is a description detailing the new way of operating with the result of generating less GHG emissions than in a business-as-usual case. The business-as-usual case is referred to as the baseline in the methodology description. The comparison between emissions of the new and the baseline case yields CERs, provided that the project activity is judged as additional. 3.2 Additionality

A project activity is additional if it would not be executed without the CDM. Article 12 of the Kyoto Protocol defines additionality as “Reduction in emissions that are additional to any that would occur in the absence of the certified project activity.” Moreover, project activities funded by Overseas Development Aid (ODA) are deemed automatically to be non-additional.

Distribution based on Project Status (180 Samples)

3.3. Major Phases

Generally, the CDM process has three main phases. The first one consists of planning the activity, the second one of executing the plan and the final one of realizing the emission reductions. Furthermore, the realization phase can be divided into verification and
9

Carbon Credits - Implications in India as financing instrument

certification phases and an issuance phase. The planning phase can be broken down to five phases illustrated. Project Planning Phase

3.3.1 Project Identification The CDM-project starts with a project identification phase as in any normal project. During the project identification phase, the parties keen to promote the project activity, referred to as the project proponents (PPs), should formulate a Project Idea Note (PIN). In India the PIN is often referred to as a Project Concept Note (PCN). The PCN document should describe all the essential elements of the CDM-project. These essential elements are the same both for the PCN and the Project Design Document (PDD). The PDD is significantly longer than the PCN. They are mentioned later in the project design section. The UNFCCC does not provide any official PCN-template, but the DNA has its own PCN-template and it requests the PP to use it when the PCN is submitted along with the PDD to the DNA. The template can be acquired from DNA’s website. The official CDM-cycle laid out by the UNFCCC does not formally require the formulation of any kind of document in the project identification phase, but the DNA requires it later. It is

10

Carbon Credits - Implications in India as financing instrument

also a useful tool for the project proponents when in dialogue with potential stakeholders such as CER buyers and project financiers. Hiring a CDM consultant is not compulsory for developing a CDM project but it is estimated that approximately 90% of all CDM-projects done in India so far have involved one. Many project owners emphasize the importance of making the right choice when selecting the consultant as some of them have been reporting of problems in the cooperation with consultants. As some of the proposed projects can be too small to be able to carry all transaction costs required, it makes sense to use the bundling provisions of the Protocol. Instances, such as The Indian Renewable Energy Development Agency (IREDA) or certain industry associations have been designated as bundling organizations. Many other public, private or NGO organizations can also act as bundling organizations.

3.3.2 Project Design While designing a project activity, the project participants should make sure that the planned project activity will contribute to the host country’s sustainable development and that the planned project activity is additional. While formulating a CDM project, the project proponent needs to address legal, financial, incentives, taxation treatment and business model options issues. Finally, it needs to be defined whether the project is a small scale or a normal scale CDM project. A small-scale project has advantages such as the use of a simplified Project Design Document and additionality test. 37% of projects registered at the CDM EB are small-scale projects. The concrete product of this phase is the PDD, in which the PP have clearly and concisely described the intended project activity. The PDD has to address such issues as the baseline methodology, the duration of the project activity, the justification for additionality, the monitoring methodology and plan, the calculation of Green House Gas emissions by sources, the environmental impacts and the stakeholder comments.

3.3.3 Host Country Approval After the PDD is deemed satisfactory, the PP has to submit both the PCN and the PDD to the host country DNA to apply for a Host Country Approval (HCA). The Indian DNA requires
11

Carbon Credits - Implications in India as financing instrument

both the PCN and the PDD, even though the official UNFCCC’s endorsed process requires only the PDD. The DNA requires the project to be additional and the project activity to promote sustainable development. There are three dimensions for sustainable development: financial, environmental and social. Additionally, in the country the project needs to be approved by the local State Pollution Control Board (SPCB), before it can be submitted to the DNA. The host country approval process includes a hearing of the project proponents and an in-depth analysis of the project by the DNA and other consultants. The DNA holds these hearings on a monthly basis and it can approve over twenty projects per session. Typically, the CDM consultant assists in the hearing. For unilateral projects, the HCA is enough but for bilateral projects, the PP should acquire an approval letter from the DNA of the CER buyer’s country. However, that has to be done only at the stage when the PP requests the CDM EB to transfer the CERs to the buyer. The Indian DNA has accorded host country approval to 227 CDM project design documents as of March 2006. The DNA’s work has been widely praised, and the approval process is said to be smooth and speedy.

3.3.4 Validation The project participants should have the project validated by a designated operational entity (DOE) that is accredited by the CDM EB. Typically DOEs are worldwide renowned quality assurance organizations. DOEs have been granted certain sectoral scopes (for instance, energy distribution or chemical industry) in which they are allowed to operate. The DOE checks that the project fulfils the requirements set forth by the UNFCCC, additionality being the most important issue. In March 2008, 13 companies have received DOE status worldwide, of which 7 are operating in India. The amount is expected to increase. The typical duration for the project validation phase ranges from 8 to 13 weeks. In case a new methodology has to be developed for the project, it has to be approved by the CDM methodology panel. In this case, the validation phase will take an additional 3–12 months. Following a successful validation, the project proponents can apply for project registration.

12

Carbon Credits - Implications in India as financing instrument

3.3.5 Registration During the registration phase, the DOE submits all necessary documents to the CDM EB and requests project registration. For projects generating more than 15,000 tonnes of CO2 equivalent on average per year, an administration fee of 0.164 Euros per CER is collected by the EB. The registration fee is an advance payment for the reductions achieved during the first year. The registration decision is made by the CDM Executive Board. By March 2008, the CDM EB has registered 161 projects of which 36 originated from India.

Project Execution and Realization Phase

13

Carbon Credits - Implications in India as financing instrument

3.3.6 Monitoring The approved PDD has pinpointed all the variables that need to be checked for assessing the real emission reductions of the project activity. The project participants are responsible for monitoring reductions in emissions (according to the approved monitoring plan) and reporting them to the DOE for verification purposes. The monitoring phase should produce enough quantitative data for the accredited instance, the DOE, to be able to verify the emission reduction units achieved thus far.

3.3.7 Verification and Certification The DOE is responsible for verifying the monitored results and certifying the exact amount of Green House Gas emission reductions resulting from the project activity. Finally the DOE reports the results to the CDM EB. The same DOE cannot take care of both the validation and verification work unless it is a small scale CDM project. Certification is a written assurance by the DOE stating that during a specified period, a project activity achieved the reductions in anthropogenic emissions which were previously verified.

3.3.8 Issuance of CERs The CDM EB issues a certified number of CERs within 15 days of receival of a request for issuance. The CDM EB deducts its own fee from the issued CERs, as described in the registration phase.

14

Carbon Credits - Implications in India as financing instrument

4. Eligibility A Transaction in CER involves buying of GHG emissions credits by entities from companies or governments involved in projects related to carbon emission reduction in developing countries. For example, a company in India can prove it has prevented emission of x-tons of carbon and can sell this much amount of points or carbon credits to a company in the Germany which has been emitting carbon. The industries which qualify for CDM projects are as follows: Renewable energy  Wind power  Solar energy  Biomass power  Hydel power  Geothermal  Tidal power Fuel switching from fossil fuel to green fuel like biomass, rice husk etc. Energy efficiency measures related to  Boiler  Pumps  Turbines  Installation of various speed drives  Efficient cooling systems  Back Pressure turbines Cogeneration in industries having both steam and power requirements Waste Management  Capturing of landfill methane emission to generate power  Utilization of waste and waste water emissions for generation of energy for captive use of power generation Transport  Fuel switch from gasoline and diesel to natural gas  Modal shift from air to train, road to train at macro level  Replacement of shipment of certain raw materials through road to pipelines

15

Carbon Credits - Implications in India as financing instrument

5. Carbon Financing 5.1 CDM Projects

CDM projects can be considered as any other projects with the exception that CDM projects deliver CERs as additional by-products. Usually a CDM project requires investment in more costly technology and has to cover CDM related transaction costs. The CERs generated by the CDM project are sold to a CER buyer, thus generating an additional source of income for the project making the additional costs possible. When purchasing CERs an emission reduction purchase agreement (ERPA) is made which covers the details of the transaction. CDM projects can be divided to three groups according to the type of cooperation with financiers: unilateral, bilateral, and multilateral projects. The industrial actor in the nonAnnex I country can execute the project activity all by itself, in which case the project activity is called unilateral. If a party from the Annex I country takes part in the project through funding, a project is called bilateral. Multilateral projects can be seen as bilateral projects where a third party takes care of the finance. The share of bilateral projects is estimated to be around 10% and will decrease in the future. 5.1 Bilateral Projects

In bilateral projects, the CER buyer is closely involved with the CDM project from early stages of the CDM process cycle. The CER buyer is one of the financiers of the project. The share of CDM financing from the CER buyer can vary from 1.5% (e.g. power generation projects) to 100% (e.g. municipal solid waste projects), but is usually less than 10%. PPs are free to agree on any type of contract or terms regarding future CERs to be produced. For instance, financing can be arranged using structured equity investment or CER-securitisation. The structured equity is not used very often. In this investment the buyer provides typically 10% of equity, the owner takes care of 20% and rest of the investment is financed by debt. CER-securitising refers to situations where the PP enters into a forward contract specifying a fixed price for the future CERs. Upfront payment can be used, which leads to a discounted price of CERs for the buyer. Typical discount is around the current debt interest rate of 9% in India. Usually the upfront share is between 50–100%. There is, however, always uncertainty in the seller’s ability to deliver the CERs, especially in a timely fashion. The perceived risk is reflected in the price of the CERs or in penalty clauses in the contract.
16

Carbon Credits - Implications in India as financing instrument

In bilateral projects, especially with many of the rural development projects that require either equity funding or lending, the CER purchaser has more pricing power. The lower expected price of these early stage contract CERs is due to the inherently higher risk.

5.2 Unilateral Projects In unilateral projects, the CER buyer gets involved in the CDM project when the project owner decides to make a forward contract, in the late stages of the CDM process. In these cases, the project owner is responsible for getting the project financing without an initial CDM financing from the CER buyer. The additional revenue from CERs comes when the project owner decides to make a forward contract with a buyer for the coming CERs. Another, increasingly popular option is that the CERs are sold at a spot price when they are certified. The spot price of a CER is significantly higher than with forward contracts and comes close to the price of an EUA, as there is almost no risk involved for the buyer. Despite the higher CER price compared to bilateral projects, many CDM project owners cannot afford a unilateral project due to a lack of funding for their projects without CDMfunded up-front investment. For larger and established companies financing is easily available and thus their projects are often unilateral. However, some Indian banks are considering delivering only loans collateralised by future CER revenues. In such cases, validated projects get better terms.

5.3 Financing Sources The financing patterns of CDM projects in India vary widely. Central and state government financing institutions give financing support to CDM projects. So far there have not been CDM projects totally financed by Indian banks, but they are starting to show an interest. The State Bank of India, ICICI, IDBI and Yes bank are to name a few. Banks do not act as outright CER buyers but have began to offer specific financing for CDM projects. In return for a certain share of CERs, they offer lower interest rates on the project financing. Future developments might include loan schemes including carbon (future CER) collaterals. Financial institutions such as IREDA, IDFC and PFC/REC have been active in renewable energy financing and might become increasingly active in CDM project financing. According to an interviewed CDM consultant, the Indian CDM projects, if developed with an
17

Carbon Credits - Implications in India as financing instrument

experienced partner can generate interesting payback periods. The payback on equity may be as short as one to two years and on total project costs three to four years. Indian projects are of high quality and might be interesting investment targets for foreign equity funds as well, but they are often deemed as marginal projects. 5.4 CER Purchasers

CER purchasers can be divided into two groups: public and private CER purchasers. The private CER purchasers can be further divided into traders and end-users, while the public purchasers can be divided into governmental and multinational organizations. The public CER purchasers are the various governmental purchasing organizations, the most active ones being Japanese, Canadian and German organizations. In the private sector, British broker companies have been active, and they have organized tours with several potential purchasers visiting different areas to find suitable projects. Table 5.1: Active CER Purchasers in India Organization Type Examples Japan Carbon Fund, UK DEFRA's CCPO, Italy, Spain, Governmental purchase organizations Multinational organizations World Bank Ecosecurities, CO2.com, Natsource, Morgan&Stanley, Akzo Brokers/Traders Nobel, Barclays, HSBC,Pointcarbon, Rabobank Endesa,EDF, E.ON, Mitsubishi, Sony, Reco, Kyoto Electric, End-users Kepco, Depco, Shell Netherlands, Canada, Austria, Portugal, Germany, France, Belgium, Sweden

5.5 Financing transaction costs

The project transaction costs – costs for writing the PDD and having the project validated and certified, as well as legal costs – can be a significant burden on smaller PPs. These costs can form an obstacle for projects where the proponent has insufficient financial resources, as the transaction costs have to be paid before knowing whether the project will produce CERs. To
18

Carbon Credits - Implications in India as financing instrument

encourage potential proponents to start a CDM project some purchasers are ready to loan the transaction costs – possibly without collateral or interest – and sometimes they are even ready to void a part of the debt if everything goes according to plans. For example, the Canadian purchase programme requires only a payback of 50% of the transaction cost loan, if the CERs are sold to a Canadian CER purchaser. Transaction cost financing can provide a strong competitive advantage when negotiating with potential project proponents who have financial assets. 5.6 Pricing of CER’s

The price of a CER in a project depends on a variety of factors and reflects the risks of failure of the project as well as the market power of buyers and sellers. The pre-validation stage CDM projects relying on unapproved methodology have lower CER prices through the higher risk. Up-front finance is another factor affecting the price in early stage projects. Registered projects having verified vintages bear lower risk than the ones depending on future vintages. The price for verified CDM projects and issued CERs closely reflects the EUA price. Prices of Project based reductions in 2007

19

Carbon Credits - Implications in India as financing instrument

6. Risks with CDM projects and mitigants

Risks to the project

Besides the stage at which the project is currently progressing, the CER prices are strongly affected through various risks related to the project, the administrative procedures and project partners. The following lists some of the most commonly recognized risk factors affecting the CER prices in projects in India. The broad categorical classification is as follows:
 Regulatory risk  Operational risk  Price (Market) risk  Contractual (Credit) risk  Country (Policy) risk  Reputation risk

20

Carbon Credits - Implications in India as financing instrument

7. Arguments about CDM process 7.1 Advantages     Better technologies for the company which is benefiting from generation of CERs Technology transfer from developed to developing countries (Due to low cost structure in developing countries) Additional source of Foreign investment in developing countries which act as a catalyst in developing cleaner technologies Channel CDM funds to investment priorities – The CDM funds can be channelized into building or improving projects, thus reinvesting it for higher growth   Development of cleaner technologies leading to sustainable development where countries have a strategic advantage from now in terms of pollution Environmental benefits due to lesser GHG emissions

7.2 Disadvantages    Provision of cheapest way of purchasing climate destroying right Due to nature and process of complexity involved, foreign players may dominate domestic industries for the incentive if CERs CDM investment could affect national development strategies, possibly adversely affecting national decision-making processes. Until future commitment periods are agreed, the CDM may not provide incentives for financing long-term development projects and strategies.    CDM timeframe may not assist long-term development strategies as the timeframe is fore seeable till 2012 only. (Most projects - developed with short term perspective). No opportunity for less developed countries under this framework Still the mechanism leads to developed countries emitting more GHG inspite of their KYOTO caps. Historically they are the culprits for GHG emissions. The developed countries purchase CERs rather than finding new ways of reducing emissions by technological development.  Pressure to accept technologies which have adverse local impacts - CDM may attract unfavorable or unwanted technologies which adversely impact local people. The technologies should allow for sustainable development in social as well as economic and environmental terms.
21

Carbon Credits - Implications in India as financing instrument

9. Example of a Company: 9.1 SRF Limited It is an industrial group engaged in the manufacturing of industrial synthetics, fluorochemicals, industrial fabrics, packaging films and pharma chemicals. It operates a swing plant at Rajasthan, India since 1989 that produces HFC 22, CFC 11 and CFC 12 alternately on campaign basis. The main objective of the CDM project was to reduce the GHG emission through destruction of HFC 23 gases, in a proposed thermal oxidation system. The project cost was Rs. 13 crores and the benefits are expected in next ten years. SRF has been releasing this gas into the atmosphere before identification of this project as a CDM project under the Kyoto Protocol. Since April 2004, SRF has been storing HFC 23 waste gas. Thus, with the implementation and operation of the thermal oxidation system, the project will reduce GHG emission (in equivalent CO2 equivalent terms) that otherwise would have continued to occur in absence of the project. The annual sale is expected to be of 3.83 million CERs or 3.83 million tons of CO2 equivalent gases. The after tax cash flows from the project are in table Table 9.1: After tax cash-flows of SRF Description Initial Investment FY06 FY07 FY08E FY09E FY10E FY11E FY12E FY13E FY14E FY15E After tax cash flow (Rs. Crores) -13 59.362 59.362 59.362 59.362 59.362 59.362 59.362 59.362 59.362 59.362

The CER rate is taken to be a 5 USD. The Re/USD rate has been taken as 41 and tax rate @ 33%. The IIR in this case is calculated on the incremental expenditure needed for meeting CDM requirements.

22

Carbon Credits - Implications in India as financing instrument

10. Conclusion

Carbon credits emanating from CDM projects can be considered as enhancers of equity returns rather than as a reliable long term source of cash flows for projects. As soon as the future trends for carbon credits are frozen after year 2012, they would be viewed as source for long term cash flows as well. Projects ought to be developed so that they are CDM compatible. Due to OTC markets, the market is illiquid and non transparent, firms need to negotiate deals with knowledge of the market trends and potential problems arising after year 2012 deadline for current round of emissions reduction. The CERs are also heterogeneous in nature depending on origin and quality of CERs and quality of project. The CDM cycle is perceived to be long and the complexity of rules and regulations is a barrier to usage of this opportunity. With the expectation of the maturity of the carbon market, carbon credits will become an important consideration in project financing in developing countries especially India.

CDM cash flow increases IRR of the project

23

Carbon Credits - Implications in India as financing instrument

References

1. www.ieta.org 2. http://economictimes.indiatimes.com/articleshow/1212812. 3. http://unfccc.int/ 4. http://www.cdmwatch.org 5. http://cdm.unfccc.int/ 6. “State and trends of the carbon market”, study conducted by Franck Leacock for Word Bank. 7. World Bank Carbon Finance Business’s “State and Trends of the Carbon Market 2007” Report, pp 12-48 8. http://www.cliffordchance.com 9. http://www.srf-limited.com 10. http://www.indiainfoline.com 11. http://www.wikipedia.org 12. Article by Mr. Arjun of JBIMS -“CARBON CREDITS - Project Financing in India”

24