Carbon finance opportunities

Climate change poses a real and urgent problem today. The vast majority of the world’s scientists accept that significant changes in the Earth’s climate over the last 100 years are attributed to anthropogenic emissions of greenhouse gases. This is confirmed by the findings of the Intergovernmental Panel on Climate Change (IPCC). Birth and ratification of the international treaty, the Kyoto Protocol, affirms the political reality of an increasingly carbon-constrained economy. More than just domestic action on the part of the world’s richest nations is required to meet the ever more stringent greenhouse gas emissions targets. Emissions reductions projects in developing and transition countries are increasingly being used to reduce emissions in the most economically efficient manner.

The Kyoto Protocol has established the largest environmental market in the world: for the trading of ‘carbon credits’. The Protocol established mechanisms for project-based carbon trading, which have paved the way for renewable energy technologies such as hydroelectricity to seek and secure substantial new sources of finance. Hydro has been one of the most successful project types in the carbon market to date.

The period of political uncertainty over the Kyoto Protocol and its instruments such as the Clean Development Mechanism (CDM) is over, and early risk-takers in the carbon market have gained large financial rewards from investing in emissions reduction projects. Greenhouse gas mitigation is now mainstream, and makes clear business sense, with the CDM becoming a well established international financing mechanism creating billions of dollars in future carbon revenues, and leveraging billions more in investments in renewable energy and other sectors.

The carbon market

The Kyoto Protocol established for the first time binding emissions reduction targets for industrialised countries, part of what many see as an evolving process of ever-stricter targets. The Protocol’s new ‘flexible mechanisms’ for carbon trading allow emissions reductions achieved in one country to be bought by other countries struggling to meet their own targets. The costs of meeting these targets and the resultant global reduction in greenhouse gases therefore should be achieved at minimum cost. This is the world’s first truly international environmental market, and carbon the first globally traded environmental commodity.

The Kyoto Protocol’s CDM project mechanism is based on projects located in developing countries. The Joint Implementation (JI) project mechanism is for those projects in industrialised countries, predominantly countries in transition. The CDM is already operational, and 150 projects have been registered to date by the international regulatory authority (Executive Board), 27 of which are hydroelectric projects, suggesting there are many more investments to come. JI is also now operational, with the necessary institutions in place and projects already being validated.

Hydro CDM/JI projects

Emissions reductions from hydroelectric projects come from offsetting grid electricity by replacing it with a zero-emissions source of power. Since most countries grid generation is dominated by thermal fossil fuel fired plants, emissions reductions can be very large. The amount of CO2 offset by generating 1MWh of renewable power varies from grid to grid, from a low of 0.25t CO2/MWh in Brazil (dominated by hydro) to a high of 1.1t CO2/MWh in South Africa (dominated by heavy coal).

Project types

All types of hydro projects are currently being developed under the CDM/JI, including projects with dams resulting in additional flooded area, as long as the area inundated is small in relation to the electricity generated by the project. Specifically, the following types of project have been most successful in the carbon market to date:

• Run-of-river projects, e.g. featuring diversions.

• Hydro projects that use existing dams and reservoirs.

• Large scale projects with relatively small flooded area compared to the electricity generation.

• Small-scale hydro projects i.e. less than 15 MW installed capacity.

Hydro has been the most successful emissions reduction category in the CDM to date in terms of registered projects, with 27 of the 150 registered CDM projects constituting hydroelectricity generation. Of these 27, EcoSecurities - one of the world’s most experienced organisations in developing GHG emission reduction credits – has currently worked with eight hydro power projects that have been registered:

• La Higuera hydroelectric project, Chile (reg. 20 March 2006)

• La Gloria hydroelectric project, Honduras (reg. 9 January 2006)

• Yuzaikou hydroelectric project, China (reg. 18 December 2005)

• Cuyamel hydroelectric project, Honduras (reg. 26 November 2005)

• Vaturu & Wainikasou hydroelectric projects, Fiji (reg. 1 Oct 2005)

• La Esperanza hydroelectric project, Honduras (reg. 19 August 2005)

• Cortecito and San Carlos hydroelectric project, Honduras (reg. 3 June 2005)

• Cuyamapa hydroelectric project, Honduras (reg. 23 April 2005)

A closer look at some of the EcoSecurities hydro projects highlights typical project features, emissions reductions credits generated and sustainable development gains for the project host countries.

La Higuera

La Higuera is the first hydro CDM project to be registered in Chile, and the second biggest run-of-the-river project ever built in the country. A 155MW hydroelectricity project near San Fernando, Chile, it was developed as a joint venture between Pacific Hydro Chile and Statkraft Norfund Power Invest (SNPI). The project features a diversion canal and weir, tunnel, and intakes from the Azufre and Tinguirica rivers which rise in the Andes Mountains. With expected annual generation of 834.7GWh, this will lead to an estimated 470,000t CO₂ emissions reductions per year.

Yuzaikou

The Yuzaikou hydroelectric project is a small-scale run-of-river project near Rucheng Town in Hunan Province, China, with a total installed capacity of 15MW. The project is expected to supply 57,350MWh of electricity per year which amounts to annual emissions reductions of 40,500t CO₂e per year. Yuzaikou offers several benefits to the local area: enabling Rucheng County to achieve self-sufficiency in energy supply, reducing dependency on fossil fuels for energy generation and reducing greenhouse gas emissions. Also, local residents will have electricity for cooking which will contribute to protection of nearby forests, and employment and training opportunities will also be created.

Small-scale projects

Small-scale hydro projects, one example of which has been discussed above, have a maximum output capacity of up to 15MW. These projects often have substantial sustainable development benefits, and are favoured by some carbon credit buyers. In an effort to overcome the barriers faced by small projects, simplified modalities and procedures for such projects were introduced at the Marrakech UN Framework Convention on Climate Change (UNFCCC) negotiations (COP 7 – the ‘Marrakech Accords’, 2001), including: simplified baseline and monitoring requirements, and the ability to ‘bundle’ several similar projects together to spread the burden of costs.

Hydro CDM: Projects and recent developments

As mentioned previously, there are currently several opportunities to generate carbon finance from different types of hydro projects.

For new-build hydro projects that involve the construction of new dams and/or reservoirs however there are remaining issues to be addressed. Large dams, subject to public debate in recent years, have also been scrutinised heavily under the CDM regulations. There is to date no accepted methodology to account for methane emissions from the dams and reservoirs, resulting from the aerobic and anaerobic decomposition of organic materials in the inundated areas.

The emission values of greenhouse gas (GHG) emissions, specifically methane, vary widely between large lakes and reservoirs across the globe (based on the World Commission on Dams report). For example, of ten dams studied in Brazil, emissions fluctuate from dam to dam with a 500-fold difference between lowest and highest. It should be noted however that natural habitats emit methane anyway, therefore it is the net change in methane emissions due to impoundment that should be used for assessment, and not the gross emissions from the reservoir. In general, methane emissions are higher: in tropical climates; where vegetation cover is dense; where the flooded area is large relative to the MW installed capacity (e.g. low topography); and where significant quantities of organic material are washed into the reservoir by rivers and streams.

Based on the third point above, the UNFCCC has developed thresholds and criteria for the eligibility of hydroelectric power plants with reservoirs as CDM project activities. The thresholds are defined in terms of power density (Watts/m2) and clarify whether or not it is possible to use existing methodologies for a specific project and if project emissions from the reservoir are negligible and may be neglected from emissions calculations. Therefore many projects, even with dams, are eligible under the CDM/JI, and should consider carbon finance in their financial planning.

While dams may produce methane emissions this fact cannot be removed from the context of place, scale, time or how the dam compares to the other options available in any given country. Dams however are not only a renewable energy resource, but also represent a cleaner, lower emissions source than other electricity generation options, even including possible methane emissions. The largest projects proposed in the CDM to date are around 100MW (run-of-river), whereas the potential size of larger dam projects could be many times this figure. Further research is required to improve current understanding of how GHG cycle within existing basin and reservoirs and to improve capacity to predict future net emissions of new reservoir projects.

Environmental concerns

Environmental concerns must be at the forefront of CDM or JI project development and each project must meet the sustainable development criteria of the host country. For projects larger than 20MW, the EU requires that the international criteria and guidelines of the World Commission on Dams publication, ‘Dams and Development. A new framework for decision-making’, have been taken into account during project development if credits are to be sold into the EU Emissions Trading Scheme.

CDM technicals

Eligibility

Not all projects are eligible to participate in the JI/CDM mechanisms. The key eligibility requirement for participation is ‘additionality’. CDM and JI projects must reduce emissions below the business-as-usual scenario (the baseline), and they must therefore be ‘additional’ to what would have happened anyway, i.e. the project would not have taken place without the added value given by carbon credits.

It must be shown that CDM or JI revenues will make a significant difference to the project, helping to overcome investment or other barriers, and that there are alternatives to the project that are financially viable. A project may be additional even if it is profitable without CDM/JI, if there are other barriers hindering its development (technological, institutional, etc.). A tool for the assessment of additionality is now available for both large and small-scale projects. Furthermore, determining emissions reductions is inherently
difficult, due to the uncertainty surrounding what is likely to happen in a theoretical future scenario. For renewable energy projects such as hydroelectricity, the process depends on the calculation of a carbon emissions factor for the electricity grid to which the project will be connected.

Monitoring

Monitoring of emissions reductions is necessary for verifying the volume of CERs produced by a project. For hydro projects, this most importantly requires monitoring of the amount of electricity generated by the project, which directly determines the volume of CERs produced.

Transaction costs under the CDM

CDM transaction costs consist of project development costs, setting up and implementing the sales transaction, and registration costs to the UNFCCC. These costs remain relatively fixed because of the need to meet all the CDM procedural requirements. Small-scale project transaction costs vary up to US$100,000 per project, with costs for larger projects varying between US$50,000 and US$250,000. Usually, however, the CDM related costs represent a small fraction of the CER revenues generated by the project, and up-front costs can often be displaced by signing over a proportion of the future carbon credits, so that another party carries the risk associated with the CDM or JI.

Project economics

With the carbon market now maturing, for any given renewable energy investment in developing countries or countries in transition, there are now two possible revenue streams: traditional cash flows (e.g. electricity sales) and the environmental value of the investment (e.g. carbon credits). Providing that projects fulfil the eligibility requirements as set out in the CDM and JI guidelines, renewable energy projects may access significant new revenue streams. For a typical hydro project, emissions reductions will be between 600 and 900 tonnes CO2 equivalent per GWh of electricity generated, worth more than US$3500 at current prices. This means carbon credit sales could significantly increase overall revenues from a project. What CDM revenue means is that some hydro projects can go from being marginally economically viable or not economically worthwhile to becoming worthwhile with the additional revenue from CDM. In a survey carried out by the World Bank in 2001, the financial impact of CDM on two potential hydro projects was assessed which suggested CDM could have a significant positive impact upon project economics: CDM revenues increased the Internal Rate of Return (IRR) for a Chilean hydro project from 9.2% without Carbon to 10.4% with Carbon, enhancing the IRR by 13%. A Costa Rican hydro project changed its IRR from 7.1 % without carbon to 9.7% with carbon revenues, enhancing the IRR by 37%.

CDM project cycle

For projects to be able to generate carbon credits, particular processes and procedures must be followed, according to guidelines laid down by the UNFCCC. The project cycle required for the development of CDM and JI projects is outlined in the figure above. The bottom line shows the conventional project development cycle, whilst the top line illustrates the stages in the CDM process. These stages include a carbon assessment to determine the suitability of the project under CDM/JI, a Project Design Document, a formal outline of the project and expected emissions reductions, validation of this document by an independent body, and the project’s formal registration with the UNFCCC. In addition to this, contracts are signed, and carbon credits are verified, issued and sold. Most carbon project developers sell credits through Emission Reduction Purchase Agreements (ERPAs), which are contractual obligations to buy/sell credits, similar to a Power Purchase Agreement (PPA).

The main consideration is that it is necessary to estimate the carbon value of the project and to develop the CDM/JI project documentation in parallel with conventional project design. Carbon credit generation cannot be left as an afterthought but instead should be an integral part of the decision-making and financial planning process of a project, from as early a stage as possible. This is not to say that projects that are already far advanced cannot access carbon funding, but it will be easier to develop hydro CDM and JI projects if consideration of carbon finance has been integrated into project development from their inception.

Growth of the carbon market

For over 10 years a market in carbon credits has been operating and this market experienced considerable growth in volume and prices in the last two years. It must be acknowledged that prices for units of carbon emission reductions traded vary according to the commodity and several other factors such as risk-weighting, ER vintage and seniority.1 The EU and Japan dominate the buyers’ market. This market is expected to grow significantly between now and 2012, the end of the first Kyoto Commitment period. By the end of the first commitment period in 2012, the GHG market is estimated to reach several tens of billion dollars in size, representing a lucrative and rapidly expanding market. The CDM market includes a wide spread of different project types, but with renewable energy as the largest single type of project activity. An estimated 44% of the emissions reductions in the current CDM market come from the energy sector, with 11% of all the projects coming from the hydro sector, making up 25% of all renewable energy projects. There is a differential in the price paid to CDM projects and the price in the EU ETS because to date no project-based credits have been transferred into the ETS market, as the necessary institutions have not yet been put in place. As soon as this is done, the prices are expected to converge.

Financial incentives

For hydro energy companies this emerging carbon market provides a financial incentive to investigate the commercial opportunities from activities in both JI countries (e.g., Central and Eastern Europe) and CDM countries (e.g., Latin America, Asia/Pacific, Africa). If you are developing a project, it is advisable to evaluate the emission reduction potential of your project and begin contacting buyers and intermediaries at as early a stage as possible. With significant boosts to revenue possible from securing carbon finance for a range of hydro power projects, what are you waiting for?

Ruth Whittington is CDM Project Manager: Implementation, at EcoSecurities. For more information, visit www.ecosecurities.com