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1 S E C T I O N 04 CHAPTER 39 G LOBAL CARBON CREDIT MARKETS ISSUES AND OPPORTUNITIES By Kelley Gale, Partner of the Finance Department in the San Diego office of Latham & Watkins LLP, David Langer, Counsel of the firm s Environment, Land & Resources (ELR) Department in the New York office and Ryan Waterman, an Associate of the ELR Department in the firm s San Diego office I n t ro d u c t i o n In September 2007, the New York Times reported that greenhouse gas (GHG) emissions trading held the potential to become the world s largest commodity market. 1 This projection followed a May 2007 World Bank announcement that the global market for carbon dioxide (CO2) emissions credits had doubled in 2006 to US$30.1bn, of which the World Bank attributed US$24.4bn to the European Union Emissions Trading System (EU ETS), and US$5.3bn to the Kyoto Protocol s Clean Development Mechanism (CDM) programme and US$141m to its Joint Implementation (JI) programme. 2 This 2006 figure did not include the developing private market for GHG offsets (which the New York Times estimated at US$54m and growing in the US in 2007), or other state-sponsored programmes. 3 The growth of the global GHG emissions markets has spawned a dizzying array of credits, markets and trading mechanisms. Overlaying these markets are a similarly complex set of international, regional, national and local laws and regulations addressing various aspects of the global climate change problem. While the sheer size of the potential market suggests that there are significant financial opportunities, it is far less clear what role traditional project finance can play in this arena. In addition to typical underwriting criteria, as a general rule, projects that are amenable to the project finance model are ones that involve the careful allocation of most regulatory risks to creditworthy parties other than the project lenders. Despite the difficulties that would face a project financing that is aimed exclusively at the GHG emissions market, they are a real, significant and growing economic force that will have an impact on project finance transactions. For example, the outcome of the December 2007 United Nations convention in Bali, Indonesia, while largely inconclusive, suggests that this market will continue to grow. While the structure of the future GHG emissions market will depend upon the efforts of a working group charged with the task of designing a shared vision for long-term cooperative action to reduce GHG emissions it is probable that emissions trading will be part of the proposed solution. This chapter considers global GHG emissions markets, from the cap-and-trade mechanisms prescribed by the Kyoto Protocol and employed by the EU ETS, to the nascent regional cap-andtrade markets and the voluntary approaches being developed in the US. It reviews how these markets operate and how they may develop going forward. It then considers key considerations for project finance transactions that will be affected by such markets. What is a carbon cre d i t? The term carbon credit is a generic term often used interchangeably to describe at least two different commodities: GHG allowances and offsets. Allowances, established by and susceptible to trade within a cap-and-trade GHG reduction programme (such as the EU ETS), are required in order for a source to emit GHGs. In contrast, a GHG offset is a tradeable emissions reduction credit created by individual sources when they reduce their GHG emissions (such as the CDM programme created through the implementation of the Kyoto Protocol). 4 However, both allowances and offsets are designed to accomplish the same end to convert the right to emit GHG emissions into a tradable commodity in order to take advantage of market efficiencies. 1 James Kanter, Banks Urging US to Adopt Trading of Emissions, New York Times, 26 September Global Carbon Market Doubled in 2006, Driven by EU Trading, World Bank Says, BNA Daily Environment Report, 4 May 2007, A-7. 3 Louise Story, FTC Asks If Carbon Offset Money Is Well Spent, New York Times, 9 January Because CO2 is the most frequently occurring GHG, emissions credits are often popularly known as carbon credits. However, there are many other GHGs of concern that are even more potent than CO2 (even though they may be emitted in lower quantities). Notably, emissions trading programmes vary. Some allow trading only in CO2, while others permit trading in the right to emit other GHGs or allow the generation of CO2 credits through reduction in CO2 equivalent reductions of other GHGs. 249

2 Kyoto Protocol-derived systems Under the Kyoto Protocol, 37 developed countries and the EU (the Annex I countries) are required to reduce their total GHG emissions by 5.2% below 1990 levels. The Kyoto Protocol came into force in 2005 and applies through The vast majority of the carbon credits that have been traded to date relate in some manner to implementation of the Kyoto Protocol in participating nations. E u ropean Union Emissions Trading Sy s t e m One of the most well-established carbon markets is the EU ETS. This system, designed to achieve the EU s collective Kyoto commitment, relies upon a cap-and-trade programme for CO2 emissions from specified sectors. Member states submit National Allocation Plans (NAPs) to the European Commission for approval in advance of each ETS trading period, which fix both the total CO2 emissions allowances for distribution and allocations made to each covered installation. Phase 1 of the EU ETS ran from , and Phase 2 runs from 2008 to Under Kyoto, each EU member is responsible for allocating a portion of its commitment cap to affected sources in the form of EU emission allowances (EUAs). 5 Affected sources need to hold allowances equal to their annual CO2 emissions or obtain additional allowances from other sources. Sources that emit less than their allocation can sell their excess EUAs. Trading in EUAs, as reflected on the European Carbon Exchange (ECX), has shown a steady increase in volume. Average daily volumes during December 2007 were 89% higher than in December 2006, and the ECX annual volume in 2007 of 1,037,821,000 tons was 128% ahead of Since its launch in April 2005, close to 1.3bn tons of CO2 have been traded on the ECX, with an underlying market value 24bn/US$35.1bn. 7 As of this writing, the EU is considering several significant proposals that would expand the EU ETS. In December 2007, the Council of the EU proposed integration of the aviation industry into the EU ETS in 2012, by capping emission allowances at the mean average of annual aviation emissions in the period A more stringent proposal was advanced by the European Parliament in November Attempts are now in progress to reconcile the proposals. In addition, the EU has proposed a tariff on goods imported from countries, such as the US, that have not committed to mandatory GHG reductions. Clean Development Mechanism Annex I countries can use the CDM under Article 12 of the Kyoto Protocol to offset emissions in the six covered GHGs by investing in emission reduction projects in developing (or non-annex I) nations. The Certified Emission Reductions (CERs) generated by CDM projects can be transferred to reduce the source s, or the Annex I country s, emissions in order to comply with its Kyoto commitments. After a slow start, the number of CDM projects has increased rapidly. The primary market in CERs (in which future credits for a specific project are sold) grew dramatically in the first half of 2007, exceeding the 2006 market value ( 4.1/US$6.03bn against 3.9/US$5.74bn), and more than doubling its 2005 value. In 2006 and early 2007, the market expanded to include a substantial number of secondary transactions of CER portfolios (in which CERs are resold or traded after the primary project deal, usually after CERs are realised), and contracting began for CERs to be issued after 2012, a time period for which emissions targets have yet to be set. Secondary CERs were worth around 17.00/US$25.02 at the time of this writing, versus 7.00/US$10.30 to /US$19.13 in primary trades, and approximately 23.00/US$33.85 for EUAs exchangeable in the EU ETS. Spot trades and the secondary market are expected to continue to grow, with prices gradually increasing and the spread between EUAs and secondary CERs narrowing. Almost 95m CERs have been issued to date, with more than 2,600 projects at varying stages of approval and development. Most of the purchases of CERs have been made by European private sector, primarily from the UK, although some non-annex I countries have participated. 5 A portion of each EU member s Kyoto commitment may be allocated to sectors not subject to the ETS. 6 European Carbon Market, Market Update (December 2007). 7 (last visited 14 January 2008). 250

3 Among non-annex I countries participating in the CDM process, the most active have been in the Asian market, primarily India and China, with Latin America a distant third. Two industries in particular production of HCFC-22 (used as CFC refrigerant replacement and feedstock for PTFE (Teflon)), and adipic acid (feedstock for nylon-66) represent nearly 55% of CERs, compared to just less than 21% for renewable energy and energy efficiency transactions combined. This is because a byproduct of HCFC-22 production is HFC-23 which has a global warming potential of 11,700 times that of CO2, and a byproduct of adipic acid production is nitrous oxide (N2O) which has a global warming potential 310 times that of CO2. Accordingly, projects that reduce these emissions have the potential to acquire significant credits. I n t e rstate emissions tra d i n g Under the Kyoto Protocol, former Eastern Bloc nations like Poland, Hungary, and the Ukraine received GHG allocations in excess of actual emissions in order to accommodate their rapidly growing economies. This Green Investment Scheme (GIS) allows these states to trade their excess allowances to other Annex I countries struggling to make their emissions targets. In December 2007, Hungary and Japan signed a memorandum of understanding for Japan to buy surplus allowances from Hungary under the GIS. Japan is also in talks with Poland, the Czech Republic, and Ukraine to enter into similar deals, and plans to buy 100m tons of credits between 2008 and The outcome of the December 2007 United Nations conference on climate change in Bali, Indonesia, suggests that global GHG markets will continue to develop. The Bali Action Plan generally expressed the parties commitment to cooperative action on climate change, and specifically identifies measurable, reportable and verifiable nationally appropriate mitigation commitments and the use of markets to enhance cost-effectiveness of mitigation efforts. The parties established an ad hoc working group to design, by 2009, a shared vision for long-term cooperative action, both before and after the Kyoto Protocol terminates in The parties also indicated their support for the continued development of the CDM process and voted to include forest conservation in future discussions regarding the post-2012 climate change programme. While the Bali meeting provides some basis for optimism for the future of the GHG emissions markets, it stopped well short of reaching agreement on a post-kyoto market. Thus, there is remaining uncertainty on the structure of future markets after 2012 if they continue to exist at all. Developing mandatory GHG emissions markets around the w o r l d In 2009, the 10 signatory northeastern states of the Regional Greenhouse Gas Initiative (RGGI) (including Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island and Vermont) will begin the first cap-and-trade programme to reduce CO2 emissions in the US. RGGI will cap CO2 emissions from fossil fuel power plants of 25MW in generating capacity or larger. Between 2015 and 2018, the cap will be reduced by 2.5% every year, reducing CO2 emissions by 10% below 2000 levels by The RGGI states agreed that at least 25% of the CO 2 allowances will be allocated in a way that benefits consumers and supports strategic energy investment, most likely to be accomplished through some type of auction. Several states have declared that they will auction 100% of the CO2 allowances (including Maine, Massachusetts, and New York), and many other states are seriously considering a similar format. The first CO2 allowance auctions are planned for June In addition to CO2 allowances, electric generators will be allowed to offset 3.3% of their emissions through five approved offset methods, including landfill gas capture, eliminating sulphur hexafluoride leaks, tree planting (afforestation), reduced methane emissions from manure, and energy efficiency measures in buildings. Not to be outdone, in August 2007 the participants in the Western Regional Climate Action Initiative (WCI) (Arizona, California, New Mexico, Oregon, Utah, and Washington, as well as the Canadian provinces of British Colombia and Manitoba) established their goal to reduce aggregate greenhouse gas emissions by 15% below 2005 emission levels by Japan, Hungary Sign Accord on CO 2 Credits Transfer, Planet Ark, 12 December 2007, available at (last visited 18 January 2008). 251

4 Details on how the WCI plans to achieve these reductions through a regional market-based multi-sector mechanism, such as a load-based cap-and-trade programme, to achieve the regional GHG reduction goal are expected in August Early attempts are being made to interconnect these developing US markets with the EU ETS. In October 2007, US states in the RGGI and WCI regional programmes combined with two Canadian provinces, nine EU countries, the European Commission, New Zealand, and Norway to form the International Carbon Action Partnership (ICAP). ICAP will verify emissions sources and amounts, and create an international GHG emission market. Although this effort is still in its infancy, more details are expected in In November 2007, nine Midwestern governors (from Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Ohio, South Dakota, and Wisconsin), along with the premier of the Canadian province of Manitoba, entered into the Midwestern Greenhouse Gas Accord (MGA). 10 The MGA will establish GHG reduction targets, track GHG emissions through The Climate Registry, develop a market-based and multi-sector cap-and-trade system to achieve such targets, and to develop other associated mechanisms and policies as needed to achieve the [GHG] reduction targets, such as a low-carbon fuel standard and regional incentives and funding. 11 Although implementation of the MGA is still in its initial stages, the parties expect for it to be fully operational by In December 2007, the New Zealand government proposed a New Zealand Emissions Trading System (NZ ETS), which would create a market covering all sectors and GHGs. The NZ ETS theoretically could be linked to other emissions trading systems, like the EU ETS. This legislation remains in New Zealand parliament at this time. Many commentators anticipate the passage of US federal legislation regulating GHG emissions in 2009, after the US presidential contest is over and a new administration has taken office. The shape of this legislation is still being debated, but will certainly be informed by the success of the regional markets being created by state partnerships in the interim. Voluntary marke t s Chicago Climate Exchange Started in 2003, the Chicago Climate Exchange (CCX) provides a voluntary but contractuallybinding market for reducing six GHG emissions. CCX members make commitments to meet GHG emission reduction targets on an annual basis. Members that reduce emissions below their yearly targets create surplus allowances that can be banked or traded on the CCX. Members that emit above targets must purchase CCX Carbon Financial Instruments (CFIs, which represent 100 metric tons of CO2 equivalent GHGs). CFIs can be either CCX allowances (issued to each member in the amount of the target cap in any given year), or CCX offsets, which can be created through qualifying offset projects. For the CCX offsets, CCX has a verification programme in order to guarantee transparency, rigor, and integrity. Standardised rules have been adopted for eight types of emission reduction projects (agricultural methane; coal mine methane; landfill methane; agricultural soil carbon; rangeland soil carbon management; forestry; renewable energy; ozone depleting substance destruction). Other offset projects, including energy efficiency and fuel switching, can be approved on a case-by-case basis.. Approved third-party offset verifiers independently assess and verify an offset project s capacity to reduce current GHG emissions. CDM offsets (CERs) can be used as CCX offsets so long as they are not double-counted in another trading system. In its most recent report (November 2007), the CCX reported that trading volume in November surpassed 2.49m metric tons of CO2 equivalent greenhouse gas, with 34.9m metric tons of CO2 equivalent GHG traded in the history of the programme Western Regional Climate Action Initiative, Memorandum of Understanding (26 February 2007). 10 Midwestern Governors Association, Press Release, Governors Sign Energy Security and Climate Stewardship Platform and Greenhouse Gas Accord (15 November 2007) (Indiana, Ohio, and South Dakota signed the MGA as observers). 11 Midwestern Governors Association, Midwestern Greenhouse Gas Accord (15 November 2007), at CCX Market Report, vol. iv, no. 11 (November 2007). 252

5 Unregulated US market for GHG offsets Numerous entities now offer consumers the opportunity to offset their CO2 emissions. As noted above, the New York Times valued this market at US$54m and growing in For example, TerraPass and CarbonFund.org are just two of the organisations that allow individuals, organisations, and businesses to buy offsets, which are created through various means, including reforestation efforts, energy efficiency investments, renewable energy investments, and landfill gas and manure gas capture among others. California Air Resources Board In October 2007, the California Air Resources Board (CARB) adopted the forestry protocols created by the California Climate Action Registry (CCAR) to verify the creation of voluntary CO2 offsets through forestry practices. The forestry protocols are the first voluntary GHG emission protocols adopted by CARB pursuant to the California Global Warming Solutions Act of 2006 (also known as AB 32), which requires the state to reduce its GHG emissions to 1990 levels by By adopting the forestry protocols, CARB sends a positive signal to any actors considering voluntary forestry projects to offset CO2 emissions. At this stage, it is unclear whether CO2 offsets generated by such voluntary action will be available to comply with the GHG reductions to be required when AB 32 is fully implemented in However, companies are already using the forestry protocols to offset their CO2 emissions for new projects. For example, in September 2007 the ConocoPhillips Company agreed to fund a US$2.8m dollar forestry project designed to offset approximately 1.5m metric tons of CO2 emissions from its Clean Fuels Expansion Project in California as a condition to settling pending litigation brought by the California Attorney General. 13 The Climate Group s Voluntary Carbon Standard In November 2007, a group of industry, non-profit, and emissions market specialists (including non-profit The Climate Group, the International Emissions Trading Association, and the World Business Council for Sustainable Development) introduced a Voluntary Carbon Standard (VCS) for use in certifying GHG offsets traded in voluntary carbon markets, such as those traded in the US. The VCS is designed to address the need for certification that GHG offsets are real, measurable, and create permanent emissions reductions that can be independently verified. Japan s voluntary emissions plan Japan is in the midst of a voluntary domestic cap-and-trade test programme involving approximately 150 companies, 31 of which have conducted trades in the system. The Ministry of the Economy has reported that from April 2006 to August 2007, companies reduced GHG emissions by as much as 29% compared to the period. Recently, Japan announced that it is exploring a new mandatory GHG trading programme to replace the current voluntary programme. How project finance transactions are affected by emerging GHG emissions m a r ke t s While the global carbon market will create some opportunities, it is more likely that participants in project finance matters will see the GHG emissions markets more as a transaction component than a central transaction driver. Several obvious and some less obvious observations can be made based on the limited available market experience. I s s u e s Carbon credits as regulatory requirements At this point carbon credits appear to function more like an environmental regulatory requirement than as a quantifiable future income stream. Projects will face regulatory risk as a result of current and future climate change-related regulations directly through additional emission control costs or indirectly as suppliers of energy, raw materials, or parts pass along their own increasing regulatory costs. The role played by GHG allowance and offset requirements, whether imposed through the EU ETS, RGGI or in specific cases, such as the recent ConocoPhillips settlement (discussed above), is more analogous to a permit requirement than a future income stream. Even if a carbon tax is used instead of a market-based trading programme, projects will continue to face additional risks. For example, a carbon tax could dramatically increase a project s energy costs if the local electric power grid depends heavily on 13 Settlement Agreement between ConocoPhillips Company and California Attorney General Edmund A. Brown (10 September 2007), at

6 fossil fuels. Projects that are more carbon-efficient will have a competitive advantage over other similar projects and will provide a better economic risk profile. In fact, financing entities have begun to incorporate climate change risks into their project evaluations. On 4 February 2008, Citigroup, JPMorgan Chase, and Morgan Stanley jointly issued The Carbon Principles, a set of guidelines to be used in financing power plant projects. Anticipating federal GHG regulation, the Principles call for an enhanced diligence process to evaluate and account for the potential risks associated with high-ghg emitting projects. While it is too soon to determine the practical impact of the Principles, they will certainly bring additional scrutiny to traditional coal-fired power projects. Carbon credits generating project income Although carbon credits do not play a large role in project finance at this time, some projects (e.g. CDM projects) may realise income through generation and sale of offsets. While the revenue may not always be significant, it is still a potential economic value that could be left on the table if the market opportunities are not evaluated and addressed in the early stages of project development. Project documents will need to address how the income (or losses) from the carbon credits will be allocated among the parties. For example, will the credits become part of the project s collateral package? Will the sale of credits be restricted by loan covenants? How will the value of the credits be included for purposes of calculating compliance with applicable financial standards under the financing agreements? What mechanisms will be employed to mitigate the risk that credits will lose value, either due to regulatory changes, noncompliance with regulatory obligations, or market price fluctuation? Although the CDM market is still very much in a nascent stage, the experience to date highlights several regulatory and economic issues that increase the level of risk for project finance connected to the GHG emissions markets. 0The relatively short five-year life-span of the Kyoto Protocol (2008 to 2012) and the uncertainty regarding the post-2012 regime, has effectively limited the CDM market to projects that offer large volumes of GHG emission reductions at relatively low risk. Such low-hanging fruit would be expected to be the obvious preference. However, the uncertainty regarding the future of the GHG markets could inhibit projects that have longer lead times or less certain financial rewards. 0The process for registering CDM projects and certifying CERs is a complex and time-consuming task, requiring approvals from the host government s Designated National Authority, as well as certification by a Designated Operating Entity (DOE) responsible for validating the project and verifying emission reductions. As a result, the projects that have dominated the CDM market have generally been from countries (such as China, India, and Brazil) with large carbon footprints and a more stable economic and regulatory regime. Less stable or less well-developed governmental structures will increase the risk that offset revenues will not materialise. 0Recent criticism has been directed at the credibility of the emission reductions obtained through the CDM process. Prices for CERs are effectively set by the EU market and can be much higher than the cost of the underlying emission reductions. This magnifies the incentive for CDM project developers to overstate emission reductions or to take credit for illusory emission reductions (e.g., by increasing production to inflate the emission baselines). Increased scrutiny of the CDM certification process could result in higher levels of enforcement activity that, in turn, may reduce the value of some CERs, if not decertifying them entirely. 0Regulatory uncertainty under the CDM programme is magnified by the need for projects to comply with sustainability and additionality standards that are, at best, vaguely defined. Additionality presents a particularly difficult problem for CDM certification because the project must demonstrate that it is actually creating additional GHG emission reductions, i.e., that the emission reductions would not have occurred if the opportunity to generate and sell CERs was not available. Because of the current uncertainty regarding the revenue from carbon credits, projects that are financeable will generally need an alternate revenue stream to support the financing. However, if such an alternate revenue stream exists, the project may not be additional because it has economic value independent from the carbon market. Arguably, such projects could have been financed and constructed without the existence of the CDM process. O p p o r t u n i t i e s Targeted investment sources to fund new projects Outside of the traditional project finance model, alternative funding sources are being developed to support CDM projects and other clean technology or renewable energy projects. Specialised investment funds, equity investment funds developed by banks with expertise in 254

7 development of renewable projects, and venture capital groups appear to be providing more financial backing to such projects. The World Bank has recently announced a new Carbon Asset Development Fund specifically geared toward development of greenhouse gas emission reduction projects. These funds may also create opportunities to pool both investments and sources of carbon offsets such that the regulatory and economic risks involved can be shared. In addition to investment funding, many jurisdictions offer tax breaks for renewable energy projects or are requiring private investment through mandatory renewable energy portfolio standards. 14 This indirect funding can be combined with more traditional project financing mechanisms to facilitate development of projects that might otherwise present unacceptable economic risk profiles to the lending community. New project types Another effect of the developing GHG emissions markets is the advent of new types of investment projects, like carbon sequestration, afforestation, and the return to long-dormant projects, such as nuclear power. Both the EU and the US have begun testing carbon sequestration technology, which is expected to hold great promise for GHG emission reductions from the electric power industry. In addition, there is renewed interest in nuclear power development. In January 2008 the UK invited proposals for new nuclear facilities as part of its strategy for developing a secure, diverse, reduced-carbon intensity energy portfolio. In September 2007, the US Nuclear Regulatory Commission received its first complete licence application to be filed in 30 years The Commission expects to receive approximately 20 more licence applications by April Discussions at the Bali conference also raised the possibility that CO2 offsets may, in the future, become available not only through the creation of new forests (i.e. afforestation or reforestation) but also through the prevention of deforestation. Tropical rainforest deforestation is estimated to contribute 20% of annual GHG emissions. Although currently only a topic for future discussion, CO2 offsets from prevention of rainforest deforestation could have a market value of US$15bn per year. 15 In conjunction with the Bali conference, Norwegian prime minister Jens Stoltenberg announced that Norway would invest approximately NKr3bn/ 375m/US$548m per year to conserve forests in developing countries. C o n c l u s i o n The lack of clearly defined and stable regulatory programmes to govern the carbon markets will continue to present challenges for traditional project finance deals, which rely on stable and relatively predictable economic risks. At present, the complexity and evolutionary nature of the market mechanisms can make it difficult to assess and mitigate the risks associated with projects connected to the markets. However, the large economic value and momentum of the markets suggest that there will be investment opportunities and substantial benefits to be gained in this arena 14 For example, as part of its climate change policy, the European Commission has set an objective of 20%, renewable energy in the EU energy mix by Many US states also have renewable energy portfolio standards. 15 Alan Zarembo, Paying Other Nations to Be Green, Los Angeles Times, 12 December

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