Clean Development Mechanisms: Role in the Climate Policy & Design of projects

Lazare NzeyimanaDepartment of Water and Environmentlazare.nzeyimana@sweco.se

1- Introduction: Climate Change HistoryHistorical remarksSvante Arrenius Theoretically argued the correlation between levels of greenhouse gases and atmospheric temperature1930s academic discussion without any real impact1970/80s Other more acute problems Oil shocks, CFCs ect..1987 Bruntland Commission, Our Common Future1988 Establishment of the IPCC (Intergovernmental Panel on Climate Change1992 Agenda 21 and the Rio conference led to UNFCCCUnited Nations Framework Convention on Climate Change1997 The formulation of the Kyoto Protocol (KP)

The Kyoto protocol (KP)Historical remarksEntered in to force on 16th of February 2005 when Russia signed and approaved the protocol At least 55 parties of the UNFCCC, accounting for at least 55% of the Annex 1 countries CO2eqv-emissions in 1990As of 14th of January 2009, 184 countries and one regional economic integration organization (the EEC) have deposited instruments of ratifications, accessions, approvals or acceptances.63.7% of the total CO2 emissions for 1990 of the Annex I Parties have ratified the Protocol.

The Kyoto Protocol (KP)Separates Annex 1 countries and non Annex 1 countriesAnnex 1 countries Developed economies and economies in transition according to UNFCCCNon Annex 1 countries Less developed economies according to UNFCCCObligations for an Annex 1 underwriter of the KPEmission reduction targets for the period 2008 2012 (-5% in total for all Annex 1) compared to the base year 1990Setting up of national greenhouse gas inventory for 1990 and forward with yearly reportingImplement national programmes for implementation of a climate friendly society including informational activitiesSetting up of specialized entity that deals with all Kyoto related matters

The Kyoto ProtocolContent An Annex 1 country is assigned AAUs (Assigned Amount Units) equal to their 1990 emissions minus their respective emission reduction target

Number of AAUs = Total ton CO2eqv1990 Total ton CO2eqv reduction2008-2012, yearly

Each country is obliged not to emit more CO2eqv than number of held AAUs +/- purchased/sold other emission rights through Kyoto flexible mechanismsThis means the system has a flexibility, enabling Annex 1 countries to fulfil obligations (quantified emission limitations) through market mechanismsMarket mechanisms enables cost efficient emission reductions

The Kyoto Flexible MechanismsInternational Emission Trading (IET), Cap and trade - AAUsJoint Implementation (JI) - ERUsClean Development Mechanism (CDM) - CERs

All mechanisms to keep greenhouse gases at set level within specified time period!

International Emission Trading (IET) - Cap and tradeAll Annex 1 countries are given a certain amount of emission allowances (corresponding to a cap)AAU Assigned Amount Unit, equivalent to emissions in base year 1990Tradable between countries as bilateral tradeTransferable through JI or CDM project mechanismsCap is lowered for each trading period

Example of International Emissions TradingCountry A&B both emits 100 000 ton CO2 equivalentsThe Kyoto allocates 95 000 AAUs (Assigned Amount Units) eachDeficit of AAUs 5 000 AAUs

Two choices to fulfill Kyoto obligations: 1. Buy 5 000 AAUs for market price (95 000 AAUs + 5 000 AAUs = 100 000 AAUs = actuall emissions)2. Reduce emission with 5 000 ton for the cost of X EUR/ton (95 000 AAUs = 100 000 ton 5000 ton = 95 000 ton = actual emissions)3. Reduce emissions with 10 000 AAUs and sell the 5000 in surplus (95 000 AAUs 5000 AAUs = 90 000 AAUs = 100 000 ton 10 000 ton = 90 000 ton = actual emissions)Market price per AAU 5 - 30 Country A (Selling)Cost for reducing emission 5 Country B (Buying)Cost for reducing emission 30

Clean Development Mechanism (CDM)CDM - Project based mechanism of the Kyoto protocolAn Annex 1 country can use emission reductions from a project in non Annex 1 country to fulfil required emission reductionsThe Annex 1 country is referred to as financing party and the non Annex 1 country as the host countryCO2 equivalent Certified Emission Right (CER)When the project has been approved by the CDM executive board, CERs are issued and transferred to the financing partyIn reality increases the cap, but also increases the system boundariesAn emissions reduction in a country without quantitative emission limitations will still result in a net zero balance of the cap

CDM Statistics

CDM Statistics

CDM Statistics

2- Actors and stakeholders

UNFCCC institutions in the project cyclesCDM projects structureCDM Executive BoardDesignated National Authorities (DNA)Designated Operational Entities (DOE)

Commercial actors in the project cycles1- Profit driven organizations who does what?Project finance institutions (Development banks, commercial banks)Buyers of creditsProject developers

2- Market participants who does what?Trading sector participantsBrokersFinancial speculatory actors

3- The market system

Carbon ExchangesEUAs traded in many exchanges that have clearing servicesEUA Contracts, spot tradeFinancial contracts such as futures for EUANordpoolEuropean Energy Exchange EEXEuropean Climate Exchange ECX

Financial sector involved!

Non compliant sectorCarbon Off-settingCompany goodwill/profilingIndividuals (ex. transport)Can be purchased from other than UNFCCC projectsThe New South Wales GHG abatement schemeChicago Climate ExchangeGold Standard Quality projects, may increase value of ERUs/CERs

The carbon market system in the EU - flow of CO2 allowances and cashCDM BoardJI Committee

Non Annex 1 countryAAUs for Annex 1 country

Annex 1 countryCDM projectsJIDeveloperUNFCCCFinancial InstitutionBuyer of CER/ERUERUs Track ICERsProject financingCarbon financing ERU paymentCarbon financing CER paymentProject financingERUs CERsERUs Track IITrader/BrokerEnd user, Trading sectorparticipantCarbon Credit ExchangeEUA, AAUEUA, AAU, ERU, CERJIFocal PointCO2 allowanceFinacial FlowEUA, AAUEUA, AAU from NAP

4- The projects

CDM Project lifecycle

The PDDContent of the PDDChoice of methodologyApplicabilityScenarios, definitions and casesBaselineForward scenario for emissionsIdentification of alternative scenariosProject boundaries and activitiesProject emissions and leakageAdditionalityMonitoring methodologySpecifications of monitoring parameters for measurements

MethodologiesDifferent types of methodologies (2009)

CDM project activities (larger projects)76 approved large scale methodologies40 approved small scale methodologiesAfforestation and reforestation CDM project activities10 approved large scale methodologies5 approved small scale methodologies

Example of CDM methodologiesAM0036 Fuel switch from fossil fuels to biomass residues in boilers for heat generationAM0001 Incineration of HFC 23 waste streamsAM0031 Baseline Methodology for Bus Rapid Transit ProjectsAM0035 SF6 Emission Reductions in Electrical GridsAR-AM0002 Restoration of degraded lands through afforestation/reforestationAR-AM0004 Reforestation or afforestation of land currently under agricultural useAR-AM0008 Afforestation or reforestation on degraded land for sustainable wood productionAMS I.B. Mechanical energy for the user with or without electrical energyAMS I.C. Thermal energy for the user with or without electricityAMS III. B. Switching fossil fuels

PDD emissionsProject emission calculation

ERy = BEy PEy LEy

Where:ERy = Emission reductions during the year y (tCO2/yr)BEy = Baseline emissions during the year y (tCO2/yr)PEy = Project emissions during the year y (tCO2/yr)LEy = Leakage emissions during the year y (tCO2/yr)

To pass the additionality testAdditionalityCriteriaArgumentationEvidence

BureaucracyRationale

TracabilityTransparencyMeasurabilityEquality

ServicesExamples where SWECO can offer services:

Compilation PDDsFeasibility study of projectsTechnical Due Diligence Financial Due Diligence Negotiation with buyers (ERPAs)

To sum up .

Thank you for your attention!SellerBuyerCDM-MarketSweco

Thank you very muchAsante saana

I would like to start with a quick look in the history books to understand why you are all sitting here today, wanting to learn about climate change and the Kyoto protocol.

The discussions about the CO2 problem can be traced back as far as the late 19th century. A Swedish scientist, former Noble price winner Svante Arrenius, actually stated that an increased amount of carbon dioxide in the atmosphere theoretically should increase the temperature on earth, and by using too much fossil fuel this effect could be achieved by human hands. The problem was again discussed in the academic sphere during the 30ies but was not seriously considered as a problem. The 80ies had its own headline environmental problem which was the ozon layer disappearing due to the frequent use of CFCs and it was not until the beginning of the 90ies until the issue of CO2 emissions was raised again.

1987 Gro Harlem Bruntland, published the report Our common future, from the work of the World Commission on Environment and Development, widely referred to as the Brundtland Commission, developing the broad political concept of sustainable development. The Brundtland Commission provided the momentum for the 1992 Earth Summit/UNCED and further the Agenda 21. This work set the ground for the discussions that led up to Kyoto protocol in 1997, that finally set the direction for the future of the world, namely to try to curb climate change to limit the emissions of green house gases.

The flexible mechanisms within the Kyoto protocol are created to not increase the emissions of greenhousegases in the atmosphere. The mechanisms are threefold and divided into Cap and trade, Joint Implementation and Clean Development Mechanisms. It is important to understand how these mechanisms are not separated but are dependent on each other and the activities that goes on within each program. The purpose of the JI and the CDM is not only to mitigate greenhouse gases. There are other objectives with these schemes as well. Among many can be mentioned: Other positive environmental effects like improved air quality and reduction of pollutants, heavy metals etc., and technology transfer to the country developing the project

Before we continue I would like to know how familiar you are with the Kyoto lingo? May I use the abbreviations when I talk or would you like me to spell out all the abbreviations? As the protocol states all members of the protocol are assigned a specific amount of emission allowances corresponding to the level of emission they had in the base year 1990. This amount may not be exceeded. Of course this was a big problem during the negotiations of the Kyoto protocol, when should the base year be set. All nations obviously tried to set the base year so that the emission levels would favor them. In the end the year 1990 was set to enable the former Soviet countries to have a big surplus of emission allowances and the United States to have a large deficit, thus kick-starting the market with large flows of allowances from the former Soviet countries to the United States, forming sort of a financial contribution to the former Soviet countries. Today the reality is different but still the protocol is valid since it has fulfilled the demands set when signed in 1997.

The emission allowances that are assigned the participating countries are called AAUs Assigned Amount Units. Each AAU is equivalent to one ton of carbon dioxide and allows the country possessing the AAU to emit one ton of CO2.

The idea with cap and trade is that a country should have the possibility to limit its emissions and sell the assigned AAUs to other countries, that may have the necessity to emit more CO2 than they have been assigned units, on the basis that the market price for the AAU is higher than the marginal cost to decrease emissions with 1 ton of CO2.

These AAUs are transferable through the JI mechanism and can be increased in number through the CDM mechanism. Each period the total cap for emissions and assigned AAUs is lowered, thus step by step lowering the emissions to levels that will stop the rise in temperatures on earth.

This is a very simplified example of how the cap and trade works:

During the trading period the cap has been set 5 % lower than actual emission making both countries short on 5.000 AAUs. In this case the alternatives are to lower emissions by 5.000 ton/period and use the 95.000 AAUs to declare actual emissions during the trading period or to buy 5.000 AAUs from somebody else that does not need them.

Then the country can use 100.000 AAUs to declare the actual emission during the trading period. All in all country A has to lower emissions with 10.000 tons to be able to sell 5.000 to country B, and the decrease of 5 % will be realized.

CDM, Clean Development Mechanism are projects conducted in countries with developing economies, without any quantitative undertaking towards the Kyoto protocol. The investor country is of course an Annex 1 country.

The emission allowance generated by a CDM project are referred to as CERs, certified emission rights. In the case with the CDM project the host country does not have any AAUs to convert to CERs so they are newly issued by the UN and added to the system.

The rationale is though that since a decrease in emission have been accomplished on a global level that would not have accomplished otherwise, by adding CERs to the Cap and Trade system will still keep the level of emissions unchanged. In reality the cap is increased, but also the system boundary for emission.

For the CDM projects the mayor contact in the UN are the CDM board. The CDM board approves methodologies and issues CERs when projects are implemented and emission reductions validated. The project developer does not have any direct contact with the CDM board unless he would like to submit a new methodology. We will talk more about the methodologies later.

The designated National Authority is the entity in each country responsible for handling the registration of CDM projects. Any host country wanting to implement CDM project should have one.

The Designated Operational Entity is an organization accredited by the UN to validate CDM projects and the emission reductions from a project

For JI projects the functions of these bodies are similar. The Supervisory committee is the entity in the UN handling all issues related to JI projects. Depending on in which country the project is registered the JI Supervisory committees role differs.

The focal point is the national body handling national issues like registering the PIN, writing letters of approval etc. The focal point is equivalent to the DNA for CDM projects.

The accredited Independent Entity has the same function as the DOE, that is to accredit the projects and monitor emission reductions.

Without the commercial actors there would not be any market. These organizations are in this game for the money, because they believe that it is possible to make money and still contribute to the world health.

The project financiers are the ones that supply the base financing for the project. These are often development banks or commercial banks that would found any project with reasonable risks. However, the very nature of the projects and the additionality principle of the projects make them less suitable for commercial financing. This is why the project mechanisms may make the projects bankable, meaning that they are attractive for lenders with reasonable risk.

The institutions are often also the buyers of the CO2 allowances, making them also part of the carbon finance. For example, World Bank, EBRD, ABRD or NEFCO are all development banks that have funds allocated to manage a portfolio of CDM projects that generates CERs.

There are also market actors that specifically specialize in purchasing CO2 allowances. They have a business model that is based on managing a portfolio of projects to minimize the risk of default on the ERPA. Such a player makes money to buy the credits cheap from the project developers and then sell them at market prices. The market price on a 2008 December futures contract for an EAU is currently close to 22 EUR.

The price stipulated in an ERPA is between 3 8 EUR depending on the risk of the project. One must understand that many of the projects do not generate as many CERs as expected, many of them do not even come to a start, because of various reasons. So the margin the purchasers of the CO2 allowances have is reasonable.

The project developers are the organization that develop the project activities. They are responsible for the physical implementation of the project activity, they buy the equipment, they purchase the fuel or whatever need to be done to start executing the emission reductions. The EUAs are today traded in many different market places. Any exchange with a clearing service could start a trade with financial and physical contracts with the EUAs. The physical trade is done through a spot market and the financial contacts are mostly standardized yearly future contracts for 1-4 years delivery time.

These contracts can be traded on for example: Nordpool, the Nordic power exchange which I think has sold its financial clearing to OMX, EEX, the European Power Exchange situated in Germany or the most liquid market, the ECX, the European Climate Exchange.

The most important thing is that this means that the financial sector is involved and when this happens it is usually a long term engagement. There also exists a non compliant sector that has evolved outside the world of the Kyoto protocol. These are companies that do not have any quantitative target to meet on emissions. They do it for totally different reasons.

The most usual reason is goodwill or company profiling. They do not want their company to have any ecological footprint. So by buying carbon credits nobody else can use them to declare their emissions they take out credits from the market and liquidate them.

Some individuals may feel that they do not want to further increase global warming by their activities so they buy carbon credits to offset the effect from a journey with an aero plane they have made.

The non compliant sector is not as big as the compliant, but it is big enough to create market participants specializing in offering these kind of services.

One thing that is not so good is that there will always appear somebody who wants to make money out of other peoples guilty consciences. Since nobody controls this sector of the market, it is hard to really be sure that the carbon credits actually has resulted in a decrease in emissions somewhere.

The gold standard is an initiative to try to get around that problem. It is an independent organization that labels project of very high environmental standard. This way the buyer can be sure the credits come from a good project.

Other initiatives aside from the EU ETS is the Chicago Climate Exchange, the first in the world of its kind and the Australian New South Wales GHG abatement scheme. The PDD is the document with all the information needed for the DNA/AIE and the UN bodies to approve the project.

To create a PDD the choice of methodology is crucial. There are different methodologies for different types of projects. The easiest way to get your project approved is by using an already existing methodology. These methodologies have been used by other project developers and have already been proven to be useful as a case for mitigation of greenhouse gases. The methodology describes how exactly the technology used should contribute to mitigation of greenhouse gases.

It includes the definition of when the methodology is applicable. The project developer should state this in the PDD, what case in the methodology that is applicable to the project in question.

The baseline scenario which describes the situation had not the project been implemented. Identification of alternative scenarios that might have occurred if the project had not been implemented. If there are any other reasonable scenarios that strongly deviates from the baseline, the project will not qualify.

The definition of project boundaries and description of project activities.

The project emissions and any leakage/indirect emissions from the project.

The project additionality. The project developer must bring forth evidence that the project would not have been implemented had it not been for the project mechanisms. This could be argued for several reasons, while the most common one is financial.

The last part of the PDD and the methodology should describe the monitoring of the project and what measurement that should be done to calculate the emission reductions. The methodologies are divided into different categories. They are large scale, afforestation and reforestation and small scale projects. In total you can see that 122 methodologies are approved. The CDM methodologies are also applicable to the JI projects.

Here are some examples of methodologies that are approved by the CDM board. As you can see the technology to achieve emission reductions can be very different. The four first are from the large scale category, the second ones from afforestation and reforestation and the third ones are small scale methodologies.

Read examples!!!

The project emissions are almost always calculated in the same basic manor. The main components are the baseline emissions, the project emissions and project leakage. When these have been derived it is possible to calculate the emission reductions and hence also the financial return for the project developer.

This formula is almost the same in most methodologies, but the way to derive these numbers differs. Some of them might be hard to calculate due to uncertainties inthe development of the country, depending on fuel, specifics, efficiencies of technology employed.

The most difficult would be the baseline scenario. Fortunately there are a lot of PDDs available on the web and many conclusions can be drawn from them. The whole UN system is very transparent and a lot of information can be found on the UNFCCC webpage. The whole system has been quite constructed in a step by step approach so that it should be easy understand. What is needed though is time and patience to really look trough all the material available, since there is quite a lot.

One of the key elements in the PDD is to show that your project is Additional. This means that the project would not have looked the same, or would not have been implemented if the project flexible mechanism had not been in place.

The project can be additional in many different ways. The general view point is that there should exist some kind of barriers that would prevent the project activity from taking place and that would not be considered as a barrier for at least one other alternative. The most common barrier is a financial barrier,

This means that the project activity is not financially the most beneficial alternative and that the project financing mechanism is the only way the project activity would be implemented. Then the project is additional if there exists other alternatives that are more financially sound.

The additionality can also be argued for technological reasons, environmental reasons. The only limit here is creativity and this picture that describes how to get your project classified as additional.

On what criteria is your project additional, financial/technological, what are the arguments for this criteria and how should you prove it? There is also an excellent guide to use in most cases attached to the methodology. The UN circus is quite demanding and requires a lot of work. The result of this is as you understand that the projects will be profitable for investors only if they will generate a certain amount of CO2 allowances.

There is however a good reason for all this bureaucracy. And that is the projects must have traceability, it should be possible to determine from where a CER/ERU comes from (they all have a special ID). If somebody declares their emission with CO2 allowances made from paper it might not be so credible

The system must be transparent, open for criticism, create correct market valuations and be liquid and open to everybody. To take part of information on the market rules, market prices and news that might affect projects and prices.

The projects must have standardized methods for measurements, otherwise it is difficult to assess the real values of the projects, and the real effect on climate change. Last the system must treat all participants equal, to drive competition, boost liquidity in markets and to constantly develop new ways of mitigating greenhouse gases. SWECO can help investors and project developers to write the PDDs. The market price of a PDD is approximately 50.000 USD so that is the extra cost to develop a PDD. Remember that there are also costs for registering PDDs and for the CDM board to issue the CERs even if they are not usually as high as the costs to develop a project.

So if you have a project that is not big enough, it might not be financially sound to go ahead to register it as a CDM or JI project, you need to know your numbers!

If wanted, SWECO performs Due Diligence and feasibility studies of all kinds. SWECO can also help a project developer to negotiate with buyers of CO2 allowances and help them conclude the ERPA, Emission Rights Purchase Agreement. So, thank you for your attention, we should have a coffee break and Lazare will continue after the break.