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The World Bank Pricing Approach vis-à-vis Market Trends

The World Bank Pricing Approach vis-à-vis Market Trends. (This information is confidential until the official release Of the State and Trends of the Carbon Markets 2006). HCC Meeting, Cologne, April, 2007 Alexandre Kossoy, Philippe Ambrosi, Eduardo Dopazo. Outline. Updated Market Trends

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The World Bank Pricing Approach vis-à-vis Market Trends

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  1. The World Bank Pricing Approach vis-à-vis Market Trends (This information is confidential until the official release Of the State and Trends of the Carbon Markets 2006) HCC Meeting, Cologne, April, 2007 Alexandre Kossoy,Philippe Ambrosi, Eduardo Dopazo

  2. Outline • Updated Market Trends • DECRG State and Trends of the Carbon Market 2006 • 2007 preliminary trends • The World Bank Pricing Approach • Methodology (transparency and coherence) • Price adjustment factors (risk allocation and broader commercial conditions) • Bank competitive advantages • Consistency between the WB and the Market • Deals Signed by the WB (prices paid vs. approach) • Evolution WB Prices (vis-à-vis market prices)

  3. Updated Market Trends

  4. Latest Market Evolution Carbon is mainly a financial trading market • US$30 billion in 2006(US$11 billion 2005), mainly from EUA trading • Market value arises from trading:sale, re-sale for hedging, arbitrage + compliance Project-based market still growing • Higher volumes and pricesin 2006: CDM and JI doubled in value • Biggest Primary CER Sellers: China (61%) and India(12%) US$ 10.4 /tCO2e CER I $ 10.9 US$ 7.2 /tCO2e ERU $ 8.7 US$ 5.2 /tCO2e Source: State and Trends of the Carbon Market 2007, The World Bank

  5. Prices: Up across the Board

  6. Primary CERs traded on average at US$ 10.87 strong impact of EU-ETS (Q1) and Chinese floor price (second half of 2006) fixed forward contracts dominate non-firm deliveries coupled with zero-premium call options for additional V/CERs - US$ 8-10 Secondary CERs market grew rapidly in H2’06 standardization of CERs: guaranteed-delivery CERs, with almost all risks to the seller (ITL) financial institutions, large compliance buyers and speculators fixed and indexed fwd at a 10-20% discount to EUAs reacts financially to developments in the EU ETS (for instance swaps bet. EUA’08 and 2ndary CERs) and to LT expectations (limit on imports or CERs origin) Eastern enthusiasm: ERUs traded at US$ 8.62 financing the key to a successful negotiation: up to 50% upfront not uncommon, backed-up by LoG by reputable banks some convergence w/CERs expected but upfront implies a discount and uncertainty re: issuance rules may also translate into a discount 5-yr crediting period limits full potential Prices: Up across the Board +52% +43% +58%

  7. EU-ETS: disconnection PhI / PhII Ph I is long pushing EUA prices < € 1 • Fundamentals of utilities: • mild weather patterns & low gas prices helped push prices down last winter • position hedged for Phase I • Compliance players buying PhI EUAs and banking CERs for Ph II (Ph II expectations and China price floor drive CER prices) PhII expected to be short (1,000-1,500 MtCO2e) • EU decision on 19 NAPs, representing >80% of PhI. allowances: cut of proposed caps by 9.4% (5.8% below 2005 emissions). • Not-so-strict supplementarity limits (?) imports of CERs & ERUs: 1,000-1,300 MtCO2e • Ph II from balanced to marginally short: • trade-off CER/ERU vs coal to gas switch • Extension of other sectors, notably aviation (2011) marginally change demand-supply balance And beyond? A strong signal to the market from EU • industrialized countries to 30% below 1990 levels by 2020 • or a unilateral target of -20% within EU (EU-ETs operational) • RGGI and California demand underwhelming in early years; rules regarding import of offsets unclear

  8. The World Bank Pricing Approach

  9. The World Bank pricing approach • W.B. used to be “price maker” in early Kyoto stages; new approach leads to a “fast follower” positioning in the market • focus on transparency and consistency in setting prices for projects across the portfolio ($2 Billion); • assures equitable benefit sharing for sellers and buyers • Selection of appropriate transaction (“benchmark”) • Benchmark price should be in line with prices recently paid by other market players for similar deals • Selected benchmark requires relatively complete market information for key price determinants • Benchmark shall be representative (volume) • Adding/subtracting adjustments for different risk components and risk allocation in ERPAs • Goal: obtain price ranges for typical risk profiles • Price ranges set limits which apply to each deal • Values within the range for each transaction

  10. Adjustments vis-à-vis the Benchmark • Risk Factors • Project risk (project’s construction and operation, financial closure, creditworthiness of seller/guarantor, sponsor’s experience, technology, … ) • Kyoto regulatory risk(up to registration - methodology, validation and project delay, issuance - verification, review by the CDM EB, crediting period renewal - baseline robustness) • Purchase beyond 2012 • ERPA Terms(seniority, first right of refusal, call option, sweeping clause, overcollateralization, …) • Additional price premia / discounts (buyer’s willingness) • Additional community and/or environmental benefits • Market premium/discount for technology, and region/country • Price adjustments • Upfront payment (25% ERPA or CAPEX, guarantee) • Costs and expenses (lump sum recovery or price reduction)

  11. PROPOSED ADJUSTMENT RANGES PRICE ADJUSTMENTS Lower range (high discount/low premia) Mid range Higher range (low discount/high premia) 1. PROJECT RISK: no financial closure financial closure non-creditworthy counter-party creditworthy sponsor/guarantor risky technology well-proven technology non-competitive sector competitive advantage 2. KYOTO REGULATORY: > VER contract > VER contract: > CER contract Country with non-CF experience Country with established DNA Country with established DNA New/non-tested methodology Approved methodology Approved methodology Questionable eligibility/additionality Clear eligibility/additionality Clear eligibility/additionality Weak baseline (crediting renewal) Robust baseline (renewal) Robust baseline (renewal) > CER contract with risky factors (buyer's reinvestment risk) 3. ERs BEYOND 2012: Lack of info to price 4. ERPA TERMS: Subordinated delivery Acquisition of first ERs Fixed annual amount (no sweeping) Seniority on delivery Minimum amount = expected amount Sweeping clause Overcollateralization First right of refusal for additional ERs Guarantees 5. PRICE PREMIA/DISCOUNTS : 5a. COMMUNITY Resettlement / unemployment Measurable community benefits 5b. TECHNOLOGY Low ecological benefit (HFC23) High ecological benefit (RE / EE) 5c. COUNTRY / REGION Portfolio concentration in the Region Cultural or geographical preferences 6. UPFRONT PAYMENTS: Calculated financial impact of amount financed in ER prices 7. COSTS & EXPENSES Calculated impact of the amount financed in ER prices or cost recovery from ER payments Adjustment Ranges Pari-pasu delivery

  12. Bank’s Competitive Advantage (vs. higher prices in the mkt) • Purchase beyond 2012:higher ERPA value and important for underlying finance (i.e. longer revenue streams for debt service coverage; consistent with RE/EE’s investment payback profile); • Fixed prices: no fluctuation for lenders’ debt service coverage (parallel purchase allowed for seller’s access to upside); • Upfront payment:provides minimum cash requirements for underlying finance normal standards ~(30% / 70%); • Capitalization of preparation costs supports implementation; • No delivery guaranteein ERPA terms improves project’s bankability (i.e. ERPA as “equity”, not liability); • VERs: ensures flow, increase bankability (no KP-related risks); • Monetization with payment abroad(escrow) eliminates Country risks (i.e. currency convertibility and transfer risks)

  13. Underdelivery in LFG projects is a new commercial issue Sellers start to recognize the risk involved in delivery guarantee 27.7% Source: UNFCCC webpage

  14. Consistency between the WB and the Market

  15. Data from July'06 up-to-date $9.30 Average prices paid (no BioCF): $9.92 Average prices applying pricing approach (no BioCF): 6.6% Differential: Data from 1H'06 $7.50 Average prices paid (no BioCF): $9.03 Average prices applying pricing approach (no BioCF): 20.3% Differential from April to June'06: Increasing consistency between Pricing Approach and ERPAs signed Deals evaluated show increasing consistency between prices paid after negotiations and recommended prices based on the Pricing Approach (6.6% since July 2006, from 20.3% in 1H’06)

  16. Bid 1 P1 Bid 2 P2 Bid 3 P3 Bid 4 P4 Q1 Q2 Q4 Q3 “Dutch Auction” as Market Tool • All bidders pay the auction clearing price (= P4) • Lowest price bid does not receive requested quantity • All bidders have same seniority in delivery of the allocated quantity • Annual CERs are distributed on pro-rata basis, for e.g. Buyer 1 gets Q1/Qavailable Price, $/tCO2e P4 = Auction clearing price Qavailable Quantity of ERs

  17. Thank you!www.carbonfinance.org HCC Meeting, Cologne, April, 2007 akossoy@worldbank.orgpambrosi@worldbank.org edopazo@worldbank.org

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