Using Kyoto mechanisms for funding oil and gas sector projects Lamon Rutten, Chief, Finance and Energy

1. NOT AN OFFICIAL UNCTAD RECORD Using Kyoto mechanisms for funding oil and gas sector projects Lamon Rutten, Chief, Finance and Energy United Nations Conference on Trade and Development (UNCTAD)

2. Overview The Kyoto Protocols’ Clean Development Mechanism (CDM) How to generate Certified Emission Reductions (CERs) What are CERs worth? Using CERs to leverage access to finance Concluding remarks NOTE: RATIFICATION OF THE KYOTO PROTOCOL WILL INFLUENCE CER PRICING, BUT EVEN WITHOUT RATIFICATION, THERE IS A MARKET FOR CERs

3. The Kyoto Protocol and CDM The Kyoto Protocol, once ratified, commits developed country signatories to reduce greenhouse gas emissions by 5.2% (compared to their 1990 levels) by 2008-2012. Article 12 of the Protocol allows developed countries and countries with economies in transition, so-called Annex I countries, to meet their greenhouse gas reduction commitments by engaging in what is called “Clean Development Mechanism (CDM) projects”. Annex I countries receive certified emission reduction (CERs) credits for investing in projects that result in additional reductions in the emission of greenhouse gases in developing countries. For this, the reductions must be approved and certified.

4. As of 15 April 2004, countries representing 44.2% of Annex I emissions had ratified the Kyoto Protocol. Russian ratification would bring the Kyoto Protocol into force. But Russia continues dithering... But even if the Kyoto Protocol is not ratified, a new EU Directive on Greenhouse Gases Emission Trading will also provide for international trading in CERs. Moreover, a number of NGOs and corporates are buying CERs on a voluntary basis, and there are also a number of government and investors’ programmes in place. So in any case, the market will be there, even though prices are far from certain.

5. The greenhouse gases covered by the Kyoto Protocol: The market is largest for CO2. But there are also markets for the other greenhouse gases. Payments are a function of the contribution of the gas to the greenhouse effect. E.g., for each ton of methane emissions reduction, the price would be 21 times as high as that for the reduction of CO2 emissions. CO2: carbon dioxide CH4: methane N2O: nitrous oxide HFCs: hydrofluorocarbons PFCs: perfluorocarbons SF6: sulphur hexafluoride Emission measures are commonly expressed as « CO2 equivalent ».

6. Eligible sectors E.g., reducing gas flaring; making energy generation more efficient; reducing emissions in energy generation; improving transport. Energy Industrial processes Solvent use Waste Land-use change, and forestry Improving efficiency of energy use; reduce emissions from industrial production. Improving agricultural techniques (e.g., less fertilizer), reducing emissions (e.g., different irrigation techniques for rice production). Better handling of waste water; improve efficiency of waste incarneration. Afforestation and reforestation (e.g., new timber plantations); selective harvesting In practice, many of these possibilities have not yet been tested.

7. For a further discussion on the Clean Development Mechanism, see UNCTAD, 2000. http://r0.unctad.org/ghg/publications/cdm-report.pdf

8. And on the implementation mechanisms, UNCTAD, 20003 http://r0.unctad.org/ghg/sitecurrent/download_c/publications.html

9. How to generate Certified Emission Reductions (CERs) The obligations under the Kyoto Protocol are obligations of countries. Governments « repackage » these obligations, e.g. in developed countries by forcing specific emission limits onto individual companies. If these companies produce less emissions than they are allowed to, they can sell the difference (if they produce more, they pay fines). Also, companies in both developed and developing countries can develop « autonomous » projects that reduce emissions, or that sequestrate greenhouse gases; if they meet the requirements of a specific procedure, they then get CERs. CERs resulting from CDM investment become assets that can be traded in emerging carbon markets. But whether CERs (or unused emission permits) can be sold outside of the country is a sovereign decision – states retain the rights for international trade.

10. In principle, there are good possibilities in the oil and gas sector. E.g., • reduce gas flaring (in different ways – re-injection, more efficient flaring, using the gas for local or international markets) • replace a fuel by a cleaner one • improve energy efficiency in the oil and gas sector (including in transport) • reduce emissions (e.g., of sulphur in refineries) • Both direct contributions (e.g., using gas instead of coal) and indirect ones (bringing the gas to a place where it will be used to replace a “dirtier” fuel) could generate CERs.

11. An African gas project that generated carbon credits The AMPCO methanol project, Equatorial Guinea CMS Noble 50% 50% Guarantee of payment of interest on the notes Private placements in two US$ 125 million issues Institutional investors AMCCO 90% of equity (US$ 244.4 million) US$ 200 million political risk insurance Government of Equatorial Guinea OPIC US$ 173 million loan 10% of equity (valued at US$ 27 million) AMPCO Raytheon US$ 322.5 million turnkey contract 20-year contract for supply of gas Alba field operators

12. The US Initiative on Joint Implementation (USIJI), which administers the U.S. Government's process for reviewing and accepting carbon dioxide emissions reductions, has determined that the AMPCO project will lead to a reduction of a total of 71.27 million metric tons of carbon dioxide equivalent during the project's 25-year life span

13. In its projects, the World Bank has found significant improvements in internal rate of return when including CER sales:

14. Procedure to get CERs The project designoriginates from the host country, and could be in cooperation with some other entity. Feasibility studies based on the project's potential and local conditions should be assessed as well as receiving approval from the host government. Validationby the operational entity can take place where the operational entity resides. Operational entities can be located anywhere as long as they qualify. The operational entity passes the validation report on to the Executive Board of the CDM for registration. The project participants monitor the project according to the approved monitoringplan, which is approved in the validation and registration stages. The operational entity reviews and audits, including on-site visits, to verifythe GHG reductions. The operational entity then delivers a report to the Executive Board of the CDM certifyingthe reduction. Based on the certification report, the Executive Board will issue the CERs. 1 2 3 4 5 6

15. Some operational bottlenecks: Determining the size of the emission reductions. Reductions are measured as the difference between emissions with the project, and a “baseline” of emissions. The baseline can be difficult to establish. This quantification must be clear, conservative, and based on “sound science”. Then, this number is reduced by a certain percentage to account for uncertainties. Proving “additionality”. Article 12 of the Kyoto Protocol provides that, in order to be creditable, emissions reductions must be “additional to any that would occur in the absence of the certified project activity.” It was agreed that the CDM authorities implementing this provision should not adopt any rigid test of additionality, and thus, additionality should not mean that the project would not be undertaken without the CER payments. However, additionality criteria have become more stringent, and this part of the process is in flux.

16. Implementation can be difficult, time-consuming and costly A major problem: the high costs of the procedures. For large energy projects, these can approach a million $. For smaller projects, there are simpler rules; but even then, the average cost that the World Bank has had were, as of mid-2003, US$ 250,000 per project (a transaction cost of some 7%). Part of the reason for the high costs: limited capacity in developing countries, and ill-prepared governments. But: certain investors (e.g., the World Bank) are willing to cover these costs, to be reimbursed only if the project is successful, through part of the CERs generated in the project.

17. Transaction Cost Estimates (source: EcoSecurities), (US $) • A) Up-front (pre-operational) Costs: • ER Feasibility Assessment 12,000 - 20,000 • Monitoring & Verification Plan 5,000 - 20,000 • Registration 10,000 • Validation 10,000 -15,000 • Legal Work 20,000 – 25,000 • Total Up-front Costs:57,000 – 90,000 • B) Operational Phase Costs: • Sale of CERs Success fee in region of 5 -10% of CER value. Higher for a small project than a large project. • Risk Mitigation 1-3% of CER value yearly. Mitigation against loss of incremental ER value as a consequence of project risk. • Monitoring and Verification $3,000 – 15,000 per year See UNCTAD 2003 (rubber)

19. How much are CERs worth? Current market prices are volatile and depend to a considerable extent on the “quality” of the certificates. Markets are segmented. 2002 prices per ton of CO2: - Dutch tenders (to buy from developing countries): 4.5-4.6 $ per ton - UK spot trading: 7-9 $ per ton - Prototype Carbon Fund buys at 3-4 $ per ton, sells to investors for 5.5 $ per ton. US$ per ton of CO2

20. Why aren’t CERs worth more? In the EU, an internal price of US$ 15 per ton of CO2 is expected. Companies have to pay 40 $ per ton in fines if they exceed their quota (and after 2007, this will be US$ 100 per ton). In Japan, the costs of reducing emissions can be as much as 100 US$ a ton. So, you’d expect firms to scramble to buy CERs, driving up prices to worldwide equilibrium levels. But this is not happening, nor will it happen soon. The reason: market distortions. Markets will remain segmented: Western governments allow only limited purchases of CERs outside of the country.

21. How are prices for CERs determined? The market is still very segmented, and fungibility of CERs is limited. Efforts are underway to create trading platforms – e.g., the Chicago Climate Exchange is starting this month to trade (auction)CERs, mostly targeting voluntary purchases by US companies, municipalities etc. But most of the trade is bilateral; with only a limited part passing through brokers. It’s Governments that determine where CERs can come from – and decisions can be politically-driven. Thus, there are many segmented markets. Moreover, NGOs and corporates are often willing to pay more for CERs that come from attractive projects.

22. Major buyers are: • international public/private funds (World Bank’s Prototype Carbon Fund, Community Development Carbon Fund,  BioCarbon Fund, Netherlands’ Clean Development Facility) • Private investment funds )- e.g., a 200 mln $ fund managed by Natsource. • NGOs (to take them off the market) • Corporates who want to « warehouse » CERs for future use. (« banking »)

23. Using CERs to leverage access to finance When CERs are sold to an investor, this is generally under a 7- or 10-year contract. This contract sets out the price to be paid, and the quantity to be bought. Normally, payment is only on delivery. However, such contracts are a good underlying for financings backed by the 7- or 10-year receivables. This can take the form of prepayments (the financier prepays the CERs to be delivered, and sells them on to the investor); or pre-finance (the contract is assigned, and payments are made through an escrow account).

24. Standard mechanism Agreement with host government Host government Investor Under Kyoto Protocol, contracts are for 7 (with 2 possible renewals) or 10 years (no renewal). Sales contract for CERs: sponsor has to deliver certified CERs Project sponsor Fînanciers Financing agreement

25. In principle, the investor could make a prepayment for the CERs to be produced over the time of the contract.However, major investors such as the World Bank currently don’t like these risks, and do not pay CERs before actual delivery (they already take the risk that CERs are not accepted by the Executive Board of the CDM and feel this is enough). Structured finance banks should feel more comfortable with a prepayment arrangement - or a secured pre-finance…and it can represent 5-15% of the total investment in a project.

26. One structured finance mechanism Agreement with host government Host government Investor Payment Escrow account Sales contract for CERs Assignment Project sponsor Financiers Financing agreement Reimbursement Assignment of titles, rights etc. Project

27. Note that CERs are paid in hard currency, which could allow an investor hard currency revenue for a project that otherwise would generate only local currency. CERs could also be used to pay suppliers - e.g., an equipment supplier, who would use the CERs to meet his own CO2 reduction obligations. Again, this could be a way to overcome hard currency problems.

28. Mitigating the risks in the structured finance mechanism Agreement with host government Host government Investor Assignment (step-in rights) Political risk insurance Agreement with national government Insurance company Project sponsor Due diligence; insistence on consultation procedures; legal opinions Political risk insurance (non-ratification Kyoto Protocol) Insurance company Project

29. Mitigating the risks in the structured finance mechanism • This agreement will set out the commitments of the host governments towards the project sponsor. This is similar to the undertakings governments give for, say, a power project. It will: • specify when the project sponsor is entitled to receive the CERs • allocate some of the risks – e.g., what if because of government intervention, the project does not meet its emission reduction targets? • when will measurement start? • what if there is a technical problem in the measurement process? • how is force majeure defined? • what if the Kyoto Protocol does not come into force? Host government Agreement with national government Project sponsor Project

30. The securitization mechanism Hedge counterparty Special Purpose Vehicle Futures, options, swaps Buyers Sale of notes Sale of CERs on market Buyers of notes Financing agreements Sales contracts for CERs Possibility of risk tranches Project sponsors This type of aggregation may be crucial for some countries Assignment of titles, rights etc. Projects

31. See for a discussion on how CERs can help project finance, and the risks involved, UNCTAD 2003http://r0.unctad.org/ghg/sitecurrent/download_c/publications.html Structuring and Contracting CDM Transactions Structuring Transactions 1. Upfront Payment for Future Stream of CERs 2. Forward Contract for Delivery of CERs at Fixed Prices 3. Forward Contract for Delivery of CERs at Floating Prices 4. Option Payment for Future Delivery of CERs 5. Spot Market Issues around Contracting Transactions Delivery Risk Timing Risk Counter-Party Credit Risk Country Risk & Currency Risk

32. One risk: “future” CERs do not have the same legal status as “current” ones. Once the CERs have been actually generated and certified, they are irrevocably valid, protecting the buyer and freeing the seller from any liabilityr. The stream of possible future CERs would be non-certified. But after the project has been registered with the CDM authority, the future CERs would be sellable as “promissory notes” in the forward/futures/options market, with a market discount based on the risks that anticipated future credits would not be earned and certified. These promissory notes will only become CERs if the emission reduction is indeed delivered.

33. Concluding remarks • The possibility of getting CERs may well influence the choice of optimal technology (e.g., for energy generation) • CERs can have a considerable positive impact on project economics • There are many (possible) projects in the African energy sector which lead to reduced greenhouse gas emissions • But to “translate” this into CERs which can generate finance is difficult • Once a project has started, it’s too late to try to be paid for any resulting CO2 reduction (there is no “additionality”). So, the earlier one starts looking at CER possibilities, the better.

34. For more information: http://www.unctad.org/ghg