Mitigating risks associated with Emissions Reduction Purchase Agreement

SUSTAINABLE MARKET SOLUTIONS FOR GLOBAL ENVIRONMENTAL PROBLEMS

TBLI EUROPE, Paris, November 9-10, 2006

CER risk mitigation through Emissions Reduction CER risk mitigation through Emissions Reduction Purchase Agreements Purchase Agreements

Ranjan MoulikDEXIA Crédit Local


The backdrop

Achieving significant greenhouse gas reductions on a global scale is urgent: institution of “cap and trade”

under the auspices of the Kyoto Protocol. National allocation plans set up to formalise commitments of consenting parties to the Protocol (EU case)

Optimal use of the opportunities of market based Flexible Mechanism will assuage compliance burden.

Nov./Dec. 2005 COP/MOP1 in Montreal: consolidated operational aspects of the rules and modalities of the Flexible Mechanisms through the adaptation of the 2001 Marrakesh Accords.

EU to finalise NAP II in Nov 2006 and hopefully clarity on post 2012 at Nairobi in Nov; 2006.


The “products”

• Carbon transactions : purchase contracts where one party pays another for a given quantity of GHG emission reductions (allowances or “credits”) that the buyer can use to meet its compliance objectives.

• Payment for emission reductions can be made using cash, equity, debt, or in-kind contributions

• Two main categories:

• Allowance-based transactions, in which the buyer purchases emission allowances created and allocated (or auctioned) by regulators under cap-and-trade regimes, such as Assigned Amount Units (AAUs) under the Kyoto Protocol, or EUAs under the EU ETS.

Project-based transactions, in which the buyer purchases emission credits from a project that can credibly and verifiably demonstrate that it reduces GHG emissions compared with what would

have happened otherwise - CDM and the JI Framework under the Kyoto Protocol, generating CERs and Emission Reduction Units (ERUs) respectively.

EU Linking Directive: mechanism to convert units from one scheme into units from the other - Allows for the use of CERs in the first phase of the EU ETS for compliance.

Allows for the use of CERs and ERUs, subject to a quantitative limit to be provided in the national allocation plans in the second phase of the EU ETS.



The requirements:• The functioning of the CDM Executive Board• The functioning of the JI Supervisory Committee• Article 17 of the Kyoto Protocol to be complied with if transfers from one registry to the other has to be

ensured.• The International Transaction Log (ITL) to be in place


EU ETS : operational in January 2005. Increasing volumes & trades :

• Traded volumes in EU allowances via brokered-OTC transactions were 8.44 Mt CO2 in 2004, versus 306.68 Mt CO2 traded volumes in 2005 (including exchanges).

The EU carbon market


The price behaviour


The market / price drivers

• Policy & regulation: largely responsible for high volatility (sharp peaks & troughs)

- the NAPs,

- Hot air,

-JI mechanism fine tuning (Track 1 & 2),

-Post 2012 & banking

• Economic & corporate growth rates

• Efficiency measure undertaken by compliance burden holders

• Supply of CERs

• Weather, Fuel & Power prices

– 55% of EUAs held by power & heat sectors

– Coal / Gas substitution

– Rainfall: the hydroelectric factor

– Extremely hot summers & very cold winters


The risk factors

• Regulatory risks

- Post 2012,

- Host country institutions e.g. DNA,

• Delivery risk: registers & functioning of the ITL

• Host country institutions: DNAs, local regulatory practices

• Project specific risks: performance, additionality, under-tonnage

• Accounting uniformity and tax treatment

• Transparence: work to de done to obtain unequivocal and clear price signals (largely OTC market and data relatively scant on transaction terms & prices)


ERPAs: their objectives

• Minimise the discount to the EUA s that CERs contracts are traded: enhance fungibility to extract value

• Provide incentives for project completion and continued performance

• Implication of all parties in EB approval process (focal points, participation in due diligence)

• Avoid seller exposure to downside price risk and provide flexibility for upsides

• Ideally, buyer invests in underlying project: importance of creating mutual interests

• Creation of carbon portfolios with varying levels of risk associated: extracting value by bundling and reduce transaction costs

• Strive to create standard documentation

Mutually beneficial & optimally structured ERPAs in terms of risk allocation are most likely to be sustainable and and are least likely to default. Mutually beneficial & optimally structured ERPAs in terms of risk allocation are most likely to be sustainable and and are least likely to default.


ERPAs: illustrative structures

• A third of transactions by buyers with intent to enter into secondary transactions i.e. buyers hedge risk by selling CER contracts back-to-back(on basis of bank or corporate gtees) or hedge down-side by buying put options to sell CERs at fixed price in the future.

• Most common guarantee structures for primary transactions: Gtee applicable for a fraction of CERs delivered (25 to 50%): enables seller to secure a revenue stream and aid bankability of underlying project – however, such gtee entails price premium

• Market practice has been that largely sellers bear CER registration & issuance risk (exception: World Bank)

• Hybrid deals: portion of contracted volumes at fixed price (usually 2005-2007 vintage) and 2008-2012 vintage indexed to an EUA price paid on basis of agreed formula & payable on delivery

• In 2006, most common contracts:

- price indexed to EUA price & supported by floor – sellers offered a % of EUA spot price prevailing at delivery date.

- contract sets floor price & floats with EUA up to certain level, above which both parties share benefits

Economy & Finance

Mitigating risks associated with Emissions Reduction Purchase Agreement