CDMprojectfinancialanalysisThursday27thMarchRobert

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CONFIDENTIAL

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Date

This report is solely for the use of client personnel. No part of it may becirculated, quoted, or reproduced for distribution outside the clientorganization without prior written approval from McKinsey & Company.This material was used by McKinsey & Company during an oralpresentation; it is not a complete record of the discussion.

CDM Projects:The Financial Perspective

Robert Kelly

Regional Coordinator, CDM Capacity Development,

Southern & Eastern Africa

[email protected]

March 27th, 2008


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Unit of measure

* Footnote

Source: Source

2

Agenda

The big pictureThe big picture

Why bother with financial analysis?

Conducting financial analysis

A practical example


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Source: Source

3

The bewildering range of potential CDM projects

Wind power

Bagasse

Hydro power

Animal waste

Sewage /wastewater

Landfill

Forestry

Bio-fuels

Transport

Heavy Industry


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Source: Source

4

Not all carbon projects are born equal


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* Footnote

Source: Source 5

Not all carbon projects are born equal

970,000

520,000

318,000

206,000170,000

83,000 79,000 74,000 54,000 26,000 18,000

N 2O

Fugitive

emissions

Reforestation

Landfill

gas

Energyefficiency

(power)

Hydro Wind

Transport Bio

gas Solar

Energyefficiency

(households)

4.5m

HFCs

Average Annual CER Production by CDM Project-Type


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Carbon revenues also vary on a project-by-project basis

Biomass

energyWindHy

droSolar

Geotherm

alTidalBio

gas

Agriculture

Reforestation

Landfill

gas

Coalmine

methaneFugitive

FossilfuelswitchCement

TransportPFCs

EEhouseholds

EEindustry

EEservice

sector

EEsupplyside

Energydistribution

379

928

543

234

1,228

0

661

330762

1,711

4,128

7,934

3,039

1,101

1,179

0 91

1,811

13

827

0

Standard deviation(kCERs by 2012) Markers

indicatemaximum,mean andminimum

project sizewithin eachtechnology


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For some projects, the carbon layer is the only layer

True for some industrial projects:

e.g. thermal decomposition of HFCs

e.g. flaring of methane from urban waste dumps

e.g. capture of N2O from nitric acid manufacturing process

There is no reason why a project developer would carry outthese activities if it werent for the carbon revenue


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But many carbon projects combine revenue streams

Most carbon projects rely upon a number of revenue flows. The carbonlayer typically represents just one financial layer

Multiple Carbon Layers

e.g. an animal waste management project that claims CERs for

captured methane and claims CERs for clean energygeneration

e.g. a palm oil plantation that claims tCERs for carbonsequestration and CERs for fuel switching (the displacement ofmineral diesel by bio-diesel)


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Carbon & Non-Carbon Layers

e.g. an urban landfill project that claims credits for captured

methane and uses the methane to generate electricity

e.g. a forestry project that claims credits for carbonsequestration during the project crediting period, and then logsthe trees for timber revenues


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Carbon & Non-Carbon Layers

e.g. an urban landfill project that claims credits for captured

methane and uses the methane to generate electricity

e.g. a forestry project that claims credits for carbonsequestration during the project crediting period, and then logsthe trees for timber revenues

Contrad

ictory

revenue

streams

Comple

mentaryreven

ue

strea

ms


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Source: Source 111

So, to summarise

Different project-types (and different projects) generate differentvolumes of carbon credits

Some projects rely solely on carbon revenues

Many projects combine carbon revenues with non-carbon

sources of revenue

Financial analysis is vital to understanding a CDM project,both in advance and during the projects lifetime


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Source: Source 112

Agenda

The big picture

Why bother with financial analysis?Why bother with financial analysis?


A practical example


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Three uses for financial analysis

Is the project going to make money?1


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A CDM project costs money. Is it worth the effort?

Assumes a 10-yearproject.

Recurrent costsdiscounted at 3%

annual rate to expressin present-value terms.

Registration costs,Administration Fee and

Adaptation Fund Levynot included.

Indicative CDM Cost Profile For ATypical CDM Project

13,000

38,000

16,500

10,000

34,000

53,000

PDD

Validation

InitialMonitoring

OngoingVerification

ByDOE

Ongoing

AnnualMonitoring

Pre-RegistrationCDM Costs

Post-RegistrationCDM Costs

US$

51,000

67,500

77,500

111,500

164,500

PIN


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Source: Source 115


Demonstrating additionality2



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Demonstrating additionality investment comparison analysis

Project withoutcarbon revenue is

unprofitable

Project withoutcarbon element

Project withcarbon element

Carbon revenue

makes the projectworthwhile

Break-even point

Revenue/NPV/IR

R

Choose an appropriate financial indicator, such as IRR, NPV or benefit-costratio, to demonstrate additionality


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Source: Source 117

Demonstrating additionality benchmark analysis

Choose an appropriate financial indicator and compare it with a relevant benchmarkvalue: e.g. required return on capital or internal company benchmark

Project withoutcarbon revenue

is profitable butnot sufficiently

profitablecompared with

alternativesProject withoutcarbon element

Project withcarbon element

Carbon revenuemakes the projectattractive relative

to investmentalternativesInvestmentthreshold

Revenue/NPV

/IR

R


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Source: Source 118


Demonstrating additionality2


Structuring the project3


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Revenue flows determine more than just profits

Future carbon revenue flows can be used as collateral forobtaining loans from financial institutions

Future carbon revenue flows can be used to negotiate forwardpayment from the carbon buyer. This up-front payment can

then be used to pay for project establishment costs

The distribution of carbon revenues in time determines how

frequently the project should be verified


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Agenda

The big picture


Conducting financial analysisConducting financial analysis

A practical example


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Investment appraisal techniques

Payback period

Net present value (NPV)

Internal rate of return (IRR)

Benefit-cost ratio (BCR)


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Payback period

The payback period is the length of time taken for the inflows

of cash (i.e. revenue) to equal the original cost of investment

Measures the length of time it takes for a project to repay itsinitial capital cost:

E.g. a piece of machinery costs $10,000 and it earns acashflow of $10,000 over a 12-month period. The paybackperiod is 1 year

Acts as a proxy for risk: the shorter the payback period, the

lower the risk

Informal thresholds are typically employed: e.g. 3-5 years inBritain, 6 months in Iraq?


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Payback period - example

Year$1,000

Year 0 Year 1 Year 2 Year 3 Year 4

Project A (400) 300 110 67 0

Cumulative (400) (100) 10 77

Project B (400) 100 100 125 235

Cumulative (400) (300) (200) (75) 160


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Net present value (NPV)The weakness of the payback period is that it does not

consider the time value of money

More immediate cashflows are more valuable than moredistant cashflows

E.g. if a company puts $1,000 into a bank account earning 5%interest per year, in one years time the bank will pay $1,050. The

future value of $1,000 today is $1,050 in one years time

The present value of $1,050 at 5% interest rate in one years timeis $1,000

In effect, a dollar is worth more now than a dollar in one

years time

Why? Because there is an opportunity cost associated withinvesting money in a bank account. The company has to berewarded for investing in the form of interest


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Generating interest on an investment

0

50

100

150

200

250

300

350

400

450

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

$

Year 15:Total savings

are $420(4.2 times

greater thanthe initial

investment)


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Discounting future revenue flows

0

20

40

60

80

100

120

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

$

Year 15:Annual revenueof $100 is worth

$24in present value

terms(4.2 times less

than $100 today)


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Net present value (NPV) - example

Year$1,000 Year 0 Year 1 Year 2 Year 3 Year 4

Project A (400) 300 110 67 0

Discount Factor 10% 1.00 0.909 0.826 0.751 0.683

Present Value (400) 272.2 90.9 50.3

NPV= 13.4Project B (400) 100 100 125 235

Discount Factor 10% 1.00 0.909 0.826 0.751 0.683

Present Value (400) 90.9 82.6 93.9 160.5

NPV= 27.9

A project with a positive NPV is profitable; a project with a negativeNPV should not be undertaken


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The internal rate of return is the discount rate that produces anet present value (NPV) of zero

The IRR is the break-even discount rate. It represents the

maximum cost of finance at which the project remains viable

How to calculate the IRRUse a computer!

The IRR is determined through an iteration process, using

different discount rates until an NPV of zero is produced


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Once the IRR is found, it is compared with the companys pre-set threshold investment rate (the hurdle rate)

The hurdle rate is usually the companys opportunity cost ofcapital e.g. the interest it could make on money saved in a

bank account

The IRR decision rule:

IRR > hurdle rate accept

IRR < hurdle rate reject

The IRR provides a simple investment decision framework formanagers


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Impact of CER Revenue on the Internal Rate ofReturn of CDM Projects

The IRR uplift typically provided by carbon revenues

Technology IRR

Hydro 0.8-2.6

Wind 1.0-1.3Bagasse 0.4-3.6

Biomass 2-7

Municipal Solid Waste >5

Forestry 2-7


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According to finance theory, any project offering a positiveNPV should be undertaken

However, investment capital is often scarce when confronted

with 2 NPV-positive projects, a company may not havesufficient money to undertake both projects

The IRR represents one way of distinguishing betweenprofitable projects. However, the IRR measures % returns

not absolute financial returns


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The benefit-cost ratio (BCR) provides a means ofdistinguishing between profitable projects in an absolute sense

Present value of future cashflow

Value of initial capital investedBCR =

The project with the highest BCR represents the mostattractive investment

The minimum typical BCR of an attractive project isapproximately 1.3


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Project comparison

Project A Project B

Initial Investment 400 400

Nominal Revenue 477 560

Payback in: 2nd

year 4th

yearNPV ($1,000) 13.4 27.9

IRR 12.6% 12.9%

BCR 1.03 1.07


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Financial Indicator Strengths Weaknesses

Payback period Easy to calculate and to understand Acts as a proxy for risk and is suitable fora company whose objective is survival orwhich is operating in high risk environment

Cash flows beyond the payback periodare ignored It does not reflect inflation and opportunitycosts of money as it ignores the timing of

the flows The determination of the requiredpayback period is highly subjective

Net Present value NPV method overcomes the problem ofchanging value of money over time. It looks at projects over their wholelifetime, unlike payback

The choice of discount rate is problematic It makes the assumptions that there is asingle market rate of interest for bothborrowing and lending Does not take into account the effect of

taxation or other policy measures

Internal rate of Return IRR takes into account the value of timeand is easily understood by managers

As it measures % returns, it fails tomeasure wealth changes in terms ofabsolute amounts IRR is problematic if the cash flows areunconventional. Does not take into account the effect oftaxation and other policy measures

Benefit Cost Ratio Enables a ranking of projects whencapital is rationed

Same as for NPV


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Agenda

The big picture



A practical exampleA practical example


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Source: Source 336

Animal waste management

=

U it f


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Animal waste management Theory

Methane is produced as part ofthe normal digestive process in

animals (enteric fermentation).The CH4 is exhaled or eructated

by the animal.

Revenue Opportunity

Credits for reduced CH4

emissions; utilise captured CH4

for energy generation (andfurther carbon crediting)

Method

2 potential approaches: Modify animal feed intake Capture CH4 emissions

Complete Mix Digester

Covered Lagoon

U it f


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Source: Source 338

Methane flaring from a swine farm in Brazil: costs and revenues

US$ Year

0

Year 1 Year

2

Year

3

Year

4

Year

5

Year

6

Year

7

Year

8

Year

9Equipment costs(cover, PVC,meter, flare,etc.)

(61,363)

Installation costs(groundexcavation, etc.)

(92,000)

Maintenancecosts

(4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600) (4,600)

Other costs(operation,engineering)

(9,200)

Revenues fromthe sale of

electricity

0 0 0 0 0 0 0 0 0 0

Number ofCERs generated

25,000 69,500 69,500 69,500 69,500 69,500 69,500 69,500 64,000 60,000

U it f


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Source: Source 339

Calculating the Net Present Value (NPV)

$US Total costs Total revenue Cashflow Discounted cashflow

Year 0 -167,163 250,000 82,837 82,837Year 1 -4,600 695,000 690,400 627,580

Year 2 -4,600 695,000 690,400 570,533

Year 3 -4,600 695,000 690,400 518,672

Year 4 -4,600 695,000 690,400 471,525

Year 5 -4,600 695,000 690,400 428,663

Year 6 -4,600 695,000 690,400 389,698

Year 7 -4,600 695,000 690,400 354,274Year 8 -4,600 640,000 635,400 296,413

Year 9 -4,600 600,000 595,400 252,506

NPV 3,992,700

(Assuming a 10-year project crediting period, 10% discount rate and $10 per CER)

This project is NPV-positive: it makes financial sense to undertake the project

CERs represent the only revenue stream: demonstrating additionality isstraightforward

Unit of measure


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Adding an electricity generation component

(The annual revenue from this electricity generation component of the project is$US30,000 in Year 0, $70,000 in Years 1-7, and $60,000 in each of Years 8 and 9. The

cost of installing the required electrical equipment is $70,000 in Year 0 and $5,000 ineach subsequent year)

The NPV of the project has increased: it makes financial sense to add an electricitygeneration component to the project


Year 0 -237,163 280,000 42,837 42,837

Year 1 -9,600 765,000 755,400 686,666

Year 2 -9,600 765,000 755,400 624,248

Year 3 -9,600 765,000 755,400 567,504

Year 4 -9,600 765,000 755,400 515,918

Year 5 -9,600 765,000 755,400 469,021

Year 6 -9,600 765,000 755,400 426,387

Year 7 -9,600 765,000 755,400 387,628

Year 8 -9,600 700,000 690,400 322,071

Year 9 -9,600 660,000 650,400 275,831

NPV 4,318,110

Unit of measure


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Unit of measure

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Source: Source 441

Electricity generation without carbon revenues from the CDM

But the argument for CDM additionality has become a lot more difficult. The project developerwould have to demonstrate either that there are more attractive projects to invest in (i.e. that the

NPV, though positive, isnt sufficiently large) or that there are non-financial barriers toinvestment that the CDM helps to overcome


Year 0 -237,163 30,000 - 207,163 - 207,163

Year 1 -9,600 70,000 60,400 54,904

Year 2 -9,600 70,000 60,400 49,913

Year 3 -9,600 70,000 60,400 45,376

Year 4 -9,600 70,000 60,400 41,252

Year 5 -9,600 70,000 60,400 37,502

Year 6 -9,600 70,000 60,400 34,093

Year 7 -9,600 70,000 60,400 30,994Year 8 -9,600 60,000 50,400 23,512

Year 9 -9,600 60,000 50,400 21,374

NPV 131,757

This project is NPV-positive: it makes financial sense to undertake the project

Unit of measure


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Unit of measure

* Footnote

Source: Source 442

End

Robert KellyRegional Coordinator, CDM Capacity Development,

Southern & Eastern Africa

[email protected]

CDMprojectfinancialanalysisThursday27thMarchRobert

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