Managing Climate Change Risk in Africa: The Carbon Market

Karan Capoor

The World Bank Africa Region

CDM in Africa Workshop

Jinja, Uganda, November 11 2005

This presentation reflects the findings expressed in ‘State & Trends of the Carbon Market’ by Franck Lecocq and Karan Capoor, April 2005, The World Bank and the International Emissions Trading Association (IETA). These views are the sole responsibility of the authors. They do not necessarily reflect the views of the International Emissions Trading Association (IETA) or of IETA member companies, who cannot be held responsible for the accuracy, completeness, reliability of the content of this study or non-infringement of third parties’ intellectual property rights. The findings and opinions expressed in this paper also do not necessarily reflect the views of the World Bank, its executive directors, or the countries they represent; nor do they necessarily reflect the views of the World Bank Carbon Finance Business Team, or of any of the participants in the Carbon Funds managed by the World Bank. Finally, findings and opinions expressed in this paper do not necessarily represent the views and opinions of Evolution Markets LLC or of Natsource LLC. The CF-Assist program of the World Bank Carbon Finance Business funded this research.

• Scientists believe that the earth’s atmosphere is warming and that this is partly caused by human-induced release of carbon dioxide and related warming gases into the atmosphere from activities basic to human survival, ie combustion of fossil fuels for energy, transport and industry, from agriculture, land use and

• The objective of the Rio Climate Convention (UNFCCC) is to reduce concentrations of greenhouse gases to a level required to prevent “dangerous” warming

• What is “dangerous”? Still undefined. Warming is thought to be impacted by both the “stock” of GhGs in atmosphere as well as the “rate” of temperature change

Major Global Risk

Global Climate Change

• Many scientists believe that global warming is underway

• Although industrialized countries have emitted the most historically, the greatest impacts of warming will fall on those least able to adapt: the poor in the poorest countries and on already stressed ecosystems

• Expected impacts include increased likelihood of: extreme weather events; melting of polar caps leading to a rise in sea levels impacting coastal development; ocean warming; changes in hydrological patterns; increased desertification; increase in infectious diseases

• Likely to add stresses on water resources, food security, human health and infrastructure and constrain development in Africa

Assessing the Risk

Impacts of Climate Change

Complex Risk with Large Stakes

• Climate change: Global, Inter-generational equity issue

• Industrial countries are historically responsible for causing the Earth’s climate to change, but poor people in developing countries are most vulnerable

• Today’s development choices will affect future generations• Risk can be ASSESSED

Assessment can use the best available science to help assess the risk of climate change as it can potentially impact human loss, biodiversity, natural resources, sectors, entire economies or regions

• Risk can be QUANTIFIEDVarious Tools can be employed, e.g.

• Expected Value = Probability of Event X Loss from Event• Or, Monte Carlo Simulation• Tools presume reliable, relevant data exists or can be obtained

Managing Risk

• If deemed substantial, Risk can be MANAGED in a manner that is flexible, efficient and creates value

• Climate Change: A complex Risk

– Assessing the Risk: Global, national & local levels– Vulnerability: people, ecosystems, commodity prices, growth

– Mitigating the Risk: UNFCCC, KP, carbon finance– Adapting to the Risk: Ecosystems, Institutions,

society

• 1992 UNFCCC Rio Climate Convention

– Mitigating the Risk that Climate Change Will Occur– Adapting to minimize the impacts of climate change

• 1997 Kyoto Protocol requires Industrialized countries to reduce emissions an average of 5.2% below 1990 levels

– In some countries, emissions are up by 30% since 1990. – How would such countries reduce emissions by more than 1/3 by 2012

• Shut down production by 1/3? • Mandatory energy efficiency at any cost? • Off-shore industrial jobs? • Tax all energy consumption?

– In a globalized world economy this becomes an issue of trade competitiveness, especially for industrial sectors

– This creates the case for flexible mechanisms including CDM

Managing Climate Risk

Response to Climate Change

Why a Carbon Market?

• Regulation creates constraints on greenhouse gas (GHG) emissions of governments, firms (e.g. Kyoto Protocol obligates industrial Parties to reduce emissions by avg 5 % below their 1990 emissions over 2008-12)

• Since GHGs mix in the atmosphere, it does not matter where emissions are reduced

• Compliance with regulation can be achieved through in-house (“make”) or flexibly through purchase (“buy”) “GHG commodities”, giving rise to the Carbon Market

Annex BNon-Annex B

The Kyoto Protocol

• Assigns GHG emission targets to Annex B countries between 2008 and 2012

• 3 Flexibility Mechanisms

- Joint Imple-

mentation

- Emission

s Allowance Market

- Clean Development

Mechanism

EU Emissions Trading Scheme

• Caps over 40% of EU CO2 emissions• 2 phases : 05-07 and 08-12

• JI and CDM authorized…• But NOT LULUCF (review in 2006)

Methodology

• Limited information on carbon transactions is publicly available

• This study is based on material provided by Evolution Markets LLC, Natsource LLC, and on interviews with many market players

• Database of 487 project-based transactions (signed or advanced stage of negotiation) + aggregated data on allowance markets

Allowance Markets Exploding (in million tCO2e)

(Jan.-March)

0

5

10

15

20

25

30

35

40

2002 2003 2004 2005

Volume Traded Through Projects: Growing (in million tCO2e)

(Jan-Apr)

0

20

40

60

80

100

120

1998 1999 2000 2001 2002 2003 2004 2005

Main Buyers: European Governments and Firms In percent of volume purchased From Jan.04 to Apr.05

Other EU32%

UK12%

Gov. Netherlands16%

Japan21%

New Zealand7%

Canada5%

Australia3%

USA4%

Supply Concentrated in Middle-Income CountriesIn percent of volume sold from January 2004 to April 2005

OECD14%

TransitionEconomies

6%

Africa0%

India31%

Rest of Asia14%

Brazil13%

Rest of Latin America22%

Non-CO2 DominateIn percent of volume purchased from Jan.04 to Apr.05

Landfill GasCapture

10%

Hydro12%

Wind7%

Biomass11%

AnimalWaste18%

EnergyEfficiency

2%

Forestry(LULUCF)

4%

HFC25%

N2O4%

Other7%

0

100

200

300

400

500

600

1998 1999 2000 2001 2002 2003 2004 2005

Known Estimated

Total Value of Contracts over 1 b$ (data in million U.S.$, nominal)

(Jan-Apr)

Prices Depend on Risks(weighted average prices from Jan. 2004 to April 2005 in U.S.$ per metric tonne of CO2e)

$0.00

$2.00

$4.00

$6.00

$8.00

ER VER CER ERU

Insights on Price Differential• Large price differential:

– EU Allowances: 7 up to 27 euros / tCO2e (spot and forward contracts)

– Project-based: 3 to 8+ dollars / tCO2e (forward contracts on expected CERs)

• Allowances and project-based contracts have very different risk profiles:

– Project risks: high in CDM, none in EUAs– Regulatory risks: high in CDM, none in EUAs– Delivery risks: higher in CDM; both actual

delivery and timing of delivery

Outlook• The market has responded to regulatory signals –

now a real compliance market

• Volumes should increase rapidly for both project and allowance segments…..

• … although important uncertainties still need to be addressed

• Overall supply / demand picture (e.g. under Kyoto Protocol) is still unclear:

– How much volume will JI/CDM deliver? Issue of projects lead-time and when?

– How many allowances will Russia and Ukraine bring to market?– What happens after 2012?

Strategic Issues in CDM Market Development

Potentially Competing Interests

• CDM needs to deliver high volumes to keep cost of Kyoto compliance affordable

• Developing country government preferences going into 2nd Commitment Period negotiations is that CDM helps modernize and de-carbonize infrastructure

• “Sustainability” concerns constrains asset choice in many OECD governments, and some corporations

Market Inflection Points to Watch

• Post-2012 market signal by EU and/or KP Parties on long lead time assets

• Second phase ETS review of sequestration/ LULUCF assets

The World Bank’s Objectives

• Contribute to Sustainable Development– Support Developing Countries To Maximize Gains

from Carbon Finance – Add Value to CDM Projects, e.g. sustainable

development opportunities • Help Catalyze the Carbon Market

– Develop new markets, sectors for carbon finance to provide liquidity to the Market

– Add Value to Project Developers: Reduce Risks, Buy VERs and CERs; Provide upfront resources for project preparation and upfront financing

– Build Capacity in Client Countries

Case Study: Biomass Cogeneration

• This case combines information about two potential bagasse cogeneration projects in Uganda as an illustration

• All numbers are fictional

Case Study: Generic Biomass Project

• Sugar Company in Uganda; Commercially-oriented management and sugar production; secures cane from own estate and from out-growers

• Currently generating 3 MW electricity for own production and selling 6 MW to grid for 6 peak hours a day; no carbon

• Proposing to expand generation: negotiating to sell 6 MW (from above capacity) to grid for additional 12 hours a day and an additional 6 MW to sell for 18 hours a day

• Additional 1 MW to be generated and distributed to rural population on and around estate, including out-growers.

• Case Question: Is there a carbon opportunity here?

Q1: Is there a baseline?

• Uganda, with about 5% annual economic growth, has about 300 MW of installed hydro capacity

• Due to variable rainfall, approximately 200 MW worth of output has been generated over the past 2 to 3 years, resulting in rolling black-outs in Uganda.

• A new 51 MW diesel generating facility has been commissioned for the grid

• Applying Combined Margin approach (Average of Operating & Built Margins)

• Operating Margin (EF of grid minus hydro and renewables: EF of 51 MW diesel = 0.7 tonnes/MwH)

• Built Margin (EF of 20% of newest output added to the grid): EF of diesel again or .0.7

• Combined Margin = (0.7 + 0.7)/2 = 0.7

• Baseline exists at 0.7 tonnes/MwH for Grid Sales

• For off-grid sales, a survey of kerosene and diesel use in rural Uganda is used. It is estimated that rural residents typically consume electricity for lighting etc from highly inefficient carbon-intensive fuels. Baseline emissions estimated at 1.2 tonnes/MwH.

Q1: Is there a Project?

• Sugar Company to provide:– 6 MW for 12 hours a day for 300 days to grid = 21,600 MwH * 0.7

= 15,120 t – 6 MW for 18 hours a day for 300 days to grid = 32,400 MwH * 0.7 =

22,680 t– 1 MW for 18 hours a day for 300 days off-grid = 5,400 MwH *1.2 =

6,480

• Estimated ERs from project = 44, 280 t

• This is below CDCF threshold of 50,000 annually

• Might there be some potential for ethanol production - biofuel?

• Might the sugar factory be in a position to generate more electricity?

Q3: Is there a Likely Successful CDCF Project?

• Do the project economics work?– Investment Costs (Can they be limited considering this is not a greenfield development?)– Likelihood of a Power Purchase Agreement from the UETCL? What is the tariff likely?– Given potential for rural generation, is there a potential grant or subsidy likely from Rural Electricity

Agency? How quickly can that be accessed?– How much additional leverage is possible from Carbon finance?– Are these together sufficient to generate a return so that a bank can feel confident to lend to the

Project?• Is the project sponsor strong?

– Track record of sponsor, including credit-worthiness, financial health and direction– Experience in doing projects, raising funds, getting clearances, implementing investments, making

things happen• Social & Environmental Safeguards

– Do No Wrong: Meet WB Env/social safeguards• Community Benefits

– Do some Good: Benefit the local community, e.g. rural electricity access; contribution to Out-growers Fund etc.

• Strong, Efficient DNA– Timely clearances

www.carbonfinance.org

IF these come together in a timely and cost-effective fashion, THEN we have a successful CDCF project!

www.carbonfinance.org

State and Trends of the Carbon Market 2005 Report available at