Carbon Credit Market: An Indian Perspective
Carbon credits are a key component of national and international attempts to mitigate the growth in concentrations of greenhouse gases (GHGs). One Carbon Credit is equal to one ton of Carbon Dioxide or in some markets Carbon Dioxide equivalent gases. Carbon trading is an application of an emissions trading approach. Greenhouse gas emissions are capped and then markets are used to allocate the emissions among the group of regulated sources. There are two distinct types of Carbon Credits: Carbon Offset Credits (COC's) and Carbon Reduction Credits (CRC's). Carbon Offset Credits consist of clean forms of energy production, wind, solar, hydro and biofuels. Carbon Reduction Credits consists of the collection and storage of Carbon from our atmosphere through bio sequestration (reforestation, forestation), ocean and soil collection and storage efforts. Both approaches are recognized as effective ways to reduce the Global Carbon Emissions.
Carbon Finance and Clean Development Mechanism -
The United Nations Framework Convention on Climate Change (UNFCCC) was result of the United Nations Conference on Environment and Development (UNCED), in Rio de Janeiro in 1992. It entered into force in March 1994 and has to date (December 2006) been ratified by 190 countries. The stated objective of the Framework Convention was to stabilise greenhouse gas (GHG) concentrations in the atmosphere at levels that would prevent dangerous human interference with the climate system. To achieve this objective, all countries were required to accept a general commitment to address climate change, adapt to its effects, and report their actions to implement the Convention.
The Convention divides countries into two groups: Annex I Parties, the industrialised countries who have contributed the most to climate change, and non-Annex I Parties, which include the developing countries. The principles require Annex I Parties to take the lead in reducing their greenhouse gas emissions.
The Parties to the Convention meet once a year at the Conference of Parties (COP) to discuss and negotiate measures against global climate change. To further the goals of the UNFCCC, the Kyoto Protocol was adopted at the third Conference of Parties (COP-3) held in Kyoto, Japan, in 1997. At the meeting, the Parties to the Convention negotiated a set of legally binding quantitative targets for 38 industrialised countries (including 11 emerging market economies). These targets, usually measured as a percentage change on 1990 levels, are to be achieved on average over the first five-year ‘commitment period' of 2008−2012. The national emission targets range from -8% (e.g. for the 15 Member States of the European Union at that time) to +10% (Iceland), with the total reduction adding up to around -5%.
However, the Protocol did not become legally binding until 16 February 2005, after ratification by Russia surpassed the collective threshold level required for entry into force. All countries that have now both ratified the Kyoto Protocol and are listed in Annex B to the Protocol are therefore legally bound to limit their national emissions to the specified target levels, on average over the period 2008−2012. With ratification of the Protocol, the COP, meeting as the Meeting of the Parties to the Protocol, is now the supreme decision-making body for its implementation.
The Kyoto Protocol recognises six main greenhouse gases, each with different impact on the Global climate. The common ‘currency' of the Kyoto Protocol targets is one metric tonne of carbon dioxide equivalent (tCO2-e). Each of the other greenhouse gases can be expressed in this form (on a weight-for-weight basis) by multiplying by its Global Warming Potential (GWP).
Countries may meet their targets through a combination of domestic activities and use of the Kyoto Protocol ‘Flexibility Mechanisms,' which are designed to allow Annex I countries to meet their targets in a cost-effective manner and to assist developing countries in particular to achieve sustainable development. There are three Kyoto Protocol Flexibility Mechanisms:
• Joint Implementation - JI (Article 6);
• Clean Development Mechanism - CDM (Article 12); and
• International Emissions Trading - IET (Article 17).
Both JI and CDM are ‘project-based' mechanisms which involve developing and implementing projects that reduce GHG emissions, thereby generating carbon credits that can be sold on the carbon market. JI is a mechanism that allows the generation of credits (known as Emission Reduction Units or ERUs) from projects within Annex I countries, whereas the CDM allows the generation of credits known as Certified Emission Reductions (CERs) from projects within non-Annex I countries (i.e. developing countries). International Emissions Trading allows trading directly between Annex I Parties in the units in which each country's target is denominated, known as Assigned Amount Units (AAUs). All of these different units (ERUs, CERs and AAUs) are effectively permits allowing an Annex I Party to emit one tonne of carbon dioxide equivalent (1 tCO2-e).
The Clean Development Mechanism (CDM) is a mechanism whereby an Annex I party may purchase emission reductions which arise from projects located in non-Annex I countries. The carbon credits that are generated by a CDM project are termed Certified Emission Reductions (CERs), expressed in tonnes of CO2 equivalent (tCO2-e).
In order for a project to generate CERs, it must undergo a rigorous process of documentation and approval by a variety of local and international stakeholders, as specified under the CDM Modalities and Procedures. The key stages in the CDM project cycle are the initial feasibility assessment, development of a Project Design Document (PDD), host country approval, project validation, registration, emission reduction verification and credit issuance. The stakeholders include the CDM project developer and the CDM Executive Board (EB), as well as the Designated Operational Entity (DOE), responsible for validation and verification of the project, and the Designated National Authority (DNA), which has the authority to grant host country approval for the project.
The Conventional Project Cycle
Parties involved in financing the Project
Typical Financing Models:
Project financing (limited recourse financing) :
Under project financing, an SPV is usually established to undertake the project and to clearly define the legal limits of the project entity. The SPV enters into contracts with suppliers and buyers, and with companies to provide construction, operation and other specialised services.
Corporate financing, also known as on-balance sheet financing, is the use of internal company capital to finance a project directly, or the use of internal company assets as collateral to obtain a loan from a bank or other lender.
Leasing essentially involves the supplier of an asset financing the use and possibly also the eventual purchase of the asset, on behalf of the project sponsor.
Ownership of the asset remains with the lessor unless purchased by mutual agreement at the end of the lease. A lease may be combined with a contract for operation and maintenance of the asset.
The Financial Assessment Process -
Key Financial indicators
1. Project Net Present Value (NPV) and Internal Rate of Return (IRR)
2. Equity IRR
3. Earnings before Interest, Tax, Depreciation and Amortisation
4. Interest Cover Ratio
5. Debt Service Cover Ratio (DSCR)
Carbon Market in India-
The growing pressure on countries to address climate change has given rise to a multi-million dollar international market for buying and selling emissions of greenhouse gases. Under the Kyoto Protocol which came into force in February 2005, industrialized countries agreed to collectively reduce emissions of greenhouse gases by 5 percent by 2012 compared to 1990 levels. They can reduce emissions by investing in cleaner technologies at home, trading in emissions rights, or buying carbon credits from projects in developing countries such as India. Carbon credits are thus bought and sold in the international carbon market - much like any other commodity.
Ever since it was established in 2001, the carbon market has captured the imagination of Indian entrepreneurs. The majority of projects that have sold carbon credits so far include renewable energy (such as wind power, biomass cogeneration and hydropower); energy efficiency measures in several sectors ( such as cement, petro-chemicals and power generation); as well as the reduction of industrial gases that contribute to climate change.
The carbon market is already the fastest growing market in the world. Between 2003 and 2004, the volume of carbon credits sold by developing countries doubled, and then tripled between 2004 and 2005. In 2006 alone, carbon transactions worth $30 billion were conducted globally, transferring some $5 billion from the countries of the global north to the global south.
Of the total number of carbon contracts signed in the world so far, India has the second largest portfolio with a market share of 12 percent, behind China which had a market share of 61percent.
This is, however, just the tip of the proverbial iceberg. The Kyoto Protocol expires in 2012, and international talks have already begun to decide the shape of a new treaty that will succeed it. After 2012, the carbon market is expected to expand exponentially. Some say that it could grow to $100 billion annually, becoming a significant source of foreign capital flows from the developed to the developing world, on par with levels of Official Development Assistance.
But, despite the enormous potential of carbon financing for Indian enterprises, the benefits have so far largely been availed of by small and medium enterprises (SMEs). Public Sector Units (PSUs) have mostly remained away, in large part due to lack of knowledge. For India to cash in on the vast potential of the carbon market, a government strategy needs to be devised to derive the maximum benefits from it and address current market failures.
The country also needs to build the capacity of its Public Sector Units (PSUs) to avail of carbon finance. This can be done by systematically screening massive infrastructure and urban development projects to see if they are eligible for such finance. In many cases, domestic agencies will have to take the lead to develop projects and obtain approval from the international regulator - the Executive Board of the Clean Development Mechanism.
For instance, there needs to be a pilot project to demonstrate how the carbon market can catalyse investments in renewable energy to benefit the 400 million people in India's rural areas.
It is also difficult for sellers of carbon credits from India to know how to access buyers from industrialized countries, as the majority of transactions are done on a bilateral basis. Although there is an interest from many players in India to launch a carbon trading platform - which would enable sellers to obtain bids on their carbon credits through public trading, much like the stock market - they have been unable to do so due to a lack of regulatory clarity. India should also consider the establishment of a carbon fund, aimed at accelerating the capacity to develop carbon finance opportunities along the lines of the China Clean Development Mechanism Fund.
The private sector has a significant role to play as well. Many of the Indian projects are currently driven by SMEs and stand disadvantaged because each project generates a small quantity of carbon credits. In contrast, a buyer wishing to purchase a large volume of carbon credits can often buy the required amount from a single project in China. In India, the same quantity of carbon credits would have to be purchased from ten or more projects. Hence, the private sector needs to build its expertise to club small projects together in order to improve their market access.
Several issues lie at the heart of India's troubles with carbon commerce. They include the country's lack of preparedness, the United Nation's inexperience with the market, the technical difficulties of managing, supervising and regulating projects, and delays in the Kyoto Protocol coming into effect.
In the end, the growth of the carbon market will largely depend on the realization that the market can assist India in achieving low carbon growth, and the consequent development of a strategy to cash in on the opportunities this offers.
How does MCX (Multi Commodity Exchange) trade carbon credits?
MCX is the futures exchange. People get price signals for the carbon for the delivery in next five years. Exchange is only for Indians and Indian companies. Every year, in the month of December, the contract expires and at that time people who have bought or sold carbon will have to give or take delivery. They can fulfil the deal prior to December too, but most people wait until December because that is the time to meet the norms in Europe.
Say, if the Indian buyer thinks that the current price is low for him he will wait before selling his credits. The Indian government has not fixed any norms nor has it made it compulsory to reduce carbon emissions to a certain level. So, people who are coming to buy from Indians are actually financial investors. They are thinking that if the Europeans are unable to meet their target of reducing the emission levels by 2009 or 2010 or 2012, then the demand for the carbon will increase and then they may make more money.
Only those Indian companies that meet the UNFCCC norms and take up new technologies will be entitled to sell carbon credits. There are parameters set and detailed audit is done before you get the entitlement to sell the credit. In India, already 300 to 400 companies have carbon credits after meeting UNFCCC norms. MCX has power, energy and metal companies who are trading. These companies are high-energy consuming companies. They need better technology to emit less carbon.
Current Indian: UN Scenario -
The United Nations awarded more than 5.4 million carbon credits to an Indian company, including four million carbon credits in the single largest issuance of emission permits to a Kyoto Protocol project.
The UN Framework Convention on Climate Change (UNFCCC) issued the Certified Emissions Reductions certificates or CERs to two projects—owned by India's JSW Steel—for reducing greenhouse gas emissions between 2001 and 2006.
The projects, which were registered in January under the UN's Clean Development Mechanism (CDM), cut gases emitted through power generation from imported coal and waste gases from JSW's steel manufacturing operations.
The four million credit issuance accounts for 6.5 per cent of the total 62 million CERs allocated by the UN so far, with 42 per cent of all issued credits going to projects in India.
Future of Indian Carbon Market -
The Union government has approved 550 projects complying the Kyoto Protocol to earn carbon credits, and 330 more are awaiting the government's approval, according to Det Norske Veritas (DNV) AS.
The Designated National Authority (DNA) registered the approved projects with the United Nations Framework Convention on Climate Change (UNFCC). The other 330 projects are at the design document stage.
DNV is an Oslo-based consultancy firm, accredited to the UNFCCC for conducting the third party verification of projects, which have adopted the clean development mechanism (CDM) to comply with the Kyoto Protocol. DNV sources say that the market for carbon credit has gone down owing to the increased number of industries registered with the UNFCC.
However, with new core sector projects like power and steel coming up all over the world, especially in India, the carbon credit market will rise once again as these industries will take time to get registered with the UNFCC. The new projects are, however, adopting the CDM.
§ Climate Change Reference Guide: World watch Institute
§ International Carbon Market Mechanisms: IISD.
§ Financial Times dated 29th March 2009.