The carbon market From a Carbon Price to Carbon Finance

19 April 2023 Designator | author 1

The carbon marketFrom a Carbon Price to Carbon Finance

Patricia Rosenthal, Environmental Markets Originator

CO2, CH

4, N2O, HFC, PFC,

SF6 = UZS, EUR, JPY, USD?

UNDP Regional Workshop | Istanbul, January 21-22, 2008 | 2

Agenda

Overview of Carbon Markets

Origination – Kyoto Mechanisms

Financing with carbon Assets

Fortis Carbon Banking

Final Remarks


Fortis Carbon Banking


2004

– March 2004: Executed first trade under the EU ETS– June 2004 Executed first trade under the ISDA agreement winning Carbon Deal of the Year– November 2004: Became co-sponsor of and investor in the European Carbon Fund

2005

– May 2005: Started offering carbon clearing services– October 2005 Won best diversified financial and launched its Climate Change Leadership Index– November 2005: Signed landmark deal with European Carbon Fund for placing over 50 million tonnes – December 2005: first index-based carbon compliance trade

2006

– January 2006: European Carbon Fund awarded Most Promising investment Opportunity– February 2006: Structured and executed first ever CER call option deal– April 2006: Concluded first complete second phase strip transaction from 2008-2012– September 2006 ‘Best in Class’ for our excellent approach to climate change (Carbon Disclosure Project survey report)

2007

– Launch of Carbon Neutrality Programme– June 2007: selected by the United Nations as the Financial Services Provider (FSP) to the UN Millennium Development Goals

(MDG) Carbon Facility which will deliver 15 million Kyoto Credits. Fortis provides carbon services including custodian, financing, purchase of credits and credit marketing tools

– September 2007: Fortis wins the first ever carbon auction in Brazil and acquires 808,000 CER’s from the Sao Paulo government

Fortis – Global Leader in Carbon Fortis is a global leader in the carbon markets with a wide array of offering and has been involved since the inception of the carbon markets.Today

we serve more than 200 clients in their carbon needs

We have a dedicated team of specialised sales and analysts in carbon who can give you specialised market insight and intelligence

As a major investor in the European Carbon Fund (investing 15 million Euros), we have built up considerable experience combining commercial and legal expertise in the CDM & JI approval processes and the associated risks


Fortis: new products for the emerging carbon markets

Accepting returns in carbon

Including carbon value in financing and due diligence

Clean Development Mechanism project financing

Carbon Financial Services

Managing customers carbon accounts

Custody of other Kyoto Compliance Units

Fund custody and administration

Administration and Trust

Trading on demand or to order

Index based procurement/divestment

CER purchasing and sales

Delivery date swaps (quasi repos)

Trading Services

Co-sponsorship of the European Carbon Fund to ensure reliable deliveries of Kyoto Compliance Units for customers

Investing in and developing funds

Eliminate counterparty risk and guarantee trades

Cross commodity correlation model

Clearing CDP Climate Leadership 2006 – Top 50 Global

Co-sponsor and guaranteed placement CP for European Carbon FundInitiated index based position management contracts for customersTrading on behalf of >100 customersCross selling successfully with trust, custody, escrow & settlement


FORTIS BANK SUITE OF PRODUCTS FOR THE EMERGING CARBON MARKETFortis has been trading the EU ETS for 3 years and offers a wide range of products

Spot contracts

All standardised Forwards

Listed Futures and Options

Delivery date swaps (quasi-repo)

Bespoke cross commodity solutions including CER structures

On demand purchases and sales

The simplest form of market access. The customer simply calls Fortis for the market price and decides whether to deal or not

Liquidity access

Fortis has market access via 10 brokers, 3 exchanges and a large number of actively trading companies throughout Europe allowing to offer competitive pricing

Index based products

The customer buys or sells a predetermined quantity of EUAs over a specified period of time at the average ECX closing price for the period. This has the advantage of smoothing out the inter and intra day volatility seen in the market.

Contracts

Fortis uses the standard ISDA master agreement annex, the IETA master agreement and the IETA single trade agreement. Examples can be obtained on request. Recently adopted the GRV


Overview of carbon Markets

- Kyoto Protocol- EU ETS- Voluntary Market- Difference – CER/ERU, EUA, VER


Kyoto protocol and global greenhouse gas emissions

In 2008, the greenhouse gas market becomes a lot bigger

ETSEU25

KyotoRatified

Annex I

Rest of the World

0

5,000

10,000

15,000

20,000

25,000

30,000

World Annex I Kyoto Ratified EU25 ETS

mill

ion

ton

CO

2


Kyoto Market

ANNEX I

NonANNEX I

CO2 1

CH4 (methane) 21

N2O 310

HFCs 150-11700

PFCs 6500-9200

SF6 23900

CER

ANNEX I

ERU


CDM current statusprojects in the pipeline (volumes)

Global

China

India

Brazil

Rest

already issued

at least 1 issued, yet to be issued

registered, before issuance

LoA obtained, before registration

PDD written, before LoA


JI current status

- February saw the first JI project submitted for determination- In May Russia’s prime minister signed the country’s JI procedure, but no

LoA have been given yet - JI potential in the new EU ETS member states is limited due to double-

counting rules- For those countries JI potential is concentrated in non-CO2 projects- JI host countries remain non-EU members as Russia and Ukraine


CDM project cycle, different levels of CERsCDM project identification

Project Design Document

Validation starts

Letter of Approval

Validation ends

Registration

Monitoring

Verification + Certification

Issuance

CER Distribution

CER for compliance in EU-ETS

procedure normally takes 6 to 10 months,can occasionally go up to 18 months

After the validation by a Designated Operational Entity and the approval by a Designated National Authority, the project is submitted to the United Nations’ CDM Executive Board for registration.

If the project gets officially registered at the UN CDM EB, it is recognized as a CDM project. Following that, verification & certification occurs every 1-3 years.Upon verification, a corresponding number of CERs will be issued by the UN CDM EB. This quantity will vary compared to the planned quantity in the PDD.

CERs can be imported in the EU-ETS by transferring them from the International Transaction Log (ITL) managed by the UN to a registry account on the Community Independent Transaction Log (CITL) managed by the European Commission. The link between the ITL and the CITL has not yet been established but the European Commission has guaranteed the link will be ready before April 2009.

Primary CERs

Price of ERPA (Emission Reduction Purchasing Agreement) depends on remaining risks

Secondary CERsProject origin matters - bilateral

Secondary CERs

Project origin does not matter (if it is EU-ETS compliance)


EU Emission Trading Scheme

-To help Member States comply with their Kyoto obligations, the EU established the EU Emissions trading scheme (EU ETS) -First International Emission Scheme ever-Industry from 27 EU countries under cap and trade ~12,000 installations from ~5,000 companies-EU ETS ~ 45% of EU emissions-Large emitters of CO2 must monitor and report their CO2 emissions. Every year these companies are obliged to surrender a certain amount of emission allowances to the government


EU Emission Trading Scheme

-Compliance Mechanisms:-Get allowances for free from the government (this may change in the future)-Purchase allowances from other installations- Internal abatement-Reducing emissions outside: Kyoto Credits

-2 Phases: 2005 - 2007 (pilot phase)

2008 - 2012 (Kyoto period)-EU has already indicated that a scheme after 2012 will be in place giving more confidence the market-The use of Kyoto Credits (CER/ERU) are restricted to a limit set by member states and European Commission.-On average companies can use up to 13% (~) of their allocated certificates in the form of CERs-ERUs for compliance purposes – arbitrage potential


EU-ETS Fundamental Signals

Distance between cap and physical emissions– Physical emissions not known: forecasts, estimates, predictions / NEWS SENSITIVE

– Cap set by European Commission and member states: NEWS SENSITIVE

Weather– Precipitation impacts hydro power generation and compensation by fossil fuel fired plants

– Wind impacts wind power generation and compensation by fossil fuel fired plants

– Temperature impacts energy demand (heating in winter, cooling in summer) and corresponding emissions

Supply from Kyoto projects– Other countries outside EU also demand CERs for compliance

– Supply and Demand of CER/ERU uncertain

Primary energy prices – fuel switch– If gas is cheaper than coal, gas is preferred = low emissions

If coal is cheaper than gas, coal is preferred = high emissions

– Depends on the balance gas/coal/CO2 prices


EU-ETS Success to DateDoes emissions trading work?

Q1 : Is the market sufficiently liquid? YES!

– daily volumes increased by a factor 50 in two years

Q2 : Are EUA prices justified? YES!

– market responds logically to fundamental signals weather, news, allocations, fuel prices

Q3 : Does the ETS lead to emission reduction? YES!

– about 150Mton CO2 emission reduction in the EU power sector throughout 2005 and 2006


Voluntary Market

– Non-regulatory purpose. Usually for marketing purpose, carbon neutrality programs or companies’ strategy to be front runners in future compliance schemes

– VER (Verified Emission Reduction)– There is no unified watchdog. The process to generate those credits is not

standardized– Market is developing new standards in order to secure carbon credit quality and

to avoid double count of credits: e.g. Gold Standard Foundation, Voluntary Carbon Standard

– Those credits are traded with a premium compared to other VERs– There is no real market price. Only one future contract available from CCX

(Chicago Climate Exchanges). Other exchanges are planning to launch more VER contracts as for example Nymex in 2008

Great Increase Potential!


Price Dynamics

Variables

(Direct and Indirect)

Price Range

Weather, fuel switch (coal-gas), politics, supply of Kyoto credits, bankability

Delivery Dec08-22.18€

Politics, EUA price, ITL link, project status, guarantees

Primary Market – 8-13 €

Delivery Dec08 -17.10 €

Establishment of procedures, politics, EUA price, ITL link, project status, guarantees

Only Primary Market

6-10€

Label, quality (environmental and social)

2-10 €

ERU

CER

EUA

VER


Today’s Carbon Markets: CER/ERUs versus EUAs

Value right to emit 1ton CO2 right to emit 1ton CO2eq.

Validity EU-ETS global

Market one market, EU-ETSprimary, secondary,

different prices

Use in EU-ETS Phase Two

YES(1)import limit and (2) ITL-CITL link

EUA CER/ERU


EUA and CER/ERUsMarket opportunity (arbitrage)

Why the price difference?– link ITL-CITL not yet established

operators like to physically own what they buy– Phase Two allocations not yet finalised

Why is this arbitrage?– import limits not yet known

as long as there is a price difference, a company can exchange EUAs for CERs and cash in the price difference

– not enough CERs available to cover all needsexpected supply < expected global demand

Window of opportunity

Price difference is expected to disappear before Mid2009

– CITL-ITL linked– Phase Two allocation and import limits

fully known

0

5

10

15

20

25

30

Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08

pric

es [€

/tCO

2]

EUA Dec08 CER Dec08


1,800

1,900

2,000

2,100

2,200

2,300

2,400

2005 2006 2007 2008 2009 2010 2011 2012

MtC

O2

emissions allocations

Post 2012???

EU non ETS>50% emissions

(700) 1,000

~1,400

Global potential demand outlook

Phase II total ~1,400Mt short

CER & ERU

2,400M

JapanBAU short >1,000Mt

?(100)1,000

CanadaBAU short ~1,500Mt

?

OTHERS

US states, Australia, NZ,voluntary, …

?


Origination – Kyoto Mechanisms


CDM / JI Players

CDM/JI project developers

Construction

Trading house Plant manufacture

Energy company

Financier/Funds

Consultant/Aggregator

DOE

Carbon broker

Construction firm

Equipmentmanufacture

Financial Institutions

EB/Supervisory Board

GovernmentDNA

Governmentministries

Operator

Equipment

Order

AdviceCER/ERUs or fees

Assistance,

Guidance,

Support

Sup

port/

appr

oval

App

licat

ion

Order

Plants

constr

uction

Brokerage Fee

Buyers

OrderValidation,

registration,

verification

CE

R/E

RU

s or

interest

Financing

Risk advice

Other players(law firm)

ER issuanceRegistration

Carbon Exchanges

Exchange Fee

Buyers

payment

CER/ERUs

Compliance Buyers

Multilaterals CER/ERUs

Financial Package


Main Financial Players and Buyers CDM/JI

– Financial Institutions (EU): Fortis Bank, Merrill Lynch, Morgan Stanley, Barclays, Deutsch Bank, Dresdner, KfW, Credit Suisse

– Brokers: TFS, Evolution, CO2e– Exchanges: Noordool, EEX, ECX – Compliance Buyers: Utilities, Cement, Glass, chemical, petrochemical, oil

refineries, coke ovens iron and steel plants; energy-intensive industry, lime, brick, ceramics, pulp and paper industries.

– Multilateral: World Bank, EBRD, ADB


Origination ProcessContact Client or Prospect

Project Identification

Screening Process

Term Sheet

Due Diligence and Client Acceptance

Emission Reduction Purchase Agreement

Administration Process – project participant, monitoring, transfer of

credits

Origination process does not stop after agreement has been achieved


An example of screening criteriaFortis Carbon Desk

– Project size: The project should generate an expected quantity of at least 500,000 tonnes of CERs up to and including 2012. We accept bundled smaller scale projects. There are no upper limits to the project size. We could consider smaller projects based on other merits such as sustainability advantages.

– Technology: The project should use an approved methodology by the United Nations

– Sectors: Renewable energy, energy efficiency, methane recovery and utilization, industrial processes, waste management and fuel switch

– Start date: Usually projects that have already started or plan to start operation over the next 1-2 years


CDM project’s risk assessment

- Fortis Bank Environmental Markets has undertaken significant research in the field of CDM project risk assessment.

- A thorough understanding and assessment of the CDM project’s delivery risk will enable us to maximize our investment return by constructing a diverse CERs portfolio in terms of technology, stage, size and geography.

- Fortis Environmental Markets’ desk has developed a highly objective and auto-improving Delivery Risk Model to screen most CDM projects.

- This model combines a serie of quantitative and qualitative metrics to help us gauge a potential CDM project’s expected performance.

CountryRisk

OperationalRisk

CounterpartyRisk

TechnologicalRisk

DeliveryRisk


Delivery Risk Model applied to a biomass CDM project in China

2007 2008 2009 2010 2011 2012 TotalPlanned CERs Quantity 30,000 40,000 50,000 60,000 60,000 60,000 300,000

% of total 10% 13% 17% 20% 20% 20% 100%

Project Number CCF001Country Name CHINA

Country risk exposure 1Country Default

Probability0.18%

Adjusted Country Default Probability

0.18%

Counterparty Name N/A

Fortis/International Credit Rating

BB+

Implied Counterparty Default Probability

0.74%

Project Stage After Registration

Base Case operational failure probability

10%

Project Type Renewable - Biomass

23,684

20,602

28,223

0

5,000

10,000

15,000

20,000

25,000

30,000

Expected Performance in tonnes of CERS

Base Case Pessimistic Scenario Optimistic Scenario

2007

Expected

Performance in %

Expected Performance in tonnes of CERS

Base Case 78.95% 23,684Pessimistic Scenario 68.67% 20,602Optimistic Scenario 94.08% 28,223


Financing with carbon Assets


Factors that influence CER/ERU price

- Prices of CER/ERUs depend on a number of key factors, including:- EU carbon allowance benchmark price- Scope and methodology. Some buyers are willing to pay a premium for credits with

great environmental and social track record- Credit of the Seller- Existing relationships with buyer-seller- Stage of project development: PIN, PDD, Registered, issuance- Project Size- Does the counterparty want advance payment?- Local investment climate- Delivery guarantee and damages for non-delivery


CDM project’s IRR and its enhancement drivers

-CDM projects distinguish themselves from other projects due to the enhanced cash flows generated by CERs sales. These additional cash flows could significantly enhance the IRR. -Depending on the technology used, a CDM project’s IRR could be doubled due to CERs sales. The carbon revenue of the project thus significantly increases the project’s financial viability.- It is easy to understand that the extra IRR from a CDM project will also depend on the effective quantity of CERs issued to this project by the UN CDM EB (project Performance).

Fixed Indexed Hybrid

Description Price agreed in term sheet level

Percentage of EUA benchmark

Floor plus a portion of EUA positive movement

Benefits Stable and easier to secure finance

Possibly higher cash flow

Minimum income known in advance

Disadvantage -- Market has large volatility and very difficult to secure finance

Still very difficult to secure finance

Target People Risk averse Risk Taker Conservative Risk Taker

IRR calculation from a CDM project will very much depend on the CER price convened between the project sponsor and the CER buyer:


CDM/JI Project Financing

Risks Mitigation

Technology Risk – Proven Technology

Sponsor Risk – Equity First–Track Record

Feedstock Supply Long Term Supply Contract (Volume & Price)

Market Risk (other than CER/ERU) Offtake Contract

Country Risk ECA Insurance/Transfer

CDM/JI Market Risk STRONG Offtake Contract (Volume & Price)

CDM/JI Regulatory Risk Non


- Financial Models CDM/JI projects– Equity: a company finances part of a CDM/JI project in return for shared financial returns and CERs– Loan and Advance Payment: a company provides loan at concessional rates in return for CERs– ERPA: a company agrees to buy CER/ERUs from the project

- The main factors that affect successful closing of financing are:- The cash flow of the business to be purchased enables the business to comfortably service the

proposed debt; - a strong management team - A strong business model (a profitable history and an ability to generate a predictable cash flow)- The accounts of the business which is being purchased/built shows steady growth in revenue and

in profit margin - The purchaser is committing their own personal finance to the transaction and if the business is not

a success, they will personally suffer a financial loss.

– Financing CDM projects would be further facilitated, if– Offtakers commit to purchase credits for a long term– Country Risks are covered by the ECAs.

Project Financing CDM/JI


Nature of carbon finance for a typical CDM/JI projectCapital Markets

(Financial Institutions, Private Equity,Hedge Funds...)

Equity and/or Debt

Ownership + Dividend and/or Principle +

Interest

Power Purchase

Agreement

Cash

Main product: Electricity

Global Carbon Market

By-product: CERs

Cash

CERs


Final Remarks


Beyond 2012…

Some observations– The EU-ETS has no sunset clause; it will continue after 2012.

Currently, this commitment has only been given concrete form up to 2012. – Europe has already announced its determination to cut emissions further by up to 30% of 1990

emissions by 2020; (20% if other global regions don’t take on similar targets). – Players outside the EU have already expressed interest and are likely to start similar (compatible?)

schemes soon.– As the emission reduction target becomes more ambitious, it is very likely that high CO2 price

signals will be maintained in order to facilitate the necessary emission reductions.– To date, many of the world’s premier institutional investors have invested in CDM projects. This

strong interest is mainly due to CDM projects’ unique return profile and superior diversification benefits due to its total lack of correlation with traditional securities market.

– The next wave of carbon reduction projects will need to account for the value of carbon abatement in their discounted cash flow models, and in part rely on the carbon credits for repayment.

“Investment in clean technology is risky, as CO2 may not have a value beyond 2012”? ? ?Not including a value for CO2 in investment projections

will become increasingly hazardous

19 April 2023 Designator | author 37

Thank you

[email protected]


EU-ETS Success to Date Logical response to fundamental signals

Market Fundamental : Phase One Policy & News

market responds logically and consistently to policy & news on - allocations (number of allowances put in the market)- verified emissions (number of allowances needed)

0

5

10

15

20

25

30

Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07

price [EUR/ton]

EC likely to reject NAPs

Czech Rep. increases

allocation limit

NAP drafts generous

EC accepts 5 NAPs unconditionally

official start of EU-ETS

EC rejects revised UK NAP

EC demands cuts in Polish NAP

EC demands cuts in Czech

NAP

UK acceptssmaller NAP

EC demands cuts in Italian NAP

UK "wins" law suit agains EC

Italy publishes adapted NAP

first verified emission reports reveal lower

emissions than forecast

Phase One unanimously forecast long

The carbon market From a Carbon Price to Carbon Finance

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