CDM as financing source for projects in SEA � transaction costs of CDM compared to estimated certificate prices

D. MÖST, N. ENZENSBERGER, W. FICHTNER and O. RENTZ

Institute for Industrial Production (IIP)
Hertzstrasse 16, D-76187 Karlsruhe, Germany
Tel. +49 721 608-4689, fax +49 721 758909, e-mail

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Introduction
Introducing restrictive emission ceilings at enterprise level as well as implementing an international emission trading system in which enterprises receive tradable emission permits for the basket of six greenhouse gases (GHG) as determined in the Kyoto protocol would have a considerable impact on the production planning of business firms, especially in energy intensive sectors (electricity and heat production, iron and steel, refining etc.). With the Clean Development Mechanism (CDM) of the Kyoto Protocol, new investment possibilities arise for European investors in Non-Annex 1 countries, as e.g. Southeast Asia. Within this article, the CDM as a financing source for projects in SEA will be discussed. The article starts presenting expected prices per tonne CO2, which have been ascertained by various research institutes and consultant companies. Due to the fact, that CDM projects will only be realised if their production costs plus their transaction costs are lower than these prices, some estimations on transaction costs are given. Finally risks arising from CDM-projects will be shown and examples and types of other financing sources will be presented.

Financial viability of CDM projects
By means of the market-based Kyoto Mechanisms Joint Implementation (JI), Clean Development Mechanism (CDM) and International Emissions Trading (IET) it will be possible to trade emissions permits globally. Demand will be driven by the emission reduction commitments of industrialized countries and countries with economies in transition, the group of so-called Annex 1 countries. This emerging global market will offer challenging opportunities to a wide variety of different players in industry and business.
While for environmental taxes, the price is fixed through the states, for the flexible instruments within the Kyoto Protocol the price will be achieved through the certificate market and hence will be economical optimal. Market participants can decide whether they buy certificates or implement reduction measures by themselves. Measures with negative CO2 avoidance costs, so called no regret-actions are economic and should be made in each case (see Figure 1.1).

Figure 1.1: Profitability of projects depending on certificate price

Environmental protections projects, where the CO2 avoidance costs are below the market price of the emission certificate, should also be implemented, because the costs for the environmental investment can be achieved or regained through flexible instruments. Projects with higher CO2 avoidance costs will not be realised due to the fact that the buying of certificates is cheaper. Profitability of projects and with this project selection depends on the price for a tonne CO2. Due to the fact, that the three flexible mechanism create the same good (reduction of CO2), the price for this traded good will be the same independent from the source and the market where it is traded on. But what will be the price for emission certificates? Some models and exemplary trading systems try to determine the prices for certificates (see Table 1.1). These estimations for CO2 emission certificates range between a wide spread. The minimum price is 4 USD/tCO2, calculated by a model of ECN, and the maximum price is 22 USD/tCO2. Having in mind, that the prices calculated within these models depend on different assumptions and system boundaries (like e.g. a model for the whole world in comparison with a model for Europe), this wide price range is comprehensible.

Table 1.1: Permit Prices in Emission Trading

Summarising these values and other prognoses, CO2-certificate prices in Europe will be at about 15 Euro / tonne CO2 in the first commitment period. Due to higher reduction targets they will be higher in the following commitment periods.

Transaction costs
As early as 1937 Coase defined transaction costs to be the costs that arise from initiating and completing transactions. In the context of the Kyoto Mechanisms, transaction costs are e.g. caused by the administrative process and thus depend on the institutional framework. In principal transaction costs of CDM projects can be differentiated into transaction costs arising from undertaking projects in developing countries and transaction costs arising from undertaking a project under the CDM framework. Furthermore transaction costs accrue at different stages in the process of a transaction or project cycle (see Table 1.2).

Table 1.2: Transaction cost components (Source: [Michaelowa 2003])

In the following we will focus on transaction costs arising from undertaking a project under the CDM framework, because the emerging structure of the CDM envisages a series of formalities and institutional hurdles that a project has to overcome in order to be officially regarded as a CDM initiative and be credited with Certified Emissions Reductions (CERs). This set of institutional requirements or stages, known as the CDM �project cycle�, is designed to ensure the environmental integrity of the CDM and a degree of comparability between CDM initiatives. These stages include the preparation of a project design document, gaining host country approval, validation of the design document by an independent third party or operational entity (OE), registration of the project with the CDM Executive Board and, following project implementation, the verification and certification of the claimed emissions reductions.
Transaction costs could have a significant impact on whether CERs add to the viability of a project. Undertaking a project under CDM framework will only be viable if the costs of transacting the CERs are substantially lower than the revenue they will generate. In Table 1.3 transaction costs for a typical electricity generation projects are shown.

Table 1.3: Estimates of transaction costs (Source: [Harmelink 2001])

When considering the financial viability of a project, lenders and investors are particularly interested in assessing the cash flows over the first few years of operation. This is the most critical period when attempting to attract finance. The impact of the first 5 years CER transaction costs, in relation to the revenues over that period is shown in table 1.4. Even if the operational transaction costs (Table 1.3 section B- Operational Phase Costs and table 1.4) will only be of relevance if the project is considered viable based on pre-operational costs, they are also shown in table 1.4. Project developers generally expect up-front costs to be no more than 5-7%. Having in mind that search costs (for seeking out possible investors for the selected CDM project) are not included in the calculation, they have to be added to the general up front cost. In the example shown in table 1.4, the up front costs in percent of the emission reduction value are much higher (11,9-17,8%) than 5-7%. Therefore, this project would probably not be tenable under CDM aspects, especially as search costs would augment this figure. If the project would achieve a CO2 reduction of about 80.000 tons, the up front costs in percent of the emission reduction value would come down to 5-7%. So, this example demonstrates a first pre-calculation for projects in SEA, whether they should start efforts to get CDM as financing source by comparing transaction costs with the value of emission reductions.
It is also possible to determine the minimum amount of CERs that have to be generated, so that this project is viable in regard to the up front costs. In addition, the estimated certificate price can be varied. However, it should be noted that the above analysis does not take into account other potential costs (administration charge, �) and also risks in relation to CDM are not included.

Table 1.4: Revenue and Transaction costs

Last modified 12/11/03