As the continuing increase in environmental regulation pushes up costs and risks of compliance for the energy and industrial sectors, a new potential source of revenue for cleaner projects comes as a breath of fresh air.
In March this year, the UK Government effectively opened the UK Emissions Trading Market through an auction of emission allowances relating to an initial five-year period commencing 1st April 2002. Thirty-four companies accepted firm caps on outputs of greenhouse gases in return for incentive payments totaling £215 million. Whilst the government is not committed to further auctions, it is expected that more auctions will occur to encourage the development of a larger and more liquid market.
Direct entry participants that come into the scheme through the auction route will be supplemented by participants to climate change levy agreements later in the year. This has the potential to include some 6,000 participants involving around 8,000 sites in the UK. Rules are being prepared by Government and are expected to be available in the summer.
A third source for developing the size and liquidity of the fledgling UK Emissions Trading Market comes in the form of project based credits. The Department of Trade and Industry has commissioned a report on "Developing Guidance for UK Emissions Trading Projects," the first phase of which was published in April. The study was co-ordinated by the Centre for Environmental Strategy at the University of Surrey and is divided into two phases. Phase one looks at policy issues surrounding the assessment of emissions reductions from projects; Phase two will aim at providing guidance for project developers.
The project sector opens up a range of opportunities as companies that are excluded from the existing direct entry market are able to generate emission trading credits through the project sector. Key amongst these companies are the UK electricity generators, which are ineligible for inclusion as direct participants through the auction process. The ability of electricity generators to engage in project based activity brings in an important group to attempt to deal with climate change through market based instruments. It is hard to see how this challenge could be effectively met without engaging a sector as important as the electricity generators in some way or other. The opportunity may also appeal to companies currently operating under negotiated agreements. Where these companies have operations outside those caught under the agreement, the project sector provides a potentially attractive compliance hedge. For some companies, meeting targets negotiated under the climate change agreements may prove to be more difficult than originally thought. Generating credits from alternative activities could be an attractive compliance tool to these targets and a potentially cheaper way of protecting against penalties under the climate change levy than buying credits in the new emissions trading market.
Project based credits should also provide an attractive means of supporting development based activity. The ability to generate additional revenue streams in areas of new or improved technologies, without subjecting the company to firm wide caps on greenhouse gas output, should generate more interest in developing the more significant advances in emission reduction technologies that will be required if a serious impact is to be made in reducing global concentrations in the atmosphere.
The discussion as to how to implement project based credits is not new. Project based credits provide an essential element of the group of flexibility mechanisms identified under the United Nations co-ordinated efforts to limit the effects of climate change as signed up to by most of the nations of the developed world by way of the Kyoto Protocol.
The University of Surrey report wisely picks up and builds on many of the concerns and conclusions that have been in debate at the international level for many years. Whatever system the UK adopts at the national level, it is important that it fits within EU and Kyoto based mechanisms as these come into effect over the next few years. Adopting the same language and general approach should minimise conflict between the national and international schemes at a later date.
So how does this work? The process is to award credits to project developers who develop projects that directly or indirectly generate less greenhouse gases than would have been generated had no such action been taken. Whilst it is relatively simple to state the principle, the processes involved in achieving this principle have proved to be contentious and difficult to address on a basis that does not make the exercise unduly expensive to implement. Credits are market based instruments that can be bought and sold in the market at the prevailing market price. In simple terms, the cleaner project is subsidised through the market mechanism by companies that would otherwise be over their limits in terms of their own greenhouse gas outputs. This is not to say that buyers of credits are necessarily environmentally bad companies. The capital structure of a company may make it extremely difficult to cut greenhouse gas outputs at an economical cost in the short term (e.g., existing plant may have, say, a 10 year remaining life). By buying credits from a cleaner project, it is possible for the existing company to continue existing production on its existing capital base whilst meeting voluntarily or potentially mandatory emissions targets by buying in the available credits that arise from project based activity. It is perhaps easiest to explain this by way of an example.
Company A has a turnover of £500M on an asset base of £200M and a profit margin of £50 per unit on 1 million units. In order to achieve this, it emits 10M tonnes per year of carbon dioxide equivalent gases ("CO2e").
Under current conditions, the company therefore emits 10 tonnes CO2e for each unit produced. This is at zero cost to production. The company has no incentive to spend even £1 to reduce this output.
Let us assume the company voluntarily, under the current UK scheme or mandatorily under a future UK scheme, EU scheme or Kyoto scheme, agrees to reduce carbon output by 10% to 9M tonnes. It can do this by (i) reducing productions output by 100,000 units, (ii) by replacing its capital stock at a net price of £160M to make it more efficient or (iii) by buying credits. It is possible that neither option (i) nor (ii) will be possible due to, in the case of (i), existing supply contracts or, in the case of (ii), available capital funding. Ifexisting credits are trading at around £3.5 per tonne, it is possible for the company to acquire the 1M tonnes of allowances it requires for £3.5M. However, it does not know what the price will be over the next seven years, by which time it will be ready to replace its capital stock.
Company B intends to develop a similar project at a cost of £200M but recognises that by using a different process which will increase the cost to £220M, it can save 2M tonnes of CO2e output per year without any difference to the underlying product.
Ignoring competitive issues between Company A and B, this is the ideal fit. Company A can acquire the 1M tonnes of allowances it requires for the next seven years at, say, £3 per tonne per year, saving £500,000 per year on the amount acquired relative to today's market price. This also enables it to fix its exposure over the next seven years through having a fixed price for the period. For Company B, this enables it to cover the additional cost of the project and reduce its own CO2e output sufficiently to cover its own 1M tonne reduction obligation. From an environmental and economic point of view, this achieves the aim of reducing CO2e output for a given production output (assuming the new project is replacing equivalent output elsewhere or the output increase would have occurred in any event) at the lowest cost. It will also be in the best interests of Company A to refit its production capacity when the right date arises to redress the competitive disadvantage it now has to Company B, due to the transfer of value through the credits to the cleaner production process. New technology should assist in this. Whilst it is unlikely that two companies in direct competition would get together in this way, it is likely that this scenario would arise through the introduction of banks or other financial intermediaries.
The price at which carbon will trade will depend on a variety of factors, the most important of which will be demand and supply. Demand will be driven by compliance requirements such as the nature of government schemes (voluntarily or involuntarily), the breadth of companies covered by the scheme requirements and the initial levels at which threshold entry levels are based. Supply will be driven by access to markets, available sources, cost of compliance and speed of technological development. With the successful completion of the auction process, a few secondary market trades going through and work underway to establish a workable index for credit trading, clearing such pricing will become easier over time, enabling these types of trades to go ahead on a more regular basis.
From a developer's perspective, the aim is to identify projects that may or should qualify for project based credits. Project based credits under the clean development mechanism ("CDM") as part of the Kyoto Protocol have been available, at least in theory, since January 2000. It is likely that many projects in development now would not close before the UK project rules are in place and may well be eligible under the UK scheme rules. These projects could therefore generate a significant additional revenue stream over a considerable number of years, potentially greatly enhancing internal rates of return and in some cases making more difficult projects easier to finance. It is envisaged that these carbon streams will be separately financeable, enabling banks and other Finance parties to monetise revenue streams from highly creditworthy counterparties even where the underlying products are sold to a retail or higher risk counterparty.
The type of projects which developers should consider would include those where there is some form of new technology, capital equipment or process whereby emissions of greenhouse gases are reduced or traditional forms of energy sources are reduced or offset, thereby directly or indirectly reducing damaging emissions into the atmosphere. If this basic criteria is met, it is certainly arguable that the project would be able to go forward as an eligible project for further analysis.
The relevant steps in the project accreditation process are likely to follow a fairly basic procedure. At the initial stages, the developer will carry out the preparation of a project design document in consultation with the relevant body of Government. This will then be subject to independent validation and verification before moving on to implementation by the developer if the project is approved at this stage. The developer will then monitor the project and subject the project outputs to independent verification. Once verified, emissions reductions will be notified to the relevant body of government for issuance of appropriate credits. The project credits will be individually identified and recorded through a national inventory tracking register. The developer will be able to sell the credits in the open market on a forward basis at any time during this process or when issued on a spot basis for immediate delivery under an account entry system.
Key elements in the identification and applicable standards to apply in assessing project eligibility are considered in detail in the University of Surrey report. Those issues include the much discussed question of additionality (what the applicable test should be for a UK project to fall within the scheme); assessing quantification of the baseline (the measure of what outputs would be without the relevant project being undertaken); crediting lifetime (over what period and at what level should project credits be issued); and project boundaries (to what extent should direct effect on unrelated participants and indirect effects be taken into account in assessing the emissions savings generated).
Whatever the format of the UK national scheme, it is vital that the approach adopted is consistent with multinational schemes under EU or Kyoto initiatives and that costs are maintained at minimal levels. It is clear from the report that these factors will be important in structuring the new scheme. On this basis, it appears that project developers should soon be able to look to a new source of revenue for cleaner project based activity and would be wise to include in any current development plan an analysis of the likely eligibility of the project to benefit from project based credits.
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