We asked Martin Endelman of the Asian Development Bank to explain how the ADB and other institutions are working to support clean energy project financing. Mr. Endelman is Principal Financial Sector Specialist, Central and West Governance and Finance Division, and a veteran of the ADB’s co-financing operations since 1998.
Well structured “clean energy” (CE) projects, which improve energy efficiency or use indigenous forms of renewable energy, are playing a vital role in helping developing economies of Asia address their energy security and climate change concerns. But many of these CE projects can be difficult to finance because they are small, are located in unfamiliar markets, use newer technologies, or depend on untested laws, regulations and international treaties, including the Kyoto Protocol.
Under the Kyoto Protocol (and possibly under similar post-Kyoto Protocol mechanisms), industrialized countries listed in Annex B of the Protocol can in part satisfy their emissions reduction obligations by purchasing certified emission reduction credits (CERs), often called “carbon credits,” generated by CE projects in developing countries. Because of this, a portion of CE project financing needs can be met with (a) prepayments for CERs made by carbon credit funds or individual buyers under emission reduction purchase agreements (ERPAs) at a discount to the “pay on delivery” price, or (b) carbon finance provided by specialist project financiers, secured by “bankable” ERPAs and the cash flows they will generate when CERs are delivered in the future.
To mobilize either form of finance—and minimize the discount or margin used to compensate for risk—certain risks may need to be reallocated to or shared with private sector insurers, ECAs, multilateral institutions, and other risk takers through carbon finance or delivery guarantees. These guarantees could cover a carbon credit buyer against a portion of the risk of non-performance by the CE project, or cover a project lender against these risks as well as buyer payment risk. The ADB and other public and private institutions are collaborating on ways to do this.
Carbon Finance Guarantees—Risks Covered
Carbon finance guarantees could broadly cover project, host country or carbon buyer risks depending on the needs of the project, client and financiers. But more capacity and better pricing might be achieved if brokers and lead underwriters sell down or reinsure some or all of following “sub-risks” with ECAs, multilateral institutions and other specialist risk takers who have a particular appetite for or ability to mitigate such risks.
- Project sub-risks, including a) commercial risks such as project completion, operator, technology, supply and off-take, insolvency and other similar risks; and b) natural force majeure risks such as fire, storms, wind damage, pestilence, floods or droughts.
- Host Country sub-risks, including a) denial of justice risk involving the arbitrary decision by the Host Country to repudiate any required regulatory approval without due cause; b) export/import license cancellation and embargo risk; c) war and political violence risk (but this will depend on the location of the project and the availability of project level insurance for such risk); and d) community or NGO opposition risk causing modifications or delays in project implementation.
- Carbon Credit sub-risks, including a) documentation risk associated with delivery agreements that include broad force majeure clauses making the timing of CER delivery uncertain, and that generally have inadequate terms and conditions to deal with prepayment mechanics; b) legal title disputes due to host country jurisdictions having inadequate or unenforceable legislation recognizing CER rights; and c) mark to market risk caused by the project entity or CER buyer trying to renegotiate or defaulting on its obligations should the market price for CERs at the time of delivery be substantially higher or lower than the contracted price.
- Kyoto Protocol sub-risks, such that (a) the project may be rejected by the Protocol authority; b) CERs may be restricted in their import into the European Union Emission Trading Scheme or individual EU member states ; c) the basis on which the project is initially assessed and approved changes to exclude certain activities and project types; and d) actual greenhouse gases may not be properly monitored and accounted for so that the project will not generate as many CERs as expected.
- Other structures that can help mobilize finance for CE projects that are being developed include a) risk-sharing mechanisms that help local financiers support smaller CE projects with loans in local currency; b) subordinated contingent loans, which can help facilitate deployment of clean coal power generation and other technologies for much larger CE projects; and c) new and more broadly available prepayment vehicles that could support post-2012 mechanisms. Readers interested in more details regarding these structures and other ways to mobilize finance for clean energy projects in developing countries in Asia may refer to Josh Carmody and Duncan Ritchie’s 2007 Investing in Clean Energy and Low Carbon Alternatives in Asia, Manila ADB (pdf). ■