CARBON CREDITS

Burning of fossil fuels is a major source of industrial greenhouse gas

emissions, especially for power, cement, steel, textile, and fertilizer
industries. The major greenhouse gases emitted by these industries
are carbon dioxide, methane, nitrous oxide, hydro-fluorocarbons
(HFCs), etc, which all increase the atmosphere's ability to trap infrared
energy and thus affect the climate.

The concept of carbon credits came into existence as a result of

increasing awareness of the need for controlling emissions. The
mechanism was formalized in the Kyoto Protocol, an international
agreement between more than 170 countries, and the market
mechanisms were agreed through the subsequent Marrakesh Accords.
The mechanism adopted was similar to the successful US Acid Rain
Program to reduce some industrial pollutants.

Carbon credits are generated by enterprises in the developing world

that shift to cleaner technologies and thereby save on energy
consumption, consequently reducing their Green House Gas (GHG)
emissions. Credits can be exchanged between businesses or bought
and sold in international markets at the prevailing market price.
Credits can be used to finance carbon reduction schemes between
trading partners and around the world. For each tonne of carbon
dioxide (the major GHG) emission avoided, the entity can get a carbon
emission certificate which they can sell either immediately or through
a futures market, just like any other commodity.

The certificates are sold to entities in rich countries, like power utilities,
which have emission reduction targets to achieve and find it cheaper
to buy 'offsetting' certificates rather than do a clean-up in their own
backyard. Credits can be exchanged between businesses or bought
and sold in international markets at the prevailing market price.
Credits can be used to finance carbon reduction schemes between
trading partners and around the world.

This trade is carried out under a UN-mandated international convention

on climate change to help rich countries reduce their emissions.

CLEAN DEVELOPMENT MECHANISM CDM /CARBON CREDITS

Introduction

Studies on climate change have underscored two points. First that

atmospheric commons, namely the Earth’s carbon absorbing capacity,

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is finite and depletable and that growth of GHG emissions, even at
their present level pose a threat to humankind.

Secondly, it has been established that per capita GHG emission is

strongly correlated with economic prosperity. Further, it is recognized
that without increase in GHG emissions or access to appropriate
alternative technology options, developing countries would not be able
to pursue their socio-economic goals. Kyoto Protocol is a global
cooperative attempt to address both these issues.

Kyoto Protocol

In December 1997, the Third Conference of Parties (COP) to the United

Nations Framework Convention on Climate Change (UNFCCC) adopted
the Kyoto Protocol. The protocol requires developed countries (listed in
Annex 1 of the protocol) to limit their Greenhouse Gas (GHG) emissions
to individual targets, resulting in on an average 5.2% reduction in the
GHG emission from their 1990 emission levels, in the commitment
period 2008-12. The protocol for the first time in the evolving climate
change regime, provided for legally binding emission commitments by
annex 1 parties. The protocol covers six main Greenhouse gases CO2,
CH4, N2O, Hydro-florocarbons, Perflorocarbons and Sulphur
Hexafluoride. The protocol provided three Co-Operative
Implementation Mechanisms (CIMs) to enhance flexibility and to
facilitate development of cost effective means of achieving the targets.
These mechanisms are Joint Implementation and Emission Trading,
both of which are co-operative mechanisms applicable to Developed
Countries (Annex 1 countries) only. Clean Development Mechanism
(CDMs) provides for co-operation between Annex 1 (developed)
countries and non annex 1 (developing) countries.

Kyoto's 'Flexible mechanisms'

A credit can be an emissions allowance which was originally allocated

or auctioned by the national administrators of a cap-and-trade
program, or it can be an offset of emissions. Such offsetting and
mitigating activities can occur in any developing country which has
ratified the Kyoto Protocol, and has a national agreement in place to
validate its carbon project through one of the UNFCCC's approved
mechanisms. Once approved, these units are termed Certified
Emission Reductions, or CERs. The Protocol allows these projects to be
constructed and credited in advance of the Kyoto trading period.

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The Kyoto Protocol provides for three mechanisms that enable
countries or operators in developed countries to acquire greenhouse
gas reduction credits

• Under Joint Implementation (JI), a developed country with

relatively high costs of domestic greenhouse reduction would set
up a project in another developed country.

• Under the Clean Development Mechanism (CDM), a

developed country can 'sponsor' a greenhouse gas reduction
project in a developing country where the cost of greenhouse
gas reduction project activities is usually much lower, but the
atmospheric effect is globally equivalent. The developed country
would be given credits for meeting its emission reduction
targets, while the developing country would receive the capital
investment and clean technology or beneficial change in land
use.

• Under International Emissions Trading (IET), countries can

trade in the international carbon credit market to cover their
shortfall in allowances. Countries with surplus credits can sell
them to countries with capped emission commitments under the
Kyoto Protocol.

These carbon projects can be created by a national government or by

an operator within the country. In reality, most of the transactions are
not performed by national governments directly, but by operators who
have been set quotas by their country.

Clean Development Mechanisms (CDMs)

CDMs are of particular interest to developing countries, as it provides

for investment in projects in developing countries for their sustainable
development, while generating GHG abatements that may be
transferred to the annex 1 countries towards meeting their targets
under Kyoto Protocol.

The operational mechanism of CDMs involves an investment by a legal

entity from an Annex 1 country in a project in Non Annex 1 country,
which results in emission reductions. The investment decision would
include an agreement between the two parties and their respective
countries on the dispensation and transfer of the emission reductions
resulting from the project. These emission reductions have to be
certified by an appropriate authority (the CDM Executive Board,

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provided for under the protocol) and then these Certified Emission
Reductions (CERs, commonly known as carbon credits) can be used to
meet Annex 1 commitments under Kyoto Protocol.

A project activity will be eligible for consideration as a CDM project if it

is aligned with the national needs and priorities and contributes to the
sustainable development of the host country. Further, the projects
must fulfill the following criteria.

(i) Voluntary participation by each party involved i.e it is

not driven by any regulatory compliance requirement;

(ii) Real measurable and long-term benefits related to

mitigation of climate change effects.

(iii) Reduction of emissions that are additional to any that

would occur in the absence of the project activity in question
i.e. the Sponsor would not have undertaken the project in a
business as usual scenario and that in undertaking the
project, the sponsor has overcome barriers that may be
related to investment, common practice/prevalence or
technology or other barriers.

(iv) The activity must ensure access to environmentally

sound technology needed by the developing country.

Broadly, projects that contribute to credible and sustained reduction in

GHG emissions qualify as CDM projects. The following broad categories
of projects have been recognized as CDM projects.

(i) Renewable Energy Projects (Solar Power, Wind Power,

Biomass based power,
small hydel etc);

(ii) Fuel substitution ( e.g. coal to oil to gas to hydrogen in Power

Plants, Manufacturing Process Industries, automobiles etc);

(iii) Energy Efficiency improvement and waste heat utilization

projects;

(iv) Other project activities that reduce anthropogenic emissions

by sources;

(v) Carbon sequestration projects (Forestry etc.);

(vi) Management of methane emissions from municipal landfills;

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 (vii) Management of methane emissions from agriculture and
cattle manure management; and

(viii) Fuel shift from liquid fuel to CNG/LPG in the transport sector.

The manner of transfer of CERs will depend on the nature of

agreement between the contracting parties. Some of the preferred
modes adopted in various cases include:

(i) Investment by an entity from one of the annex 1 country

directly in a project, in lieu of the CERs that are expected to
accrue therefrom.

(ii) The entity enters into agreement to purchase CERs from

a developing country entity or access the open market, as and
when they are required to meet certain commitments.

(iii) Many annex 1 governments are floating tenders for

procurement of CERs

(iv) There are multilateral institutions like the World Bank

and IFC, who have been engaged by annex 1 country
governments and private sector corporations to purchase
carbon credits (CERs) on their behalf. The World Bank group
has nearly US$ 1.06 billion of such funds for buying CERs.
Similarly, there are other funds set up by EBRD, JBIC and
some governments.

(v) Some of the MNCs and large corporates are themselves

buying carbon credits.

(vi) CDM provides for banking of CERs, wherein the emission

reductions prior to 2008 may be banked for use in the
commitment period in 2008-12.

STEPS IN CDM PROCESS

Stage I: Project Design Document (PDD) and Monitoring Plan

preparation

The Project Sponsor shall be required to develop a CDM Project Design

Document (PDD) for the identified opportunities/candidate projects in
the PDD format approved by CDM Executive Board. This would inter

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alia, address the requirements of the Kyoto Protocol and the CDM
Executive Board’s (CDM-EB) procedures. The main tasks, in developing
a PDD, would involve:

(i) Preparatory work – data collection, review of policies;

(ii) General description of the project;

(iii) Delineation of project boundary and identification of leakages;

(iv) Assessment of various baseline methodologies and selection

of the most appropriate one. This would also include a scan of
approved projects or approved methodology to ascertain if
there are approved methodologies which may be directly
applied to this project;

(v) Development of a new baseline methodology, in the event

none of the existing approved/proposed baseline
methodologies are found appropriate for the project;

(vi) Application of the selected/developed baseline methodology

to the project;

(vii) Demonstration of various additionalities for the project;

(viii) Estimation of project GHG emissions and

absorption/abatement/avoidance including direct/ indirect
onsite/ offsite emissions;

(ix) Assessment of various monitoring and verification (M&V)

methodologies and selection of the most appropriate one.
This would also include a scan of approved projects or
approved methodologies to ascertain if there are approved
methodologies which may be applied to this project;

(x) Development of a new M&V methodology, in the event none

of the existing approved/proposed methodologies are found
appropriate for the project.

(xi) Estimation of potential streams of CERs.

(xii) Environmental Impact Assessment for the project;

(xiii) Local stakeholder consultation;

(xiv) Sustainability assessment of the project;

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Stage II: Host country approval

Project Sponsor is required to secure a Host Country Approval from the

Designated National Authority (DNA) hosted at Ministry of Environment
and Forests, GoI. This involves completion of a Project Information Note
in the format prescribed by Ministry of Environment and Forests and its
submission together with the PDD to Ministry of Environment and
Forests. The Project sponsor would be required to make a presentation
to the DNA on an appointed date.

Stage III: Validation

Validation is the process of independent evaluation of a project activity

by a designated operational entity against the requirements of the
CDM on the basis of the project design document. The Project sponsor
is required to appoint an independent third party for validation of the
project. CDM-EB has approved certain entities e.g. DNV, TUV, SGS etc.
as Designated Operating Entity (DOE) for undertaking validation. The
Validation process also involves a Public Disclosure of the project for
30 days at the UNFCCC website. This is also organized by the validator.

Stage IV: Approval of Baseline Methodology by CDM –EB/Meth

Panel

In the event a new baseline methodology is developed, the same shall

be reviewed by the Methodology Panel of UNFCCC/CDM-EB and on its
recommendation, approved by CDM – EB. A new baseline methodology
should be submitted by the designated operational entity to the
Executive Board for review, prior to a validation and submission
for registration of this project activity, with the draft project design
document (CDMPDD), including a description of the project and
identification of the project participants.

Stage V: Project Registration

Registration is the formal acceptance by the Executive Board of a

validated project as a CDM project activity. Registration is the
prerequisite for the verification, certification and issuance of CERs
related to that project activity. A validated project is required to be
registered with CDM-EB of UNFCCC. This is usually the responsibility of
the Designated Operating Entity. The Project sponsor is required to pay
a registration fee.

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Stage VI: Monitoring and verification

Verification is the periodic independent review and ex post

determination by the designated operational entity of the monitored
reductions in anthropogenic emissions by sources of greenhouse gases
that have occurred as a result of a registered CDM project activity
during the verification period. Certification is the written assurance by
the designated operational entity that, during a specified time period,
a project activity achieved the reductions in anthropogenic emissions
by sources of greenhouse gases as verified.

On registration of the project, the Project sponsor is required to

appoint one of the DOEs as a verifier. The verifier conducts an audit of
the project activity after its commissioning
and its becoming operational, as per the approved monitoring and
verification protocol (included in the PDD registered with CDM-EB), to
estimate and certify the actual volume
of ERs generated on account of the project activity. The sponsor may
appropriately select
a verification cycle i.e. Annual, Half Yearly, Quarterly etc.

Stage VII: Issuance of CERs

The certification report, submitted by the DOE to CDM-EB/Registrar,

shall constitute a request for issuance to the Executive Board of CERs
equal to the verified amount of reductions of anthropogenic emissions
by sources of greenhouse gases. The monitoring and verification
entity, after completing the process, submits its report to CDM EB,
which constitutes a request for issuance of Certified Emission
Reduction (CERs). The CERs are issued as per the allocation plan
outlined to the CDM-EB at the time of Project Registration.

Emission markets

For trading purposes, one allowance or CER is considered equivalent to

one metric tonne of CO2 emissions. These allowances can be sold
privately or in the international market at the prevailing market price.
These trade and settle internationally and hence allow allowances to
be transferred between countries. Each international transfer is
validated by the UNFCCC. Each transfer of ownership within the
European Union is additionally validated by the European Commission.

Climate exchanges have been established to provide a spot market in

allowances, as well as futures and options market to help discover a

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market price and maintain liquidity. Carbon prices are normally quoted
in Euros per tonne of carbon dioxide or its equivalent (CO 2). Other
greenhouse gasses can also be traded, but are quoted as standard
multiples of carbon dioxide with respect to their global warming
potential. These features reduce the quota's financial impact on
business, while ensuring that the quotas are met at a national and
international level.

Currently there are at least four exchanges trading in carbon

allowances: the Chicago Climate Exchange, European Climate
Exchange, Nord Pool, and PowerNext. Recently, NordPool listed a
contract to trade offsets generated by a CDM carbon project called
Certified Emission Reductions (CERs). Many companies now engage in
emissions abatement, offsetting, and sequestration programs to
generate credits that can be sold on.

How buying carbon credits can reduce emissions

Carbon credits create a market for reducing greenhouse emissions by

giving a monetary value to the cost of polluting the air. Emissions
become an internal cost of doing business and are visible on the
balance sheet alongside raw materials and other liabilities or assets.

By way of example, consider a business that owns a factory putting out

100,000 tonnes of greenhouse gas emissions in a year. Its government
is an Annex I country that enacts a law to limit the emissions that the
business can produce. So the factory is given a quota of say 80,000
tonnes per year. The factory either reduces its emissions to 80,000
tonnes or is required to purchase carbon credits to offset the excess.

After costing up alternatives the business may decide that it is

uneconomical or infeasible to invest in new machinery for that year.
Instead it may choose to buy carbon credits on the open market from
organizations that have been approved as being able to sell legitimate
carbon credits.

• One seller might be a company that will offer to offset emissions

through a project in the developing world, such as recovering
methane from a swine farm to feed a power station that
previously would use fossil fuel. So although the factory
continues to emit gases, it would pay another group to reduce
the equivalent of 20,000 tonnes of carbon dioxide emissions
from the atmosphere for that year.

• Another seller may have already invested in new low-emission

machinery and have a surplus of allowances as a result. The

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 factory could make up for its emissions by buying 20,000 tonnes
of allowances from them. The cost of the seller's new machinery
would be subsidized by the sale of allowances. Both the buyer
and the seller would submit accounts for their emissions to prove
that their allowances were met correctly.

India is emerging as a serious player in the global carbon credits

market. This has prompted Eco-Securities, originator, developer and
trader of carbon credits, to set up office in India.

The Indian carbon credits market is estimated at $40-50

million. Could you elaborate on this?

The Indian market is extremely receptive to Clean Development

Mechanism (CDM), mooted under the Kyoto Protocol. A number of
ideas for CDM are being formulated and the Government is monitoring
several projects. At Eco-Securities, we are looking at a range of sectors
— renewable energy projects such as wind, hydro, biomass and
industrial energy efficiency projects and HFC reduction projects.

How do you measure Certified Emission Reductions (CERs) or

carbon credits?

It varies from sector to sector. To get the baseline, you calculate the
amount of emissions that would be emitted in the absence of projects
to take care of pollution. For instance, you measure the number of
megawatts versus emissions from a co-generation power plant and
compare it with a wind plant, which is a zero emission plant. One credit
or CER is equivalent to one tonne of emission reduced.

If the credit comes with a fixed unit value, what drives their
future values during trade?

Basically, the credit enables companies to comply with emission

reduction obligations. In Europe, everyone is talking about the high
prices in the allowances market. These companies need allowances, if
they don't they have to buy credits or pay a fine. So, it is basically a
question of supply and demand of allowances and credits. So what
companies in Europe try to do is to reduce their emissions internally —
switch off the lights when they go home for instance. If they have two
allowances and emit three, then they try to reduce it back to two but
when they cannot meet the whole lot they go to the market.

So the value of the credit is not dependent on its intrinsic

value but on the demand supply situation?

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It is a commodity. The price depends on how many need the
commodity. It is dependent on weather patterns. Majority of entities
requiring credits are in Europe, followed by Japan and Canada. So if
there is a harsh winter and you have to generate much electricity to
heat up homes, then prices go up. At the beginning of 2005, the winter
was very mild and it rained instead of snow. There was a lot of water in
reservoirs, which helped to generate hydroelectric power, which has
low carbon emission. At that point, the prices of carbon credits went
down.
What people do is enter into long-term contracts with the promise of a
certain number of credits. Promises are subject to a variety of things -
country risk, credit risk, political risk; also CDM risk. These risks are
what determine the price of carbon credits. That's why a promise to
deliver CERs is different from buying allowances in the spot market.
They are totally different contracts with totally different price
structures.

What has been the response globally to CDM?

The response to CDM has been tremendous. The number of projects

formulated worldwide is large. More than 1,000 potential projects have
emerged but not all of them will fulfil the requirements of the United
Nation's CDM regulations. So far, 93 projects have been registered with
the CDM Executive Board.

Where does India stand in the offering of these credits and

what is the interest towards Indian credits?

Carbon credit is a carbon credit irrespective of where it comes from. Of

course, entities would like to deal with trustworthy counter parties or
with developers or sellers in a country that is dynamic in expediting
the approval of these projects. Which is the case in India. So in that
respect, there is interest in working with Indian businesses because the
Government has been pretty proactive.

For the carbon credits business, is such interest the equivalent

of paper quality as normally asked of financial instruments?

You apply the same relative discount between countries, which you
apply to commercial paper and it would reflect the price that is paid for
credit from different countries. So in that respect there is a differential.
For example a project in Afghanistan is not going to get a lot in
comparison to the baseline price for one in India.

You have cited the need for better quality projects. Could you
explain?

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Basically, projects that fulfil the requirements of Kyoto Protocol. In
India, gates have just opened for CDM projects, so there is a bit of
euphoria. The reality is that a lot of initiatives and ideas were pushed
into the CDM arena. All of these may not be eligible and may not get
registered. By `quality project' the first criteria we are referring to is
that we look for projects that are serious and fulfil the requirements,
objectives and rules of CDM. Second, there are other attributes you
expect from any investment. We need counter parties with experience
who are serious and committed to reducing emissions and who take
social and environmental obligations seriously.

Carbon credits basically seek to encourage countries to reduce their

greenhouse gas (GHG) emissions, as it rewards those countries that
meet their targets and provides financial incentives to others to do so
as quickly as possible.

There is moolah to be made in all this. Surplus credits that are

acquired by overshooting the emission reduction target can be sold in
the global market. One credit is equivalent to one tonne of CO2
emission reduced. Carbon credits are available for companies engaged
in developing renewable energy projects that offset the use of fossil
fuels.

The Multi-Commodity Exchange of India (MCX), the country’s leading

commodity exchange, may soon become the third exchange in the
world with a licence to trade in carbon credits.

The Chicago Climate Exchange (CCX), North America’s first and only
multi-sector marketplace for reducing and trading greenhouse gas
(GHG) emissions, today announced a licensing agreement with MCX.
Many Indian companies have already been re-rated on the stock
markets on the basis of the bonanza that will accrue to them when
carbon trading kicks off.

Under the agreement, the Chicago exchange will list mini-sized

versions of its European Climate Exchange (ECX) Carbon Financial
Instruments (CFI) and Chicago Climate Futures Exchange, Sulfur
Financial Instrument futures contracts on the MCX trading platform.

At present, the trading in carbon credits takes place on two stock

exchanges — the Chicago Climate Exchange and the European Climate
Exchange.

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