The main objective of Clean Development Mechanism (CDM) is to promote sustainable development in developing countries and to allow industrialized countries to earn emissions credits from their investments in emission-reducing projects in developing countries. A particular CDM project cycle involves a wide range of transaction costs which may include the following:
- Project identification and selection: Costs incurred by project developers and potential investors in identifying prospective projects.
- Project development and baseline determination: Information costs related to the preparation of a project concept note providing relevant information on project baseline, expected additional emission reductions and corresponding costs.
- Project validation: The process of independent evaluation of a project activity on the basis of the project design document.
- Project approval: Projects need to be approved by the host government.
- Project registration: Registration is the formal acceptance by the relevant international bodies of a validated project as a CDM project activity.
- Project implementation: Monitoring and enforcement costs of contracts during construction, start-up and operation phase.
- Project monitoring and reporting: Measurement of data for the determination of actual GHG emissions.
- Project certification: Written assurance by a designated operational entity that, during a specific time period, a project activity achieved the emission reductions as verified.
- Transfer and use of emission permits: Transactions costs at that stage include reporting of transfers of emission permits to dedicated registries.
Financing Requirements of CDM Project
Any CDM project requires a tremendous amount of administrative work which makes carbon finance a complicated undertaking. The administrative cost per project falls in the range $90,000 to $150,000 and completion of the associated processes takes about 12 months. Projects therefore have to be on a scale large enough to benefit.
During the early stages of planning a project, the chances of the project not proceeding (for example because the necessary permits cannot be obtained), and therefore not generating any future revenue, are significantly higher. Therefore, although the costs associated with the planning stage (typically in the hundreds of thousands of dollars) are much lower than construction costs, the risk is much higher and different forms of finance are required.
The largest costs associated with a CDM project are incurred at the construction stage, where even a relatively small engineering project can cost several millions of dollars. At this stage, for a commercially viable project, lenders and investors will only provide finance on the expectation that, on completion of construction and commissioning, the project will go on to generate revenue.
Depending on the type of financing, the project sponsor will have to present different kinds of data and documentation to the lender at different stages. For example, for project financing, a minimum requirement for international banks is a business plan which includes at least feasibility studies, financial statements and financial projections. For corporate finance on the other hand, relationship banks may be more focused on collateral and long-term client relationships.
Types of Carbon Finance
In general, there are three forms of finance that can be used to develop projects: grants, loans (debt) and equity. Most projects will incorporate a varying mix of two or more of these sources of finance.
A grant is an amount of money provided by a third party to a project, person or organization that contributes to the objectives of the third party. In general, grants are provided to projects that are commercially marginal, and they do not need to be repaid (provided the stated purpose of the grant funding is achieved). Grants are typically provided by government organisations and only cover a percentage of project costs; other forms of finance are also therefore required.
A loan or debt is an amount of money provided by a third party to a project, person or organization that must be repaid either during or at the end of its agreed term, plus interest over the period of the borrowing. The majority of loans to projects are provided by banks.
Equity financing is a typical financial instruments used by companies to improve profitability. Equity may be provided by project sponsors or third party investors. Equity providers will wish to ensure that the project produces a return on their investment as set out in the business plan or prospectus. Some of the major sources of equity are venture capital funds, private equity funds and share issue via stock market. As carbon market mature, investments in CDM projects promise higher return on investments. Any project that delivers the best in terms of return on capital will get a priority in the use of equity capital for investors.
Mezzanine finance bridges the gap between equity and bank debt. As a hybrid product, mezzanine shares characteristics with both bank debt and equity. A mezzanine investment can be structured in various forms. Mezzanine pricing typically comprises two distinct elements. The first is a current yield that the mezzanine investor contractually receives and so is similar to interest on bank debt. The second component can be a warrant or option on the ordinary shares, or some other mechanism that provides an interest in the equity of the business.