Right now, as GTR goes to press:
• Amul Gogna, managing director of the newly-formed Carbon Rating Agency, is going through the due diligence process as the company prepares to rate its first carbon credit transaction.
• A multilateral bank is considering how it will extend payment to projects generating carbon credits – before the issuance of the carbon credits.
• Zurich is scouting for another carbon credit-based project for which it can insure. The company has underwritten three transactions thus far under its new climate insurance programme, and would like to close the year with a few more complete.

These examples alone may not be evidence enough of a matured market for carbon credit transactions. Indeed any discussion of trade finance transactions involving the use of carbon credits must be prefaced by the observation that relatively few have come to market.

“The informal feedback I have received is that there are few banks actually doing these deals – although a lot of people are talking about it,” says a banker at one institution active in receivables discounting of carbon credits.

But the above examples could however point to a future where carbon credits are just yet another commodity around which trade and project finance deals are, if not routinely, then frequently, structured. Buyers, sellers, insurers, rating agencies and bankers, all of the key components of a working marketplace, are beginning to assemble.

But they arrive cautiously and feeling their way. This is still a very new market as defined by the Kyoto Protocol on Climate Change, which went into effect in February 2005, and potentially could close by 2012 unless the UN develops a post-2012 regime. There are other challenges as well that must be overcome, some specific to this novel market, and some typical of any new market, before we will see a regular stream of deals.

Yet despite the uncertainty, several transactions in which carbon credits have been used as part of trade or commodity financing have come to market – some publicly, many more privately.
Hybrid deals
Most of the structures can be best characterised as half trade and half project finance. That is, there is all manner of project finance risk inherent to these transactions including construction, regulation, and licensing risks and longer tenors, but the actual structures are based on trade finance principles. How the originators and bankers knit the two disciplines together differs from transaction to transaction. “The market is so immature at the moment that every deal is new, more or less,” Geoff Sinclair from head of sales and trading, at Standard Bank says.

“Theoretically, one can do all of the things with a carbon credit that one can do with normal commodity,” he continues. “Increasingly, it is being viewed as just another commodity coming off of a project that enhances both the revenues streams and also the financiability of the project.”

For instance, there have been a few prepayment transactions, most notably the US$48mn deal last year in which the Asia-based trading company and supply chain manager Noble Group prepaid an Indian corporate for the generation of its tradable Certified Emission Reductions (CERs). Noble has secured tradable CERs for the next five years from Gujarat Fluorochemicals in India under the Kyoto Protocol Clean Development Mechanism, which allows companies to invest in processes that reduce carbon dioxide emissions. HSBC’s structured trade finance team in Hong Kong structured the deal; Calyon Credit Agricole CIB participated up to 50% of the transaction as co-MLA (See GTR March-April 2008 edition for full deal write-up)
Also, some banks are discounting receivables in this space, although they remain very tight-lipped about their activities.

Another form these deals are taking is a collateralised debt obligation (CDO)-type structure in which a portfolio is divided into a number of tranches via an offshore SPV and then sold to investors, with tranches assigned seniority based on deliverability.
Some of the structures that Credit Suisse and EcoSecurities, a company that specialises in the sourcing and structuring of gas emission reduction projects, are developing can roughly fit in this CDO category. Last December the duo announced the completion of a structured sale of over 5mn Certified Emission Reductions (CERs).

The structure holds the rights to credits from a diverse pool of Clean Development Mechanism (CDM) projects that were developed by EcoSecurities. According to the two companies, the structure provides exposure to different levels of CER delivery risk as well as a geographically and technologically diverse portfolio.

Several multilateral banks also participate in the carbon credit market, buying credits from emerging market projects. The European Bank for Reconstruction and Development (EBRD), for example, has been active in this space since 2003, with the establishment of the Netherlands Emissions Reduction Co-operation Fund and then later the EBRD-EIB Multilateral Carbon Credits Fund.

The EBRD-EIB fund is devoting €40mn, out of the fund’s total of €190mn, to carbon credit trade between sovereign governments, providing that the money resulting from the sales of the credits are devoted to clean energy or green projects. According to Friso de Jong, analyst, carbon finance, at EBRD, Russia, Ukraine, Bulgaria, Romania and Poland all offer good potential for direct trade of carbon credits between governments.

The EBRD’s main carbon credit-related activity can be typified by its expected purchase through the Netherlands Emissions Reduction Co-operation Fund of carbon credits generated by a Bulgarian hydropower project. The project involves the construction of nine small-scale hydro power stations along the Iskar River, 40km north of Sofia. The investment will provide a source of renewable energy, with no Co2 emissions and will save 371kt of CO2 up to and including 2012. Vez Svoge, subsidiary of Italian energy services provider Petrolvilla & Bortolotti, and the Svoge municipality will build the plants.

The first batch of credits will be delivered at the beginning of next year, and will be used by the Netherlands to meet their emission reduction commitments, as set under the Kyoto Protocol.

The EBRD has signed four projects for a total amount of €14.6mn over the last year. The first deliveries of the carbon credits are expected early next year, which is when payment is typically made. The EBRD, however, has paid in advance, before the issuance of the carbon credits, for at least three projects, totaling €5mn.

The EBRD is among the institutions leading the way by providing advance payment. At least one other multilateral bank is investigating how it can extend such financing to its clients, according to a source.

New tools
These structures will continue to evolve as new tools become available to deal originators. For instance, a handful of insurance and reinsurance companies are entering this area, says consulting firm Point Carbon’s managing director, Veronique Bugnion.

Suisse Re and Munich Re, for example, have announced they are willing to guarantee certain elements of project risk, she notes.

Zurich, which began offering political risk insurance for carbon credit transactions this year, is another example. So far, the insurer has completed three transactions.

One was a pipeline project in Eastern Europe in which the investors bought into the deal to reap the carbon credits from the remediation of the pipeline. Zurich provided political risk to cover not only the standard risks in this type of insurance but also regulatory risk and sovereign non-payment, providing the insured promised to use arbitration in any dispute.

In another project Zurich covered the credit risk of the obligor of an agri-project in which leftover waste will generate methane gas. Capturing it will generate electricity and carbon credits. “In this case we are covering the stream of payments for the project in general, but the carbon credits are an important part of that revenue stream,” Lindene Patton, climate product officer for Zurich financial services group, explains.

These are not off the shelf cookie-cutter deals, she emphasises. “The pipeline transaction was heavily negotiated.”
Rating carbon deals
Another recent development expected to facilitate deals and trading is this summer’s launch of the Carbon Ratings Agency at the London Stock Exchange.  It will offer detailed credit ratings for carbon offset assets in the clean development mechanism (CDM), joint implementation (JI) and voluntary markets. Assets will be rated based on the underlying project, an assessment of the likelihood of it delivering its stated emissions reductions in the stated time period and the economic and social development benefits that the project may or may not bring. “Rating these transactions will give confidence to investors that are still waiting to see how the market develops,” Gogna says.

Bugnion says the deal structure for carbon credit transactions are already becoming more sophisticated even as these accompanying products such as  insurance only begin to ramp up. “Things started simply with forward trading. Now we are evolving toward a whole range of new structures that include options off the allowances to the pooling of the deliverables of a number of different projects, and thereby reduce the risk of any one individual project to layering weather risk together with the carbon credit.”
Uncharted waters: Post 2012
Still though, for all the advances made in deal structure and supporting tools and multilateral programmes, these remain uncharted waters and entering them is a leap of faith.

At the moment, the regulatory regime stops at the end of 2012, presenting a serious issue for deal structures. The UN is currently negotiating the next phase, post 2012, however few believe it will take shape before 2010. One of the main challenges is the uncertainty about what will happen after 2012, says Paul Mudde with Sustainable Finance & Insurance, a consultancy in the financial sector with a focus on credit insurance and sustainable development. “The price of carbon credits is driven somewhat by politicians and the statements they make,” he observes.

In the main, however, pricing of carbon credits is a reflection of supply and demand today, not what market participants think it will be after 2012. The price paid per carbon credit last year averaged about €8.90, according to a World Bank report.

Moscow-based C6 Capital, an investor that focuses on carbon-credit trading in Russia and Ukraine, has given much thought to the various exit scenarios it might have available to it, and at what cost. “When building our models and business plans we considered different scenarios – the early selling of ERUs (Emission Reduction Units) on the basis of a forward contract or with a pre-payment, for example,” says principal Alexander Klimanov.

But the ERU market is not as developed as the CER market. “We will probably have more information, about how it performs next year,” he says.

Meanwhile, the firm is looking for a strategic investor for the two-and-a-half year old company, and the future price of carbon credits will no doubt factor into that investor’s view of the company and market. Indeed as Klimanov and his associates go through the valuation process with a prospective buyer, the result may well be another telling indicator of the direction the market will ultimately take.