The Paris Agreement, as a global response to climate change, aims to limit global warming to 1.5º. It established binding commitments for all Parties in order to prepare, communicate and maintain a Nationally Determined Contribution (NDC), and apply national measures to achieve them. Article 6 of this Agreement establishes a voluntary international cooperation mechanism, applicable to meet or achieve greater ambition in a country’s NDC. Finally, during COP 26 at Glasgow November 2021, international trading for carbon markets provided an expected framework since the negotiations led into rules and procedures for Article 6 mechanism to be applicable.
Market and non-market cooperation mechanisms are contemplated. Article 6.2 refers to cooperative approaches, in which Parties could choose to meet their NDCs while using Internationally Transferred Mitigation Outcomes (ITMOs). Article 6.4, for its part, focuses on carbon credits that can be generated in host countries in order to benefit from clean energy and, at the same time, meet the objectives of the Paris Agreement. Apart from that, Article 6.8 not only recognizes the importance of non-market approaches to assist NDC compliance to promote mitigation and adaptation ambition, but also increases public and private sector participation and offers opportunities for coordination between instruments and relevant institutional arrangements.
Governments have carbon pricing instruments that create carbon markets, such as Emission Trading Systems (ETS) or tax-and-offset hybrid. Some of them accept carbon credits. However, in the course of time, this possibility has been increasing. Undoubtedly, the voluntary cooperation mechanism established in Article 6 of the Paris Agreement opens up new market possibilities. The established market mechanisms create new mixtures for existing markets, blurring the currently-disappearing-line between voluntary and regulated markets.
We expect carbon offsets can be used to meet Paris Agreement goals or voluntary targets. But it depends on country policies. Getting into a clear landmark to know how these new possible markets will certainly require domestic decisions and regulations.
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Written by Alexis Leroy, CEO ALLCOT
Carbon offsets are just as valid and valuable as renewable power
Anyone involved in developing clean energy projects around the world will be familiar with the demands of securing project finance. Lenders typically want to see a solid revenue stream before they consider financing renewable energy or low-carbon energy projects.
Normally, a Power Purchase Agreement (PPA) fits this requirement: a long-term offtake agreement with a high-quality buyer offers confidence that the project will generate steady cash flow to service its debt.
Occasionally a PPA by itself may not be regarded as a sufficient guarantee of performance, or the off taker’s credit quality may not be sufficiently strong. In such instances additional security can be added in the form of liquid guarantees or performance bonds.
But there is another revenue stream that can play its part: carbon offsets.
Carbon offsets represent the saving in emissions of carbon dioxide and other greenhouse gases (GHGs); they’re measured against a baseline in which the project would use legacy technologies. In this way a wind farm, a solar park or a waste-to-energy plant represents savings in GHG emissions compared to coal or even gas-fired power.
The world is waiting for a new global offsets market to replace the Clean Development Mechanism (CDM) that will end when the Kyoto Protocol is superseded by the Paris Agreement in 2021. But in the meantime, there are plenty of opportunities to develop and sell carbon offsets for some existing markets. The revenues generated should help secure project finance.
South Africa and Colombia are leading the way in creating high-confidence markets for carbon offsets, by allowing them to be used in part payment of their respective national carbon taxes and thereby granting them a monetized value – at least on paper.
Besides, the International Civil Aviation Organisation is preparing the launch a global offsetting market for airlines in January 2021. Demand for offsets from airlines participating in CORSIA is projected to reach as much as 174 million tonnes of CO2 equivalent (tCO2e) tonnes in 2025 and could be nearly 8 billion tCO2e by 2040.
And beyond these formally established, government-backed markets is a wide variety of voluntary carbon offsetting programs operated by large industrial, commercial and retail companies around the world. According to Forest Trends, nearly 49 million offsets were retired by governments, companies, and individuals in 2018.
There are plenty of challenges facing the use of carbon offsets as securities for project finance. Firstly, the revenue stream from offsets would likely form only a fraction of the overall project costs, and for some, it may simply not be worth the effort to incorporate offsets into a finance agreement.
Also, revenue streams from offset sales tend not to be regular, but “lumpy”. Offset projects must submit independent verification and reporting of the volume of emissions reduced before they can apply for the issuance of those credits, and the costs associated with that process usually mean they can only afford annual or even biennial issuance. Such periodic issuance may not be steady or regular enough to satisfy a lender.
Yet at the same time, using carbon revenue to secure financing may yield two significant benefits: the quality and the reliability of the purchaser. In the case of countries with carbon taxes that can be part-paid in offsets, the guarantor of demand is the government, and industrial emitters must abide by the law.
Similarly, in the case of CORSIA, the end-buyers will be international airlines seeking to comply with government-established, UN-approved targets.
Why is the end-use of the offset important? Because lenders are concerned not only with the scale of revenue streams from a project but also the reliability and creditworthiness of the buyers. Higher-quality off-takers will mean more security for the seller and hence for the lender.
Secondly, it’s important to understand that there is a direct link between the security of the supply of renewable electricity and the security of the supply of carbon offsets. It should be the case that any lender that relies on a PPA as security against project finance, should also be able to rely on the flow of offsets through an emissions reduction purchase agreement (ERPA).
Lenders will consider the reliability of the power project – how much power it is expected to deliver across the length of any contract – when estimating the value of the PPA. The PPA, therefore, is a measure of the potential supply of power, and it can, therefore, be a measure of the supply of carbon offsets.
In the case of many reliable renewable energy technologies – waste gas, solar and even wind power – the actual generation of power and the generation of offsets are very closely linked.
A project developer could even use future delivery of offsets as a source of seed capital for a project. This was a common practice under the UN Clean Development Mechanism. By arranging an ERPA with a buyer who is seeking offsets for some compliance or even voluntary purpose, a project developer can then use this ERPA to raise seed capital. To be sure, the volume of offsets may be subject to clipping, but the principle is sound.
So why don’t lenders take ERPAs into account? If we agree that the fight against climate change is paramount, then how can we not support carbon offsets as a valid source of capital, and indeed may be more valuable than megawatt-hours of renewable power generation?