Managing Risk and Uncertainty in Carbon Finance

1. Managing Risk and Uncertaintyin Carbon Finance Training Workshop : Project Formulation for the Clean Development Mechanism Hanoi, Vietnam September 30 – October 2, 2002

2. Managing Risk in PCF Projects • Objective: Explain how to structure carbon finance deals to improve project viability • Key issue: managing risk • Sources of risk in carbon deals • Assessing and assigning risks • Mitigating risk through financial structure • Reducing project risk through carbon finance

3. Sources of Risk • Project Risks • Construction risk (built/operated on schedule?) • Performance risk (e.g. resource risk) • Counterparty risk (will offtakers pay on time?) • Financial and business risk (is capital structure viable, debt serviceable? Is parent company sound? Will product sell?) • Baseline Risk • Eligibility--will ERs be Kyoto-compliant? • Baseline design--is the baseline robust? Will its assumptions remain valid over time? • Performance—actual performance will determine level of ERs generated

4. Sources of Risk II • Market/Price Risk • Will there be a market for project-based ERs? • Will contract price exceed market price? • Policy/Compliance Risk • What if no Kyoto Protocol? • What if host country does not ratify or comply? • Market and Policy Risk are closely linked

5. Assigning Risk General Principle of Project Finance:allocate risks to the parties with the greatest ability and incentive to manage it. So: • Sponsor bears: • most project risks • PCF bears: • baseline risk • market/price risk • policy/compliance risk • limited project risk

6. Mitigating Risk • Baseline risk: • baseline study, assessment of “carbon asset” risk • reasonable but conservative estimate of ERs • rigorous monitoring • Market risk: • market intelligence • consultations with Participants • options • Policy/compliance risk: • remedies under host country agreement (and ERPA) • assignment of AAUs (ECA countries)

7. Mitigating Risk II • (residual) Project risk: • Letters of intent with sponsor • Overcollateralization • Payment on delivery -- Upfront payments only if: • PCF comfortable with project risks • Essential to closing deal • PCF shares in upside • Remedies • Capitalization of costs • Overall: • Pricing of ERs to reflect risk.

8. Mitigating Risk III: Overcollateralization PCF contracts to purchase a conservative level of ERs.

9. Improving Project Viability through Carbon Finance Carbon finance reduces Sponsors’ risk through high-quality revenue stream and credit enhancement • PCF Pays in US $, generally upon verification of ERs • Payments can be assigned

10. Latvia Liepaja SWM Project • Project: Bank-financed sanitary landfill • Problem: additional funds required to finance methane capture and power generation • Solution: • PCF disburses in advance of emission generation, in exchange for a share of upside • Share depends on market price of ERs • Results: • PCF funds enable Liepaja to tap $5m ODA • MP reports on additional environmental aspects of project • Latvia (not PCF) receives windfall if ER prices increase

11. Latvia Liepaja SWM Project Sponsor’s share of excess ERs increases with market price.

12. Uganda West Nile Hydro Project • Project: new IDA-supported power concession • Problem: Bidders need certainty about revenues • Solution: IDA funds capital subsidy; PCF provides: • Payment in advance of ER delivery (early years) • “Guaranteed” US$ payment stream subject to operator performance • PCF gets share of later ERs at no cost • Result: Reliable, low-risk revenue stream to sponsor may result in lower cost to Uganda, consumers

13. Brazil Biomass/Pig Iron Project • Project: Eucalyptus plantation; Charcoal-based pig iron production • Problem: Inadequate cash flow to plant trees • Solution: Use US$ ER payments to secure and repay loan; amortization schedule = ER payments. • Results: • PCF eliminates country, currency, transfer risk by paying creditor directly • Loan tenor extended from 2 years to 6 years • Company only pays interest on loan • Critical to deal financing

14. Brazil Biomass/Pig Iron Project ER payments are used to amortize commercial loan.

15. Chile ROR Hydro Project • Project: 26-MW plant to be built by private sponsor • Problem: Is baseline coal or gas? • Solution: PCF contracts firm to buy 1m ERs; buys option on additional ERs assuming coal baseline • Results: • PCF pays out firm contract ($3.5m) by 2014 if gas turns out to be baseline; 2010 if coal is baseline • Sponsor gets small option premium for incremental ERs • PCF has right (but not obligation) to buy additional, likely ERs from solid project • PCF covers reinvestment risk from under-performers

16. Chile ROR Hydro Project PCF purchases 1 m tonnes (based on gas baseline)…

17. Chile ROR Hydro Project …and options for additional ERs.

18. Risk Mitigation in PCF Transactions Conclusions • Carbon finance can: • Improve IRRs (at zero cost to project) • Help secure financing, reduce project risk • PCF assumes most carbon-related risks in carbon purchase transactions • Price depends on residual risk • Building carbon finance into projects can make them bankable • We are here to help, as part of your team.