The addition of a revenue stream that flows from avoided carbon emissions ought to improve the economic case for many low-carbon projects in the developing world. But how much impact has the main carbon finance vehicle – the Kyoto Clean Development Mechanism – had so far on proposed cogeneration schemes? Julie McLaughlin, Pieter-Johannes Steenbergen, Juan Carlos Parreño and Bodhi Datta find out.

The Clean Development Mechanism (CDM) is one of the three flexible mechanisms of the Kyoto Protocol and allows for the purchase of Certified Emission Reductions (CERs) by industrialized nations from sustainable development projects in developing nations (for example projects concerning renewable energy and energy efficiency) as a means of complying with domestic emission limits. In addition, CDM projects can be used for compliance under the European Union Emissions Trading Scheme (EU ETS). The European Parliament approved the scheme in 2003 to prepare European nations for the entry into force of the Kyoto Protocol. Key European industries (for example electricity generation, pulp and paper, ferrous and non-ferrous metals, and cement) are forced to comply with their emission limits.

This article describes how CDM can uplift cogeneration project development because of this demand for CDM projects under the Kyoto Protocol and EU ETS. First we provide some background on CDM and the whole process cycle from design to commercializing issued CERs. Then we provide some financing models to ensure project developers can benefit from CDM. The current market outlook provides a perspective on what we might expect for the future, so we close our discussion by looking at potential opportunities for cogeneration CDM project development.

What is the CDM?

The CDM is a mechanism that allows an industrialized nation listed in Annex I of the United Nations Framework Convention on Climate Change to buy emission reductions which arise from sustainable development projects that are in non-Annex I (developing) nations (see Figure 1). The carbon credits that are generated by a CDM project are termed CERs, expressed in tonnes of CO2 equivalent (tCO2e).

Figure 1. How the CDM works
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For a project to generate CERs, it must undergo a rigorous process of documentation and approval by a variety of local and international stakeholders. The key stages in the CDM project cycle (see Figure 2) are the initial feasibility assessment, development of a Project Design Document (PDD), host country approval, project validation, emission reduction verification and credit issuance. The figure shows the interdependencies of the activities that need to be undertaken as part of the process and which stakeholders are responsible for carrying out each activity. These stakeholders include the CDM project developer and the CDM Executive Board (CDMEB), as well as the Designated Operational Entity (DOE), which is responsible for validation and verification of the project, and the Designated National Authority, which has the authority to grant host country approval for the project. A CDM project can be thought of as a conventional project with an additional CDM-specific component. Figure 2 also compares the CDM project cycle with the conventional project cycle.

Figure 2. The CDM project cycle
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It is worth noting, however, that in reality it is possible that the various actions and events throughout the CDM project cycle will not fall neatly into the three phases. For example, it may be possible to commercialize the carbon credits even before a PDD has been fully developed – provided a buyer is willing to take on the risks associated with passing the various hurdles of host country approval, validation and registration. On the other hand, a project may be put through the CDM project cycle after it has already been constructed, provided that evidence can be provided that the incentive from the CDM was seriously considered in the decision to go ahead with the project.

Figure 2 shows that the same broad types of finance are typically applicable to the three phases of a CDM project and a conventional project. The planning phase is very high risk and therefore only suitable for equity or grant funding. The risk associated with the construction phase is high to moderate and remains so until technical and financial completion can be demonstrated, making this phase suitable for a combination of debt and equity. The costs associated with ongoing operation and maintenance are typically covered by the project’s revenues, and the risk associated with this phase is much lower.

Once the project is registered, CERs may be issued at any time, following verification by a DOE and a formal request for issuance to the CDM EB. All CDM projects must satisfy certain requirements specified in either the Kyoto Protocol or the Marrakesh Accords. These include requirements that the project:

  • complies with the eligibility criteria (for example sustainable development criteria) of the host country and other parties, and receives project approval by the host country
  • provides real, measurable and long-term benefits related to the mitigation of climate change using a baseline and monitoring methodology
  • delivers reductions in emissions that are additional to any that would occur in the absence of the certified project activity
  • does not result in significant environmental impacts and undertakes public consultation
  • does not result in the diversion of official development assistance (ODA).

How can project developers benefit from CDM?

Registration as a CDM project can increase the financial attractiveness of a project in two ways: CER revenue can simply increase the project IRR and mitigate risks by virtue of providing a relatively long-term revenue stream denominated in hard currency (euros or US dollars), often backed by a highly rated counterparty.

At the time of writing, 685 CDM projects are registered with the CDM Executive Board. Clearly, all these projects have obtained financing of one kind or another to cover their CDM-specific project costs. The majority of the CDM-specific project costs occur during the planning phase. They must therefore be regarded as high risk because they will not be recovered if the project fails to be implemented. Such costs must therefore be covered by risk capital – either equity or grants, which do not have to be repaid if the project does not eventuate. The situation is more complex with regard to the costs incurred during the construction phase. As noted elsewhere, these costs are generally much larger than the planning phase costs, yet CDM projects are still relatively ‘small’ (typically under $20 million).

Market outlook: what is happening?

The overall expected CER flow from all 261 cogeneration projects currently in the 31 May UNEP RISO pipeline totals almost 150 Mtonnes of carbon emissions. This represents a potential of €1 billion in CER revenues.

Potentials are constrained by success in passing the whole CDM process cycle, for example becoming registered and issued CERs. As of today, the status of development for cogeneration projects range from validation to registration. The overview in Table 1 disregards projects that have been identified but were not yet submitted for validation to the DOE.

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Geographically, these cogeneration projects are mostly concentrated in India, China and Brazil (see Figure 3).

Figure 3. Geographical distribution of the top five and other projects (in number of projects)
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Regarding the project size, the yearly issuance of CERs per cogeneration project averages to 90.7 ktCO2. Figure 4 shows that 75% of the projects produce 0.7-103 ktCO2. Figure 5 shows that the average installed capacity (expressed in megawatts either from electrical or thermal power) of the cogeneration projects is 23 MW, and 75% of the projects range from 0.5-27.3 MW.

Figure 4. Distribution of project size according to amount of carbon dioxide offset
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Figure 5. Distribution of project size according to power output
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The distribution of project types is represented in Figure 6. Some 98% of the cogeneration projects are of the biomass energy and energy efficiency types. The tendency is the same with regards to generation of CERs. Specifically, the most frequent types are in the bagasse and iron & steel sectors, with respectively 100 (38%) and 50 (19%) projects (also see Table 2).

Figure 6. Distribution of project type by number of projects
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Challenges: case studies

The main hurdles to implementation that cogeneration projects face under the CDM are related to the applicability of CDM methodologies and to additionality, which means that a project is able to demonstrate emission reductions are additional to those that would occur in the absence of the project activity. Generally speaking, cogeneration projects require a significant investment in infrastructure that cannot be recuperated with CER revenue (carbon financing) alone. On the other hand, CDM projects abating industrial gases like HFCs, PFCs and N2O have payback periods of two years or less only considering carbon financing and easily pass the ‘additionality’ test.

For several reasons, cogeneration projects often confront issues that prove additionality. First, numerous cogeneration projects reach fruition in the absence of carbon financing, making it more difficult to prove that a project requires carbon financing for implementation. Second, cogeneration projects frequently result in cost savings for the project developer through efficiency, further complicating the financial additionality argument. Third, cogeneration technology is often available in the host country, which can invalidate the ‘common practice’ additionality argument in the view of the CDMEB.

In practice, however, it is evident that numerous industries are not motivated to implement cogeneration projects in the absence of CER revenue, despite access to technology and long-term cost savings. One example is the sugar mill industry in Mexico, where only 1.7% of sugar mills employ biomass for 100% of their energy, even though it is cost effective and low risk given bagasse production. Similarly, India has 74 projects seeking CDM certification, but only 21 have succeeded in actually achieving registration with the CDMEB because additionality questions are increasingly raised regarding whether cogeneration with bagasse should be considered common practice in India.

Cogeneration projects that use biomass face another barrier to entry: securing a long-term biomass source. Projects that do not have biomass residues associated with their operations are subject to price volatility in the biomass market. Even those projects which own the biomass residues are forced to justify the use of biomass for energy when market prices are high.

A palm oil biomass project in Malaysia
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On the other hand, there are several CDM success stories for cogeneration projects. As stated previously, 87 cogeneration projects (33% of the total projects that have reached validation) have achieved CDM registration with the Executive Board. Sahabat is one such project, developed by EcoSecurities. Sahabat is an empty fruit bunch (EFB) biomass project implemented by Felda Palm Industries in Malaysia. Before the implementation of the CDM project, Felda was stockpiling the 500,000 tonnes of EFB a year generated by its mill operations. By installing a 7.5 MW Shin Nippon turbine and Eckrohr Kessel boiler for biomass cogeneration, Felda was able to save over 7 million litres of diesel a year, generate almost 60,000 tCO2e equivalent of emission reductions and resolve its EFB disposal problems. The CER revenue over a 7 year crediting period accounts for 6% of the total investment costs, which, while insufficient to cover all project costs, makes the project feasible in conjunction with the fuel savings and waste disposal benefits.

Challenges: methodological issues

For a project to achieve CDM certification for the emission reductions it achieves, it must be developed using an approved methodology. Each methodology has a set of applicability conditions and guidelines that dictate whether or not it may be applied for a specific project. Certain projects encounter difficulties in matching project conditions with methodology applicability requisites. Others stumble in calculating and proving their emission baseline scenario from which they will be generating emission reductions.

The most common issues encountered when applying methodologies for cogeneration projects include:

  • Defining the applicable methodology where partial or complete fuel substitution will occur.
  • Calculating the baseline given seasonal fluctuations of more than one fuel type and clearly justifying scenarios in the absence of project activity.
  • Proving and measuring the baseline emissions where the production of methane gas comes from the decomposition of biomass stockpiles and landfills. Methane emissions can fluctuate with changes in biomass competition and ambient temperature, frequently necessitating a corresponding change in monitoring method.
  • Proving additionality of greenfield plants or expansions using new technology, for example inclusion of back-pressure turbine cogeneration plants.
  • Addressing international boundaries, the spatial project boundary and international borders; and the export of power to international grids, which is only permitted under CDM if power is exported to another non-Annex 1 country.
  • Incorporating the effect of efficiency changes since supply/demand-side efficiency projects with fuel switch result in a capacity increase due to efficiency measures.
  • Addressing the extent of applicability for efficiency projects – boiler versus entire plant.

Eligibility of smaller CDM projects for bundling in order to reduce transaction costs is limited to 45 MW thermal input savings or to those projects implemented within 1km and registered within 2 years of each other.

The process of addressing the methodology challenges stated above requires the co-operation of project developers, CDM developers and the CDM Executive Board. Constant clarification requests and amendments to existing methodologies contribute to move the process forward but are often time consuming.

Market prospects: where are the opportunities?

Numerous opportunities exist to develop new cogeneration projects in the developing world under the CDM framework. Developing projects under the CDM is especially attractive when considering the additional revenue source beyond cost savings from the production of energy itself. CDM cogeneration projects are most prevalent in the biomass and self-generation sectors, representing 102 (39%) of the total cogeneration pipeline respectively. While it may be that specific countries like Brazil and India have already implemented the most attractive biomass cogeneration projects, the potential for similar projects in other developing countries remains quite high. Furthermore, by implementing CDM projects under methodologies for biomass or energy efficiency for plants’ own generation, the projects benefit from the numerous lessons learned by those who have already completed the process.

In addition to the CDM cogeneration project types that have an established track record (see Table 2), many others have yet to be exploited. Such is the case for cogeneration opportunities in the petroleum refining industry. The petroleum refining industry is one of the largest users of cogeneration in the US. Where process heat, steam or cooling and electricity are used, cogeneration plants are significantly more efficient than standard power plants because they use waste heat, taking advantage of what are losses in standard plants. In addition, transportation losses are minimized when CHP systems are located at or near the refinery. Since supply-side energy efficiency only comprises 0.4% of existing CDM cogeneration projects, the prospect is quite promising for implementing such projects under the CDM in large oil-producing countries in the Middle East, Africa, South America and Asia.

Identifying specific opportunities for cogeneration projects under the CDM in developing countries requires leg work. Researching industry opportunities and common practice in each country of interest is essential. However, it is usually not sufficient in and of itself. An understanding and presence at the local level is demanded as well to succeed in the identification, evaluation and eventual implementation of cogeneration projects. The fact that only 33% of the proposed cogeneration projects have actually achieved CDM registration to date demonstrates the complexity of the processes. Only through hands-on development is a project likely to address effectively the numerous requisites laid out by the applicable methodologies and reap the benefits of certified emission reductions.

Julie McLaughlin is Manager, Co-ordination & Resources Unit, EcoSecurities, Oxford, UK. Pieter-Johannes Steenbergen, Juan Carlos Parreño and Bodhi Datta are also with EcoSecurities

About EcoSecurities

EcoSecurities is in the business of originating, developing and trading carbon credits and structures. It guides greenhouse gas emission reduction projects through the Kyoto Protocol, working with both project developers and buyers of carbon credits.

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