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Søren E. Lütken is a senior adviser at the UNEP Risø Centre located at the Danish Technical University.
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Financial Engineering of Climate Investment in Developing Countries
Nationally Appropriate Mitigation Action and How to Finance It
By Søren E. Lütken
Wimbledon Publishing CompanyCopyright © 2014 Søren E. Lütken
All rights reserved.
The climatic consequences of the way we live may be the greatest challenge humanity has ever faced. The challenge does not necessarily lie in the immense actions that need to be concerted to confront it, but rather in how difficult it is to grasp. Although by now most have realized that something is wrong with the weather, the real consequences of the dramatic shifts in the climate, which are being warned against by climate scientists in ever more alarming phrasing, still seem like science fiction. Moreover, while we can calculate – and have calculated – the cost of inaction, and realize that it may be cheaper to prevent the problem, we are much better at accommodating the costs of natural disasters that require immediate relief, rather than replacing perfectly functional, even brilliantly engineered, technology that just is not compatible with a zero-emission future. In all likelihood, therefore, we may have to depend on our eminent adaptation skills when faced with the clear and present dangers – dangers that will only become clearer as emissions continue to grow.
Structured negotiations on meeting the climate challenge have been on-going since 1992. Compared to the amount of time it has taken to build the carbon-based economy, that is not very long – particularly when considering that what is fundamentally being negotiated is the dismantling of this carbon-based economy. With hydrocarbons deeply entrenched in the economic system, and promises of wealth still embedded in exploration in a growing number of developing countries, having 200 countries arrive at a consensus to forego such promises of wealth takes more than a science-fiction-like warning.
In this respect, negotiations have brought about a rather swift pricing of carbon emissions. The Kyoto Protocol in 1997 managed to set a cap on emissions, however limited, and allowed trading in emission allowances, thus effectively taxing hydrocarbons. The flagship of the Kyoto Protocol, the Clean Development Mechanism (CDM), even brought the carbon price to developing economies promising rents from developed countries' carbon market if emissions were reduced on a project-by-project basis. Project-based carbon accounting systems were established, trading models were developed, and a whole new industry was created in the process. In those 17 short years the global challenge was faced, a global architecture was established, a market mechanism was developed and operated – and wrecked. The CDM and the market that supported it rose and fell in a matter of 10 years. The carbon market crashed in 2012 for a number of reasons, including the international financial crisis, the expiry of the Kyoto Protocol's first commitment period, and because the Protocol's relevance had been eroded by global economic development. At its expiry, less than 13 per cent of global greenhouse gas emissions were under the constraint of the Protocol. Whatever the replacement emerging from negotiations, it will have to address expectations that a much larger share of global emissions have to come under some sort of constraint.
Attempts to establish a replacement for the Kyoto Protocol have been on-going in international climate negotiations for years, so far with astonishingly little progress in lieu of the calamities in store for humanity, and life on Earth as a whole, if the current emission trends are allowed to continue unrestrained. One of the founding principles of the Framework Convention is the division of labour expressed as 'common but differentiated responsibilities'. In short that means that developed countries should take the lead in mitigation efforts, assisting developing countries with technology, finance and capacity building to enable them to do their part while leaving sufficient room, in emission terms, for their continued development. During those negotiations, developed countries as a whole were still the larger emitter, but the balance has shifted rapidly leaving the developing economies as the largest emitter by far.
In May 2013 the concentration of carbon dioxide in the atmosphere reached 400 parts per million (ppm). This number was the first possible target mentioned as a desirable stabilization level for greenhouse gas concentration in the atmosphere during initial negotiations in the beginning of the 1990s, but was raised to 450 ppm. This increase is still somewhat compatible with the ambition – internationally agreed upon since 2010 – of keeping the average global temperature increase below 2 degrees centigrade as 450 ppm leaves about 50 per cent chance of meeting the target (see, e.g., OECD Environmental Outlook to 2050 (2011)). Currently, the average annual increase is about 2 ppm. By a layman's simple calculation this would give all the countries of the world 25 years to keep emitting carbon dioxide – and then after that stop entirely! There are many more advanced, and correct, ways of presenting these calculations – none of which improve the prospects of meeting the challenge.
The luxury of time enjoyed in the early days of climate change negotiations is over. The division of labour has ebbed out, slowly eroding the division between developed and developing countries' obligations – a division that in any case was more on paper than in action when observing the enormous renewable energy investments undertaken in many developing and transitional economies and how much emissions have been outsourced from developed economies into the unaccounted-for emissions accounts of low cost manufacturing regimes.
While these equalizing trends were greatly unintended during the drafting of the Convention and the Protocol, an intended equalization has slowly found its way into negotiation texts. This intention has been on the part of developed country parties that are increasingly realizing that whatever effort they might agree to would be in vain unless the rapidly growing economies in Asia and Latin America would constrain their growth in emissions – and begin to reduce these emissions in the near future. The fact is that from 1990 to 2010, the developed countries listed in Annex 1 to the UNFCCC reduced their emissions from 19 to 17 gigatonnes of CO2 equivalents (reasons untold), whereas the developing countries increased their emissions from 16 to 31 gigatonnes. Consequently, they became the source of the global increase in greenhouse gas emissions by 58 per cent over the 20 year period that preferably should have seen a change in the trend.
These simple yet alarming statistics are at odds with traditional development objectives. Suddenly, the 'development first' principle seems somewhat shortsighted. Unless the trends in emissions are changed dramatically in the short term there may not be much development to speak of at all, and trends would need to change dramatically in developing countries.
It is not that the developed countries are off the hook. They still need to cut their emissions ambitiously – to the tune of 80 per cent by 2050 according to the UNEP emissions gap report 2013 (UNEP 2013). But the figures underscore the urgency of addressing the spiralling emissions from countries in transition and practically all others, maybe with the exemption of countries least developed. Inventing the term of 'Nationally Appropriate Mitigation Action' to frame efforts in 'non-Annex-1' countries for relative emissions reduction is therefore highly appropriate in itself – even timely if looking at traditional dynamics of international negotiations.
The Nationally Appropriate Mitigation Actions (NAMAs) represents a major shift in approach to the division of responsibility. It brings net emissions reduction in developing countries into the global climate change regime architecture, without an international offsetting mechanism, like the CDM, through which any emissions reduction achieved in a developing country would be countered by a similar increase in emissions in a developed country. The NAMA concept, therefore, is not only appropriate in a national context for developing countries, it is also very appropriate internationally.
Bringing the NAMA from concept to implementation, however, has its challenges. Many of these challenges originate in current financing structures, in the entrenchment of the carbon economy, and in the fact that most lower emissions alternatives come at a cost higher than the hydrocarbon alternative. Financial engineering of NAMAs will not change this; thus it is not about making the cost disappear – it is about mobilizing the will to entertain it. This can be done by making the cost look more appealing – by reducing it, shifting the burden among parties, aligning payments with other benefits, reducing risks, increasing payback times, and dozens of other means – even to the point of finding 'free' funds.
Of course there is always the promise of continuously falling prices on emission free technology that ultimately will turn these alternatives into the preferred economic choice. In such cases the financial engineering may contribute to their competitiveness – or the hope, from a climate protection perspective, that the concept of 'unburnable carbon' takes root and significantly drives up oil and coal prices. In the meantime, however, the financial engineering of NAMAs is an indispensable discipline, if these mitigation actions are to make any dent in the rapidly growing emissions in developing countries.
This book uses the term 'financial engineering', which is a field normally taught at business schools for people with aspirations in investment banking. It includes tools like swaps and derivatives, options and repo market strategies and a host of other techniques, which are not addressed in this book. There are many books and courses serving this segment. The term 'financial engineering' is used in this context for the financing principles, which can materialize the billions of investment dollars that would be needed in the coming years in response to the climate challenge – increasingly so in developing countries. The NAMA is the new concept that can make this happen, and the financial engineering of NAMAs is what will help developing countries deliver an adequate response.
This book is not rich in formulas and calculations, but rather focuses on the instruments available for the promotion and structuring of public and private economic interaction. It is realistic in the sense that it illustrates what does and does not have prospects, while also including concepts and ideas that are imported from other areas of finance. It has an implicit focus on leveraging, which is currently the preferred term to illustrate public – private interaction (despite its connotations of 'us' and 'them' as opposed to a more collaborative effort), as well as on the dual meaning of 'leveraged funds', depending on whether the funds are leveraged from the private or public sector.
Importantly, the focus of this book is on the financing of the NAMA – not on the financing of the preparation of the NAMA. The technical assistance is left out in this regard, partly because it is already an on-going activity rapidly on the rise in the donor community, and also because there is not much engineering in the provision of a grant. Furthermore, it is not the technical capacity that reduces emissions; it is the investments in physical assets with a low emission profile.
It is perhaps due to the focus on technical assistance that many NAMAs are being developed without much concern for their financial basis. Most NAMA guides treat finance as an afterthought, and not as a planning and structuring tool. However, developing the skill to write a NAMA proposal is not the same as pulling together financiers in a financing model that is not a grant. Instead, it requires a model that includes both public and private sources and instruments, addressing asset financing and operational costs. Without the understanding and acceptance, from the outset, that the chosen financial model is as much the identity of the NAMA as its technology focus or its link to national development policies, many NAMAs are likely to remain project proposals with little chance of materialization. The dialogue between the traditionally separate spheres of climate policy development and project finance needs to commence at the beginning of NAMA development, not at the end.CHAPTER 2
CLIMATE CHANGE AND NATIONALLY APPROPRIATE MITIGATION ACTION
The Nationally Appropriate Mitigation Action, or NAMA as it has come to be known, first appeared at the 13th Conference of the Parties to the UNFCCC in Bali, Indonesia, in 2007. Prior to it were the coining of the fundamental 'common but differentiated responsibility' principle in 1992 in the Climate Change Convention; its re confirmation in the Kyoto Protocol in 1997; the operationalization of the Protocol in Marrakech in 2001, and the entering into force of the Protocol just two years earlier in 2005.
The first steps to moving away from this division of labour were taken with the Bali Roadmap, which launched a new process to enhance implementation of the Convention that stipulated a return to 1990 levels of greenhouse gas emissions by 2000. The Kyoto Protocol revised this for developed countries reducing 'their overall emissions of greenhouse gases by at least 5 per cent below 1990 levels in the commitment period 2008 to 2012' – a target that, despite all controversy about insufficient action, in fact has been achieved. The Bali Action Plan (UNFCCC, 2007) states that in order to 'Enhance national/international action on mitigation of climate change', developing countries will take 'Nationally appropriate mitigation actions ... in the context of sustainable development, supported and enabled by technology, financing and capacity-building, in a measurable, reportable and verifiable manner'. This is the first mention of the Nationally Appropriate Mitigation Actions (NAMAs) in the international climate change negotiations. From here the concept has evolved, slowly. By 2010, differentiation between internationally supported actions and unilateral actions, for the first time, stipulated that 'developing country Parties will take nationally appropriate mitigation actions ... aimed at achieving a deviation in emissions relative to 'business as usual' emissions in 2020 through own initiative and employing their own financial means.'
The 2010 Cancun Agreements establish that 'developed country Parties shall provide enhanced financial, technological and capacity building support for the preparation and implementation of nationally appropriate mitigation actions of developing country Parties' (UNFCCC, 2010). Cancun also established the Green Climate Fund (GCF) as a vehicle for deploying USD 100 billion per year by 2020 mobilized from developed countries to finance mitigation and adaptation actions in developing countries. The figure stemmed from a speech given in June 2009 by then British Prime Minister Gordon Brown in the run-up to the high-profile 15th Conference of the Parties in Copenhagen later that year – at which 100+ state leaders blatantly failed to produce the highly anticipated global climate deal.
From a negotiations perspective incremental progress has been achieved in Durban at COP17 with the Durban Platform being established eroding some of the divisions between developed and developing countries in terms of emissions reduction, and in Doha at COP18, where Parties agreed to establish a work programme to understand the diversity of NAMAs, only to achieve practically nothing in Warsaw at COP 19.
The Identity of a NAMA
Over the past decade, investment bankers have had to come to terms with the Clean Development Mechanism, which was a product – eventually the flagship – of the Kyoto Protocol. very few bankers took up the challenge of familiarizing themselves with the mechanism; the few that did embraced it as an addition to the financial landscape, while most embarked on emissions trading, buying Certified Emissions Reductions (CERs) from such CDM projects and on-selling these carbon offsets mainly in the European Emission Trading System.
Meanwhile, the 'climate community' consisting of development professionals in a multitude of roles have promoted the mechanism as a climate finance instrument without much interaction with the finance sector, and without much willingness to perform any reality check of the mechanism's actual functionality – which will be addressed in the following chapter. Moreover, in the middle of the development professionals and the bankers, there has been a consulting sector that has equally promoted the mechanism. This has been mostly for the business opportunities it offers, in terms of production of documentation needed for registration of projects under the CDM, which allow the projects to generate CERs.
Excerpted from Financial Engineering of Climate Investment in Developing Countries by Søren E. Lütken. Copyright © 2014 Søren E. Lütken. Excerpted by permission of Wimbledon Publishing Company.
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Table of Contents
List of Figures and Tables; List of Abbreviations; Foreword; Preface; Chapter 1 Introduction; Part I What Is; Chapter 2 Climate Change and Nationally Appropriate Mitigation Action; Chapter 3 Learning from the CDM; Chapter 4 Defining NAMA Finance; Chapter 5 The Financing Tools . . .; Chapter 6 . . . And the Financiers; Chapter 7 Engineering and Leveraging the Finance; Part II What Ought to Be; Chapter 8 Challenges to NAMA Finance – Mandates, Aggregation and Lack of Instruments; Chapter 9 Roles of the Green Climate Fund; Chapter 10 Conclusion; Notes; References; Index