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<p align="left"><font face="Arial"><strong><small>About The Author:<br>
<br>
</small></strong><span lang="X-NONE" style="color: black"><font size="2">
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon
Markets Group has practiced law related to the finance of environmental and
energy projects and companies for 40 years. In particular, he has analyzed
and executed a wide variety and substantial value of project financings. He
chairs the American Bar Association’s Committee on Carbon Trading and
Finance, serves on the Board of the American Council for Renewable Energy,
and has been a senior official in the Federal Energy Administration. He is
a graduate of Brown University, Yale Law School and Harvard Business School.</font></span></font></p>
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<img src="../images/feldman.gif" alt="Washington Viewpoint by Roger Feldman" border="0" width="375" height="75"><p align="left"><b><u><br>
November 2007</u></b></p>
<p align="center"><font size="6"><b>Of Turnips and Tulips and Carbon</b></font></p>
<p><strong>by Roger Feldman --
</strong><b>Andrews Kurth, LLP</b><strong><br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine
Magazine: 2008/01/26</em>)<br>
</font><span style="font-size: 10.0pt; font-family: Palatino; color: black">
</span></p>
<div>
Everyone has heard of tulip-mania, when flower price speculation ran
rampant -- until the financial bubble burst: an historic dot.com
experience that, of course, we are immune to. . . The unspoken fear
today (sometimes dismissed as carping criticism) is that our
scientifically plotted market-based approach to reduction of greenhouse
gases could fall prey to this too-human tendency to push markets toward
pure speculation -- whenever they are not tethered to the ground by
ineluctable or exceptionally rigorous market design -- in short, unless
they are more like markets for turnips than tulips.<p>That’s the basis
for this plainspun wisdom in considering whether the US is ready to
project-finance itself into carbon-neutral nirvana. In the United
States, in the current state of the law, you can project-finance turnips
only if you don’t make believe they are tulips. Policymakers can change
the market rules to make it otherwise; they can stimulate great gobs of
voluntary carbon credit offsets; but then the energy economy (and
perhaps the nation’s future) will be in Dutch. If you recognize
voluntary carbon credits as the modest garnish for renewables and
efficiency that they are today, it will at least help some additional
flowers bloom.</p>
<p>There are three elements to this hypothesis: (1) the limits of
project finance, (2) the somewhat exotic form of the US voluntary carbon
emission reduction market (as distinguished from the Kyoto market), and
(3) the potential of the integrated multi-revenue-stream project finance
model to take advantage of the US carbon market.</p>
<p><b>1. The Limits of Project Finance</b></p>
<p>As every energy lawyer knows, there is nothing magic about project
finance. It is a limited-recourse type of financing which becomes
available to those project sponsors who have expended enough early stage
risk capital to get a proposed energy production asset to the point
where one or more lenders and speculative equity investors will finance
its construction and then look to its operation to produce firm revenues
to pay them back. The sponsors and equity investors in these situations
receive a premium for the hard work of sponsoring the project when it
generates a larger revenue stream than the cost of this borrowed money
and ultimately commands a substantial sales price, based on a market
assessment of the future value of the market of the revenue stream for
the product produced (megawatts, mcf, environmental emissions credits).</p>
<p>In our convoluted world, nominally averse to government interference
with markets, energy regulation has been pressed into service
repeatedly, in different ways, to assure that the turnips of megawatts
have a sufficiently firm and likely future robust market price, notably
through establishing quotas for output purchases, either at a price (old
PURPA) or of quantities (new RPS). In related developments, production
tax credits, grants, and low interest loans have been governmentally
superimposed on projects’ economics to offset technological economic
non-competitiveness. When prospects then look good for “PURPA-machines”
or REC percolators, we have seen crazes over the years -- “tulipmania”
if you will -- for cogeneration plants, merchant combined cycle plants,
mega wind farms. The policy theory is that initially infant industries
will grow to a sustaining level in this way, so that the incentives will
not be required. Sometimes the theory is right.</p>
<p>Hence the impetus to apply the sparkle, which regulation can bring to
project finance, to the pressing concern with reduction of greenhouse
gases, or -- as it has been short-handed -- “carbon reduction.” Weren’t
efficient markets created for SO<sub>2 </sub>and NOX? Is not the carbon
cap and trade model, however nascently regional in America, the proven
precursor of an efficient system? Hasn’t Kyoto proved that this model
can be applied in the more environmentally civilized world outside of
the USA? Hasn’t project finance been applied to facilitate these markets
through offset creation? Perhaps so. But can’t we push further to the
impatient belief that the same approach can be followed in America with
voluntary credits? Well, maybe.</p>
<p><b>2. Challenges to US Voluntary Carbon Reduction Project Finance</b></p>
<p>There is, however, reason to be skeptical, reason related to the
limitations of project finance absent major supportive regulatory
infrastructure just discussed and because of certain characteristics of
the US Voluntary Emission Reduction Credits (VERs) which distinguishes
Certified Emissions Reductions (“CERS”) in the legally structured
“compliance” markets created by Kyoto. VERs in the US can only be
sturdy, project-financeable turnips when they represent a commodity
which, for example, utilities or other emitters must buy if they are to
comply with the applicable legal regime (like “compliance” RECs based on
purchase of specified renewable outputs, whose value to utilities is
defined in their own state jurisdictions). Otherwise, VERs in effect,
represent nothing more than a willingness to buy documentary evidence of
someone else’s prior good behavior as an “offset” -- moral or
psychological in the eyes of purchasers -- whose acquisition and
retirement strikes a modest blow against atmospheric pollution. At most,
acquisition of the VERs represents a hedge by carbon polluters against
the coming of some future compliance regime.</p>
<p>This is very different under Kyoto, where such offsets, generated
under strictly defined and priced CDM/JI programs <u>do</u> produce such
a legal right, which may be applied to offset a legal obligation under
applicable trading schemes. The existence of a market for these legal
rights is understandable and the ability to monetize the credits through
project finance is presented. The intrinsic value of offset credits may
be impaired by flaws in the administration of the core trading program
where purchasers make use of the offsets, but at least the ground rules
are clear. From a project financing standpoint, the resulting Certified
Emission Reduction Credits are a stable turnip crop; their value may be
speculated-on to a modest extent like tulips, but if they are sold
pursuant to a workable Emissions Reduction Agreement with a solid
counterparty, project finance deals can and have been done. However,
unlike electric power today, the forward price carbon curve has not been
predictable enough that future contract sales can be a meaningful part
of such transactions.</p>
<p>As crafted in the international setting, all projects must be real,
verifiable, permanent, “additional,” and unique. The specific carbon
reduction attributes of each project must be identified -- including
notably the monitoring protocols. In the US, however, there are several
protocols and verifiers in the field, and diversity reigns. While
buyers, of course, may want to minimize reputational, delivery, and
financial risk, they may be attracted to VERs because of their unique
special marketing fits as offsets for their product lines.</p>
<p>In short, in the US, there remains a need for both VER fungibility
and assurance of credit standing of the counterparties. There is
currently a joint ABA-ACORE Emissions Marketing Association effort, with
which I am involved, to develop a standardized contract in this area: a
so-called VERPA that might, in principle, be project financed. But given
the diversity of factors at play in the marketplace, it can’t get far
beyond directing the parties in an orderly way to identify the
underlying factors which define the contract. Instead of a “supermarket”
with VER commodities, we still have boutiques with idiosyncrasies.</p>
<p>Consequently, the best project finance counsel in the VERPA market
can do is remind clients to:</p>
<dir>
<dir>
<dir>
<dir>
<p>1. Demonstrate clear title over reductions they
purport to offer. </p>
<p>2. Include the carbon finance component in the
project financial projections, not as an afterthought.
</p>
<p>3. Use an established, reputable verifier and ideally
follow one of the most commercially desirable quality
standards. With the lack of availability of certain
types of verifiers, planning ahead for their services is
crucial. Furthermore, with standards proliferating,
clients will need to get competent advice on which to
select.</p>
<p>4. Focus on established project types, the ones
accepted by any compliance regime such as RGGI or CA AB
32, plus those most desirable to buyers in the VER
market. </p>
<p>5. Plan for quality monitoring and assurance. </p>
<p>6. Focus on new or relatively new projects. </p>
</dir>
</dir>
</dir>
</dir>
<p>Of course the US is now seeing the development of a series of
regional programs emerging, like RGGI for example, where types of offset
mechanics are being defined (with greater categorical flexibility than
CDM). The finance of projects certainly will be enhanced much further as
liquidity in the markets based on a functional and predictable market
grows; that can be the byproduct of initiatives like RGGI.</p>
<p><b>3. The Potential of Multi-revenue Stream Projects</b></p>
<p>But something can be done to foster GHG reduction finance in the near
term -- if project developers do not confine their vision to the finance
of carbon reduction credit machines. Many integrated biomass and biofuel
projects -- which gather feedstock, gasify it, make power, and possibly
make biofuels -- have the potential for multiple non-energy revenue
streams which can be monetized. These include not only SO2 offsets, RECs,
tipping fees, and energy sales, but also Voluntary Carbon Credits. One
of the great strengths of project finance is that it can blend such
multiple sources of revenue into a single creditworthy revenue-supported
deal. It can do so even better where carbon credits can be taken
advantage of as an upside “kicker.” That is the near term future of US
carbon finance. Regulatory developments might contribute to this
possibility in ways such as the unbundling of the environmental from the
green energy characteristics of RECs, thereby creating more potential
revenue streams to support overall project finance.</p>
<p>Turnips finance; tulip bubbles burst. Regulatory lawyers and policy
makers should recognize this. Real progress in using project finance to
facilitate GHG reduction in the current US market will be made by
adhering to this perspective.<br>
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<p class="MsoBodyText" align="left" style="margin-bottom:0in;margin-bottom:.0001pt;
text-align:left"><font face="Arial" size="2">
<span lang="X-NONE" style="color: black">ROGER FELDMAN, Co-Chair of Andrews
Kurth LLP Climate Change and Carbon Markets Group has practiced law related
to the finance of environmental and energy projects and companies for 40
years. In particular, he has analyzed and executed a wide variety and
substantial value of project financings. He chairs the American Bar
Association’s Committee on Carbon Trading and Finance, serves on the Board
of the American Council for Renewable Energy, and has been a senior official
in the Federal Energy Administration. He is a graduate of Brown University,
Yale Law School and Harvard Business School.</span></font></p>
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