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each project will need more than one investor. The entrepreneur
I is also transferred some technology for this indivisible invest-
Introduction ment project (or the emission reduction projects) with stochastic
I
f the Kyoto Protocol (KP) is ratified, then the Annex I returns.
countries1 will face emission reduction targets. However, The product of the project at the end of the period is emission
these emission reductions can be partly offset by the three reduction credits (carbon credit), which is of interest to the
flexible mechanisms of the Kyoto Protocol – the joint imple- investor. Here the carbon credits are the difference between the
mentation (JI) in Article 6, clean development mechanism (CDM) hypothetical baseline emissions and effective emissions. The
in Article 12 and emissions trading (ET) in Article 17 respec- entrepreneur is interested in other direct benefits provided by the
tively. Emissions trading allows the Annex I countries to trade project as well as indirect benefits like employment, increased
emission reduction units that are above or below their emission power production or improved environmental quality. For ex-
quotas agreed in the protocol in supplement to the domestic ample, in the case of the Latvia project the benefits to the host
actions. The application of ET requires a full international country are low public health risk, waste disposal and landfill
agreement and a well-established trading market. JI allows trans- gas-fired power. However, the entrepreneurs have no direct
fer of emission reduction units (ERUs) resulting from emission rights over the carbon reductions (carbon credits) and so
reduction or removal projects (carbon offset projects) among the cannot market them. The project would be undertaken only if
Annex I countries. The CDM allows transfer of ERUs resulting the entrepreneur has enough capital inputs and if the return from
from carbon offset projects (like afforestation and forest the project at least equals the opportunity cost of capital. Investors
preservation) between Annex I and non-Annex I (developing) agree to finance this project only if it fetches at least the carbon
countries (which do not have emission reduction commitments). credits which they would have obtained if they had invested on
If the Annex I countries decide to benefit through JI or CDM, their own.
there will be a large group of firms (henceforth called investors)
interested in investing in projects abroad and several firms in II
developing countries (henceforth called entrepreneurs or Risks in JI/CDM Projects
implementers or agents), who are interested in taking up these
emission reduction projects through initial capital financing. JI and CDM seem quite flexible, but in reality they can be risky
There can be small projects as well as large projects but the and very costly for various reasons making the mechanisms
investors’ investment is limited to projects that would not have shaky. There are mainly three kinds of risks associated with the
occurred without co-financing or the additionality component of projects, which may lead to project failure: non-performance,
the baseline project and would be limited to the cost of carbon non-cooperation and exogenous risk [Mitchell and Parson 2001].
offsets generated. This would increase the internal rate of return The non-performance risk arises because of the project parti-
(IRR) of the project and make it profitable.2 For example, cipants’ intentional non-performance of their obligations. For
consider the case of the Latvia-Liepaja gas recovery project. example, implementers of a reforestation project might plant
The baseline project objective is to implement modern waste less land than promised or plant it badly; investors might fail
management system, the funds for which are raised in the to provide promised funding, training or other resources. Second,
entrepreneurs’ own country. The additional feature of this project projects may fail due to lack of expected cooperation from
is installing energy cell technology for enhanced degradation of non-participants. To succeed, many projects require coop-
biodegradable waste, collecting landfill gas containing 50 per eration from actors not involved in project negotiations and not
cent methane and generating electricity using this captured bound by explicit obligations to the project, particularly host-
methane gas.3 The investor would invest only in this additional country government agencies (if they are not involved in project
feature of the project. Also in some large projects like hydro negotiation). These risks may result in emission reductions below
projects the scale of inputs for the project exceeds the personal expectations despite the participants’ efforts. Such situations are
wealth of any single investor. This implies that in such cases particularly likely in the resource-poor contexts of non-Annex I
CO2 2
CO CO2 2
CO
IV
ΩΩ Contracting, Monitoring or Delegation?
ΩΩ
As both participant as well as project risk underlie CDM, the
$ -–Money
Money – Technology CO2 ––Carbon
Carboncredits
credits
final outcome depends on the type of contracting, that is, con-
- Technology tracting with no monitoring, just monitoring, or both or using
an intermediary. In the context of multiple investors and
Source: www.prototypecarbonfund.org multiple implementers, using an intermediary might be an
efficient way to diversify the project portfolio risk, given that
financing where the price for offsets is paid on delivery of the the return in individual project is independent across different
offset after the periodic verification of the offsets achieved. In projects. In the real world scenario, entrepreneurs take up all
case the projects require initial capital financing, the PCF will project risks, including risks that cannot be controlled such as
attempt to limit the initial financing to the cost of generating technical uncertainty or non-cooperation of non-participants.
the emission reduction. The launch of the PCF has raised hope However, in the context of CDM such an approach will deter
for these project-based reductions under CDM and JI. participation and innovation in the programme, as new and riskier
If the KP or similar protocols are in place in future, the scope technology will never be encouraged. Further, in instances when
for such carbon trading or carbon projects can be substantial. project failure is unambiguously due to project risk, such sanc-
It is estimated that the gross annual demand for ERUs between tions (that entrepreneur takes all the risk) are likely be difficult
2008 and 2012 is 1400-2400 Mt CO2 (without the US) of which to impose, and may not have the desired effect. Hence, the only
the demand for Annex B sinks is around 330 Mt CO2 [Lecocq way out is to design proper incentives in order to avoid the failure
2000]. As the carbon credits are the difference between the of projects. In this section, we will see how to implement the
hypothetical baseline and effective emissions, they depend on projects efficiently using the basic principal-agent model. The
the effort put in by the agent and also some external factors. Here investor can either contract with entrepreneurs to provide incen-
the main difficulty arises from the investor’s inability to perfectly tives or monitor to prevent the entrepreneur shirking or do both
observe the actions of the agent due to high monitoring costs to get carbon credits given the entrepreneur’s participation
and technical non-feasibility. The investors therefore face two constraint and the investor’s budget constraint. The expected
types of asymmetric information. The entrepreneurs have private carbon credit depends on the entrepreneur’s performance and also
information about their baseline emissions and the impact on the on some stochastic variables which cannot be controlled by the
production function of this investment; and private information entrepreneur. When there are multiple principals and agents to
about their own actions (from now on referred to as effort) during implement JI and CDM, an intermediary can be introduced to
the project period. To simplify it further, if the projects fetch diversify independent risk, save transaction and monitoring cost,
a high return to the agent (and carbon reductions are directly and strengthen bargaining power in contract renegotiation. We
related to the output) then it can be win-win for both investor discuss below the incentives under vaious heads.
as well as entrepreneur. However, if the projects are not that Contracting with entrepreneurs: The type of contract depends
profitable from the entrepreneur’s point of view (that is, if carbon on whether the projects are of high return or low return from
credit is the main outcome and no by-products, which yield the entrepreneurs’ point of view. High-return projects are defined
monetary benefits to the agent), the investor has to induce the as those that can fetch direct benefits for hosting countries’
entrepreneur to put in full effort and avoid shirking (as a lower entrepreneur or manager without much risk. This kind of project
target is not of interest to the investor; it delays compliance). not only produces carbon reduction, but also produces other
Here the investor is interested in effort rather than output because products, which are economically attractive to the entrepreneur
carbon reduction is dependent on hypothetical baseline emis- (that is, they enjoy a good rate of return even without funding
sions. If the agent claims that the baseline emissions are low and from the investor). For example, consider the case of a power
show higher offset potential, it is not of interest as lower targets plant operated by a firm using waste rice husk or waste peanut
are reached and the investor has over-invested. To ensure that shells as fuel, to produce electricity using the conventional
the agent is acting responsibly with full commitment, the investor Rankine steam cycle technology. As this technology has been
has to use a compensation scheme to optimise the agent’s com- in use for more than 100 years and is commercially competitive
pliance effort, so that his behaviour is in line with the investors’ with existing sources of electricity, this fetches direct returns to
targeted output (that is, the emission reductions are really achieved). the entrepreneur (if not, it at least saves the cost of electricity).
Only with a properly designed scheme can the agent put in This is an ideal project in which both parties are better off.
appropriate levels of effort and meet the target. If the number However, the principal may incur higher transaction costs to
of projects and investors is large then it may be more efficient verify the baseline carbon emissions. For instance, renewable
Not much space to give Let the agent take the risk. There is
much space to give incentive to the
Incentives to agent because of agent but limited by project risk
participating constraint
Low
beginning of the project. To verify that self-reporting is reliable measures should be explored so that the ERUs from small deals
the investor has to incur second-party and third-party monitoring can compete with high-volume low-cost projections
if necessary. If the project failed due to unforeseen factors despite (www.prototypecarbonfund.org). Given this heterogeneity of
good performance, the agents are required to demonstrate full transactions, determining a price for the ERUs is also a challenge
performance before credits are disbursed [Goldsmith and Basak due to the absence of a public liquid market. The prices also
2001]. vary from contract to contract, depending on the level of risk
In the above cases, the design of incentives is under the standard inherent in the transaction and the underlying project. Prospective
CDM project model involving an exchange in which a single market prices will depend largely on evolution of demand and
investor receives credits and a single entrepreneur is paid for supply. This makes the whole mechanism quite risky and com-
generating them. However, as the CDM develops, some projects plex. As the intermediary is risk-neutral he can bear all the risks
may involve multiple participants on the investor side, with and give a pro rata share of emissions to all the investors according
credits being allocated among them as part of the project design. to their investments in the fund.
Such large emission reduction projects are ideal as they have As discussed in the introduction there is some non-participant
low transaction costs.7 However, larger projects would also require risk (from governments) associated with the CDM mechanism.
managing a mixed portfolio of projects, including innovative and Projects in different sovereign states may face different risk
high-risk ones, of which some – or many – fall short of expec- premia owing to the perceived level of risk of default or project
tations. This is similar to diversification of risk of individual failure due to the general nature of the economy or the nature
stocks in a stock portfolio. As discussed earlier, this would be of the government. So using an intermediary with reputation and
extremely costly for the investors and in such cases using an bargaining power would minimise risks. The intermediary in this
intermediary would be highly beneficial to both the parties. case can be powerful in influencing governments in undertaking
There are several other reasons in support of the use of in- projects and subsequently contribute to the overall system suc-
termediary apart from diversifying the portfolio. As discussed cess. Further a large intermediary like the World Bank can ensure
earlier though it is ideal to have large projects because of low successful screening of the participants due to its experience by
transaction costs, many countries have small-scale renewable linking current or future participation to past performance. EPW
energy and energy efficiency opportunities that can enhance their
rural economies and provide clean technology in manufacturing Address for correspondence:
and infrastructure. Financing tiny projects of hundreds of watts haripriya@mse.ac.in
to a few KW of installed power, or to mass distribution of single
energy-efficient appliances, such as air conditioners/solar water
Notes
heaters, is very difficult (involving high transaction costs)8 and 1 Most of the developed and industrialised countries.
also challenging. The costs rise with the number of operational 2 Assuming a revenue stream based on emission reduction (at US $3 /t
Co2e) the change in IRR for some of the projects are given below:
entities involved and significantly for smaller projects. However, Energy efficiency – district heating (2–4), wind (0.9–1.3), hydro (1.2–
as the benefits of CDM should reach smaller countries, such 2.6), bagasse (0.5–3.5), biomass projects (upto 5.0), municipal solid waste
projects need to be encouraged. This implies that cost reduction (75.0) (www.prototypecarbonfund.org).
The Director, ATREE, 659, 5th A Main Rd, Hebbal, Bangalore 560024
Phone: 80-3533942, 3530069 Fax: 80-3530070, Email: director@atree.org or info@atree.org