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BANKS IN CARBON FINANCING: CASHING IN ON CARBON

M.Saravanan, Assistant Professor, Post Graduate Department of International Business, Sree Narayana Guru College, KG Chavadi, Coimbatore 641 105 Email.: shravan.murugan@gmail.com Mobile No.: +91 99434 37749

WHAT IS CARBON FINANCING? Carbon financing is the term used for carbon credits to help finance Green House Gas (GHG) reduction projects where industrialized countries can make up for their carbon reducing obligations under Kyoto (industrialized countries collectively agreed to reduce GHG emissions by 5% by 2012 compared with 1990 levels) through purchase of emission reduction credits from projects in developing countries. Under Kyoto Protocol, governments are separated into two general categories: first, developed countries, referred to as Annex I countries which have GHG emission reduction obligations and second, developing countries, referred to as non-Annex I countries which have no GHG emission reduction obligations but may participate in the Clear Development Mechanism (CDM). Failure on the part of any Annex I country to meet its Kyoto obligation will incur penalization resulting in submission of 1.3 emission allowances in a second commitment period for every ton of GHG emissions in excess of cap in the first commitment period (20082012). So as to avoid penalization, Annex I countries can purchase GHG emission reductions from financial exchanges, from CDM projects of non-Annex I economies, from other Annex I countries under the Joint Implementation (JI) or from Annex I countries with excess allowances.
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When non-Annex I countries with no GHG emission restrictions undertake GHG emission reduction projects under CDM they receive carbon credits which can then be traded/exchanged with Annex I countries in the world market. ROLE OF BANKS The growing sense of urgency among countries worldwide to combat the impending catastrophic effects of global warming has paved the way for the birth and growth of a multimillion dollar international market for carbon emission trading of buying and selling Greenhouse Gases (GHG). The global carbon trading market is unique in the sense that the sellers are from India or other developing nations, while the buyers are from industrialized countries. The objectives of both the parties are quite contrary; while buyers want carbon credits at cheaper rates, sellers want to maximize the value. Being unknown to each other, they will be carrying preconceived notions and misgivings about the genuineness of the contract. This is where banks have a pivotal role to playact as financiers of emission reduction projects and bring together buyers and sellers on a common platform through credit mechanisms such as: Letter of Credit (L/C) is one such financing mechanism, where a buyer guarantees payment through his banker for goods received from the seller. L/C is an assurance to the seller that he will receive the payment and the same can be availed through an escrow account with the bank. This apart, Carbon Delivery Guarantee is another mechanism through which banks provide guarantee to the buyers of carbon credits that the same will be delivered by sellers as per the terms of the contract (quantity, delivery schedule, etc.) This enables buyers and sellers to enter into long-term future contracts. Banks can thus tap the investment potential of receiving huge amounts by way of advances to these projects from overseas buyers. Apart from financing CDM projects and providing loans against carbon credit receivables, banks offer a single point delivery of services such as advisory services, value-added products like securitization of carbon credit receivables, delivery guarantees, escrow mechanism, etc. to their customers. Indian Banks rush in to capitalize on the high-risk, high-return carbon financing trade. In China, European companies buying carbon credit enter into agreement at the beginning of the project and also provide finance for project development. But in India, since the project size is small; many companies are seeking finance from financial institutions. Domestic banks such as ICICI, IDBI, HDFC and SBI are gearing up to tap this new high risk and high-reward business of
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carbon financing, where the margins are quite lucrative in the range of 1-3%, higher than for other projects. Apart from generating high margins that include commission, brokerage, etc. from the carbon credit transactions, banks cite broadening of the product portfolio as key incentive to enter this market. Carbon trade provides scope for other businesses like technology transfer, capital investments, cross-border funding products and remittances and also enables banks to provide an international platform for buyers and sellers and increase the scope of allied business. "Financing of CDM projects becomes an extension of banking services that we provide to retain our customers." PV Anantha Krishnan, Executive Vice-President and Country Head, HDFC Bank, Discovering carbon finance as a lucrative business opportunity, Banks have started latching on to the carbon credit bandwagon. They feel financing clean development mechanism (CDM) projects a good and feasible business proposition. A few banks have joined the carbon credit bandwagon, for instance: In October 2002, The World Bank entered into an agreement with Infrastructure Development Finance Company (IDFC) wherein IDFC is to handle carbon finance operations in the country for various carbon finance facilities. The agreement initially earmarked a $10-million aid in World Bank-managed carbon finance to IDFC-financed projects that meet all the required eligibility and due diligence standards. SBI in September 2007 entered into MoUs with MITCON Consultancy Services Ltd., Ecosecurities India Private Ltd., and Cantor CO2e India Private Ltd. to provide onestop destination to industries for CDM projects and emissions trade. It has also recently entered into a MoU with KFW (a German firm) carbon fund for jointly exploring financing of sustainable CDM opportunities in various development and industrial sectors. The bank has also cleared one such loan valued at Rs.8cr, against the receivable to a biomass-based power plant in Indore. Also in the offing are 3-4 such loans pending clearance which will be considered once they complete purchase agreement formalities with their buyers. ICICI Bank in June 2008 signed a $200 million line of credit from Japan Bank for International Cooperation (JBIC) to fund carbon credit-related projects. The bank is involved at all stages of carbon credit project cycle and look forward to providing full range of services in this space. Services offered by the bank include assistance to clients in identification of CDM projects and registration of the same and finally issuance of carbon credits in association with
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our partners by funding and private equity syndication for CDM projects and structuring carbon credit transactions. Also, the bank is working with SMEs for carbon credit market. Apart from it, the bank has formed a dedicated vertical to work on opportunities arising to Indian SMEs from climate change and carbon credits. The bank has a multi-pronged approach as it has tied up with consultants to help extend advice on setting up carbon credit linked projects and on energy conservation etc to the clients. The bank is also putting in place shortly an awareness program for their clients on the need to be energy efficient. These would also include programmes to showcase successful energy conservation and CDM projectsall this would create a facilitative support system for SMEs keen to take advantage of the CDM mechanism to reduce their power costs as also contributing in their own way to a clean environment. ICICI Bank has also signed a MoU with Agrienergy Consultancy (the Indian arm of the UK based consultancy, Agrienergy Ltd.) to promote carbon credit business in the country. Agrienergy's services will include participation throughout the carbon credit project cycle, right from assistance to clients in identification of CDM projects, their registration with UN Executive Board and recurring verification, while ICICI will provide services in the areas of commercialization of Certified Emission Reduction Certificate (CERC), coordination and banking services and debt-financing of CDM projects. Similarly, IDBI has set up special desk offering end-to-end solutions to corporates of carbon credit business. The bank has certain tie-ups for technical and financial assistance, and the products developed include providing guarantees for carbon deliveries and escrow services for payment. Going a step further, both ICICI Bank and IDBI Bank have plans to form alliances, "We have formed a dedicated team for carbon credit. Efforts are also taken to forge alliances for this initiative. The bank has launched `Go Green'a program which gives SMEs an opportunity to reduce their carbon footprint," said Sanjeev Mantri, GM, Small Enterprises Group of ICICI Bank. THE WORLD BANK & CARBON FINANCE: The World Bank Carbon Finance Unit's (CFU) initiatives are part of the larger global effort to combat climate change, and go hand in hand with the World Bank and its Environment Departments mission to reduce poverty and improve living standards in the developing world.
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The CFU uses money contributed by governments and companies in OECD countries to purchase project-based greenhouse gas emission reductions in developing countries and countries with economies in transition. The emission reductions are purchased through one of the CFU's carbon funds on behalf of the contributor, and within the framework of the Kyoto Protocol's Clean Development Mechanism (CDM) or Joint Implementation (JI). Unlike other World Bank development products, the CFU does not lend or grant resources to projects, but rather contracts to purchase emission reductions similar to a commercial transaction, paying for them annually or periodically once they have been verified by a third party auditor. The selling of emission reductions - or carbon finance - has been shown to increase the bankability of projects, by adding an additional revenue stream in hard currency, which reduces the risks of commercial lending or grant finance. Thus, carbon finance provides a means of leveraging new private and public investment into projects that reduce greenhouse gas emissions, thereby mitigating climate change while contributing to sustainable development. As per reports, World Bank carbon funds and facilities have 186 projects with an estimated asset value of $2.3 billion. RISK-REWARD TRADE-OFF As a developing country, India does not have any emissions reduction target, but it is able to sell certified mission reductions (CERs) pursuant to the CDM, to large emitting countries that have emission reduction targets under the Kyoto Protocol. Some of the banking institutions in India are engaged in these types of projects whereby they could earn net income spreads ranging from 1-3% after careful analysis of the projects. However, despite huge potential, the initiative taken by banks to fund carbon finance projects is moving at a snail's pace, further aggravating the risk factors for new financial institutions which are entering the carbon market. While the industry has huge growth potential it also has high and varying degrees of risks associated with carbon credit financing which depend on the nature of the project and the level of its financing. Financing a project that has the potential to earn carbon credits has varying degrees of risk depending on the stage at which you finance such a project. Thus, such a financing is quite challenging, more so in the case of clients that do not have a strong balance sheet to support the project. The returns can be good if a bank is present across the complete cycle of such projects,

right from financing to CDM registration and finally trading of the issued carbon credits," says Sanjeev Mantri, GM, Small Enterprises Group of ICICI Bank. There are several project specific risks which include: underperformance, capital/operational costs overrun, currency risks caused by inflation and market risks such as the insolvency of counterparty, and banks need to develop proper financing mechanisms factoring in the unique risks presented by CDM projects. Regulatory risks at central and state levels form the core element of commercial risk which can be overcome with effective approval rules. The other risks include failure of technology, procedural delays, political risk, credit risk, negligence in dealing with carbon instrument delivery risk, etc. Balancing the risk-reward tradeoff forms the crux of carbon financing. Financing projects that are not supported by strong balance sheet pose significant challenges and entail additional risks, such as operational risk, price risk, default risks, project registration risk, execution risk, policy risk, etc., Another hurdle is the exchange risk. While banks can apply hedging tools for forward contracts involving huge amounts to mitigate the risk, effective regulatory clarity will strengthen and encourage banks to actively participate. As an Annex II country, India has generated US$3.5 billion in carbon revenue since 2001, according to the National CDM Authority, Ministry of Environment and Forests, Government of India. This implies significant opportunity for Indian banks. This opportunity is bounded by limitations imposed by the lack of clear accounting guidelines. Carbon financing is a groundbreaking concept, and by and large banks are still learning how to judge risk and therefore determine financing structures. WHAT MORE NEEDS TO BE DONE Despite being the second largest seller of carbon credits in the world, India still lags behind China as the price expectations of sellers in India are much higher than those across the globe. World Bank spokesperson. While India has a relatively well-developed banking system, it seems project proponents have been unable to access carbon finance due to lack of suitable project finance instruments for this purpose and a conducive policy framework for project entities to optimize utilization of this

window. There is a potential for the market share to go up through market-based initiatives such as developing the Carbon Finance Fund (CFF) and integrating it with the ongoing efforts. The CFF would act as a platform for financial resource management, carbon trade, information collection & dissemination, and technical support through extensive domestic and international cooperation. In addition, Novel financing instruments, such as special purpose vehicles, CDM bonds, etc., can be developed with efficient and transparent procedures. Regulatory risks at central and state levels form the core element of commercial risk which can be overcome with effective approval rules. Also, there need to be a robust structure with simplified procedures, creating awareness and providing updated information about related benefits to project owners, promoting local expertise on project development and encouraging international participation of buyers and investors, and providing tax incentives to banks for financing CDM projects which in turn will cost-effectively reduce GHG emissions, while contributing to the growth of economy in a sustainable manner. That will further spawn new opportunities for banks. REFERENCES / SOURCES: ICAFI University - Press - www.books.iupindia.org www.financialexpress.com images.google.com

ANNEXURE I COUNTRY EU 15*, Bulgaria, Czech Republic, Estonia, Latvia, Liechtenstein, Lithuania, Monaco, Romania, Slovakia, Slovenia, Switzerland US*** Canada, Hungary, Japan, Poland Croatia New Zealand, Russian Federation, Ukraine Norway Australia Iceland TARGET (1990** 2008 / 2012) -8%

-7% -6% -5% 0 +1% +8% +10%

* The 15 States who were EU members in 1990 will redistribute their targets among themselves, taking advantage of a scheme under the Protocol known as a bubble, whereby countries have different individual targets, but which combined make an overall target for that group of countries. The EU has already reached agreement on how its targets will be redistributed. ** Some EITs have a baseline other than 1990. *** The US has indicated its intention not to ratify the Kyoto Protocol.

Note: Although they are listed in the Conventions Annex I, Belarus and Turkey are not included in the Protocols Annex B as they were not Parties to the Convention when the Protocol was adopted. Upon entry into force, Kazakhstan, which has declared that it wishes to be bound by the commitments of Annex I Parties under the Convention, will become an Annex I Party under

the Protocol. As it had not made this declaration when the Protocol was adopted, Kazakhstan does not have an emissions target listed for it in Annex B. ANNEXURE II There are 23 Annex II countries and the European Union. Turkey was removed from the Annex II list in 2001 at its request to recognize its economy as a transition economy. These countries are classified as developed countries which pay for costs of developing countries: 1. Australia 2. Austria 3. Belgium 4. Canada 5. Denmark 6. Finland 7. Germany 8. France 9. Greece 10. Iceland 11. Ireland 12. Italy 13. Japan 14. Luxembourg 15. Netherlands 16. New Zealand 17. Norway 18. Portugal 19. Spain
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20. Sweden 21. Switzerland 22. United Kingdom 23. United States of America

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