PROJECT REPORT ON

CARBON CREDIT FUTURES

SUBMITTED BY

ROHAN P SANGHAVI

M.M.S. FINANCE (2007 – 2009)

PROJECT GUIDE

PROF SUNITI NAGPURKAR

UNIVERSITY OF MUMBAI

VIVEKANAND EDUCATION SOCIETY’S

INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
CHEMBUR, MUMBAI
 CERTIFICATE

I, Prof. Suniti Nagpurkar, hereby certify that Mr. Rohan Sanghavi, student of Vivekanand

Education Society’s Institute of Management Studies and Research, has successfully

completed the study project on “CARBON CREDIT FUTURES” in the academic year 2008 –

2009. The information submitted is true and original to the best of my knowledge.

Date:

Place:
______________________________
(Signature of the guide)
 DECLARATION

I, Rohan Sanghavi, student of Vivekanand Education Society’s Institute of Management Studies

and Research, hereby declare that I have completed the study project on “CARBON CREDIT

FUTURES” in the academic year 2008 – 2009. The information submitted is true and original to

the best of my knowledge.

Date:

Place:
______________________________
(Signature of the student)
 ACKNOWLEDGEMENT

I would like to express my utmost sincere gratitude by taking this opportunity to thank the

following individuals for their assistance in accomplishment of my project.

I owe a deep sense of gratitude to Prof. Suniti Nagpurkar, my project guide, for her constant &

unfailing attention and involvement. In addition, she has provided me with valuable insights,

constructive comment and continuous support under her supervision.

I would also like to thank Kirti madam and Geeta madam, Librarians of the college for

extending a wholehearted help to me.

Heartfelt thanks to my peers for helping with their suggestions.

EXECUTIVE SUMMARY:

In 1997, Kyoto Protocol, a voluntary treaty was signed by 141 countries to reduce the emissions
of Global House Gases by 5.2% below 1990 levels by 2012. Certified Emissions Reductions
(CER) or Carbon credits are certificates issued certifying reduction in emissions.
The developing countries have been exempted from any such restrictions. These certificates can
be traded in the market and purchased by firms which find purchasing emission credits to offset
its emissions lower in cost. Thus an opportunity has emerged for firms in developing countries
like India, Brazil and China to boost their earnings by complying with norms.
However not all projects are eligible for registration under the Clean Development Mechanism
under the Kyoto Protocol. As a result a large number of advisory firms have spawned. In
addition an entire market has been developed around the same. The key participants apart from
the project developers are, including not limited to, verification, certification and financing
institutions.

In India this opportunity has manifold implications affecting not only industry but also
government, financial institutions and civil society at large. Most importantly this has opened up
a new source of cash flow in project financing making unviable projects viable by exceeding the
hurdle rate for investment returns. Industry will need to adapt to the changing opportunity that it
brings along i.e. higher return on investments along with risks that are inherent in carbon credit
project financing. In my opinion, it will be realistic on part of firms to consider this mode of cash
flows in project financing. Further this provides a strategic role for the countries to benefit from
the cash flows that can be invested in cleaner technologies for sustainable development.
 Table of Contents

SR. NO. TOPIC PAGE NO.

1 Global Warming 1
2 Introduction to Carbon Credits 4
3 How Does Carbon Credits Save the Planet? 8
4 Advantages & Disadvantages of Carbon Credits 10
5 The Clean Development Process 11
6 CDM Mechanism in India 16
7 Joint Implementation 20
8 Who can Trade in Carbon Credits? 23
9 Carbon Credit Markets 28
10 Classification of Carbon Credit Assets 31
11 Pricing of Carbon Credits 34
12 Futures Market 38
13 Tax Treatment of Carbon Credits 45
14 Example of SRF Limited 48
15 Conclusion 50
16 India Proves it As Well 51
17 Is There a Post 2012 Market? 52
18 Bibliography 53
GLOBAL WARMING:

What is global warming?

Global warming and climate change both refer to an increase in average global temperatures.
Records of surface temperatures over the last century show that there has been a gradual increase in
average temperatures around the world. Although some of this is due to natural causes, it has also
been argued that human activities that produce greenhouse gases and that alter the earth’s surface
may be accelerating the warming process.

One of the environmental threats our planet faces today is the potential for long – term changes in
the earth’s climate and temperature patterns known as global climate change. Scientists estimate
that as a result of global climate change, the earth’s average temperature could increase as much as
six and a half degrees Fahrenheit by the year 2100. While this may not sound like much of an
increase, if the temperature increase approaches the six and a half degree mark, the earth will be a
much different place than we know it today.

To prevent this sort of disruption to the many natural and human systems that everyone on our
planet depends on, we must all work to control global climate change. Determining the potential
causes of global climate change has been a long – term process that has involved the work of
thousands of scientists around the world. An important step in this process was made in 1995 when
over 2500 scientists from around the world agreed for the first time that emissions of greenhouse
gases from human activities have influenced the global climate. As a result, the question is no
longer whether humans are altering the world’s climate, but where, when, and how much. The
great importance of this scientific conclusion is that we now know that in order to prevent the onset
of catastrophic changes to the earth’s climate, humans must reduce their emissions of greenhouse
gases.

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What are greenhouse gases (GHGs)?

GHGs are chemicals present in the atmosphere that have certain radiation blocking properties
which trap the sun’s energy in the earth’s atmosphere, creating a type of insulation. This leads to
higher temperatures on earth than would otherwise occur. They are defined by UNFCCC as “those
gaseous constituents of the atmosphere, both natural and anthropogenic, that absorb and re-emit
infrared radiation”.

Annex A of the Kyoto Protocol lists six main greenhouse gases that urgently need to be reduced or
limited:

- Carbon dioxide (CO2)

- Methane (CH4)
- Nitrous oxide (N2O)
- Hydrofluorcarbons (HFCs)
- Perfluorcarbons (PFCs)
- Sulphur hexafluoride (SF6)

The groups of such gases, which are responsible for removing greenery from our planet, are called
greenhouse gases.

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Consequences of Global Climate Change

Although climate change may result in some benefits such as extended growing seasons or more
moderate temperatures in some areas, the overall effects are likely to be harmful.

• Sea-level rise, as a result of climate change, could lead to the loss of many coastal wetlands,
and entire island nations could disappear. Changes in the quality and availability of water
resources could occur and worsen conflicts over water use.

• Healthy forests could be greatly reduced as the range of tree species shifts.

• Humans could suffer from increases in the spread of infectious diseases, heat-related deaths and
air pollution.

• Global climate change could potentially cause sea levels to rise as oceans warm and expand
and also as a result of ice cap and snow cover melting.

• The worldwide redistribution of disease vectors – the animals, insects, microorganisms and
plants that transmit diseases – which is already upon us could increase due to global climate
change. Many tropical diseases such as dengue fever, yellow fever and malaria are beginning to
be seen at higher latitudes and altitudes as warming occurs. This warming could potentially
result in a greater number of people being exposed to these deadly diseases.

• Many ecosystems could have a difficult time adjusting to the rapid rate of climate change if the
world does not reduce greenhouse gas emissions. Especially, parasite species such as weeds,
rodents, insects, bacteria and viruses will quickly reproduce and colonize disturbed
environments.

• There are also likely to be significant economic and social costs as agriculture is forced to make
painful adjustments in response to climate changes. Droughts, floods and storms could become
more severe, and entire agriculture regions could become disrupted as rainfall and temperature
patterns shift.

It is also hard to predict how relationships between crops, weeds, pests and livestock will evolve.
The result could be an inability to provide adequate food resources to a growing world population.
This could lead not only to higher food prices, but also to increased conflict throughout the world
as people compete for resources in a very different global environment.

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INTRODUCTION OF CARBON CREDITS

Carbon credits have emerged as an important instrument in the financial markets. The primary goal
is to reduce emission of green house gases. By permitting allowances to be bought and sold, an
operator can seek out the most cost-effective way of reducing its emissions, either by investing in
cleaner machinery and practices or by purchasing emissions from another operator who already has
excess capacity.

Concept of Carbon Credits

Carbon credits are a key component of national and international emissions trading schemes that
have been implemented to mitigate global warming. They provide a way to reduce greenhouse
effect emissions on an industrial scale by capping total annual emissions and letting the market
assign a monetary value to any shortfall through trading. Credits can be exchanged between
businesses or bought and sold in international markets at the prevailing market price. Credits can
be used to finance carbon reduction schemes between trading partners and around the world.

There are also many companies that sell carbon credits to commercial and individual customers
who are interested in lowering their carbon footprint on a voluntary basis. These carbons off setters
purchase the credits from an investment fund or a carbon development company that has
aggregated the credits from individual projects. The quality of the credits is based in part on the
validation process and sophistication of the fund or development company that acted as the sponsor
to the carbon project. This is reflected in their price; voluntary units typically have less value than
the units sold through the rigorously-validated Clean Development Mechanism.

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Birth of Carbon credits

Kyoto Protocol

The issue of climate change and global warming became the topic of International concern in the
1980s and since then has been subject to debate and several agreements on scientific issues,
voluntary actions, legally binding greenhouse gas emission targets, rules for implementation and
mechanisms. At the 1997 Climate Change Convention in Kyoto, the primary topic of discussion
was the reduction of greenhouse gases (GHG), which are believed to be the principal cause of
global warming. Kyoto Protocol is a voluntary treaty signed by 141 countries, including the
European Union, Japan and Canada for reducing GHG emission by 5.2% below 1990 levels by
2012. However, US who accounts for one-third of the total GHG emission, is yet to sign the treaty.
The preliminary phase of the Kyoto Protocol ends in 2007 while the second phase starts from 2008.
The penalty for non-compliance in the first phase is Euro 40 per ton of carbon dioxide (CO2)
equivalent. In the second phase, the penalty is hiked to Euro 100 per ton of CO2.

Carbon credits are certificates issued to countries that reduce their emission of GHG (greenhouse
gases) which causes global warming. Carbon credits or Certified Emissions Reductions (CER) are
a "certificate" just like a stock. A CER is given by the CDM Executive Board to projects in
developing countries to certify they have reduced green house gas emissions by one ton of carbon
dioxide per year. For example, if a project generates energy using wind power instead of burning
coal, it can save 50 tons of carbon dioxide per year. There it can claim 50 CERs (one CER is
equivalent to one ton of carbon dioxide reduced).

Ideally, Carbon credits can essentially be viewed as a means of empowering the market to care for
the environment. The legislations can set inflexible environmental targets for the industry with the
flexibility to meet the objectives in any manner, it chooses to. The industry must find the lowest
cost solutions to meet these objectives with all the flexibility at their disposal. The emissions cap is
decided under the Kyoto Protocol and the level of reductions by time frames has been specified.
The emissions are easily tradable and thus results in lower abatement costs. All this allows
permanent reduction in emissions from a certain decided baseline. However, a certain industry can
purchase emission credits to offset its emissions from somewhere else at a lower cost.

5
Implementation Roadmap

In 1990 UNO (United Nations Organization) feeling an immediate need to decrease the emission of
greenhouse gases into the atmosphere released the Kyoto Protocol. As a result under the UNFCC
(United Nations Framework Convention on Climatic Change) industrialized nations entered into a
legally binding agreement to reduce the collective emissions of greenhouse gases (GHG) by 5.2%
compared to the 1990 level; calculated at an average over the five year period of 2008-12. Separate
national targets have been given to US (7%), European Union (8%), Japan (6%) and Russia (0%).
The reduction is to be done on six greenhouse gases – carbon dioxide, methane, nitrous oxide,
sulphur hexafluoride, HFCs and PFCs. Further the protocol reaffirms the principle that
industrialized countries have to pay and supply technology to other countries for climate related
studies and projects. The Protocol came into force in February 2005 giving GHG emission limits
for each developed country included in the protocol. In order to facilitate reaching emission limits,
three additional mechanisms were agreed upon in the Marrakesh Accords in 2001. These are the
Clean Development Mechanism (CDM), Joint Implementation (JI) and Emission Trading (ET).

JI (Joint Implementation)

Developed countries can implement projects that reduce emissions or remove carbon from the
atmosphere in other developed countries in lieu of ERUs (Emission Reduction Units). These ERUs
can be used to meet the emission reduction targets. JI projects must have the approval of all parties
involved and must lead to emission reductions or removals that are additional to any that would
have occurred without the project. ERUs can only be issued from periods onwards of year 2008
although JI projects can be started from year 2000 onwards.

6
CDM (Clean Development Mechanism)

Developed countries can implement projects that reduce emissions or remove carbon from the
atmosphere in other developing countries in lieu of CERs (Certified Emission Reductions). These
CERs can be used to meet the emission targets.

The protocol stresses that such projects are to assist the developing countries host parties in
achieving sustainable development. Further the protocol refrains developed countries from using
CERs generated out of nuclear facilities to meet the targets.

Emissions Trading

The protocol provides that developed countries can acquire units from other developing parties and
use them towards meeting their emissions targets, but must be prepared to transfer the units when
they do not require them for compliance. This enables developed countries to make use of low cost
opportunities to reduce emissions. Only some developed countries with emission limitation and
reduction commitments specified in the protocol can engage in such an activity.

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HOW DOES CARBON CREDIT SAVE THE PLANET?

Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to
the cost of polluting the air. Emissions become an internal cost of doing business and are visible on
the balance sheet alongside raw materials and other liabilities or assets. By way of example,
consider a business that owns a factory putting out 100,000 tonnes of greenhouse gas emissions in
a year. Its government then enacts a law that limits the emissions that the business can produce. So
the factory is given a quota of say 80,000 tonnes per year. The factory either reduces its emissions
to 80,000 tonnes or is required to purchase carbon credits to offset the excess.

8
After costing up alternatives the business may decide that it is uneconomical or infeasible to invest
in new machinery. Instead may choose to buy carbon credits on the open market from
organizations that have been approved as being able to sell legitimate carbon credits.

• One seller might be a company that will offset emissions by planting a number of trees for
every carbon credit you buy from them under an approved CDM project. So although the
factory continues to emit gases, it would pay another group to go out and plant trees which
will draw back 20,000 tonnes of carbon dioxide from the atmosphere each year.

• Another seller may have already invested in new low-emission machinery and have a
surplus of allowances as a result. The factory could make up for its emissions by buying
20,000 tonnes of allowances from them. The cost of the seller's new machinery would be
subsidized by the sale of allowances. Both the buyer and the seller would submit accounts
for their emissions to prove that their allowances were met correctly.

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ADVANTAGES & DISADVANTAGES OF CARBON CREDITS
Advantages
• Better technologies for the company which is benefiting from generation of CERs

• Technology transfer from developed to developing countries (Due to low cost structure in
developing countries)

• Additional source of Foreign investment in developing countries which act as a catalyst in

developing cleaner technologies

• Channel CDM funds to investment priorities – The CDM funds can be channelized into
building or improving projects, thus reinvesting it for higher growth

• Development of cleaner technologies leading to sustainable development where countries

have a strategic advantage from now in terms of pollution

• Environmental benefits due to lesser GHG emissions

Disadvantages
• Provision of cheapest way of purchasing climate destroying right

• Due to nature and process of complexity involved, foreign players may dominate domestic
industries for the incentive if CERs

• CDM investment could affect national development strategies, possibly adversely affecting
national decision-making processes. Until future commitment periods are agreed, the CDM
may not provide incentives for financing long-term development projects and strategies.

• CDM timeframe may not assist long-term development strategies as the timeframe is fore
seeable till 2012 only. (Most projects - developed with short term perspective).

• No opportunity for less developed countries under this framework

• Still the mechanism leads to developed countries emitting more GHG inspite of their KYOTO
caps. Historically they are the culprits for GHG emissions. The developed countries purchase
CERs rather than finding new ways of reducing emissions by technological development.

Pressure to accept technologies which have adverse local impacts - CDM may attract unfavorable
or unwanted technologies which adversely impact local people. The technologies should allow for
sustainable development in social as well as economic and environmental terms.

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THE CLEAN DEVELOPMENT PROCESS

Generally, the CDM process has three main phases.

1] Project Planning Phase

2] Project Execution Phase

3] Project Realization Phase; furthermore, the realization phase can be divided into verification and
certification phases and an issuance phase.

Project Planning Phase

The planning phase can be broken down to five phases illustrated.

Project Identification

The CDM-project starts with a project identification phase as in any normal project. During the
project identification phase, the parties keen to promote the project activity, referred to as the
project proponents (PPs), should formulate a Project Idea Note (PIN). In India the PIN is often
referred to as a Project Concept Note (PCN). The PCN document should describe all the essential
elements of the CDM-project.

11
These essential elements are the same both for the PCN and the Project Design Document (PDD).
The PDD is significantly longer than the PCN. They are mentioned later in the project design
section. The UNFCCC does not provide any official PCN-template, but the DNA has its own PCN-
template and it requests the PP to use it when the PCN is submitted along with the PDD to the
DNA. The template can be acquired from DNA’s website.

The official CDM-cycle laid out by the UNFCCC does not formally require the formulation of any
kind of document in the project identification phase, but the DNA requires it later. It is also a
useful tool for the project proponents when in dialogue with potential stakeholders such as CER
buyers and project financiers. Hiring a CDM consultant is not compulsory for developing a CDM
project but it is estimated that approximately 90% of all CDM-projects done in India so far have
involved one. Many project owners emphasize the importance of making the right choice when
selecting the consultant as some of them have been reporting of problems in the cooperation with
consultants. As some of the proposed projects can be too small to be able to carry all transaction
costs required, it makes sense to use the bundling provisions of the Protocol. Instances, such as The
Indian Renewable Energy Development Agency (IREDA) or certain industry associations have
been designated as bundling organizations. Many other public, private or NGO organizations can
also act as bundling organizations.

Project Design

While designing a project activity, the project participants should make sure that the planned
project activity will contribute to the host country’s sustainable development and that the planned
project activity is additional. While formulating a CDM project, the project proponent needs to
address legal, financial, incentives, taxation treatment and business model options issues. Finally, it
needs to be defined whether the project is a small scale or a normal scale CDM project. A small-
scale project has advantages such as the use of a simplified Project Design Document and
additionality test. 37% of projects registered at the CDM EB are small-scale projects. The concrete
product of this phase is the PDD, in which the PP has clearly and concisely described the intended
project activity. The PDD has to address such issues as the baseline methodology, the duration of
the project activity, the justification for additionality, the monitoring methodology and plan, the
calculation of Green House Gas emissions by sources, the environmental impacts and the
stakeholder comments.

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Host Country Approval

After the PDD is deemed satisfactory, the PP has to submit both the PCN and the PDD to the host
country DNA to apply for a Host Country Approval (HCA). The Indian DNA requires both the
PCN and the PDD, even though the official UNFCCC’s endorsed process requires only the PDD.
The DNA requires the project to be additional and the project activity to promote sustainable
development. There are three dimensions for sustainable development: financial, environmental
and social. Additionally, in the country the project needs to be approved by the local State
Pollution Control Board (SPCB), before it can be submitted to the DNA. The host country approval
process includes a hearing of the project proponents and an in-depth analysis of the project by the
DNA and other consultants. The DNA holds these hearings on a monthly basis and it can approve
over twenty projects per session. Typically, the CDM consultant assists in the hearing.

For unilateral projects, the HCA is enough but for bilateral projects, the PP should acquire an
approval letter from the DNA of the CER buyer’s country. However, that has to be done only at the
stage when the PP requests the CDM EB to transfer the CERs to the buyer. The Indian DNA has
accorded host country approval to 227 CDM project design documents as of March 2006. The
DNA’s work has been widely praised, and the approval process is said to be smooth and speedy.

Validation

The project participants should have the project validated by a designated operational entity (DOE)
that is accredited by the CDM EB. Typically DOEs are worldwide renowned quality assurance
organizations. DOEs have been granted certain sectoral scopes (for instance, energy distribution or
chemical industry) in which they are allowed to operate. The DOE checks that the project fulfils
the requirements set forth by the UNFCCC, additionality being the most important issue. In March
2008, 13 companies have received DOE status worldwide, of which 7 are operating in India. The
amount is expected to increase.

The typical duration for the project validation phase ranges from 8 to 13 weeks. In case a new
methodology has to be developed for the project, it has to be approved by the CDM methodology
panel. In this case, the validation phase will take an additional 3–12 months. Following a
successful validation, the project proponents can apply for project registration.

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Registration

During the registration phase, the DOE submits all necessary documents to the CDM EB and
requests project registration. For projects generating more than 15,000 tonnes of CO2 equivalent
on average per year, an administration fee of 0.164 Euros per CER is collected by the EB. The
registration fee is an advance payment for the reductions achieved during the first year. The
registration decision is made by the CDM Executive Board. By March 2008, the CDM EB has
registered 161 projects of which 36 originated from India.

Project Execution and Realization Phase

Monitoring

The approved PDD has pinpointed all the variables that need to be checked for assessing the real
emission reductions of the project activity. The project participants are responsible for monitoring
reductions in emissions (according to the approved monitoring plan) and reporting them to the
DOE for verification purposes. The monitoring phase should produce enough quantitative data for
the accredited instance, the DOE, to be able to verify the emission reduction units achieved thus
far.

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Verification and Certification

The DOE is responsible for verifying the monitored results and certifying the exact amount of
Green House Gas emission reductions resulting from the project activity. Finally the DOE reports
the results to the CDM EB. The same DOE cannot take care of both the validation and verification
work unless it is a small scale CDM project. Certification is a written assurance by the DOE stating
that during a specified period, a project activity achieved the reductions in anthropogenic emissions
which were previously verified.

Issuance of CERs

The CDM EB issues a certified number of CERs within 15 days of receival of a request for
issuance. The CDM EB deducts its own fee from the issued CERs, as described in the registration
phase.

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CDM MECHANISM IN INDIA

The CDM was created to give a cost effective option for developed countries to achieve their
emission reduction targets. In the CDM, an organization from a developed country can obtain
Certified Emission Reductions (CERs) by reducing emissions in a developing country where a
comparable reduction requires substantially smaller investments. The country and the organization
receiving the CERs from the CDM project are allowed to add the corresponding amount of CO2
emissions to its emission quota.

India qualifies to be a host country for the CDM projects only. India is considered as one of the
most potential countries in the world for CDM projects. This is due to its large power sector that
depends on fossil fuels, and to the proactive policies of the Indian government towards CDM. The
power sector alone is estimated to emit 433 million tonnes of CO2 per annum. The total CO2
reduction potential through CDM projects in India is estimated to be around 300 million tonnes.
The largest potential is in the renewable energy sector with 90 million tonnes CO2 equivalents. The
total expected average annual CER’s from registered projects by India are about 22 million having
a 15% world share.

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 India CDM

Methodology

In India the Designated National Authority (DNA) is hosted by the Ministry of Environment and
Forests (MoEF). In addition to the DNA, India has many state-level nodal agencies promoting and
facilitating CDM-projects in their area. These organizations can be of assistance in setting up
contacts with public organizations to arrange CDM projects, or in approaching a larger number of
small-scale possible project proponents. They can act also as bundling agencies, i.e. combine a
number of small-scale CDM projects and handle financial management for bundled projects.

The CDM also allows an industrial actor in the developing country to reduce its Green House Gas
emissions and to sell the reduction units to a party in the developed countries. The GHG reductions
and the way to reduce them have to be approved by the CDM EB. The GHG reduction achieved
though a CDM project is quantified as a Certified Emission Reduction (CER), one CER
corresponding to one tonne of CO2 equivalent. An industrial actor in a developing country can
execute the project activity all by itself, in which case the project activity is called unilateral. If a
party from a developed country takes part in the project through funding, a project is called
bilateral.

The technical way to reduce Green House Gas emissions is called a methodology. A methodology
is a description detailing the new way of operating with the result of generating less GHG
emissions than in a business-as-usual case. The business-as-usual case is referred to as the baseline
in the methodology description. The comparison between emissions of the new and the baseline
case yields CERs, provided that the project activity is judged as additional.

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RISKS WITH CDM PROJECTS.

Besides the stage at which the project is currently progressing, the CER prices are strongly affected
through various risks related to the project, the administrative procedures and project partners. The
following lists some of the most commonly recognized risk factors affecting the CER prices in
projects in India. The broad categorical classification is as follows:

• Regulatory risk: - The risk that a change in laws and regulations will materially impact a
security, business, sector or market. A change in laws or regulations made by the government
or a regulatory body can increase the costs of operating a business, reduce the attractiveness of
investment and/or change the competitive landscape.

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• Operational risk: - A form of risk that summarizes the risks a company or firm
undertakes when it attempts to operate within a given field or industry. Operational risk is the
risk that is not inherent in financial, systematic or market-wide risk. It is the risk remaining
after determining financing and systematic risk, and includes risks resulting from breakdowns
in internal procedures, people and systems

• Price (Market) risk: - The risk that the value of a security or portfolio of securities will
decline in the future

• Contractual (Credit) risk: - Credit risk is the level of probability that a debtor will not meet
the repayment obligations. It is associated with all debtors, including individuals, businesses,
issuers of securities such as bonds, or others.

• Country (Policy) risk: - The risk that an investment's returns could suffer as a result of
political changes or instability in a country. Instability affecting investment returns could stem
from a change in government, legislative bodies, other foreign policy makers, or military
control.

• Reputation risk: - Reputation risk is the risk that negative publicity regarding an institution’s
business practices will lead to a loss of revenue or litigation.

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JOINT IMPLEMNTATION ENTERS MARKET

Carbon credits from clean energy projects comprise the greatest share of the JI market, with
slightly less than two thirds of volumes transacted over 2003-2006. ERUs from Energy Efficiency
Improvement and Fuel Switching projects came first at 28%, followed by Biomass, Wind and
Hydro with respectively 13%, 12% and 10% of the market. N2O projects from industrial
installations account for 8%. This picture could change notably in the coming years as Russia and
Ukraine bring opportunities from the oil, gas and power sectors. The UNEP/RISOE pipeline for JI
indicates expected credits by 2012 from reducing fugitive emissions will come from pipelines
(44%), emission reductions from Energy Efficiency Improvement and Fuel Switching (32%) and
CMM (12%). Unlike in developing countries, where green-field projects have long lead times,
many such opportunities in JI countries are associated with existing facilities and sites and have
relatively shorter lead times. Many such projects are likely to be implemented within the 2012
time-frame provided financing is available before the window of opportunity starts to close. The
figure below shows the various JI Asset Classes

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Location of JI projects:

The near-tripling in transactions volumes through 2007 seems to confirm the market’s interest in JI
potential, after years of hesitation. Market’s focus moved from Eastern Europe to Russia and
Ukraine, with roughly one-third of market share each. The EU decision on double counting has
substantially restricted the potential of JI largely to projects outside the scope of EU ETS (for
instance, CMM, LFG or N2O, for instance), thereby limiting the growth of the pipeline in the
newer EU Member States. Therefore the dynamic growth in the JI pipeline occurred almost
entirely in Russia and Ukraine, which now account for 69% and 21% respectively of the project
pipeline of expected 2012 supply. The number of track II projects nearly quadrupled from 34
projects in January 2007 to 129 projects in the pipeline as end of March 2008. If approved, these
129 projects are expected to deliver 240 million ERUs by 2012, which are almost four times the 66
million ERUs that were expected from the pipeline back in January 2007.

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With the establishment of JI procedures in a number of countries, especially in Ukraine and Russia
-the two biggest suppliers, regulatory uncertainties would appear to have been substantially
reduced. However, procedural bottlenecks continue to hamper JI potential. Launched officially in
October 2006, the Track II JI project approval process has so far decided on only two projects out
of 129 submitted, approving one project in April 2007 (energy efficiency at a cement plant in
Ukraine) and rejecting one in February 2008 (hydro rehabilitation in Bulgaria). With more Parties
expected to gain eligibility in the coming months, one may wonder to what extent project sponsors
will contemplate shifting their projects from track II to track I (including early movers) to speed up
process – in spite of the reputation risk mentioned by some market participants.

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WHO CAN TRADE CARBON CREDITS?

Eligibility as seller
Kyoto Protocol has laid down various requirements for participation in CDM and JI. They are
discussed below, both at the level of the host country and at the level of the entities. It is of course
a matter for each Party to the Protocol to introduce its own domestic laws to regulate the
participation of its entities in the implementation of the Protocol. It is also important for potential
sellers and buyers of forward carbon credits who participate in CDM or JI activities to investigate
the domestic participation requirements as well.

Eligibility as seller at host country level (CDM Projects): -

To host a CDM project, countries must meet the following requirements:
(a) Appoint a designated national authority (DNA) to represent the government in that country.
The DNA has an extremely important role to play in scrutinizing the proposed CDM project and
approving it, which is one of the prerequisites for a CDM project to be registered. The DNA is also
the country’s contact point for the CDM Executive Board.
(b) Be a Party to the Kyoto Protocol.
(c) Maintain its eligibility status from the beginning of the project activities to the end, since the
entities authorized to transfer CERs can only do so if the host country continues to fulfill its
requirements. In addition, afforestation and reforestation CDM projects require host countries to
report what their definition of forest is to the CDM Executive Board by selecting one of the
following:
• A single minimum tree crown cover value between 10 and 30 per cent.
• A single minimum land area value between 0.05 and 1 hectare.
• A single minimum tree height value between 2 and 5 meters.
Any country’s eligibility to take part in CDM activities will be checked through the validation
process when the CDM project is registered. If the Designated Operational Entity (DOE) finds that
the host country is not or is no longer eligible, the project will not be accepted for registration as a
CDM project. The eligibility or otherwise will also be checked automatically when CERs are
transferred from the CDM registry to a national registry by a transaction log to be established and
maintained by the Secretariat.

23
Eligibility as seller at entity level (CDM Projects): -

The participation of “private and/or public entities” in CDM projects must be authorized by the
relevant Party to the Protocol. A DNA can give authorization by submitting written approval of the
participation of a specific entity as a project proponent in a particular CDM project activity. The
DNA of a hosting developing country involved in a proposed CDM project activity shall issue a
letter of approval stating that:
(a) The Party has ratified the Kyoto Protocol.
(b) The approval of voluntary participation in the proposed CDM project activity has been granted.
(c) The proposed CDM project activity contributes to sustainable development.

There is no definition of what an entity should be, but it is assumed that an entity is a company or
other legal personality with the power to legally bind itself to a contract. The detailed procedures
and precise definitions have been left to the discretion of each Party.

JI projects: Eligibility requirements of from host countries

Any Developed country may host a JI project and transfer the ERUs resulting from such a project
to another developed country, provided it is in compliance with the participation requirements.
To fulfill its obligations, hosting developed countries must appoint their Designated Focal Point
(DFP) and have their national guidelines and procedures approved for implementing JI projects, in
addition to meeting the requirements. UNFCCC is to maintain a publicly accessible list of
developed Parties that meet the eligibility requirements and of those that have been suspended.

JI projects: Eligibility requirements for entities wishing to participate as sellers

Authorization by the developed Party is required for “legal entities” in the country to participate in
JI projects. However, authorized entities may only transfer or acquire ERUs if the authorizing Party
is eligible to do so at that time. The detailed procedures for authorization have been left
to the discretion of each Party.

24
Eligibility as buyer at country level

CDM projects: eligibility requirements for Countries wishing to participate as buyers

There are more participation requirements for an developed country than for the host country of the
seller of forward carbon credits. To be able to take part in a CDM project and acquire CERs, a
developed country must meet the following requirements:
(a) Appoint a DNA to scrutinize and approve the CDM project on behalf of the government.
(b) Be included in Annex I with a commitment inscribed in annex B and comply with the following
eligibility requirements:
(i) Be a Party to the Kyoto Protocol.
(ii) Have its assigned amount calculated and recorded.
(iii) Have a national system to estimate emissions and removals.
(iv) Have a national registry.
(v) Have submitted the most recent annual inventory.
(vi) Submit supplementary information on its assigned amount.

Any developed country authorizing entities to engage in CDM activities must not only comply with
the eligibility requirements at the beginning of the project but also remain compliant throughout the
project, as the entity’s ability to transfer or acquire CERs is dependent upon the country continuing
to fulfill those requirements. The parties to the contracts must visit the UNFCCC website, which is
expected to maintain a publicly accessible list of those Parties that are included in developed
country but that do not meet the requirements above or that have been suspended.

25
Eligibility as buyer at entity level

CDM projects: Eligibility requirements for Entities wishing to participate as buyers

The participation of entities in CDM projects must be authorized by a relevant country Party to the
Protocol. Authorization by a DNA of a specific entity’s participation in a specific CDM project
activity shall be stated in the written approval. The DNA of a Party involved in a proposed CDM
project activity shall issue a statement that includes the following information:

(a) The Party has ratified the Kyoto Protocol.

(b) The approval of voluntary participation in the proposed CDM project sactivity has been
granted.

What is motivating the buyers?

26
JI projects: eligibility requirements for countries wishing to participate as buyers

In contrast to the host country, the buyer country must meet all of the following participation
requirements:
(a) Appoint its Designated Focal Point (DFP) for approving projects.
(b) Submit its national guidelines and procedures for approving JI projects, and comply with the
following eligibility requirements:
(i) Be a Party to the Kyoto Protocol.
(ii) Have its assigned amount calculated and recorded.
(iii) Have a national system for the estimation of emissions and sinks of all GHGs.
(iv) Have a national registry.
(v) Have submitted the most recent annual inventory.
(vi) Submit supplementary information on its assigned amount.

JI projects: eligibility requirements for entities wishing to participate as buyers:

Entities that wish to participate in JI projects to acquire ERUs must be authorized to do so by their
countries, which must be Parties to the Protocol. Each country remains primarily responsible for
the fulfillment of its obligations under the Kyoto Protocol and shall ensure that such participation is
consistent with the Marrakesh Accords. Entities may only acquire ERUs if the authorizing Party is
eligible to do so at that time.

27
CARBON CREDIT MARKETS

WHO ARE BUYING?

European buyers dominated the CDM and JI market for compliance and at the close of 2007, their
market share reached almost 90% (up from 2006). Private companies have been the most active
buyers, with 79% of volume transacted in 2007, up slightly from 77% in 2006. Japan is back in the
carbon compliance market with its 2007 market share nearly doubling from 6% to
11% market, with both public and private sector intensifying their activity. A key towards the
achievement of the Kyoto target by Japan is the coordination between the Government’s Kyoto
Protocol Target Achievement Plan and the Keidanren Voluntary Action Plan, a voluntary
commitment by major industries to stabilize CO2 emissions from fuel combustion and industrial
process at 1990 level by 2010. In late 2007, major industries announced that they would tighten
their targets under the Keidanren Voluntary Action Plan, thereby assuming responsibility for 45 to
76% of the additional Kyoto gap. Part of these additional efforts could also translate into extra
demand for Kyoto units, including CDM and JI.

28
WHO ARE SELLING?

For the third consecutive year, China was the world leader in CDM supply with a 73% market
share in terms of 2007 transacted volume (compared to 54% market share in 2006). Leading
62% of primary CER supply so far under contract, China is still the destination of choice for buyers
of credits, who cite its large size, economies of scale in origination, and its favorable investment
climate. Buyers generally reported the ability to close primary forward carbon transactions in the
range of €8-11, with one or two notable transactions at above €13 in the last few months.

China consolidated its position as the pre-eminent carbon supplier, by quadrupling its number of
projects in the pipeline from January 2007 to March 2008. China is well ahead of other countries in
the CDM pipeline with 53% of potential CER supply until 2012, and, with 1104 projects, also
pulled ahead of India in the number of projects in the CDM pipeline. China also nearly doubled its
expected CER deliveries by 2012 over that period of time.

Brazil and India, at 6% market share each, transacted the highest volumes after China, although
this represented a drop in volumes for each from 2006 levels. Africa followed with 5% of the
market.
Compared to their position in the CDM pipeline, India and Brazil have a relatively low market
share of transactions. Market participants repeatedly cited high price expectations in these two
countries, and reported that project sponsors focused on transacting issued CERs at attractive prices
in the range of €15-16.50 instead of selling (riskier and therefore less remunerative) forward CER
streams. With CER issuances gradually ramping up and the market infrastructure for spot CER
transactions being operational; one could reasonably expect higher volumes of spot primary
transactions reaching the market in the coming years. This may also indicate an inclination away
from the conventional, standalone ERPAs from the past, with implications for their value as project
finance instruments.

29
A number of countries entered the project pipeline for the first time, particularly in Sub Saharan
Africa and Central Asia and transacted volumes grew several-fold in a number of other countries,
most notably in Malaysia and Indonesia. Although they account for a much smaller share of the
primary CDM market, some countries in Africa (Kenya, Uganda, Nigeria), Asia (Malaysia,
Philippines, Thailand) as well as in Eastern Europe and Central Asia (Uzbekistan), reported sharp
increases in transaction volumes. Projects in Africa have contracted to supply about 50MtCO2e to
the market so far, with more than 20MtCO2e transacted in 2007 alone.

30
CLASSIFICATION OF CARBON CREDIT ASSETS

HFC23 destruction projects, although still the dominant asset class transacted (34% CDM market
share), peaked in 2005 (when HFC had a 67% CDM market share) (Figure Below). This could be
interpreted as a sign that the stream of HFCs is drying up, especially given questions regarding the
treatment of new HCFC-22 facilities under the CDM Projects for the destruction of N2O – another
potent GHG with a global warming potential of 310 –started to appear in the transaction database
in 2006, on the basis of two approved methodologies. N2O projects captured a 13% market share
of volumes transacted in 2006. There remain quite a few N2O projects not yet transacted, although
most appear to have been committed exclusively for contract to a buyer. In the next year or so they
could be among the ones that buyers find desirable – because of their large volumes and low
delivery risk. Together with HFC23 projects, they account for 50% of purchases since 2003 (at 480
million tCO2e) and represent 40% of expected deliveries by 2012 in the CDM pipeline.

31
Methane in the Market

Coal Mine Methane (CMM) saw an absolute increase over 2005 volumes transacted during 2006
(With a market share constant at 7%). Among projects targeted at abating methane emissions this
could be one of the asset classes gaining importance in the future with relatively important and
more predictable volumes.

Landfill gas (LFG) projects saw their market share drop from 8% to 5% in 2006. This asset class
showed weak project performance and delivery yield in the early set of Issued CERs. To date,
some 40 million CERs have been issued across all asset classes (4% of the total volume of CDM
transacted so far). Preliminary analysis of the overall project yield defined as the ratio of the
actually issued CERs to the expected emission reductions according to the project design document
over the same period indicates an average yield of 80% across all asset classes with considerable
fluctuations across asset classes and within a given asset class. In particular, carbon assets from
LFG score the lowest, with an expected yield close to 20%. Reasons cited include, among others,
overestimation of the potential generation of gas at the modeling stage, inadequate design of gas
capture systems, suboptimal operation of the landfills, or other external factors. A delay in a
project’s start date caused by something unrelated to the carbon process e.g., difficulties in
obtaining the required equipment, a late permit, or the failure to close its financing as expected, can
substantially reduce the likely volumes that can be delivered by 2012.

Share of Clean Energy Jumps

Carbon credits derived from renewable energy saw their share increasing by 50% in 2006, at 16%
compared to 10% in 2005, buoyed mainly by China’s decision to identify these alternative sources
of energy as a priority. The share of transactions from energy efficiency projects and fuel switching
projects increased dramatically from 1% last year to 9% in 2006. Those were mostly energy
efficiency projects at industrial facilities. Demand-side management energy-efficiency projects
were held back by methodological challenges (additionality requirements for activities that are
considered economically rational or because of issues with monitoring). It is, of course the case,
that many economically rational activities are not always implemented for a wide variety of
reasons, e.g. barriers to information or inertia in consumer behavior.

32
LULUCF and Agro-forestry Credits

Carbon assets from Land Use, Land-use Change and Forestry (LULUCF) remain at 1% of volumes
transacted so far. Their regulatory complexity and limited market access to the EU is likely to limit
their demand. On the other hand, the proven community benefits and competitive cost may result
in some additional demand from public buyers, including European governments. Voluntary
markets may consider less complex and costly ways to manage permanence risk than the current
approach of temporary credits under the CDM. Large classes of LULUCF assets including possibly
soil sequestration, fire management and avoided deforestation, among others, remain attractive
opportunities to promote sustainable development in Africa and in other natural resource-based
economies, but are still systematically excluded from the CDM and other regulatory markets.

33
PRICING OF CARBON CREDITS: -

Factors influencing price: -

In the context of a contract to sell or buy carbon credits to be created in the future, the price to be
agreed by the parties to the contract will be influenced by one or more of the following factors,
although this is not an exhaustive list:

1. Buyer’s break-even point: If the buyer is an entity that has an obligation to reduce
greenhouse gas (GHG) emissions and that is seeking to purchase carbon credits as a less
costly way of meeting its obligations than having to reduce emissions in its own country,
then the entity will not pay more for carbon credits than it would cost to carry out the
reduction, taking into account all associated costs and risks.

2. Seller’s cost and the viability of the investment project: The cost of producing carbon
credits will be determined by a number of factors, including the type and size of the project,
the technology used the baseline emissions level, the crediting period, etc. and will vary
from project to project. The seller naturally wishes to sell the carbon credits at a price that is
higher than the production costs. Also, if the decision to invest in a specific Clean
Development Mechanism (CDM) or Joint Implementation (JI) project depends solely on
the successful sale of carbon credits at a particular price, then the seller will naturally try to
obtain at least that price.

3. Market factors: During the negotiation of a contract, the carbon credit market cannot be
ignored. Both the prevailing market, as well as the perceived future market, will provide a
reference to be taken into consideration in the negotiation of the price. Thus, it is important
to pay due attention to market trends. Market information may be collected from various
sources such as brokers, the Internet, etc. However, it is always important to consider
matters, including the time of delivery, the transaction costs, the cost of any financing,
payment terms and the risks involved, to arrive at an effective comparison with the
prevailing market price.

34
4. Parties to the contract: The competence and creditworthiness of the parties to the contract,
both buyers and sellers, are also important, especially since it may take years, once the
contract has been finalized, before the plant or facilities are constructed and all the carbon
credits are delivered. The price may also be influenced by the capabilities of the seller
and/or of the seller’s contractors to effectively manage the project and to construct the plant
or facilities that are to achieve reductions in the emission of GHGs.

5. Transaction costs: There are certain inevitable costs and expenses that arise from following
the procedures required under CDM or JI, such as the costs of engaging a DOE for a CDM
project or an Accredited Independent Entity (AIE) for a JI project.

6. Terms and conditions of the contract: The agreement of the parties to the contract on the
price will also reflect the burdens imposed on each party by the terms and conditions of the
contract. If these impose a greater possible liability upon the seller, the seller will only be
prepared to accept such onerous terms and conditions if the price is attractive enough. By
the same token, if the buyer believes it bears the greater possible liability, it may be able to
insist that its acceptance is dependent upon the price being low enough to make its
agreement to the contract economically worthwhile.

7. Risks: In a contract where the parties propose to sell and buy carbon credits that will be
generated and delivered in the future, the buyer may be reluctant to enter into such a
contract, and/or unwilling to pay a good price, if the project involves a significant degree of
uncertainty of actually receiving the carbon credits on time and in the quantity agreed upon.
Depending on the type and location of the project, it can easily take three or more years
after the investment decision has been taken before the plant or facilities have been
constructed and commissioned. As pointed out previously, in most cases, GHG emission
reductions or GHG removals can start to accrue only after investment has been made in the
plant or facilities and these have become operational and/or forests have grown to the
required extent. Throughout the phases of planning, construction and operation, anything
could happen to the project that may affect achievement and delivery of the carbon credits
and, generally, the longer the time span, the more risks are involved. Examples of risks are
set out in chapter 8, together with a discussion of defaults and remedies. Thus, all other
factors being equal, the price of carbon credits of a vintage further into the future could
involve more risks than carbon credits of an earlier vintage and this factor may be reflected
in the price.

35
Terms of payment: -

The parties will negotiate the terms of payment on the basis of various factors, such as price, the
creditworthiness and financial strength of each party, market conditions, the time since the
conclusion of the contract to delivery, any milestone payment obligations, any risks involved in the
project or any country risk, other terms and conditions of the contract and so forth. Naturally,
sellers want to be paid early, even before they have delivered the carbon credits to the buyer, while
buyers want to be able to pay late, only after they have received the carbon credits.

• Cash on delivery: Perhaps the most basic and straightforward method of payment is “cash on
delivery”, where payment is effected in full against delivery of the carbon credits to the buyer. If
the contract envisages more than one delivery, then payment may be made each time the carbon
credits are delivered, applying the agreed unit price or as otherwise agreed.

• Payment before delivery of carbon credits: The legal implications of payment being made
before completion of delivery may be different, depending on the nature of such payment in the
contract and the applicable law. The payment may be part of the total contract amount or an
advance payment or payment of some other nature. With a payment in advance, the amount paid
may be recovered as a credit against the total payment due when the carbon credits are successfully
delivered. Moreover, the contract may provide for the advance payment to be recovered if the seller
fails to deliver the carbon credits in line with the contract. Thus, it is always advisable to clearly set
out the nature of such a payment method in the contract, together with details of how and when any
amount paid will be refunded to the buyer in case of partial or entire non-delivery.

• Payments based on key milestones: As an alternative to cash on delivery, if the seller and
buyer have agreed on periodic payments reflecting progress in the project cycle until completion of
delivery of the carbon credits, it may be prudent to link each advance payment to the occurrence of
relevant key milestones in the project cycle of the CDM or JI project. In this case, each advance
payment is made once a key milestone is achieved toward the successful completion of the project
and the generation and issuance of the carbon credits. The key milestones could be:

36
a) The project is approved by the DNA or DFPs of either one or both of the countries involved.

b) The project is registered by the CDM Executive Board or by the Joint Implementation
Supervisory Committee, after validation by a DOE or an AIE.

c) The plant facilities become operational.

d) The emission reductions are verified and certified by a DOE or determined by an AIE.

The milestone-based advance payments may be made upon production of supporting documents.
Any advance payment is, by definition, refundable to the buyer, either with or without interest, if
the seller fails to deliver the subject of the contract. However, it is important that the advance
payment obligation is clearly understood as agreed between the parties and defined in the contract,
precisely in accordance with such agreement. The central issue here is the payment obligation,
before the price has been “earned” or before the obligation under a contract has been fulfilled by
the seller. While the parties to a contract are negotiating the milestones which will set off the duty
to pay, they should also negotiate and agree on the dates by which each milestone should be
achieved. These provisions should take into consideration the remedies that the buyer is entitled to
in the case of a delay or if it becomes impossible to achieve a particular milestone.

37
FUTURES MARKET

Benefits of Futures Trading

• Efficient Price Discovery

• Hedging platform
• No Counter party Risk
• Reference Price
• Provide ready market to off-load (Large Buyers & Sellers)
• Transparency in Pricing
• Integration of domestic and Global markets

Utility of Futures Trading

38
Futures Contract Specifications: -

Type of Contract Futures Contract Specifications for Certified Emission Reduction

Units (CERs)

Name of Commodity Certified Emission Reduction (CER) – Carbon Credits

Ticker symbol CERNCDEX

Trading System NCDEX Trading System

Basis Mumbai (NCDEX) - Exclusive of all Taxes, Levies and Duties

Unit of trading One lot of 500 CERs (Carbon Credits)

Delivery unit One lot of 500 CERs (carbon Credits)

Quotation/base value Rs. per CER

Tick size Rs. 0.20

Quality specification Certified Emission Reduction (CERs) is a unit pursuant to Article

12 and requirements there under, as well as the relevant
provisions in the CDM modalities and procedures and is equal to
one metric tonne of carbon dioxide equivalent, calculated using
global warming potentials defined by decision 2/CP.3 or as
subsequently revised in accordance with Article 5 of the Kyoto
Protocol or its successor agreements or decisions under United
Nations Framework Convention on Climate Change.

Quantity variation Up to +/- 250 CERs

Delivery center At notified delivery centre at MUMBAI

39
 Hours of Trading As per directions of the Forward Markets Commission from time
to time. Currently,
Mondays through Fridays:
10:00 a.m. to 11:30 p.m.
10:00 a.m. to 11:55 p.m. (during US day light saving period)
Saturdays: 10:00 a.m. to 2:00 p.m.
The Exchange may vary the above timing with due notice

Opening of contract Initially, only December 2008 contract will be launched.

Intermediate or subsequent contracts may be launched with the
permission of the Forward Markets Commission.
Closing of contract All open positions for which delivery intentions have not been
received or for which delivery intentions have been rendered but
remain unmatched for want of counterparty to settle delivery, will
be cash settled at Final Settlement Price.

Maximum price The daily price limit will be 6% and will be raised to 9% after a
Fluctuation 15-minute cooling period if the price limit of 6% is reached.

s Member level limit: 66000 lots or 15% of market wide open position which
ever is higher
Client: overall 11000 lots
The above limits will not apply to bona fide hedgers.

Initial margin 6%

Special margins In case of additional volatility, a special margin at such other

percentage, as deemed fit, will be imposed in respect of
outstanding positions, which will remain in force as long as the
volatility exists, after which the special margin may be relaxed.

40
 Due date/Expiry of 10th day of the delivery month. If 10th day happens to be a
Contract Saturday, Sunday or Holiday, then the due date shall be the I
mmediately preceding trading day of the Exchange.

Delivery logic Both options

10 days prior to expiry Buyer Clearing Members with open long position may seek any
specific additional requirement/information from Seller Clearing.
Member though the Exchange system. Any such request for
additional information will be considered at the discretion of the
Exchange and any information made available by the seller can
be conveyed to all the Clearing Members with open long position
subject to any terms and condition that may be imposed by the
Exchange.

Between 5 and 3 days The delivery intention can be given during three business days
(excluding Saturday) prior to expiry from fifth business day to third business day prior
To the expiry of the Contract. The Clearing Member with short
open position can give their intention to deliver CERs along with
the "compulsory requirement / information from seller".
Seller may also submit additional information as sought by the
Buyer Clearing Members through Exchange system. Seller
Clearing Member can also submit any special terms and
conditions of sale of CER as may be permitted by the Exchange
on the Exchange trading system.

From 2 days prior to The Buyer Clearing Member with the long open position can give
y their intention to take delivery and record their rejection of
projects which they do not intent to consider for buying CERs.

At Expiry The Exchange will match the intention of the buyers and sellers
and will allocate CERs for delivery. The actual delivery will be
effected to the extent of matched quantity and unmatched
quantities will be closed out at the Final Settlement Price at the
expiry of the contract.

41
Expiry +1 day If the Expiry Date is E then, Pay-in and Pay-out for unmatched
intentions would happen on E+1 day. If such a E+1 day happens
to be a Saturday, a Sunday or a holiday at the Exchange, clearing
Banks, Pay-in would be effected on the next working day.

Expiry +5 day The seller and the buyer Clearing Members will submit required
documents and complete "Post Expiry Formalities" as laid down
by the Exchange. The Pay-in from the buyer, Payout to Sellers
and transfer of CERs to Buyers will happen for those CERs
where the formalities are completed, on Fifth Business day
(excluding Saturday, Sunday or a holiday at the Exchange,
Clearing Banks) after expiry of the contract. The failure of the
Seller or Buyer to complete the formalities will be considered as
“failure to meet delivery obligations” and the defaulter(s) will be
liable to pay penalty as specified by the Exchange. The decision
of the Exchange will be final and binding on both Buyer and
Seller Clearing Member and their clients as the case may be.

Pay-in and Pay-out Schedule for pay-in and pay-out will be declared by the
Exchange from time to time.

Penalty structure The penalty structure for failure to meet delivery obligations will
be as per Circular no. NCDEX/TRADING-091/2007/235 dated
October 4, 2007 The Exchange will have right to change the
penalty structure.

Change of Delivery The Exchange reserves the right to change the delivery procedure
Structure in the interest of the market participants after approval of the
Forward Markets Commission.

Final Settlement Price The Exchange proposes to do price polling for the guaranteed
deliverable CERs for the corresponding contract expiry date from
the national and international sources to decide the Final
Settlement Price. International polled prices will be converted
into India Rupee equivalent on the basis of Exchange rate as
notified by the Reserve Bank of India on that particular day

42
Working of Futures Market

For Example

Annual emission of companies A and B (each) = 100,000 tonnes of CO2 equivalent per year.

National allowance permitted = 95,000 tonnes of CO2 equivalent per year.

Current market price of an allowance = US$10 per tonne of CO2.

43
Therefore, the short fall in both the cases is (100,000 – 95,000) = 5000 allowances. The companies
have a choice between reducing their emissions by 5000 tonnes or by purchasing 5000 from the
market. The selection amongst the options depends upon the costs incurred under each of them.

Company A calculates that cutting its emissions will cost it US$5 per tonne, so it decides to do this
because it is cheaper than buying the necessary allowances. Company A even decides to take the
opportunity to reduce its emissions not by 5,000 tonnes but by 10,000. Therefore, Company A
spends US$ 50,000 on cutting its emissions by 10,000 tonnes at a cost of US$5 per tonne, but then
receives US$50,000 by selling the 5000 allowances which it no longer needs at the market price of
US$10 each. This means that it fully offsets its emission reduction costs by selling allowances,
whereas without the emissions trading scheme it would have had a net cost of US$25,000 to bear
(assuming that it cut emissions by only the 5,000 tonnes necessary).

Company B is in a different situation. Its reduction costs are US$15 per tonne i.e., higher than the
market price, so it decides to buy allowances instead of reducing emissions. Company B spends
US$ 50,000 on buying 5,000 allowances at a price of US$10 each. In the absence of such norms, it
would have had to cut its emissions by 5,000 tonnes at accost of US$75,000. This way, emissions
trading bring a total cost-saving of US$50,000 for the companies in this example. Also the revenue
generated from the sale of credits provides economic benefits to the developing countries to
compete with the industrialized nations.

44
TAX TREATMENT OF CARBON CREDITS

Financial Accounting Issues of CDM Credits in India

India is one of the major players in the global market on the supply side of CERs. Indian
companies have started getting credit of CERs and some of them have also entered into sale
arrangement with buyers in the international market. As this is a new concept, it has given rise to
interesting financial accounting dimensions. Issues involved are
(i) How to account for expenditure on CDM projects.

(ii) Whether or not to account for self-generated CERs held with registry

(iii) If credits are to be accounted, at what point of time these should be recognized in books of
accounts and at what value

(iv) How to account for sale consideration of CERs and its disclosure in accounts and notes.

Answers to these questions are found within existing pronouncements of ICAI as well as Schedule
VI requirements. Taxation issues will naturally follow.

CER Sale is Other Income, Not Turnover

We can safely conclude from the discussion above that sale proceeds of CER credits cannot be
included in Turnover. Section 43A(11) of the Companies Act, 1956, defines ‘Turnover’ as “the
aggregate value of the realization made from the sale, supply or distribution of goods or on account
of services rendered, or both”. Part II of Schedule VI to the Companies Act, 1956, requires a
separate disclosure of “profits or losses in respect of transactions of a kind, not usually undertaken
by the company or undertaken in circumstances of an exceptional or non-recurring nature, if
material in amount”. Though CERs are goods, their sale is undertaken, if not in exceptional
circumstances, certainly on non-recurring basis. We have already seen that a CDM project cannot
be a profit/cost centre in itself, and, therefore, it is neither possible nor desirable to attempt to work
out separate profit or loss of any CDM project, with an accuracy expected from accountants. A
combined reading of Section 43A and Schedule VI of the Companies Act clearly establishes that
sale proceeds of CERs should be disclosed as a line item in schedule of other income, if amount is
material.

45
Revenue Recognition on Sale of CER Credits

As we have already concluded that CER credits are goods, their sales proceeds have to be
recognized in financial accounts as per para.11 of the Accounting Standard 9 (‘revenue
recognition’). The conditions of para.11 are self explanatory, and are reproduced below:
In a transaction involving the sale of goods, performance should be regarded as being achieved
when the following conditions have been fulfilled:
(i) The seller of goods has transferred to the buyer the property in the goods for a price or all
significant risks and rewards of ownership have been transferred to the buyer and the seller retains
no effective control of the goods transferred to a degree usually associated with ownership.
(ii) No significant uncertainty exists regarding the amount of the consideration that will be derived
from the sale of the goods.

Self-generated CERs Held with Registry

Self-generated CERs held with registry cannot be included in Inventories as defined in Accounting
Standard-2, as they are not held for sale in the ordinary course of business. On the other hand, such
credits meet all the criteria of ‘Intangible Asset’ as defined in Accounting Standard-26 i.e.
(i) Identifiability,

(ii) Control over a resource,

(iii) Expectation of future economic benefits flowing to the enterprise.

Para 19 to 23 of Accounting Standard-26 deal with recognition and initial measurement of an
intangible asset. Para 20, which is the operating portion of this section, provides that an intangible
asset should be recognized if, and only if:
(a) It is probable that future economic benefits attributable to the asset will flow to the enterprise
(b) The cost of asset can be measured reliably.
Since we have already demonstrated that availability of CER credits is only an additional benefit of
a CDM project, it would be impossible to measure the cost of self-generated CER asset reliably.
Thus it can be concluded that though self-generated CERs held with registry are
Assets (Intangible), they cannot be recognized in Accounts due to specific requirements of
Accounting Standard-26.

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Accounting Carbon Credits as per AS- 12

Some experts, having admitted that there are presently no guidelines/standards for accounting of
Carbon Credits, have suggested that they be accounted as Government Grant. There logic is based
on the definition of the term ‘Government’ prescribed in para 3.1 of AS-12, which reads:
“Government refers to government, government agencies and similar bodies, whether local,
national or international.” The logic forwarded appears to be misplaced, as in case of financial
transactions arising out of carbon credit, monetary consideration will not flow from any
government or government agency. In total gambit, UNFCC CDM registry acts as a Demat banker
recognizing CER credits and keeping an account of it. There is no grant at all from any agency.
Further, as soon as Carbon Credits are accounted as Government Grants, Accounting
Standard-9 ‘revenue recognition’ will cease to operate, leading to other accounting and taxation
complications.

Tax Planning

CER credits are indeed intangible assets, held with registry. CER credits acquired from other
parties for the purposes of trading are recognized in the books at the cost of acquisition, whereas
self-generated CER credits are not reflected in financial accounts. As issues for accounting of CER
credits will appear for the first time in Financial Year 2006-07, it is important to disclose
the accounting policy adopted for this purpose. It would be appropriate to disclose units of CER
held with registry in notes bi-furcating between purchased and self-generated. As CERs are capital
assets, tax liability should be admitted under the head Capital Gain, and claim for concessional rate
of taxation should also be made if credit is held for more than 36 months immediately preceding
the date of transfer. This gives an opportunity to take a decision about timings of sale of such
credits, keeping a balance between cash flow needs, interest factor and difference in rate of tax
between long-term and short-term holdings. As there would be no cost of acquisition for self-
generated CER credits, section 55(2) of the Income Tax Act will come into operation, and total sale
consideration will be liable for Capital Gains Tax (long term/short term) according to the period of
holding. In Indian circumstances, if sale of CER credits happen to overseas buyers, of the property
held overseas, such sale, though sale of ‘goods’, will not attract any sales tax.

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EXAMPLE OF SRF LIMITED: -

It is an industrial group engaged in the manufacturing of industrial synthetics, fluorochemicals,

industrial fabrics, packaging films and Pharma chemicals. It operates a swing plant at Rajasthan,
India since 1989 that produces HFC 22, CFC 11 and CFC 12 alternately on campaign basis. The
main objective of the CDM project was to reduce the GHG emission through destruction of HFC
23 gases, in a proposed thermal oxidation system. The project cost was Rs. 13 crores and the
benefits are expected in next ten years. SRF has been releasing this gas into the atmosphere before
identification of this project as a CDM project under the Kyoto Protocol. Since April 2004, SRF
has been storing HFC 23 waste gas. Thus, with the implementation and operation of the thermal
oxidation system, the project will reduce GHG emission (in equivalent CO2 equivalent terms) that
otherwise would have continued to occur in absence of the project. The annual sale is expected to
be of 3.83 million CERs or 3.83 million tons of CO2 equivalent gases. The after tax cash flows
from the project is in table.

After tax cash-flows of SRF

Description After Tax Cash flow (Rs Crore)

Initial Investment ‐ 13

FY06 59.362
FY07 59.362
FY08E 59.362
FY09E 59.362
FY10E 59.362
FY11E 59.362
FY12E 59.362
FY13E 59.362
FY14E 59.362
FY15E 59.362

The CER rate is taken to be a 5 USD. The Re/USD rate has been taken as 41 and tax rate @ 33%.
The IIR in this case is calculated on the incremental expenditure needed for meeting CDM
requirements.

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Conclusion

Carbon credits emanating from CDM projects can be considered as enhancers of equity returns
rather than as a reliable long term source of cash flows for projects. As soon as the future trends for
carbon credits are frozen after year 2012, they would be viewed as source for long term cash flows
as well. Projects ought to be developed so that they are CDM compatible. Due to OTC markets, the
market is illiquid and non transparent, firms need to negotiate deals with knowledge of the market
trends and potential problems arising after year 2012 deadline for current round of emissions
reduction. The CERs are also heterogeneous in nature depending on origin and quality of CERs
and quality of project. The CDM cycle is perceived to be long and the complexity of rules and
regulations is a barrier to usage of this opportunity. With the expectation of the maturity of the
carbon market, carbon credits will become an important consideration in project financing in
developing countries especially India.

CDM cash flow increases IRR of the p

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CONCLUSION:

There is a great opportunity awaiting India in carbon trading which is estimated to go up to $100
billion by 2010. In the new regime, the country could emerge as one of the largest beneficiaries
accounting for 25 per cent of the total world carbon trade, says a recent World Bank report. The
countries like US, Germany, Japan and China are likely to be the biggest buyers of carbon credits
which are beneficial for India to a great extent. The Indian market is extremely receptive to Clean
Development Mechanism (CDM). Having cornered more than half of the global total in tradable
certified emission reduction (CERs), India’s dominance in carbon trading under the clean
development mechanism (CDM) of the UN Convention on Climate Change (UNFCCC) is
beginning to influence business dynamics in the country. India Inc pocketed Rs 1,500 crores in the
year 2005 just by selling carbon credits to developed-country clients. Various projects would create
up to 306 million tradable CERs. Analysts claim if more companies absorb clean technologies,
total CERs with India could touch 500 million. Of the 391 projects sanctioned, the UNFCCC has
registered 114 from India, the highest for any country. India’s average annual CERs stand at 12.6%
or 11.5 million. Hence, MSW dumping grounds can be a huge prospect for CDM projects in India.
These types of projects would not only be beneficial for the Government bodies and stakeholders
but also for general public.

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INDIA PROVES IT AS WELL

The United Nations has awarded more than 5.4 million carbon credits to an Indian company,
including four million carbon credits in the single largest issuance of emission permits to a Kyoto
Protocol project.

The UN Framework Convention on Climate Change (UNFCCC) said on its website that the
Certified Emissions Reductions certificates, or CERs, were issued to two projects—owned by
India’s JSW Steel—for reducing greenhouse gas emissions between 2001 and 2006. The projects,
which were registered in January under the UN’s Clean Development Mechanism (CDM), cut
gases emitted through power generation from imported coal and waste gases from JSW’s steel
manufacturing operations.
The four million credit issuance accounts for 6.5 per cent of the total 62 million CERs allocated by
the UN so far, with 42 per cent of all issued credits going to projects in India. CERs, each
equivalent to the reduction of one tonne of carbon dioxide (CO2), trading on a secondary market
are currently valued at around 14.50 euros.

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IS THERE A POST 2012 MARKET?

Preliminary findings from IETA’s recent Market Sentiment Survey indicate that more than 90% of
respondents believe that the GHG Market is an established instrument that will continue post 2012.
In addition, more than 65% of those surveyed anticipated that a global market will be established in
the next 10 years. In this context, the recent EU announcement regarding its climate and energy
policy for 2012-2020 and beyond appears to been taken seriously by the business community.
Investment decisions are now more likely to take into account the high likelihood of a carbon-
constrained environment, at least in the EU. Similarly, the recent announcement by the
Government of Canada, including a role for CERs, banking and credit for early action may also
trigger efforts by Canadian companies to start identifying and pursuing abatement options at home
and abroad. Developments in the EU, USA, Canada and Australia have helped kick off a modest
post-2012 market in abatement domestically; however there is much ambiguity about the extent to
which CDM and JI will play a role in compliance.

Since there is still some uncertainty at play about details of each of these post-2012 regimes, there
is some risk that origination of new carbon projects tapers off. This should not imply however a
weakening of prices for CERs and ERUs in the short run as there still is some strong residual
demand before 2012 to be met. Further, if the emerging North American regimes encourage early
action and banking of CERs, this could stimulate further demand. Some buyers have been
purchasing post-2012 vintages, extending the horizon of the stream of carbon revenues and
improving the financial viability of projects that require additional help to meet hurdle rates. The
uncertainty about demand post-2012 may justify a lower price – given the uncertain compliance
value of the credits that may be generated. The most common way to address post-2012 uncertainty
in the market is through a zero premium call option provided to the buyer in which the strike price
is at the same level as the contract price for pre-2013 vintages or at the prevailing market price
should there be a system in place in which the reductions can be used for compliance. Some buyers
do not put a value on this option at the moment, and sellers are essentially giving away the option.
But this may evolve quickly as more confidence appears on the post-2012 front.

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 Bibliography
Books and Journals

• Concept of Carbon Credit – ICFAI Journal

• State and Trends of the Carbon Market 2008 – World Bank Report
• Report on Carbon Credit – MCX
• Business World
• Carbon Credit – A Marketing Perspective – Carbon Credit Advisory

Websites
• www.unfccc.int
• www.carboncredits.com
• www.carbonplanet.com
• www.wikipedia.com
• www.livemint.com
• www.zeroyourcabon.com
• www.ncdexspot.com
• www.pewclimate.org
• www.worldbank.org
• www.mcxindia.com

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