CDM in Africa: Facing the Hurdle of Conventional Finance

Climate change threatens the world as a whole – and Africa in particular, because increases in droughts and floods mean more on a continent where the population is already struggling to make ends meet. The continent therefore has more than most to gain from financing schemes that promote sustainable development and slow climate change – but will Africa be in a position to benefit?

Second in the Series: The Road to Accra, leading up to the October Katoomba Meeting in Accra, Ghana.

16 September 2009 | The Kyoto Protocol’s Clean Development Mechanism (CDM) offers an opportunity for projects in developing countries with the potential to reduce greenhouse gases compared to the baseline situation (i.e. business-as-usual situation ex ante to the project implementation) to secure extra revenues from Certified Emission Reductions (CERs; or commonly called carbon credits) which they receive in proportion to greenhouse gas emissions that they have reduced. Governments and companies in developed countries buy these credits, as they can use them as part of their greenhouse gas emissions reduction commitments under the Kyoto Protocol.

Since the Kyoto Protocol came into force, over 4,000 CDM projects have reached different stages of their CDM development, with around 1,800 already generating carbon credits. On average these projects reduce more than 300 million tons of greenhouse gases per year. With estimated prices of around €10 paid per carbon credit, a basic math calculation shows revenues of over €3 billion transferred annually to developing countries in support of these climate protection projects.

Africa, however, is trailing – we are tempted to say as usual – behind the rapidly growing market for project based carbon credits and is host to a meager 2% share of the global CDM pipeline. The main reason for this unfortunate situation lies in the difficulties associated with finding conventional project finance in Africa – and not so much in an often-debated lack of (CDM) capacity on the continent.

Why is Africa Trailing?

According to World Bank estimates, Africa has the potential for more than 3,200 clean energy projects which could provide more than 170GW of additional power generation capacity and thereby reduce about 740 million tons of greenhouse gases per year. Even greater emission reductions can be gained in the agriculture and forestry sectors, or by gas flaring and waste management technologies.

Despite this great emission-reduction potential, African countries have so far failed to benefit much from the CDM. Currently, there are 33 CDM projects registered on the continent, which constitute only 2% of the global total. The lion’s share of global projects are hosted by China (32%), followed by India (27%) and Brazil (10%).

South Africa leads the continent with 16 projects, followed by Egypt with five and Morocco with four.

These statistics show that CDM projects currently go first to those countries where the underlying project financing is easily available. Is project finance then the main hurdle hindering the success of CDM in Africa?

Carbon Finance is No Panacea

Africa suffers no shortage of great project ideas that expect financing from the CDM, but project developers need to understand that carbon credit revenue itself accounts for just 20% of the underlying financing of CDM projects on average.

That means the project has to be somewhat viable financially before the carbon revenue tops it off.

Let’s, for example, examine the conventional financial calculations for a biomass-to-energy project in Nigeria.

Let’s assume the math gives you an internal rate of return (IRR) of 12%, which you then find isn’t luring potential investors. So you investigate carbon finance, and that brings your IRR to 17%, and they bite.

This is the logic behind the CDM: that carbon finance can turn borderline projects into viable ones because their greenhouse gas reductions and subsequent carbon credits revenue make them worthwhile to investors. This also highlights the fact that the CDM is neither a panacea for projects that make no financial sense at all – nor an added bonus for projects that are profitable without carbon finance.

CDM finance is meant to tip the balance in favor of climate-protection projects that would just miss the profitability threshold without them – and therefore not be implemented.

The Cost of CDM Registration

Project developers often balk at paying for CDM registration, but that cost is insignificant compared to the revenue that one can expect – especially when you consider that a project that is bankable and has reached financial closure is unlikely to face further hurdles.

In fact, it costs just €80,000 or so to bring a simple project under the CDM process to the point of registration by the CDM Executive Board, and complex projects like afforestation and reforestation top out at €120,000. When you consider that an average CDM project generates around 30,000 to 50,000 carbon credits per year for up to 21 years at a price of roughly €10 per carbon credit in mind, it’s worth the cost.

But while costs related to the CDM process are low, it is unlikely that a conventional project would not require several million Euros to be implemented. A reasonable renewable energy project – for example, a biomass-to-energy project with just 5MW of installed capacity – will need an investment of at least €10 million, which will rise to €15 million and even more for solar photovoltaic. A composting plant that is taking only 500 tons of waste per day – an amount any small city in Africa is easily producing – will require at least €5 million to be implemented. The list of examples could be continued. If this financing is organized – complete with a feasibility study, a business plan, and financial closure – the CDM is unlikely to be a problem.

The Need for Capacity Building?

As we saw above, Africa’s meager slice of the global CDM pie is concentrated in three countries – South Africa, Egypt and Morocco – and all three are clearly emerging countries or even wealthy countries compared to the likes of Chad, Somalia or Rwanda. This fact supports the thesis that the CDM is growing in countries that have easy access to conventional financing.

We draw from here another seemingly straightforward conclusion: namely, that spending time and money on building capacity in Africa for the development of CDM projects is secondary. There is no question that the CDM development process is very complex, but its complexity is easily overcome if there is a bankable project that can be accepted as a CDM project.

Plenty of Demand for African Projects

Our experience, especially in Africa, shows that there are many CDM project developers that will never go beyond the great ideas that they have. But we have never come across a bankable project with CDM potential that has not been developed as a CDM because of its complexity or the lack of a maximum of €120,000 to finance the CDM process.

In fact, as soon as there is any bankable project with CDM potential in Africa, all the players in the carbon market are literally fighting to contract the project. In many cases consultants, brokers and buyer of carbon credits even take up all the cost of CDM development when they contract in advance carbon credits that will be delivered in years to come.

International institutions and development organizations supporting capacity building for the CDM in Africa should instead concentrate their efforts on finding solutions to make conventional project financing work for Africa. Africa has an almost eternal problem with national and foreign direct investment. But we are sure if a potential CDM project can be financed, its CDM part can easily and successfully be developed.

Here Is the Money; Where Are the Projects?

The appetite to invest in Africa is increasing – with funds, development agencies, banks and even private individuals willing to take comprehensive shares in CDM projects in Africa.

Although this is much appreciated, many of those interested investors are looking for bankable projects, i.e. projects with comprehensive feasibility study and business plans developed with at least a minimum equity financing already in place. Such projects are coming more and more from Africa, but the lion’s share is still idling at development stage, with developers lacking money to take projects to a comprehensive stage. We believe there is a strong need for seed money in Africa.

Many development agencies – especially those spending a lot on supporting CDM capacity building – should perhaps think more in the direction of providing project developers with the seed money, which in most cases is far below €100,000. Investors will be more attracted when a comprehensive project is presented to them, not just a great idea with no basic studies done. More venture investment is needed for Africa to tap the huge CDM potential.

This emphasis on project finance may seem naí¯ve. However, for us, while we are aware that many other African related barriers to the CDM exist, or at least are widely discussed, project finance is of prime importance to the success of CDM development in Africa. Of the other barriers, however, the prevalent risk perception of Africa by foreign investors is worthwhile considering.

Isn’t Africa Too Risky for Investors?

CDM-specific discussion papers or forums and conferences present Africa’s risk as perceived by international investors as a serious hurdle to the success of CDM in Africa.

It is clear that many outsiders still perceive Africa as a risky field for investment, even if this might be decreasing. In terms of the CDM, however, the CDM related revenues account at best for just about 20% of the overall revenue.

This means that 80% of the overall financial risks are related to the actual project itself.

In fact, we saw that in most cases the CDM is taking an insignificant share of the overall financial risk of any project. As mentioned earlier, the CDM development costs rarely go above €100,000, but on the other side, the revenue to be expected from the CDM ranges on average from €300,000 to €500,000 per year. This is based on the assumption of an average annual generation of between 30,000 and 50,000 carbon credits at a price of €10 each.

The pure CDM return for a project is, therefore, extremely attractive.

If we add to this the fact that the investment for the implementation of the physical project is always in the order of millions of Euros, we see that when a project can exist, the CDM part of it cannot fail to be tapped. Thus even if the risk perception that many investors have for Africa is true, there will be the CDM development, when there is a project implemented with a CDM potential.

Redirecting the Debate

There are efforts at the international level to help Africa benefit from the CDM, a concept that proves to be one of the best sustainable development tools for the least advanced economies.

The ruling body of the CDM, for instance, is working hard to reshape the concept to make it more beneficial for African countries.

Concepts like Program of Activities (PoA) and Reducing Emissions from Deforestation and Degradation (REDD) are very advanced in their development and are being tested already in the market. The PoA is to make the typically small size of CDM projects in Africa more attractive by combining many small projects in different locations into one large project. The REDD concept is to include avoided deforestation as a CDM activity. REDD will particularly benefit Africa where more than 70% of emissions are based on forestry and agricultural activities.

On a more political level, the European Union Emissions Trading Scheme (EU ETS) has clearly expressed its interest in accepting carbon credits from Africa beyond 2012, and this independently of what international negotiations about the future of the Kyoto Protocol post-2012 will lead to.

Thinking Beyond Kyoto

On the market side, few organizations are committing themselves to purchasing carbon credits beyond 2012, when the Kyoto Protocol expires. The most important organization currently buying those carbon credits is the Post 2012 Carbon Credit Fund advised by First Climate. The Fund was established by five leading European public financing institutions, all with Aaa ratings – the European Investment Bank (EIB), Caisse des Dépots, Instituto de Crédito Oficial, KfW Bankengruppe and the Nordic Investment Bank – with the express intention of providing certainty to the carbon credit market beyond 2012.

Launched in March 2008 as the first of its kind, the Fund is in the process of investing €125 million in carbon credits generated in the period 2013-2020. Already the Fund has invested in a composting and landfill project in Lagos, Nigeria and continues to look for further opportunities in Africa.

All these efforts are very important now and for the future of CDM in Africa. But they will only be helpful if the conventional financing of projects is working for Africa. We strongly recommend that the debate be redirected to finding solutions for making conventional project finance work for Africa. The CDM is the icing on top of the cake. No matter how much icing there may be, it cannot be enjoyed if there is no cake to hold it.

Please see our Reprint Guidelines for details on republishing our articles.

Additional resources