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Emission Reduction Credits are Ready for a Makeover

Updated: Jan 17, 2023

As grid-connected renewable energy-based carbon credits see their way out of the market, a new wave of emission reduction technologies can benefit from the same principles that historically contributed to driving down the cost of wind and solar.

In a time of optimism and skepticism about carbon markets, emission reduction credits––particularly those from renewable energy projects––bear the brunt of criticism in the quest for a healthy supply of high-quality carbon credits. It’s clear now that most grid-connected renewables projects have outgrown their role in the carbon markets. Still, new emission reduction technologies that must scale rapidly can apply these lessons today.

The bad news: carbon credits from grid-connected renewable energy projects will continue to be issued in the market for the next decade, despite questionable additionality claims.

The good news: renewable energy projects are a powerful success case for carbon finance. Similar principles may very well apply to a suite of industries––from concrete and steel production to industrial chemicals and even livestock and oil alternatives.

The state of renewable energy-based emission reduction credits

The UNFCCC developed ACM0002 under the Clean Development Mechanism to support the development of grid-connected renewable energy projects in low-income countries. At the time, renewable energy projects were nowhere near cost-competitive with fossil fuels. Investing in a renewable energy project didn’t make financial sense in a business-as-usual case. Any energy investor would choose to finance a coal or natural gas plant over a solar farm.

The premise behind the ACM0002 is that the revenues generated from the sale of carbon credits would help improve the rate of return for a renewable project and allow it to make comparable financial sense to a fossil fuel-based project. As a result, the investment would shift toward less carbon-intensive energy projects and away from coal or natural gas-fired plants that would be in operation for decades. After the EU ETS stopped accepting Kyoto Protocol-based credits following a flood of bogus credits in 2012 (mostly from Russian and Ukrainian joint implementation projects), this methodology found its way into the voluntary carbon market at much higher rates.

Over time, wind and solar installation and module costs dropped dramatically alongside improvements in capacity factors resulting in an overall decline in the levelized cost of electricity. Technologies were improving. Costs were dropping. Gradually, these projects started to become more financially attractive. This was certainly not the case when the Clean Development Mechanism was operationalized in 2008, and this rapid cost decline is a massive win for the energy transition.

Global Weighted Average Total Installed Costs, Capacity Factors and LCOE for onshore wind and PV, 2010-2021 (IRENA 2021)

This success case also means that many of these projects shouldn’t be funded by carbon credits. By 2018, many experts were urging Verra and the UNFCCC to re-evaluate the relevance of carbon credits for these projects. After all, one of the most important criteria for high-quality carbon credits is additionality: if it weren’t for using carbon financing, the project would have never happened. After feedback from public consultation, Verra decided to re-evaluate which projects would still qualify for the VCS Program.

By the end of 2019, grid-connected renewable energy projects in non-least developed countries (see LDCs) were excluded from Verra’s registry.

A summary below:

Summary Chart of Verra Renewable Energy Project Exclusions in the VCS (Verra 2022)

Determining additionality: the devil’s in the details

While Verra took action to update its standards, it’s likely that many of the grid-connected projects approved in the years before this decision would not pass a more rigorous additionality test. I wanted to explain this better by looking at a specific example: a 300MW grid-connected solar project in Rajasthan, India, approved in 2019.

To determine whether a project is additional or not, clear steps are defined in the CDM’s tool:

  1. First-in-kind: is the project first-in-kind? If yes, it’s additional.

  2. Alternatives analysis: if not, alternatives have to be evaluated, including whether laws and regulations would require the development of this project over one of these alternatives.

  3. Investment analysis: is the project unlikely to be the most financially attractive alternative, or is the project expected to be economically unattractive overall? If the project is financially attractive, it wouldn’t be considered additional and would be better suited to raise private capital.

  4. Barrier analysis: is there at least one barrier preventing this project from moving forward that the CDM would alleviate? Is this barrier not present for alternative projects? If a project faced a barrier that other projects would not, then sure, it would be additional.

  5. Common practice analysis: Are there no similar activities observed? If there are similar activities, are there clear distinctions that explain why the CDM would be required in this case? If there are similar activities and there isn’t a justifiable distinction that would warrant the use of the CDM, then it’s not additional.

This project developer decided to use investment analysis to prove its additionality. To set the benchmark cost of equity, the project developer used the CDM’s 9.79% cost of equity and added the Indian 10-year inflation forecast of 3.8% to it––bringing the benchmark to 13.96%. The project calculated its equity IRR to be 7.79%, and based on the benchmark, the project is considered additional. Still, some questionable claims make it hard to believe that a project like this would be additional:

1. Is 7.79% a realistic IRR? Given the history of cost reductions and exponential solar installations in India, it seems likely that investment appetite would be high. The Government of India reported that the average IRR of solar and wind projects in the country was around 9-11%. Further, CEEW found that equity IRRs hovered around 14.9% in 2020. I wonder how a project like this could have such a lower IRR compared to similar projects.

2. Are the cost and revenue inputs accurate? It’s hard to tell based on the project description without the financial model. Still, even a slightly different module price can dramatically change the equity IRR of a project like this. Based on the CEEW and IEA’s sensitivity analysis, pennies on the dollar per Watts peak can change a project’s equity IRR pretty substantially:

Sensitivity Analysis of Higher Module Prices to EIRR (CEEW 2021)

Though it may be two years after its registration, government officials in Rajasthan stated that they would purchase electricity generated by solar projects at 3.14 INR per unit over 25 years versus the lower rate in the project description. When even pennies can skew an IRR, these little details can totally shift the decision-making paradigm. It’s hard to be confident in an additionality claim.

3. Are there really no similar activities observed? From 2014 to 2019, India saw an astonishing tenfold increase in renewable capacity (though it is still behind on its ambitious 2030 targets). Rajasthan’s Solar Energy Policy released in 2019 has played a role in solar’s growth in the country: as of 2022, Rajasthan had developed more than 20% of the country’s solar capacity––about 10.5 gigawatts out of the total 49 GW capacity across India. It’s hard to imagine that this solar project is unique among this level of adoption in the state.

The curious part of IRR benchmarking for carbon projects is that it is in the project developer’s best interest to be exceedingly conservative in its modeling. In a usual investment scenario, we would want to see the most efficient use of capital and higher IRRs, but this additionality rationale can end up distorting the assumptions underlying a project’s financials to make IRRs seem lower than they might be in reality so a project can qualify for issuing carbon credits. So while I don’t highlight this project up to tear it down––it may well be accurately represented––it’s hard for me not to be suspicious knowing what we know about the solar market in India.

Lingering additionality headaches

Unfortunately, many of these credits are still on the market and will be for quite some time. According to Carbon Direct, grid-connected renewable energy credits still made up around 45% of credit issuances in 2021.

All Issuances by credit type, Mt (Carbon Direct 2022)

Since most of these projects have a credit-issuing time horizon of at least ten years, it’ll take several years to cycle through these credits. The 300 MW solar project in Rajasthan? Those credits will continue to be issued until October 2030, for instance.

I do think these contracts ought to be fulfilled to ensure confidence in carbon credits as a financing mechanism, but as we think about how many corporations have purchased many of these credits with murky additionality claims, it might be wise to find a way for companies to account for this particular additionality setback in future engagement in the carbon markets.

The Next Generation of Emission Reduction Credits

In my last post, I wrote about how the supply of carbon credits will eventually shift to permanent, removal-based credits by 2050. Still, decades between then and now will rely heavily on emissions reductions. Using carbon markets to drive down costs of nascent technologies and build up market demand can be a powerful tool in achieving climate targets––if this capital is used effectively.

As Pedro Martins Barata from the Clean Development Mechanism stated, “if the carbon market did anything to contribute to lowering [the cost] – even if it accounted for 10% of the cost reduction we saw in those years – that 10% is huge, that 10% is forever”.

Many climate tech startups with breakthrough decarbonization solutions will likely face similar challenges in cost-competitiveness that renewables faced in the past. Emission reduction-based credits could shift demand away from carbon-intensive business-as-usual practices by helping to drive down the green premium of many of these technologies. Fortunately, a few startups are leading the way and could usher in a new generation of high-quality emission reduction credits when we need them most.

Two startups, in particular, have already developed methodologies approved by Verra: CarbonCure, a startup that is decarbonizing concrete production, and Mootral, a startup that is helping to reduce cattle-based methane emissions through feed additives.

While grid-connected renewable projects may have outgrown their days in the carbon markets, their success in cost reductions and rapid scale would be incredible to catalyze in nearly every tough-to-decarbonize industry.

Next, I’ll dive deeper into how these climate tech companies are tapping into the carbon markets and what this means for other startups building the future of a decarbonized economy.

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