The carbon finance market has experienced a backlash in recent months. Not only has the European Emission Trading Scheme experienced plunging values for carbon credits, but the certification and eligibility mechanisms for emissions reduction projects have attracted considerable levels of scrutiny and criticism. Scepticism in Europe, the lynchpin of the current carbon trading system, coincides with renewed interest among policy-makers in the US in such a system.

The current problems with the system, which have pushed politicians, development finance institutions, and carbon traders onto the defensive, obscure a larger difficulty that renewable energy producers have experienced in using carbon finance to bring their projects to fruition. Developers that have spoken to Project Finance complain of a certification regime that is cumbersome and complicated by a lack of regulatory and fiscal support for renewables.

This difficulty is not universal, however. Developers in China, India and South Korea have enjoyed considerable success in raising finance for wind and small hydroelectric projects in particular. But their counterparts in Latin America have enjoyed very little success, and those in South East Asia and Africa virtually none.

Who abates wins

Carbon finance is by design agnostic about the source of its emissions reductions credits. The central argument behind the clean development mechanism (CDM) enacted under the Kyoto Protocol is that market forces can best allocate capital towards the best sources of reduction credits. (For more background to the market, see Project Finance, October 2006).

Thus, projects that destroy emissions of HCFC 22 and 23, industrial gases that contribute to global warming by several factors greater than carbon dioxide, are cheap to implement and produce vast quantities of emissions credits, which can be bought in turn by carbon funds or European and Japanese corporates cheaply and applied to their reductions targets. This is why HFC projects account for 34% of contracted carbon credits in 2006 (and nitrogen dioxide abatement projects another 13%), while small hydro, wind, biomass, and other renewable energy projects accounted for 16% combined.

The returns available to all parties in such a transaction are simply not available to renewable energy developers, a definition that for the purposes of this discussion will exclude methane capture projects. Wind, biomass and small hydro developers all need to raise vastly larger quantities of capital for their projects than abatement or capture projects. They also tend to produce far smaller quantities of carbon credits.

Renewable energy producers simply receive credits according to the amount of carbon dioxide created by the fossil-powered generators that they displace. In many less developed markets the proposition is straightforward, since wind or small hydro power usually displaces expensive and dirty fuel oil- and diesel-fired units. Coal and gas-fired capacity, however, is likely to be more competitive in price, particularly over wind.

The regulatory framework that host governments put in place to encourage renewable energy affect not just projects' energy economics, but the ease and limits of their access to carbon finance. Developers need to scrutinise the terms of their power contracts (if any), and look at the generation mix that supplies their offtakers.

For renewables generators that dispatch into merchant markets the task is even more daunting. Assuming that a generator can offer a competitive price, it will need to access data that proves that at this price carbon dioxide producing capacity has been driven offline.

While Western commentators and NGOs have concentrated on weaknesses in the mechanisms for certifying emissions reductions from industrial facilities, energy developers can complain, with some reason, that they face a certification regime that is extremely arduous.

Vital or helpful?

Behind both, apparently contradictory, complaints lies another central factor in the carbon regime. The mechanism is designed to support projects that otherwise would not be economically viable, using a principle known as additionality, and not to reward behaviour that is already in the economic interests of the producers. HCFC-22 projects, no matter how small in capital costs, are eligible for CDM, while recycling industrial gases into lucrative secondary uses may not.

Renewable energy producers are caught in this middle ground. "I have to be very careful how I talk about our attitude to carbon credits," says one New York-based developer. "As part of our certification process we have to convince the secretariat that carbon finance is central to the economics of our project."

Nevertheless, given the quantities of credits that a wind or hydro project would produce relative to its energy sales, their capital costs, and expected gearing, carbon finance still provides a small slice of a sponsor's equity return, if any. One Chinese developer was less circumspect than his US counterpart, recently telling the New York Times that his 24MW Houxinqiu wind farm did not need carbon credits to be profitable, but that the credits were a useful source of future development capital.

There has been little sign of a change in bank attitudes towards the receipt of carbon credits and their inclusion in credit analysis. Few banks would include such credits in their of debt service coverage ratios. It is conceivable that a bank with a substantial carbon credit trading operation might provide an underwritten credit purchase agreement in support of a financing mandate, but this would likely price credits at a low level and be of benefit primarily to poorly-capitalised projects.

Xacbal goes merchant CDM

Grupo Terra's Xacbal hydroelectric project in Guatemala illustrates how marginal CDM can be to an elegible producer. Xacbal is a 94MW run-of-river hydroelectric project located in the Quiche region of the country. It is eligible for credits, both by its likely displacement of bunker oil-fired capacity, and the social and environmental infrastructure investments it has made.

Of Xacbal's $226.8 million cost, $167.4 is funded through a term loan lead arranged by Royal Bank of Trinidad & Tobago. This loan had a tenor of 15 years, an impressive feat for a merchant project anywhere, let alone one in Guatemala. It was priced at 355bp over 3-month Libor in year one, 320bp in year 2, 315bp in year three, and 300bp thereafter.

Among the lenders the lead arranger brought in were FMO ($30 million), GTC Bank ($15 million), the Central American Bank for Economic Integration (CABEI, or BCIE, according to its Spanish initials, $90 million). RBTT retained the remainder of the loan. Terra is a Honduran energy, infrastructure and telecoms group.

The deal is notable both for its tenor, but also for its debt/equity ratio of 3:1, reducing to roughly 4:1 following completion, when Terra can withdraw just over $11 million in equity. The deal's economics depend upon the receipt of energy and capacity payments on the country's deregulated power markets, whether as spot transactions or under contract. But the plant will be an exceptionally low-cost producer, demand in the country is rising rapidly, and the majority of planned capacity additions will use gas or fuel oil.

Carbon credits are not a major factor in the financing. The lead arranger's debt service coverage ratio, at 1.28x, does not factor in carbon revenue, the sponsor will not sign any offtake contracts for carbon credits until completion, and the only reference to credits comes where carbon revenues are pledged to lenders if the DSCR falls below 1.1x. This, then, is the state of the lending market: carbon credits have some value in a downside scenario.

Xacbal is just one of a slew of projects designed to take advantage of SIEPAC, the interconnection system for Central America and Mexico that is set to be complete in 2008. Cutuco Energy is proposing a combined power and LNG project for the coast of Costa Rica, while Guatemala alone has an estimated 5,000MW hydro capacity and 1,000MW of geothermal potential.

The country's incentives for renewable energy are limited to ten-year breaks on income and corporation taxes, and a break on the import duties for renewable energy generation equipment. Given the available incentives and the structure of the domestic and regional power markets, renewables is likely to mean small hydro for the foreseeable future.

Brazil and Mexico content to tinker

Neighbouring Mexico has a much more highly regulated power market: a state-owned monopoly, the CFE, at the centre, with various independent power producers operating around the fringes. Power is either generated by the CFE, sold to it under long-term contracts, or sold to larger industrials that must technically own stakes in this capacity.

Developers in Mexico have built renewable energy projects either to sell them to the CFE at completion (as short-term public works contracts, OPFs), or as self-supply contracts. While Mexico has an impressive wind resource, to date hydro has predominated, although the CFE has said that it is likely to procure wind capacity as public works contracts. A mechanism – the wind bank – exists for independent renewables producers to smooth out some of the volatility of wind and water levels.

But no direct subsidies or preferential tariffs exist, nor even a comprehensive tax credit system along the lines of the flawed production tax credit in the US. A low-cost hydro producer with an understanding bank, such as Conduit Capital's Mexhidro portfolio, can access financing, although that process was still fraught. (Search "Mexhidro" for more details). Developers operating in the country, should they sign the necessary contracts and find a willing bank, tend to view carbon revenue as an extra yield on equity, and nothing more.

Brazil, conceivably, holds out the promise of a carbon regime integrated into a tariff framework for renewables. The PROINFA scheme has brought some 200MW in wind capacity to financial close, in the form of the Ventos do Sul and Rio Fogo wind farms.

The scheme has attracted praise from developers, at these those willing to invest in Brazil, and combines generous tariffs, funded through a surcharge on electricity bills, with ready financing from the country's development bank, BNDES. Electrobras, the country's main, government-owned electricity supplier, has contracted for 1,422MW of wind capacity, 1,192MW of small hydro capacity and 685MW of biomass capacity up to the end of 2007.

Still, PROINFA is not without its critics. Not only have foreign developers attacked the Real-denominated wind tariff as too low, before muting their objections as the Real appreciated against both the Euro and the Dollar, but the development of a domestic wind turbine industry has not been fast enough to overcome restrictions on equipment imports. Enercon's Wobben subsidiary is the only domestic manufacturer, indeed the only manufacturer in Latin America.

Biomass producers avoided the first round of the scheme altogether, saying that they could obtain better prices from Brazil's standard electricity auctions. Biomass is set to receive more sustained attention under a second phase of PROINFA, for which studies are proceeding at an unhurried rate, but the feed-in tariff is likely to replaced with a mixture of generation targets and possibly a certificate-based regime.

And the scheme does not include carbon finance, since the Brazilian government has decided to retain all carbon credits at the state level. This has not pleased many developers, who say that they would prefer to be able to retain this upside, and it means that carbon funds have to deal an unusually powerful supplier. But the trade-off between credits and generous tariffs is one with a compelling logic, although biomass projects, which have to date not benefited from PROINFA tariffs, have enjoyed considerable success in getting certified for carbon credits.

Right countries, wrong banks

Emerging markets governments find it difficult to justify payments to renewable power producers given their deficiencies in infrastructure elsewhere and thus divert carbon revenue to such subsidies, providing earnings from the CDM are meaningful, and banks and lenders are comfortable with the resultant tariff framework. And unless lenders begin to assign more meaningful cashflows to carbon credits, a bankable tariff will be much more attractive.

Latin America's producers are stuck at an awkward stage of development, with only Brazil's BNDES fulfilling the role of a powerful and active long-term domestic lender to renewable power producers. Mexico's Mexhidro turned to Scotia Inverlat, a domestic subsidiary of a Canadian lender, while Guatemala's Xacbal turned to RBTT, a Trinidadian lender, if one with a growing Central American franchise.

Banking is not the only obstacle to getting projects off the ground, since the aforementioned lack of subsidies, as well as a difficulty in procuring cheap wind turbines or providing lenders with suitably robust wind or hydrological data are also factors. Latin America and Africa, conspicuously, do not have as many wind turbine and solar panel producers as China and India.

Chinese and Indian producers also have ready access to debt, or the capacity to raise it on a corporate basis if need be. Tata Power, for instance, recently closed a Rs352 crore ($79.3 million) loan with the Asian Development Bank for two wind projects in India. The 100MW portfolio was also financed with Rs91 crore from the Indian Renewable Energy Development Agency. Chinese developers can access cheap debt funding from state-owned banks, and get a tariff that is simply mandated by the state's National Development and Reform Commission.

Korea has also enjoyed success in promoting renewable projects, since in 1992, when Kyoto was signed, it was still considered an emerging market. Several wind producers have closed export financings for wind projects, and Korea also experienced its first large-scale solar financing. All of the above projects benefit from generous tariff regimes, whereby the government compensates buyers of power for the difference between its announced tariff for renewables and the market price of power.

A Korean wind project, Gangwon, was one of the first large-scale renewables projects to reach financial close after Kyoto came into effect in February 2005. Sponsored by Unison, the plant raised a Eu36 million EKF facility from BNP, a W40 billion backed by a Kemco liquidity facility, and a Eu27.7 million uncovered loan. The project gained CDM certification in March 2006.

Most recently, Dongyang Engineering and Construction secured $140 million equivalent in Won-denominated debt for the 20MW Sinan-gun solar project. The providers of the debt, split into $120 million senior and $20 million junior tranches, were SC First Bank, Kumho Life Insurance, Tong Yang Life Insurance, National Federation of Fisheries Cooperatives, and Kwang Ju Bank. Sinan-gun has not yet applied to the CDM secretariat for consideration, but should be eligible.

The most perplexing hold-out from the global carbon market is South Africa. The country boasts a vibrant local banking sector, a creditworthy national power company, Eskom, a small high-technology sector, and huge amounts of coal capacity to displace. But so far, it has yet to produce any large-scale renewable energy CDM projects. According to development bank officials familiar with the country, South Africa's hinterland, the other countries of Sub-Saharan Africa, will also need to develop as hosts of CDM projects, but that process will take time.