Risk and return of project-based climate change mitigation: a portfolio approach
Introduction
The Kyoto Protocol allows countries to acquire emission permits1 from projects carried out abroad. Transfers of permits from industrialised countries and countries with economies in transition listed in Annex B of the Kyoto Protocol are called Joint Implementation (JI). Through the Clean Development Mechanism (CDM), permits generated in projects in developing countries may be acquired. In many countries, domestic firms are allowed to use permits acquired via JI and the CDM for compliance with legally binding emission limits.
The economic advantage of the Kyoto mechanisms is obvious: Since the marginal abatement costs of reducing emissions of greenhouse gases (GHG) are much lower in many developing countries and countries with economies in transition (host countries), a given reduction in emissions can be achieved at much lower cost. Yet, this reasoning implicitly assumes that the risks of such projects are at an equal level at home and in the host country. Only if this is the case, low-cost abatement projects in developing countries can be superior to domestic activities. If the risks are high compared to the benefits, private companies are likely to refrain from using project-based mechanisms and rather undertake domestic mitigation measures, even if they are more expensive at first sight (Janssen, 2001; Springer, 2003).
In this paper, we present a framework for evaluating investment risks of project-based climate change mitigation. We examine projects whose return is exclusively based on the net cash flow from the emission permits generated. Key investment risks of project-based climate change mitigation are identified for six main project types. Since not all project types are affected by the same factors, diversification of investments is a promising risk reduction strategy. We present a methodology for quantifying risk and return of climate change mitigation investments and illustrate it using a sample of projects from the US Voluntary Reporting of Greenhouse Gases (VRGHG) Program.
Springer (2003) examines the risk reduction potential of diversification using data from pilot projects carried out under the Activities Implemented Jointly (AIJ) program. We extend his risk analysis and provide another illustration using a different sample of projects. We use emission reduction data from the VRGHG Program run by the US Energy Information Agency. Cost data for some of the projects in the public database have been gathered and enable us to calculate returns in terms of emissions reductions per dollar invested in each project. Substantial differences between the returns of different project types can be observed. Analogously to portfolio theory applied in financial markets, we measure project risk as the variance of project returns. The returns of the projects we examine vary strongly over time. We find that investing in a portfolio of projects reduces risk significantly compared to investments in single projects. An optimised portfolio performs up to 10 times better than single low-risk projects. This implies that carbon funds are a promising way to reduce the risks of project-based climate change mitigation.
The rest of the paper is organised as follows: Section 2 describes and compares the risks faced by investors in different types of climate change mitigation projects. In Section 3, we describe our approach and the data used. We illustrate the diversification effect for a portfolio of projects from the VRGHG program and discuss data requirements. Section 4 concludes.
Section snippets
Risk analysis
In investment analysis, risk refers to the possibility that the actual return of an investment deviates from its expected value. Risks are thus directly traceable to returns. Risks and returns can be defined in different ways depending on the perspective of the investor. In this article, we use the term “climate change mitigation project” as a general term referring to projects that either reduce GHG emissions or sequester carbon. In the following, we briefly discuss the risks of conventional
Risk diversification
One way to reduce the substantial risks involved in project-based climate change mitigation activities is portfolio diversification (Janssen, 2001; Springer, 2003). The basic idea behind it is simple: The more projects or assets an investor owns, the less he is affected by the failure of a single project. The correlation of the returns of the assets is an important parameter. The lower it is, the greater are the gains from diversification. Portfolio diversification is widely applied in theory
Conclusions
Climate change mitigation investments are exposed to price, cost, and quantity risks. In this paper, we focus on quantity risk because the other risks are more difficult to assess quantitatively. We describe environmental, technological, economic, and social factors which affect project activity levels and thus quantity risk. These factors do not influence the project activity level of all project types equally, which implies that diversification of investments is a promising risk reduction
Acknowledgements
This is a revised version of our IWOe Discussion Paper No. 99. We thank Sven Bode, Karl-Heinz Flatnitzer, Josef Janssen, Michael Rumberg, Matt Varilek, and two anonymous referees for helpful comments and discussions. The paper was written as part of the European Research and Development Project “Implementing the Kyoto Mechanisms—Contributions by Financial Institutions (IMKYM-COFIN)”. We wish to thank the companies that provided cost data for their co-operation. Financial support from the
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