Innovation in Climate Finance

October 2015 - On July 15, 2015, the Pilot Auction Facility held the first-ever auction of price guarantees for carbon credits from projects that reduce methane emissions. The auction attracted 28 bidders from 17 countries across the globe. There were 11 auction rounds. At the end of the auction, 12 bidders were left standing to purchase 8.7 million carbon credits worth of guarantees with a strike price of $2.40.

The origin of an innovative facility

Urgent action is needed to limit climate change, reduce greenhouse gas emissions, help countries build resilience and prepare for a world of dramatic climate and weather extremes. Public resources are limited and the collapse of carbon prices has removed an important incentive which encouraged the private sector to invest in clean technology projects. It has also left many projects that reduce greenhouse gas emissions at risk of being decommissioned.The Pilot Auction Facility for Methane and Climate Mitigation (PAF) was created as a result of a report from the Methane Finance Study Group, an international group of experts convened in 2012 at the request of the G8 to review innovative financing approaches to methane abatement. In its design and development phase, the PAF also benefited from the support of Partners in the Climate and Clean Air Coalition. The Methane Finance Study Group identified 1,200 methane projects that were at risk of being decommissioned due to a low price of carbon credits. At the same time, the additional revenue required to unlock these investments and to allow continued operations was found to be small. The Study Group estimated that, across all developing countries, methane-reducing opportunities could entail a reduction of as much as 8,200 million tCO₂e at less than $10 per ton in incremental cost financing. The PAF aims to stimulate investments in these types of projects by providing a guaranteed minimum price for their carbon credits. This guarantee is backed by the resources in the facility, which is hosted in and managed by the Word Bank Group. As of July 1st, 2015, the PAF had received $53 million in contributions from Germany, Sweden, Switzerland and the United States, and has a total funding target of $100 million. The PAF innovates by using an auction to set the level of its price guarantees and to allocate them. The competitive nature of the auction determines the minimum price required by the private sector to invest in climate mitigation projects, therefore maximizing the impact of public funds and achieving the highest volume of climate benefits per dollar. The winning bidders must pay a ‘premium’ to purchase the price guarantees, an important feature to make sure that they have “skin in the game,” a financial incentive to deliver the carbon credits.

A World Bank bond creates a price guarantee

The World Bank issues a special type of bond to deliver the price guarantee, with the premium being simply the bond purchase price. Under the terms of the bond, the bondholders will have the right, but not the obligation, to sell the carbon credits generated by their climate-friendly projects to the PAF at the guaranteed price determined by the auction.This option gives bondholders a choice: If carbon prices in international markets rise above the guaranteed price, bondholders will simply sell their credits to the market, and the PAF will have achieved its objective (to stimulate private sector investment in mitigation) at no cost to it. If carbon prices remain low, the bondholders will sell their ERs to the PAF at the price determined by the auction. Another attractive feature of these bonds is that they can be freely traded after they are issued. This means, for example, that if the buyer of the bond has a project that is not generating the volume of carbon credits anticipated, he can sell the bond to another developer who thinks his project will generate eligible ERs and can make use of the price guarantee. This tradability maximizes the likelihood that the PAF will achieve its full potential to reduce emissions.

The details of the first auction

The auction on July 15, 2015 was structured as a reverse auction, where bidders bid down the level of the guaranteed price, or strike price, while the premium is fixed. A few months before, the PAF had announced the criteria which specified the types of carbon credits that would be eligible to be redeemed for payment of the price guarantee. The first auction focused on Certified Emission Reductions (CERs) issued from methane-reduction projects at landfills, agriculture and wastewater sites. Many of these projects are located in Brazil, India, Indonesia, Malaysia, Mexico and Thailand. Over the preceding nine months, the PAF team held several workshops in these countries, as well as webinars and informational campaigns, and maintained an active website, in order to ensure a strong and competitive participation in the auction.The first auction had a budget of $25 million. In other words, the auction could allocate a maximum of $25 million worth of price guarantees (e.g. 5 million CERs at $5 per CER). The auction offered a series of bonds to be redeemed annually over a five year period. To ensure multiple winners in the auction, bidders were not allowed to purchase more than 2 million CERs worth of price guarantees. The starting price of the auction was set at $8.00 per CER and the premium at $0.30 per CER.As the date of the auction was announced, 90 firms or individuals who had previously expressed interest received a Bidder Application Package to participate, and were given four weeks to return it completed. The PAF Secretariat received 33 applications before the June 25th deadline. To ensure that only serious bidders would be qualified to participate in the auction, applicants were required to provide a $0.06 per CER refundable deposit. The deposit, wired by the applicant, determined his maximum eligibility as a bidder. For instance, a firm depositing a bid deposit of $60,000 was able to bid for a maximum of 1 million CERs. After the auction, these deposits were returned to the unsuccessful bidders, while the winners wired the additional required amount to buy the bond at its $0.30 per CER price. The PAF also performed an integrity due diligence review of applicants to mitigate any reputational risk associated with them.Of the 33 initial applicants, 28 firms from 17 countries were officially qualified to participate in the auction and started receiving training from NERA Economic Consulting, the auction manager. The training consisted of manuals, a webinar and a simulated auction during which bidders could familiarize themselves with the platform.

The auction day

On July 15, 2015, an hour before the start of the auction, bidders were allowed to place a “proxy bid”, letting the software bid for them automatically after they had indicated up-front the minimum price they were willing to accept. This feature is useful for bidders who are not interested in bidding, or otherwise couldn’t participate in the live auction, perhaps because they live in a remote time zone. The active bidding started at $8.00 per carbon credit and bidders got 15 minutes to indicate how many put options they were willing to buy at that level of the price guarantee. Initial demand was robust, at over 22 million tons of carbon credits. At each successive auction round, the auction manager announced a lower strike price, and bidders were prompted to indicate what quantity of CERs they were still ready to deliver at that current price. Bidders progressively reduced their demand or altogether dropped out as the price per CER went down. It took 11 rounds to reach the end of the auction, where the demand of put options went just under the auction budget. Twelve bidders were left standing to purchase 8.7 million CERs worth of guarantees at $2.40 per CER.

Future auctions and scale up

The first auction shows that there is a robust and competitive demand for the price guarantees offered by the PAF. The PAF has already started working on its next auction, which could test a different approach, such as a forward auction where the premium is bid up and the strike price, or guarantee price, is set by the auction manager. This is consistent with the learning objective of the PAF, which is to test different approaches and share lessons learned. These piloting auctions will showcase the potential of the PAF as an innovative climate finance mechanism. The World Bank Group is looking forward to the potential for major impact through replication and scaling up, including through the Green Climate Fund and other public funders. Scaled-up versions could, for example, reduce greenhouse gases like carbon dioxide and other climate pollutants. On a greater scale, this is a model can be used to incentivize any outcome that can be independently measured and verified.

Scott Cantor and Brice Quesnel, The World Bank

This article was published first in Carbon Mechanisms Review 03/2015