Market Outlook Sao Paulo, Brazil October, 2005

OECD Compliance Gap Ratifying OECD cumulative target reductions will be billion tons of carbon dioxide below 1990 levels by 2012 based on their Kyoto obligations If half emissions reductions are achieved domestically the “compliance gap” to be met through trade with developing countries and transition economies through 2012 would be 2.5 – 3.0 billion tons This compliance gap is over 10 times the current carbon purchase contract volumes reported in the 2005 market intelligence report

Current Kyoto gap of Annex II: 620 MtCO 2 e

Projected Gap of Annex II: 945 – 1116 Mt/yr

Current Kyoto gap of EU15: 228 MtCO 2 e

Sources of Supply to fill the Compliance Gap - CDM The CO2/CH4 segment – “development project” segment – of the CDM market cannot more than double for 2012 delivery i.e maximum potential is 500 million tons. CDM market needs to deliver at least 1.5 billion tons

High Demand on Project Finance Negligible Demand on Project Finance High Delivery Risk Low Delivery Risk Long Lead Times Short Lead Times High Contribution to long term low- carbon infrastructure and adaptation Low Contribution to long term low- carbon infrastructure and adaptation Clean-Coal Coal-to-Gas Large Hydro Repowering of Coal and Hydro Gas Flare Redn. Gas Transmission BioCarbon sinks Urban and Agri-biz waste Industrial Energy Efficiency CDCF-type Small-Scale Projects Perflouro- carbons N2O, HFC23 5yrs6months2yrs1yr4yrs3yrs million tons by billion tons by 2012 ?? Addition One billion CDM Tons can come from HFC23, N2O, PF6

Sources of Supply to fill the Compliance Gap - AAUs Assigned Amount Units (AAUs) - Greened AAUs and Green Investment Schemes Emissions trading with EITs (Assigned Amount Units) has to be at least 2 billion tons (the EITs have the potential to trade about 7 billion tons because their emissions are significantly below their allocation under the KP due to the economic downturn)  “Greening” the AAUs to OECD Sovereign buyers will be essential - implies about $30 billion of new investment over the next 4-5 years for every billion tons of AAUs traded  Absorption capacity for new investment may limit greening option to about 1 billion tons

Current Surplus of Transition Economies: 2,180 MtCO 2 e

Explaining the Tradable Surplus “headroom” of Transition Economies

Explaining the Greening of AAU Proposition for Eastern Europe OECD Buyers AAUs $

Funding for CDM Purchases Japan, Italy, Canada, 2 nd Phase NAPs, other OECD corporates Issue Due to late entry into force of Kyoto Protocol, and weakness of first phase of European Trading Scheme NAPs, there is significant delay in obtaining authorization of OECD Government funds to purchase CDM assets for compliance and large corporates with significant reductions obligations are late to Enter the market $bn

Potential Supply for 2012 delivery Funding for CDM Purchases On the other hand the window of opportunity for the CDM Is rapidly closing. By 2006, it will not be practical or make financial sense to develop large C02/CH4 mitigation projects to meet pre-2013 compliance obligations due to long lead times to project commissioning. By 2007, even smaller carbon-rich projects will be difficult to support using carbon revenues only through 2012 Dilemma X million for pre-2013 tons

Potential Supply for 2012 delivery Funding for CDM Purchases Anticipating new funding Options: Creation of Assets in Advance of a buyer! The strategy for maximizing CDM volume relies on creation of carbon assets for later sale wherever this is feasible, e.g. using unilateral CDM, and collaborating with Banks and other intermediaries to buy a smaller percentage of a larger number of projects wherever this is financially feasible X million for pre-2013 tons

Potential Supply for 2012 delivery Funding for CDM Purchases The strategy for maximizing CDM volume relies on creation of carbon assets for later sale wherever this is feasible, e.g. using unilateral CDM, and collaborating with Banks and other intermediaries to buy a smaller percentage of a larger number of projects wherever this is financially feasible X + y million for pre-2013 tons Creation of Assets in Advance of a Buyer

A Cautionary Note To avoid a collapse in the CO2/CH4 segment of the carbon market (and continued stagnation in investment in low carbon climate friendly energy and infrastructure) we need: Immediately implemented CDM Reform embracing capacity enhancement, process streamlining and “technology additionality” agreed in CoP/MoP A CDM Market Continuity Facility to buy post-2012 vintage CERs to guarantee 10-year contracts, combined with a OECD Commitment to grandfather CDM assets into the post-2012 era

“Technology Additionality” Proposal 48(c ) approach: “The average emissions of similar project activities undertaken in the previous five years, in similar social, economic, environmental and technological circumstances, and whose performance is among the top 20 per cent of their category.” (so far no approved CDM methodology using 48c) Flexible interpretation of 48 (c) provides an opportunity for radical reduction in CDM transaction costs and the needed regulatory certainty for developers and financiers Parallel to pre-defined baselines for small-scale projects Parties could approve in December a positive list of “additional” technologies up to an initial penetration rate. e.g. up to an agreed market penetration rate, all renewables, all demand side management efficiency activities, all landfill gas capture and composting et etc is additional…

CDM’s Contribution to Post-2012 Climate Management Regime CDM’s track record demonstrates that project-by-project approaches are incompatible with future carbon market needs of large industrializing developing countries. A future market-based mechanism for carbon trade should ensure: Very low transactions costs High transparency and simplicity in regulations defining a compliance grade carbon asset Low regulatory risk that carbon assets contracted will have compliance value, allowing forward carbon contracts to be monetized and financiers to accept carbon revenues as a real contribution to project viability and bankabiity These are pre-conditions to catalyze high volumes of transactions and investment resource flows and technology transfer These conditions would allow carbon revenues to cover the incremental cost and incremental risk of much low carbon development

Project-based vs Sectoral Mechanisms in the post-2012 era Both will be required Sectoral approaches for larger energy using economies - the only means of generating the resource and technology flows on the needed scale Project-based approaches - for smaller less industrialized countries, or for low volume sectors not amenable to sectoral approaches Neither the sectoral nor project-based approaches of the future has yet been demonstrated! This the opportunity for Technology Additionality and CDM Reform

Trading Forward without Regulatory risk to buyers x yrs agreed projected headroom against validated sectoral baseline Voluntary Sectoral Approaches are Compatible with Investment Needs Business as usual – financial least cost, market failures Credible Baseline: reflecting economically least cost domestically - independently validated against policies and measures Low Carbon Path - reflecting economically least cost with incremental financing to reduce global externality - independently validated against policies and measures