Financing mechanisms
The funding mechanism for a carbon project depends on several factors. The type and scale of a project play a key role, as large-scale infrastructure projects may require debt financing. Additionally, the level of risk involved can influence the choice of financing, with high-risk projects often requiring a combination of methods. Market conditions also shape the project’s attractiveness to investors, impacting funding decisions.
The five main methods through which carbon projects are funded are forward purchase agreements, derivatives, equity financing, debt financing and lastly, grants and donations.
1) Forward purchase agreements (FPAs)
A forward purchase agreement (FPA) is a contract between a company generating carbon credits and an end buyer or intermediary. It specifies the purchase, payment and delivery of an agreed-upon number of credits at a future date under specific conditions.
The cost of capital is determined by four main factors:
Current demand and price of carbon credits.
The expected future price of carbon credits.
The credit worthiness of the company generating the credits. High creditworthiness, indicating a lower perceived risk of default, reduces the cost of capital for companies pursuing financing through an FPA.
The payout structure.
There are different types of payout structures in forward purchase agreements.
a) Payment up-front
In this structure, the company generating the carbon credits receives the entire value of the FPA at onset from the buyer of the credits. This provides the company with immediate cashflow.
Pros: Access to adequate funding enabling the company to make large investments and scale the project rapidly.
Cons: Higher cost of capital since the funder will have to factor in default risk1. The company will also have to put in a lot of effort to convince a funder to make the payment upfront.
b) Payment at predefined milestones
The company only receives payment from the buyer or intermediary once specific milestones have been met. For example, the first payment could be made after completion of the feasibility study, another one once verification is complete, etc.
Pros: A predictable revenue stream for the company generating the carbon credits. The company also has the ability to raise further investments based on guarantee payouts on every milestone.
Cons: Significant reporting at each milestone. The company also faces pressure to meet milestones within the agreed deadlines.
c) Payment upon carbon credit delivery
Payment is made only when carbon credits are delivered. This means that the company generating the credits will have to fund all the project’s development costs before credits are realized and payments made.
Pros: Lower cost of capital. The FPA can also be used as a guarantee of future revenues to secure loans from other financiers.
Cons: The company would have to raise upfront capital elsewhere. Additionally, there is a risk that the funder will default on making the agreed payment once carbon credits have been generated. There is also pressure on the enterprise’ side for them to deliver credits in order to receive payment.
2) Carbon derivatives (futures and options)
A financial derivative is a type of financial contract whose value is dependent on an underlying asset, in this case, carbon credits. They are agreements set between two or more parties that can be traded on an exchange or over the counter (OTC). Derivatives are traded to hedge against risk.
Commonly traded types of carbon derivatives are futures and options.
a) Futures
A futures contract, or simply futures, is an agreement between two parties for the purchase and delivery of an asset (carbon credits) at an agreed-upon price at a future date. Futures are standardized contracts that trade on an exchange.
Traders use futures to hedge2 their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset.
For example, consider a case of two companies, Simba and Nyati. Simba intends to buy carbon credits sometime in the future, to offset emissions that they are not able to abate. Nyati, on the other hand, is a company based in Kenya, engaging in biochar CDR. Simba decides to buy carbon credits derived from Nyati’s biochar CDR project. Given the rising demand of biochar CDR carbon credits, Simba has a feeling that the price of credits will continue to rise. The company immediately enters into a futures contract with Nyati to buy 10K carbon credits at €56.5 per credit, to be delivered in 6 months. Buying a carbon credit contract hedges Simba’s risk because Nyati is obligated to deliver carbon credits to Simba for €56.5 per credit once the contract expires.
Assume that at the end of the 6 months, the market price of biochar carbon credits is €76.5 (+ €20) per credit. Simba can choose to either accept delivery of the carbon credits, or sell the futures contract before expiration, making profit.
b) Options
Options are similar to futures in all aspects, except that in the former, the buyer is not obliged to exercise their agreement to buy the carbon credits. Options provide the buyer an opportunity to buy the credits, but not an obligation. The contract holder pays a premium for this right.
Referring to the previous example. Assume both companies (Simba and Nyati) enter into an options contract, with the same terms as the futures contract. Simba could buy a call option that gives them the right to buy the carbon credits at €56.5 per credit, which is known as the strike price. Let’s say the option costs €2 per credit.
If at the end of 6 months, the cost per credit falls to €46.5 (-€10), Simba can choose to not oblige to the options contract and buy the credits elsewhere at this price, losing only the premium paid to get into the contract (€2 per credit). If the price is higher, say €76.5 (+€20), Simba is very lucky. They get to buy credits worth €76.5 per credit at only €56.5 per credit. If Simba decide to sell the carbon credits, they would end up making a profit, even after factoring in the cost of getting into the contract (€2 per credit) and other miscellaneous costs.
3) Equity financing
Equity financing agreements involve investors gaining partial ownership of the company that is developing the carbon project in exchange for providing up-front capital. As a result, the investors will have access to revenue from future carbon credit sales and any other revenues.
If the company or the carbon project fails, the investor also shares in the losses. Therefore, the investor takes a higher risk when providing equity financing, resulting in a higher cost of capital. A strong business plan with high expected profits can convince equity investors to assign a higher valuation to the company and provide more capital for less equity.
Pros: The company gets up-front financing without the burden of debt repayment.
Cons: The company loses partial ownership and/or control over the businesses. There is also a high cost of capital to account for high investor risk.
4) Debt financing
Debt financing involves a lender, such as a bank, providing funds to a company developing a carbon project with the expectation of repayment with interest. To de-risk the loan, financiers will generally require collateral that can be seized if repayment obligations are not met. Repayments can be done in cash or by carbon credits, depending on the agreement between the company and the funder. Repayments should start once the company starts generating the credits.
The cost of capital depends on the creditworthiness of the company, the quality of the business plan, the repayment terms and the central bank’s interest rate. Debt financing has lower risks3 for the financier and a lower cost of capital than equity financing.
Pros: Companies do not lose ownership of their business and/or carbon credits. Additionally, their credit score gets better if they make their payments promptly, improving their credit history for future loans.
Cons: Companies have to make ongoing payments, whether or not they experience challenges developing the credits. They also have to present an asset to be used as collateral, which could be very risky.
5) Grants and donation financing
Grants and donation financing involves a company funding the development of their carbon project through grants and donations.
Pros: The company does not have to repay the payments made and the financiers offering the grants or donations do not get ownership of the company or the credits generated. There is also no cost of capital.
Cons: Grants and donations are not sustainable in the long run since they are one-off or limited payments rather than ongoing revenue streams.
Footnotes
The risk that the company will not fully comply with the terms of the FPA e.g. by failing to provide the credits it promised.↩︎
to mitigate or reduce risk↩︎
Since the lender starts receiving payment (interest only or interest + part of the capital) as soon as the company starts generating the credits. The lender can also sell the collateral to recover payments.↩︎