Vikram Widge heads the World Bank Group’s Climate and Carbon Finance Unit. He spoke from the UN Climate Summit about the new Pilot Auction Facility for Methane and Climate Mitigation (PAF).
Q. U.S. Secretary of State John Kerry and the Swedish Energy Agency just pledged $15 million each for the design of a new facility called the Pilot Auction Facility for Methane and Climate Mitigation. What is the PAF?
The World Bank Group is designing a new climate finance pilot that will support emission reductions in developing countries. Because of limited public resources available for climate investment, this facility leverages private capital to support projects that reduce greenhouse gas emissions and are at risk of being decommissioned due to the low price for carbon credits today.
The facility tests an innovative contract structure by offering put options through an auction to guarantee a minimum price for carbon credits that a project will generate, which gives private-sector buyers, such as projects developers and intermediaries, the security of knowing that they will be paid for investments they make to lower emissions.
In its first phase, the facility targets projects that reduce methane, possibly in landfill, animal waste, and wastewater projects. Methane contributes to the formation of ground-level ozone pollution which is a major ingredient in urban "smog" that is toxic to plants and crops, threatening food security. It is also damaging to lungs, causing asthma and even heart attacks.
Q. How will the auction work for you if you are a project manager?
Say you manage a landfill and you have been capturing methane to use for power, instead of letting it be released into the atmosphere. These emission reductions have been generating carbon credits under the Clean Development Mechanism, but the price of a carbon credit is so low today that you are not even able to cover the operating and maintenance cost of capturing methane.
The World Bank will announce an upcoming auction and provide training on how it works. Once the requirements and criteria of the auction are set, it is decided whether or not your future carbon credits will be eligible for this specific auction, and it commences.
If you win the auction, you have the right but not the obligation to sell your future carbon credits to the PAF. If the price on carbon remains low, you can redeem your put option and sell the credit to the PAF at the strike price, which was determined by the auction.
If the price on carbon goes up, however, you can decide not to redeem the option and sell the carbon credits to anyone else who is willing to buy them.
Either way, the price guarantee gives you an incentive to reduce methane and generate the climate benefits.
Q. How will the facility use an auction to put a price on carbon?
The PAF plans to test auctions to sell put options that will specify a minimum price (also called a put option strike price) for emission reductions that meet certain criteria, defined up front. This is the price at which the facility guarantees to purchase future carbon credits from put option owners.
There are several ways to use auctions for this and we plan to test two types of auctions:
In a reverse auction, the guarantee price, or strike price, is what is being auctioned, and it is bid down. The starting price of the auction is set by the auction manager, which in this case is the World Bank Group. During the auction, several private-sector entities bid on the put option, finally reaching the lowest price at which they would be willing to sell their carbon credits in the future.
A premium – what the winning bidder pays to buy put options – is set by the auction manager and announced ahead of the auction. It will be significant enough to make sure that the bidder has “skin in the game,” a financial incentive to deliver the carbon credits, but not so large as to discourage those with fewer resources to participate. The premiums paid are invested in the facility to be used to support future auctions.
In a forward auction, the premium is bid up and the strike price, or guarantee price, is set by the auction manager. The strike price would be set close to the actual abatement cost of the technologies or sectors targeted by the auction round in order to ensure maximum participation and efficiency of the auction process.
Q. How is the strike price determined in a forward auction?
The strike price will be set based on knowledge of the market and data points provided by recent public tenders for emission reduction credits.
Q. Will the put options be tradeable?
Yes, in fact this is an important aspect of the auction. The put options will be tradable, which allows the holders to transfer ownership. This might be of interest to someone who bought put options thinking their project would generate a certain volume of emission reductions and, for whatever reason, it does not meet its targets. That holder can sell the options to others who have a better chance of delivering emission reductions. This will maximize the likelihood that the pilot achieves its full potential to reduce emissions. We are currently finalizing the design and should be able annonce soon how we expect to deliver these put options in a manner that make them accessible to project owners and can be delivered and traded efficiently.
It is important to note, that emission reductions currently trading on carbon markets will be ineligible – this is only for future carbon credits.
Q. Is the PAF increasing the oversupply in the carbon market?
No, the emission reductions will not be resold into the market. They will either be cancelled or used by donors for voluntary national goals. They will not be used as offsets for compliance with internationally agreed goals.
Q. Since this is a pilot, how do you envision it scaling up?
The PAF has the potential for major impact through replication and scaling up by the World Bank, the Green Climate Fund, and other public funders. We see scaled-up versions targeting projects that, for example, reduce carbon dioxide and other climate pollutants. In fact we think the model can be extended to incentivize any outcome that can be independently measured and validated.
Q. When will the first auction take place?
The first auction will likely take place in the first half of 2015, when funds from donors have been transferred to the facility and the mechanics of the auction have been set up.
Q. Who are the donors that will contribute to the PAF?
Four governments are joining the initiative. Germany was the first to announce its pledge of up to EUR15 million last week. As you mentioned, this week, Sweden and the United States announced pledges of $15 million respectively.
Other governments have shown interest in contributing, and of course the facility is open to contributions from governments, foundations and the private sector.