On 30 October 2008 the Regulation and Supervision Bureau of the Abu Dhabi government (the "RSB") published a Regulatory Policy Statement relating to certified emission reduction credits ("CERs", also known as ‘carbon credits’) available under the Clean Development Mechanism (the "CDM") of the Kyoto Protocol. The policy applies only to the power and water sector and excludes renewable energy which is to be separately considered.  

Under the proposed policy, in most cases, CER income earned by electricity and water production companies may be retained in full by those companies. However, if profits exceed a certain, pre-defined level beyond which sharing of profits would not affect the financial justification for the project, the RSB may direct a production company to share such ‘excessive or windfall’ profits with the sector’s customers, via the local utility provider (ADWEC).  

Whilst this is the first such move in the Middle East, it is noteworthy that Governments in other jurisdictions are beginning to regulate income streams from CDM projects. In China, for example, a floor price for credits is set by the National Development and Reform Commission (NDRC) (currently €8 per CER). The Chinese government is also entitled to a share of the profits on sale of credits (65% Hydroflurocarbon and Perflurocarbon Projects; 30% Nitrogen Dioxide Projects; 2% Renewable Energy).  

It is important for investors to note when assessing the economics of CDM projects that a government could initiate intervention in the CER market or alter ways in which it currently intervenes by introducing new measures in the future.  

Background: the CDM  

The CDM is an arrangement under the Kyoto Protocol allowing industrialised countries which have committed to reductions in greenhouse gas emissions (referred to as Annex B countries in the Kyoto Protocol) to invest in projects that reduce emissions in developing countries as an alternative to more expensive emission reductions in their own countries.  

The CDM is supervised by the CDM Executive Board and is under the guidance of the Conference of the Parties of the United Nations Framework Convention on Climate Change ("UNFCCC").  

The CDM allows emission-reduction (or emission removal) projects in developing countries to earn CERs, each equivalent to one tonne of CO2. These CERs can be traded and sold, and used by industrialized countries to meet a part of their emission reduction targets under the Kyoto Protocol.  

The RSB's objective and consultation process

In February 2008, the RSB issued a consultation paper concerning the treatment of any income received by the Abu Dhabi water and electricity production companies from the sale of CERs.  

The RSB’s stated objective is "to provide a commercial environment conducive to the efficient development of CDM projects while at the same time ensuring production companies do not benefit from “excessive” returns to the exclusion of the sector’s customers".

Following comments received from stakeholders, the RSB issued draft proposals in June 2008, which proposed that production companies would be required to separately report their income earned from CDM projects. However, they would only be required to share any benefits with utility providers if a realised profit was shown to be excessive by reference to a pre-defined benchmark.  

This policy has now been published in final form, with a few amendments to take account of further comments from stakeholders on the calculation of relevant revenues and the appropriate level of the benchmark.  

The RSB's proposed policy  

Application of the policy  

The RSB's policy applies to all existing power and water production companies and to new or future independent water and power projects (IWPPs), unless the applicable power and water purchase agreements (PWPAs) provide that the competitive bidding process takes account of prospective CER revenue.  

The policy does not apply to renewable energy or Carbon Capture and Storage (CCS) projects which will be reviewed once the other elements of the proposed financial and regulatory model for these projects have been clarified. Whilst carbon capture is not currently an approved methodology for the purpose of the CDM, it is hoped that this position will change in time, although despite speculation that an approval of CCS would be forthcoming at the UNFCCC conference of the parties in Poland this December, approval was not forthcoming on this occasion.  

Treatment of CDM profits  

Production companies are required to obtain the prior written consent of the RSB to sell CERs generated by their projects because such sales fall outside the scope of their licences.  

The RSB's consent to the sale by production companies of CERs will be conditional on an undertaking to give ADWEC at least 50% of profits from CDM earnings over a threshold.  

To determine whether or not the threshold is met, the following procedure will apply each year:  

  •  Calculate the opening and closing net asset value for the CDM project;
  •  Calculate the average of the opening and closing net asset value ("Average NAV");  
  • Calculate the earnings of the CDM project before interest and tax ("Annual CDM Earnings");  
  •  Calculate the percentage of Average NAV that Annual CDM Earnings represents ("Applicable Percentage").  

If the Applicable Percentage exceeds 15%, on average, over any three year period, then the threshold will have been met and at least 50% of the profits over this threshold will be given to ADWEC.  

In order to establish whether the threshold has been met or not, production companies will be required to keep separate accounts for CER income and CDM costs.  

The production companies' existing licences and PWPAs will remain unchanged and payments under the fuel efficiency bonus/penalty mechanisms in existing PWPAs will be excluded from the calculation of CDM earnings. This means that where a CDM project relates to fuel efficiency, the project company will retain its upside under the PWPA in addition to potentially receiving revenue from CERs.

Comments on the proposed Policy

RSB's discretion

The policy statement is not clear as to the percentage of profits in excess of the threshold which the production companies will be required to share. The document states that this percentage will be "at least 50%".  

It appears that this wording allows the RSB the discretion to direct production companies to give ADWEC more than 50% of these "excess" profits.  

Investors may wish to discuss with the RSB the extent to which it anticipates exercising this discretion.  

Calculation of NAVs  

The calculation of the Average NAV is central to the calculation of whether the profit threshold has been reached. However, the policy does not provide detailed guidance on how the NAVs should be calculated and as to the discount rate that is to apply to the calculation.  

We assume that the discount rate that is applicable for the purposes of the PWPA will be relevant but investors may want to clarify how the RSB anticipates this calculation should be made.  

Change in Law arguments under PWPAs  

During the consultation process ADWEC took the position that revenues generated by sales of CERs would trigger the "Change in Law" provisions contained in most existing PWPAs. This was on the basis that ratification of the Kyoto Protocol by the UAE amounted to a change in law.  

If correct, this would mean that a production company would not benefit economically from CER revenue. This is because Abu Dhabi PWPAs provide that if there is an increase of revenue received by a production company because of a change in law, there will be an adjustment to the tariff payable to ensure that the production company has the same economic return that it would have had if there had been no such increase in revenue.  

The RSB has taken the view that whether ADWEC's assertion is correct is a question of the contractual interpretation of the relevant PWPAs and, therefore, not its concern and a matter for ADWEC and the production companies to agree.  

However, the RSB does say that the calculation of any entitlement of ADWEC under such provisions should take account of profits shared under the regulatory policy.  

It would be advisable for investors to consult legal advisors and thereafter reach an understanding with ADWEC on how any relevant "Change in Law" provisions will affect revenues from the sale of CERs in relation to existing PWPAs. In our view, the argument by ADWEC is not clear cut and different interpretations of the PWPAs could be formulated