Q & A on the Pilot Auction Facility for Methane and Climate Change (PAF)
What is the PAF?
The PAF is a new climate finance pilot that will support emission reductions in developing countries. It will use public resources in an efficient manner to leverage private capital in support of projects that reduce greenhouse gas emissions and are not being realized, or are at risk of being decommissioned due to the low price for carbon credits today.
The PAF 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. This gives private-sector investors, 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. 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.
How will the facility use auctions?
The PAF will use 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.
The PAF plans 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 manger 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.
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 in order to ensure maximum participation and efficiency of the auction process.
The first auction will use a reverse auction.
How does the put option work, from the perspective of a project owner?
A project owner, for instance at a landfill, may be capturing methane to use for power, and lowering methane emissions. These emission reductions may be generating carbon credits under the Clean Development Mechanism or another carbon credit standard, but the price of a carbon credit is so low today that he cannot cover the operating and maintenance cost of capturing methane.
If the project owner wins the auction, he has the right but not the obligation to sell future carbon credits to the PAF. If the price on carbon remains low, the project owner can redeem the 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, the project owner 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 a project owner an incentive to reduce methane and achieve the climate benefits.
Will the put options be tradable?
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.
It is important to note, that emission reductions currently trading on carbon markets will be ineligible – the PAF is only for future carbon credits.
Since this is a pilot, how will it be scaled up?
The PAF has 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 carbon dioxide and other climate pollutants. This model can be extended to incentivize any outcome that can be independently measured and validated.
When will the first auction take place?
The first auction will likely take place in the first half of 2015. The World Bank will announce the date of the auction, and the criteria of eligibility of the carbon credits (types of projects, countries, etc.). Training on the auction platform will be offered to bidders.
What is the role of The Climate and Clean Air Coalition in the PAF?
The partners of the Climate and Clean Air Coalition were instrumental in the design and launch of the PAF. In recognition of the synergies between the initiatives, the CCAC Secretariat has been invited to serve as an official observer on the PAF’s Participants Committee. The CCAC also helps share information to its membership on the PAF through its website: http://www.unep.org/ccac/Events/tabid/130297/Default.aspx