Price-setting and quantity-forcing policies, by themselves, do not remove all the market barriers that may prevent many developers from financing their projects. 

Financial incentive policies are designed to provide financial and fiscal incentives for investments in renewable energy by reducing the costs of such investments. For grid-connected renewable energy technologies, the most important of these policies can be characterized¹ as falling in four broad categories: policies that:

	Reduce up front capital costs (via grants)
	Provide loans, loan guarantees and other financial assistance
	Reduce capital or operating costs (via tax credits)
	Enhance revenue streams through carbon credits

Grants

Grants to grid-connected renewable energy projects can come in the form of buy-down grants or development grants.  There are multilateral, bilateral, and national sources for these grants. 

Buy-down grants are used to lower the cost of a renewable energy project or system that is yet commercially viable but have promising potential in the long term. For grid-connected renewables, grants have most often been used to promote technology demonstration projects, but they have seldom been used to promote market applications of projects – generally because the size of the projects can lead to very high grant program costs and can cause market distortions.

Buy-down grants can come in the form of co-investment funds, which is typical for demonstration projects, or in the form of rebates, which is more common in the case of market stimulation. 

The GEF currently provides grants under several strategic Operational Programs.  Two of these directly pertain to renewable energy: OP-6, Promoting the Adoption of Renewable Energy by Removing Barriers and Reducing Implementation Costs, and OP-7, Reducing the Long-Term Costs of Low Greenhouse Gas Emitting (GHG) Energy Technologies. 

Under OP-7, the GEF is providing buy-down grants to several projects, such as fuel cell bus technologies in China, India, Egypt; solar thermal project in Mexico, and Integrated Gasification Combined Cycle (IGCC) in China. In these projects, the GEF grant is intended to help buy-down the cost of these promising low GHG-emitting technologies.

Development grants are a tool for helping to lower the high cost of development grid-connected renewable energy projects, especially in new markets, where the cost and time to development projects can be significant, amounting in some cases to millions of dollars and taking several years to complete.  Contingent development grants convert to loans if the project is successfully developed.

Under OP-6, the GEF is providing technical assistance and capacity building grants to several projects, such as theChina Renewable Energy Scale-Up Project (DOC), to remove barriers to the introduction of cost-effective renewables and increase their market penetration enough to make a sizable cut in GHG emissions.

Loans and Loan Guarantees

Loans are the primary means of securing debt capital for financing projects.  In industrialized countries where there is a technology track record and mature capital markets, long-term loans are generally available for renewable energy projects.

However, in developing countries, commercial loans may not be available because of the lack of technology experience and the level of risk perceived by the lender.  In cases where experience with the technologies exists (e.g. small hydro), the terms of the available commercial loans may not be appropriate for renewable energy projects for several reasons:

• The loan duration may be too short relative to the revenue payback of the renewable energy project
• The collateral requirements may be too severe for the project developers to meet
• The interest rate may be too high to support the returns available from the project.

To overcome these problems, various types of loan programs may be needed.  The types of programs are varied, but the more common ones include:

• Long-term loans
• Risk guarantees or partial risk guarantees to reduce collateral requirements
• Low-interest loans

The loan programs may have minimum or maximum limits, or they may limit financing to a maximum fraction of the project cost.   Sometimes these loan programs include a grant component to support the risk guarantee component or the interest rate reduction.

Bank project have implemented successful loan programs for renewable energy projects in India (file: tbd), China (DOC), and Sri Lanka (DOC).   These projects have provided financing in conjunction with commercial lending.

One of the most prominent examples is the India Renewable Energy Development Agency (IREDA), which was formed in 1987 to provide assistance in obtaining international multilateral agency loans and in helping private power investors obtain commercial loans. By 2001, IREDA had disbursed the equivalent of over US$400 million in loans for renewable energy projects in India, resulting in over 1600 MW of renewable power generation.

Tax Credits

Tax relief policies to promote renewable energy have been employed in the United States, Europe, Japan, and India.  Tax relief has been especially popular in the United States, where a host of federal and state tax policies address energy production, property investments, accelerated depreciation, and renewable fuels. State policies vary widely in scope and implementation. At least 17 states have personal tax incentives, 21 states have corporate tax incentives, 16 states have sales tax incentives, and 24 states have property tax incentives.

Investment Tax Credits

Investment tax credits for renewable energy directly reduce the cost of investing in renewable energy systems and reduce the level of risk by allowing investors to reduce their tax liability in direct proportion to the amount of tax credit they have earned.  The investor gains all the benefits in the first few years following the investment.  In the U.S. during the early 1980s, investment tax credits were use to encourage investment in grid-connected renewable energy installations.  However, there was no incentive to maintain the performance of the plant once it was installed, and this fact coupled with the lack of technology standards encouraged fraud and the use of sub-standard equipment.  For these reasons the use of investment tax credits to promote grid-connected renewable energy was generally discontinued. 

During the 1990s, India also used investment subsidies for wind energy, and these promoted large investments.  However, this policy generated concern about maintenance and long-term performance due to a lack of standards, and this was born out by lower than expected capacity factors for the early wind farms in India.

As a result of these experiences, investment tax credits are not currently favored for grid-connected renewables.    However, they are still commonly used to promote household systems such as solar hot water or PV panels, and water and space heating systems based on biomass and geothermal energy.

Production Tax Credits

Production tax credits provide investors with an annual tax credit based on the amount of electricity actually produced and fed into the electric grid.  They increase the rate of return and reduce the payback period for renewable energy projects, while rewarding producers for actual generation of energy.   Production tax credits provide investors with an annual tax credit based on the amount of electricity actually produced and fed into the electric grid.  They increase the rate of return and reduce the payback period for renewable energy projects, while rewarding producers for actual generation of energy. 

A production tax credit in Denmark provides DK 0.10/kWh (US 1.5 cents/kWh) for wind power, but few other countries have adopted similar credits. In the United States the Renewable Electricity Production Credit (PTC) provides a per-kWh tax credit for electricity generated by qualified wind, closed-loop biomass, or poultry waste resources. Federal tax credits of 1.5 cents/kWh (adjusted annually for inflation) are provided for the first ten years of operation for all qualifying plants that entered service from 1992 through mid-1999, later extended to 2001 and then to 2003. 

The PTC has been credited with driving significant capacity increases in the U.S. in the late 1990s and early 2000s.  Yet, that development has largely come only in those states with additional incentives.  The biggest problem with the PTC has been the inconsistency and uncertainty created by the federal government in dealing with the extensions of the PTC.  This has resulted in inconsistent and uneven growth in wind capacity.

In general, production incentives are preferable to investment incentives because they promote the desired outcome—generation of electricity from renewable energy.   In addition, production incentives are most likely to encourage investors to purchase the most reliable systems available, or to maintain them and produce as much energy with them as possible. Thus, production incentives are more likely to lead to optimum performance of the installed systems and a sustained industry.

At least five U.S. states have state or local production incentives for distributed electrical generation, renewable fuels, or both. These policies are similar to the federal PTC, with specific limits on technologies, dates-in-service, and maximum payout per provider and per year. Funds to support the incentives are obtained from a mixture of sources, including general funds, public benefit or environmental funds, and green electricity sales (so-called “green certificates”).

Accelerated Depreciation

Accelerated depreciation allows renewable energy investors to receive their tax benefits sooner than under standard depreciation rules. The effect of accelerated depreciation is similar to that of investment tax credits. In the United States, businesses can recover investments in solar, wind, and geothermal property by depreciating them over a period of five years, rather than the 15- to 20-year depreciation lives of conventional power investments.

India’s accelerated depreciation policy allowed 100% depreciation in the first year of operation, helping spur the largest wind power industry among developing countries. However, this policy led to large investments without sufficient regard to long-term operating performance and maintenance, resulting in capacity factors lower than for wind power installations elsewhere. This experience has contributed to the conclusion that production-based incentives are preferable to investment tax credits and accelerated depreciation, although Germany’s investment tax credits accompanied by wind turbine technical standards and certification requirements avoided the problems found in India.

Property Tax Incentives

Property taxes are generally based on the installed cost of the improvements to the property.  Therefore, if taxed at the same rate as conventional facilities, renewable energy systems, which have higher investment costs but no (or very low) fuel costs, would pay higher property taxes.    At least 24 U.S. states have property tax incentives for renewable energy. These incentives are implemented on many scales--state, county, city, town, and municipality.  These are generally implemented in one of three ways: (1) renewable energy property is partially or fully excluded from property tax assessment, (2) renewable energy property value is capped at the value of an equivalent conventional energy system providing the same service, and (3) tax credits are awarded to offset property taxes.

Other Tax Policies

A variety of other tax policies have been used in connection with grid-connected renewable energy.  These include income tax exemptions on income from renewable power production, excise duty and sales tax exemptions on equipment purchased, and reduced or zero import tax duties on assembled renewable energy equipment or on components. India, for example, has allowed five-year tax exemptions on income from sales of wind power.

Carbon Credits

The Clean Development Mechanism (CDM), an important policy instrument embodied in the Kyoto Protocol, is designed to generate both cost-effective GHG control and sustainable development benefits for host developing countries.

The CDM allows project-based GHG reductions in developing nations to be transformed into Certified Emission Reductions (CERs) which, in turn, are available to industrialized countries for use as credits against their own Kyoto emission control commitments. 

CERs produce a revenue stream for validated CDM projects that they receive only after generating emission reductions and obtaining the CERs through the CDM verification and certification processes.   However, CDM project developers often need funds or financing support during the development phase of a project, and the field of Carbon Financing has developed to facilitate the use of future CERs to support project financing.

Activities eligible for the CDM include a broad array of emission reduction measures, including renewable energy projects.    CERs can be generated through activities undertaken jointly by developed and developing countries, or through unilateral efforts by developing countries that generate CERs available for sale on an open market. 

Various institutions for supporting these opportunities are being developed or deployed worldwide, including the Carbon Finance Business at the Bank , bilateral arrangements such as the Netherlands Clean Development Facility, CER procurement programs of Austria, Denmark, Finland, Italy and Sweden as well as a number of multi-lateral initiatives.  

The Prototype Carbon Fund (PCF), the largest multilateral initiative, was established in 2000 to mobilize public and private investment in order to catalyze the market for GHG reductions.  It has also helped build capacity in both developed and developing countries by demonstrating that project-based activities represent a practical means of supporting global environmental objectives and promoting sustainable development.    By mid 2003 the PCF had committed more than $100 million to support projects in non-Annex Bnations. 

CDM Costs and Benefits

Because many abatement opportunities are less expensive in developing nations, the CDM can help reduce the overall cost of achieving global GHG reductions.   And because GHG emissions contribute equally to climate change irrespective of their geographic location, the impact on the global environment is the same. 

Activities eligible for the CDM include a broad array of emission reduction measures, including renewable energy projects.    CERs can be generated through activities undertaken jointly by developed and developing countries, or through unilateral efforts by developing countries that generate CERs available for sale on an open market. 

The process of developing CDM projects and obtaining CERs is described below.  The CDM-specific development costs vary significantly depending on the size and scope of the project, but the minimum costs are likely to total about US$50,000, which creates a problem for small-scale renewable energy projects, including small grid-connected systems.   These costs must be invested at the time of project development, but the benefits from the sale of CERs do not start to be realized until one year after start of operation.  As such, they do not provide any funds during the development process, which is often when renewable energy project developers have the most critical need for funds.

A CDM project receives a CER for every ton of carbon dioxide equivalent that the project displaces.   The Table below² provides the typical emission reductions for grid-connected renewable energy projects based on hydro, wind, geothermal solar and sustainably harvested biomass.   At a CER price of $4 per ton CO2 equivalent³ , CDM provides added revenues of 1.6 to 6.0 US$ per MWh of electricity produced depending on the type of conventional fuel displaced.  This additional cash flow generally improves the IRR on a project by only 0.5 to 3.0 percentage points.    Higher CER prices would yield proportionally higher revenues.

For renewable energy projects dealing with methane emissions, the CDM benefits are more significant, because methane has a 21 times higher GHG potential relative to CO2.  Therefore, a CER price of $4 per ton CO2 equivalent provides added revenues of 14 to 16 US$ per MWh of electricity produced depending on the type of methane gas displaced.  In addition, the projects that utilize the methane to generate electricity that displaces fossil fuels also get the fuel displacement CERs.   The total additional cash flow can improve the IRR on a these projects by more than 15 percentage points.

Projects that agricultural and forest residues can get credit for methane emission reductions depending on how the residues are currently disposed.  These projects can realize an improvement to the IRR of 3 to 7 percentage points³ .

The CDM Process

A CDM Executive Board (EB) was created by the Conference of Parties to the UNFCCC, which gave it the authority for implementing and supervising the CDM.  The key responsibilities of the EB, relative to the CDM project development process, are to:

• Approve new methodologies related to project baselines, monitoring plans and project boundaries
• Review provisions with regard to simplified modalities, procedures and the definitions of small scale project activities
• Be responsible for the accreditation of operational entities,
• Develop, maintain and make publicly available the approved rules, procedures, methodologies and standards for the CDM
• Develop and maintain the CDM registry to ensure accurate accounting of carbon credits generated - including issuance of certified emissions reductions
• Develop and maintain a publicly available database of CDM project activities

One of the eligibility requirements for CDM is that the “host” country must ratify the Kyoto Protocol and establish a Designated National Authority, or DNA, to review and approve CDM projects.  According to CDM rules, the DNA has two mandatory functions.  The DNA is responsible for issuing a written statement, on behalf of the government, confirming that (a) the country’s participation in a project is “voluntary” and that (b) a project activity assists in achieving sustainable development and is consistent with national priorities. 

All CDM projects must follow a well-defined series of steps and calculations, which must be validated and verified in order to earn certified emissions reductions (CERs).  These steps are illustrated in the figure below.

Project developers must submit their project to an independent, third party organization, called a Designated Operational Entity (DOE), which will review the project documents and “validate” the project if it satisfies all the necessary conditions for project eligibility stipulated by the CDM Executive Board. This is a necessary prerequisite for a project to receive CERs. The DOEs are similar to accounting auditors.  They must be independent and cannot benefit, in any way, from the outcomes of a CDM project.  The DOE is required to perform the following essential services in the CDM project cycle:

• Validation that the project design, as proposed by the project developer, meets all the requirements of the CDM.  The project validation work is carried out before the project is submitted to the CDM EB. 
• Registration of the CDM project with the EB.  Project proponents cannot submit projects directly to the Board.  The CDM rules state that the DOE is responsible for submitting projects to the Board.  This requirement exists to ensure that the CDM EB only receives documentation on projects that have already been “validated” by a DOE. 
• Verification of the emissions reductions that occur as a result of the project.  Verification work is done after the project starts and at fixed intervals. With the exception of SSC CDM projects, verification must be done by a different DOE than was used to validate the project.     

Certification of emissions reductions.  The DOE that carries out the verification of emission reductions is responsible for submitting a letter to the CDM EB recommending the issuance of certification for the verified emissions reductions of the project. 

CDM Project Development Steps

Step 1:      Identify eligible CDM project opportunities
Step 2:      Collect technical information to screen a project

Step 3:      Conduct preliminary screening for CDM eligibility

Step 4:       Develop a detailed project design document (PDD)
Step 5:       Submit the PDD for national approval
Step 6:       Validate and register project with CDM Executive Board (CDM EB)
Step 7:       Secure financing and implement project
Step 8:       Monitor, verify and certify project emission reductions (CERs)
Step 9:       Monetize (sell) and transfer the project CERs