Peter Weisberg, The Climate Trust
June 27, 2017
Only by leveraging private finance can we approach the scale of capital needed to address climate and conservation challenges. California, through its work to mitigate dairy methane emissions, is poised to demonstrate how to generate that leverage.
California, by law, must reduce dairy and livestock methane emissions by 40 percent from 2013 levels by 2030. To meet these goals through the installation of anaerobic digesters, the Air Resources Board’s Short Lived Climate Pollutant Reduction Strategy provides rough scenarios in which California would need to digest manure from approximately 1 million cows, investing approximately $1.7 billion dollars to process manure from 540 dairies. Dairy Cares, which represents the California dairy industry, estimates that between 100 and 200 digesters will need to be built; California currently has 11 operational digesters. Meeting these methane requirements is therefore a massive investment challenge.
Dairy farmers are price takers. If mitigating methane emissions to meet these requirements increases California farmers’ cost of production, they cannot pass the cost along to their consumers. Dairies will simply leave the state (because California’s dairies are particularly efficient producers, this “leakage” will likely increase emissions of methane per unit of milk produced and therefore global emissions). Business models that generate a return on investment are therefore key to meeting these goals.
Given the currently uncertain economics of digester projects, to incentivize the investment of this $1.7 billion into new digester projects, public support is currently needed. CalRecycle and California Department of Food and Agriculture (CDFA) estimate direct state investments or incentives of $100 million per year for five years is needed to build the manure management infrastructure needed. While we are still far from this scale, the California 2016/2017 budget allocated $50 million (in funds raised through California’s cap-and-trade system) to the CDFA to support Methane Reductions at dairies.
CDFA is currently working to distribute this funding as upfront grants to projects. According to CDFA’s Request for Grant Applications, “CDFA will fund those projects that produce the highest results in permanent annual greenhouse gas emission reductions.” Given the scale of the reductions required and the limited amount of public funding currently committed to the challenge, providing upfront grants to projects in anticipation of their future emission reductions is a risky method to achieve this goal.
Here, I propose two other models, pay for performance contracts that would provide greater certainty that public funding is spent on achieving methane reductions, and a buyer of last resort structure to further leverage existing environmental markets and private capital.
Managing risk through Pay for Performance
Under the existing grant making framework, projects are evaluated based on a projection of the greenhouse gases they can reduce over their life. Pay for performance or pay for success mechanisms instead make payments for the delivery of verified outcomes, in this case verified reductions in methane emissions. By replacing grant-making with pay for performance, Californians know their dollars are being spent on actual, not projected, reductions.
As outlined in the Conservation Finance Network’s market making framework, pay for performance structures can take a long time to develop. In the market formation and development stage, projects must develop a protocol to measure and verify the methane reduction. Thankfully, California has already done this hard work through the existing livestock protocol currently used for the cap and trade system. CDFA’s tool to forecast a project’s anticipated methane reductions to allocate its grant funding is based on this tested and credible protocol, “with some modifications to allow for the calculation of anticipated net greenhouse gas reductions.”
Environmental Incentive’s Pay for Success Strategies for Western States technical brief articulates criteria for how to choose between grant-making and pay for success incentive structures. Grant-making works well when a quantification methodology to measure outcomes does not yet exist, the public funding is a one time effort, outside project finance is not necessary, there is high certainty that grants will deliver results, and quantifying the outcome of the grant-making is not necessary. California’s work to develop digesters instead meets all the criteria for successful pay for performance programs: California is gearing up to make large amounts (~$500 million) of repetitive funding available to projects, private finance will still be key to meeting the overall investment goal, and past grants to digesters have often led to projects that are not managed successfully (see, for example, California Energy Commission’s Anaerobic Digester Implementation Issues report).
Using a grant-making framework places all the risk on the grant-maker (and the California citizens they represent) of whether or not the projections for methane reductions actually come to fruition. As we have learned from past grant-making programs, when passing this execution risk to grant-makers with little oversight and limited accountability for results, investments struggle and risks are improperly managed. A pay for performance mechanism shifts this risk back onto the entities in the best position to manage it. Private investors and lenders would provide the finance needed for projects to get built and generate actual methane reductions; developers and their investors would now be responsible for ensuring the projects are properly built and managed. Beyond improving project management, pay for performance can also greatly reduce the transaction costs associated with managing the public funds—as detailed project-by-project reviews are no longer needed. It also promotes developers that can build the most effective and efficient projects—not those developers that are good at writing grant applications and then waiting for award announcements to begin implementation.
Finding leverage through Buyer of Last Resort mechanisms
Shifting from grant-making to pay for performance alone is still insufficient. Because the government is using its public dollars to make payments for verified methane reductions, the total impact of the program is limited by funding. As in so many other conservation challenges, less funding is available than what is actually needed to meet climate and conservation goals. Finding leverage is therefore key.
Yet again, California is in an excellent position to generate that leverage. Through its cap and trade program and Low Carbon Fuel Standard, existing environmental markets for purchasing methane reductions (either as California Carbon Offsets or Low Carbon Fuel Standard credits) are up and running today. Yet, these markets face one fundamental challenge: their long-term future is in question, because they are created by policy and therefore could be taken away by policy. When evaluating the potential value from these markets, investors and lenders therefore heavily or entirely discount the revenue that they can generate. In this way, the catalyst of this payment for methane reduction is severely weakened.
Instead of substituting for these environmental markets and using public funds to purchase methane reductions, California has an opportunity to bolster the California Carbon Offset and Low Carbon Fuel Standard markets by mitigating the risk that these markets will go away. First and foremost, it can do that by establishing long-term policy with mechanisms to guarantee minimum value (like the price floor in the cap and trade market). However, while this risk is outstanding, California has an opportunity to use public funding as a buyer of last resort. In buyer of last resort mechanisms, a public entity agrees to purchase the verified benefit (in this case, verified methane reductions) at an established minimum price in the event that no other buyer can be identified. For digester projects, this could be established by giving project developers a put option, which gives digester project developers the right, but not the obligation, to sell California Carbon Offsets or Low Carbon Fuel Standard credit to the public buyer at a minimum price. With this price assurance in hand, project developers can convince lenders and investors to value the long-term revenue that these emerging and complex environmental markets can generate over time.
The law requiring California’s steep methane reductions acknowledges the significant potential for buyer of last resort mechanisms to leverage private capital and reach scale. It requires the development of a “pilot financial mechanism” to mitigate the long-term uncertainty associated with environmental credits. The Air Resources Board is currently studying the different potential mechanisms that can be used to achieve this goal—including the Contracts-for-Difference policy studied by the International Council on Clean Transportation and the World Bank’s Pilot Auction Facility.
California’s goals are laudable. The Air Resources Board acknowledges that public resources will be needed to meet them. Using these scarce public resources efficiently is key. Grant-making simply places too much risk on the public. Instead, we need to demonstrate that public funding can be intelligently managed and leveraged, by relying on pay-for performance and by recognizing the opportunity for leverage that is offered by buyer of last resort and other credit enhancement structures.
California is early in raising revenues through carbon pricing to be reinvested in climate mitigation. Intelligent and efficient use of these funds will build public trust in the reinvestment process to mitigate climate change, increasing the political will to follow California’s model in other jurisdictions. Let’s hold the investment of these dollars to a high standard and demonstrate public funds can be leveraged to accomplish the enormous investment challenge ahead of us to meet stringent climate goals.
Image credit: Flickr/NRCS Oregon