MAS and McKinsey Consider High-Integrity Carbon Credits as Complementary Financing Instrument to Facilitate Early Retirement of Asia’s Coal-Fired Power Plants

10 September 2023

On 26 September 2023, the Monetary Authority of Singapore (“MAS“) and McKinsey & Company (“McKinsey“) jointly released a working paper titled “Accelerating the early retirement of coal-fired power plants through carbon credits” (“Working Paper“).

The Working Paper explores the potential of and the challenges in using a new class of high-integrity carbon credits, termed transition credits, as a complementary financing instrument to accelerate and scale the early retirement of coal-fired power plants (“CFPPs“) without attempting to redefine a transition credit methodology, with its development being explored by other standard setters. Such carbon credits generated from the early retirement of CFPPs and its replacement with renewable energy can be differentiated from traditional classes of avoidance credits. The Working Paper also identifies the requirements to develop a high-quality market for transition credits.

The Working Paper uses an integrated framework to examine four key areas that influence the effectiveness of retiring a CFPP early using transition credits, highlights likely hurdles, and suggests practical solutions. It proposes an end-to-end approach from project inception to project development. The solution framework encompasses transactional considerations that principal stakeholders such as capital providers, carbon credit off-takers, power off-takers and renewable energy asset owners have to take in.

Briefly, the findings in the four key areas examined are set out below.

(a) Quantifying the economics of early retirement of CFPPs. The Working Paper highlights the necessity to determine the extent of the economic gap that could potentially be closed by capital from transition credits and the financing required for the transaction to be viable. A detailed financial analysis would include cashflow projections and pricing analysis as key components. A comparison of the economics between two implementation models: (i) early retirement at a specific year; and (ii) gradual rampdown of CFPP operations ahead of retirement, showed that while the latter allows for the earlier issuance of transition credits, it increases the economic gap and the complexity in estimating year-on-year reduced emissions.

(b) Leveraging transition credits as an instrument for early CFPP retirement. The Working Paper considers how to make such transition credits a credible financing tool. It emphasises that transition credits must be aligned with the Core Carbon Principles (CCP) set out by the Integrity Council for the Voluntary Carbon Market (ICVCM), including adherence to the principles of permanence and additionality.

A corporate’s voluntary action to offset emissions and a government’s emission reduction needs could drive demand for carbon credits. As such, it is important to curtail uncertainties regarding the credibility of such transition credits. This will help accelerate credit issuance and even earlier offtakes through: (i) a gradual phase-out of CFPP operations; and (ii) more aggressive retirement timelines. Approaches suggested to unlock buyers’ demand for transition credits include: (i) auction for forward sale of credits; (ii) early offtake agreements; and (iii) set up of buyer alliances or advanced market commitments.

(c) Addressing and mitigating key transaction risks. Transition credits will only be issued at the time of the CFPP’s retirement. However, pre-issuance financing stretching over a long-time horizon is often needed to secure a CFPP for early retirement and for the remaining operational life of the CFPP prior to complete retirement. The Working Paper identifies three broad categories of barriers to financing the early retirement of CFPPs: (i) ensuring sufficient principal protection; (ii) ensuring the stability and attractiveness of returns; and (iii) ensuring the financing is aligned with net zero commitments. It is proposed that a combination of different undertakings could enable greater market adoption of transition credits. These include the relevant government’s agreement to enforce CFPP closures or insurance solutions to mitigate political risk that may lead to delays in transition credit generation.

(d) Ensuring a “Just Transition”. During the project design and execution, socio-economic factors must be assessed and measures implemented to mitigate the potential harm to livelihoods and local communities caused by the early retirement of the CFPP. The Working Paper proposes the incentivisation and encouragement of stakeholder collaborations and the creation of rigorous governance, structures, and appropriate safeguards to ensure a Just Transition for all. A Special Purpose Vehicle (SPV) could be a form of high-integrity transaction structure that co-facilitates the refinancing of existing debt and the development of transition credits, while accommodating the cost variation already observed in existing energy transition programmes.

The Working Paper is paired with a transaction template which contains detailed steps and sample tools for market participants to assess and execute such transactions. The template includes a cashflow model to calculate the economic gap that could potentially be covered by transition credits and a list of standardised documents to execute the transaction.

MAS calls for interested parties to join a coalition of partners to further validate and refine the proposed transaction approach and identify suitable CFPPs to pilot integrating transition credits into the early retirement of the CFPPs.

Click the following links for more information (available on the MAS website at www.mas.gov.sg):