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Tontitown: the financial test

One of the most intuitively appealing additionality tests is also among the most controversial with environmental policy types. The financial test asks whether the revenue from carbon offsets are enough to tip the budgetary scales so that a money-losing project becomes breakeven or profitable.

Deep down, this is what most of us believe additionality is all about. If wind energy were cheaper than coal-fired energy, offsets wouldn’t serve any purpose. Everyone would just build wind farms and sell their cheap, clean electricity into the grid. Or so the logic goes.

In reality, financial additionality tests are controversial in the policy community for at least two reasons.

The first, and major, reason is that financial additionality tests establish perverse incentives for developers to favor projects with borderline finances. If additionality criteria are set up to reward only those projects that are hovering on the edge of profitability, you can be certain that developers will gravitate toward those projects. Perhaps this makes technical sense — projects on firmer financial footing presumably don’t need the revenue from offsets, and shouldn’t be competing for this pool of money. But in practice, such a system can discourage developers from seeking innovations that would improve the finances of renewable energy.

The second, more prosaic problem with a financial additionality test is that it can be darned hard to establish financial additionality. Projects often have multiple revenue streams with an inherent element of uncertainty built in. Wind farms, for example, have huge up-front capital expenditures, low operating expenses, heavy tax subsidies, and revenue from the sale of electricity (which literally depends on which way the wind blows). On top of that, they have a revenue stream from offsets (or, more properly, RECs).

It’s certainly possible to establish that RECs are the factor that tips a wind farm to profitability by, for example, examining internal rates of return and other financial metrics. But the analysis is not trivial, and not nearly the open-and-shut case that we might naively wish for.

The difficulty of establishing financial additionality for many project types is actually one reason why landfill gas flaring projects like Tontitown are generally considered to be highly additional. Unlike, say, wind farms, landfill projects only have one source of revenue: carbon offsets. There is literally no other income stream to these projects, so it becomes trivially easy to establish financial additionality. And when financial additionality is assumed, the perverse incentive problem also disappears.

With Tontitown, the case becomes more complex. The confounding factor is that the project developer may have two motivations to develop the methane flaring system: revenue from offsets and the groundwater contamination problem. Such confounds are quite common in carbon reduction projects.

So the financial additionality question becomes slightly different. Rather than assuming that any investment in the flaring system indicates financial additionality, we have to look for investments over and above what was needed to address the groundwater contamination problem. In other words, if Waste Management put in the bare minimum amount of money needed to address the groundwater problem, it will be harder to argue that offsets motivated the investment. On the other hand, if Waste Management’s investment clearly and materially exceeds what they needed to do to fix the groundwater problem, then the project should pass a financial additionality test.

The BusinessWeek article alludes to this issue by acknowledging that last year, Tontitown made an $800,000 upgrade to the methane flaring system. But a true analysis needs to go quite a bit deeper than that. We’ve been learning a lot about methane flaring systems over the past few days. There are all sorts of ways to achieve the basic goal of fixing the groundwater problem: active wells, passive wells, subsurface wells, etc. These systems have dramatically different cost profiles and dramatically different greenhouse gas reduction profiles. Teasing apart these issues constitute a key part of assessing a financial additionality claim.

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