LONDON - A combination of investment risks threatens to obstruct an already stumbling U.N.-backed $6.5 billion market in clean energy projects in emerging nations, years before the scheme's first phase is due to end.

Under the Kyoto Protocol's Clean Development Mechanism (CDM), companies or governments can outsource mandatory cuts in greenhouse gas emissions by buying offsets, called Certified Emissions Reductions (CERs), from projects such as wind farms or hydro dams in developing nations.

But with the economic downturn having already dented global investment in clean energy, a mix of political risk in the least developed nations, worries over counter-party credit and growing uncertainty over the scheme's future after Kyoto expires in 2012 could halt CDM funding in the next few years.

After peaking at $7.4 billion in 2007, investment in the CDM dipped by 12 percent last year, according to the World Bank, and observers expect it to fall further this year.

Some CER buyers have moved to the sidelines over worries that a large portion of CERs generated by projects in China will not be fungible in most emissions trading markets after 2012.

If I had a pot of money to invest in projects, they wouldn't be in China, said Michael Berends, a manager of carbon emissions origination at Dutch utility Nuon.

I don't think the CDM in China, in its current state, will survive post-2012, said another project origination manager from a major European investment bank, requesting anonymity.

About 35 percent of the near 1,900 registered projects are in China, making it the biggest player in the CDM, U.N. data show.

Over 136 million, or 40 percent of the 336 million CERs issued so far by the United Nations went to Chinese cheap-to-install industrial gas projects, so-called 'low-hanging fruit', resulting in enormous profits for their owners.

This has raised concerns that polluters are being heavily rewarded for making a minimal investment in cutting emissions.

As a result, the European Union said it will bar low-quality CERs from its emissions trading scheme from 2013, a move which many say targets industrial gas CERs, and the United States is likely to follow suit in any cap-and-trade scheme of its own.

Industrial gas projects in China are probably the most risky (but) we don't know which market will accept any post-2012 CERs from China. That's the problem, said Berends, adding that projects in India, Brazil and Mexico faced similar risks.

U.N.-sponsored climate talks in Copenhagen this December are slated to tackle post-2012 CDM reform by ironing out inefficiencies, but with major nations deadlocked over big picture issues like emissions targets and financing, many expect the CDM to be pushed down the agenda.

Some say the CDM could even be dismantled completely by 2013 if a new deal is not reached or if major emitters such as China and India do not sign up for emissions targets, and this has left investors guessing what types of offsets, if any, will be accepted in trading schemes.

POLITICAL & CREDIT RISK

African CERs are a good hedge against post-Kyoto uncertainty, said Deven Pillay, head of the South African state-owned Central Energy Fund's carbon finance division.

You're not going to tell Africa 'we don't want your offsets', Berends said. Renewable energy in the least developed nations, like a Senegalese wind farm, are the safest bet, but then you have other risks that come with Africa.

In contrast to China, Africa is home to only 2 percent of registered CDM projects, according to U.N. data.

Although the increased chance of post-2012 eligibility make African CERs tempting, buyers cite political risk as their main deterrents to investing in Africa.

Many buyers are not able to invest in Africa unless they have another angle, like assets in, or links to, certain countries, said Lucy Mortimer, global manager of CDM origination at brokers TFS Green.

While a few investors are very keen, willing to pay a premium for African offsets, not many are pushing forward.

But those project owners with CERs considered a safe bet in 2013 are not willing to sell to just anyone.

A year after the collapse of investments banks Lehman Bros and Merrill Lynch, buyers say many owners are showing a reluctance to sign contracts with some banks and offset aggregators over credit concerns.

Five years ago, no one questioned if CER buyers were able to pay. Now sellers look for good credit ratings, Berends said. Utilities or government buyers will always rank above most banks at the moment, another origination manager said.

Many large utilities have weathered the recession and their CER origination desks are playing on this strength.

It makes more sense for CER sellers to deal directly with compliance buyers. That's our selling point, Berends said.

The lack of regulatory clarity could ultimately freeze the CDM, preventing anyone from signing CER deals past 2012.

It's hard to buy anything right now. My credit, risk and legal departments would never let me sign a post-2012 contract amid all this uncertainty, Berends added.

(Additional Reporting by Catherine Hornby in Amsterdam; editing by Christopher Johnson)

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