Responsible Investor

Carbon: a new asset class?

Investors are already testing the potential of markets in greenhouse gas emissions, but what are the risks and how can they be avoided?

Carbon is much more than a new type of commodity; it is becoming an asset class in its own right. What began as a compliance mechanism is rapidly becoming more sophisticated. As investors consider moving assets into this sector, it is worth pausing to consider the dynamics of the market, how to invest in it and, of course, the potential risks and rewards.
Conceptually, the reason carbon has a value is that governments have artificially created scarcity by capping the volume of emissions that they allow their industries and domestic sectors to produce. National governments take on these targets under the Kyoto Protocol, and then cascade them down to the entities which physically create the emissions.
The assets – greenhouse gas emission reductions – are created under government-established emissions trading systems (carbon allowances) or by individual projects, which can claim ‘carbon credits’ to the extent they can demonstrate they are reducing or absorbing greenhouse gases.
Both the Stern Review and Al Gore advocate cap and trade systems to set a price for CO2 and encourage less carbon intensive activities.

Although in their infancy, these markets are expanding rapidly. In 2004, according to World Bank figures, emissions credits and allowances were traded representing 215m tonnes of carbon dioxide. By 2006 that had risen to 1,639m tonnes; worth around $30bn. Provisional data suggest that volumes rose by almost 50% in the first half of 2007. With high-profile figures such as Governor Schwarzenegger pushing for a California and possibly US-wide scheme, Point Carbon, the research company, estimates the potential market size could be $565bn.
Potential growth of that scale is one of the main reasons capital is moving rapidly into the sector; approximately $12bn so far in funds dedicated to pollution, according to New Carbon Finance, a consultant that analyses the sector. There is also much greater confidence in the EU Emission Trading Scheme (ETS). Despite the over-allocation issues experienced in Phase 1, there is a broad consensus that the political will exists to ensure there is no repeat. Evidence such as the rejection of all but the UK’s initial National Allocation Plans (NAPs) for Phase 2, with a demand (since delivered) for tighter targets, continues to support this view. Approved NAPs suggest

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