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
a shortage of around 1bn tonnes over Phase 2 of the scheme. Opinion on pricing is also bullish. Point Carbon suggests a figure of around €30 per tonne for 2008/9. This fits within our own house view that the politically acceptable band of pricing sits between €10 and €40 per tonne. Below €10 there is no incentive for change and the scheme’s credibility is doubtful; above €40 possible damage to corporate competitiveness (assuming no global equivalent scheme exists) will demand intervention of some sort.
With the possibility of 2.5bn carbon credits in existence by 2012 according to the UN, the race is on to invest in early stage projects that stand a strong chance of meeting United Nations Framework Convention on Climate Change (UNCCC) approval. The current slowness of the approval process, caused by a shortage of qualified assessors, is adding to short-term price pressure.
Another important factor influencing price is the growing demand for UN approved credits from those outside the compliance market who wish to offset their emissions voluntarily. Media focus on poor practice and ‘carbon cowboys’ has created a flight to quality, with corporates and individuals viewing the transparency and clear methodology of the Clean Development Mechanism as well worth the price premium over Verified Emission Reductions (VERs), a term for voluntary offsets. The added benefit of tightening the compliance market also adds to the appeal of UN Certified Emission Reductions (CERs). Given that voluntary offsetting is largely a PR exercise, this is hardly surprising.There is another positive side-effect to the voluntary market choosing CDM credits. To a compliance buyer, a CER is a CER; however, those in the voluntary category are extremely choosy. In working with a major UK banking group to offset its emissions, we provided CERs to very strict criteria regarding project type and geography; for example, no HFC-related credits or large hydro-electric projects.

“Point Carbon, the research company, estimates the potential market size could be $565bn.”

Those favoured were wind-based and included projects such as methane capture in Brazilian farming communities, which provide heat and power for remote communities, as well as additional income. The social aspect of the latter type of project is particularly attractive to non-compliance buyers.
What we see as a result of this move by the non-compliance market is a two-tier pricing model, where credits from the highest (perceived) quality projects command substantial premia of up to €2 per tonne. It is also possible that over time credits from less desirable projects may become more difficult to sell. This will influence future capital flows into preferred types of CDM project. In that regard, the non-compliance market is keeping Kyoto ‘honest’. Increasing emission-trading volumes also reflect a more pro-active approach to allocation management by corporates, many of whom sat on long Phase 1 positions while the price moved from

€30 to seven eurocents. Treasurers are realising that this is a balance sheet asset that must be managed like any other and that there are profitable and practical trades that can be carried out from a cash management perspective; for example by taking advantage of the spread between CERs and EU allowances for the percentage of CDM credits permitted for EU ETS compliance.
There are compelling arguments for institutional investor interest in carbon beyond the upside price potential of carbon credits, in terms of portfolio diversification benefits. Carbon shows little short or medium term correlation with the broader markets linked to corporate debt such as rates, equities and FX. It is also less correlated than commodities, which now show stronger relationships following massive inflows of institutional capital.
Many market makers in carbon initially established their emissions desks within their commodities teams. However, as the market develops, it is clear that carbon is not a commodity; at a fundamental level, there is not a finite amount of it. However the most important factor is due to the fact that is was conceived by governments and is subject to substantial international intervention. It therefore does not display the standard supply and demand characteristics of commodities. Carbon also shows other signs of becoming a distinct asset class. With a liquid underlying flow market, it is akin to the early days of the credit default swap markets – with similar potential for exponential growth.
The advent of carbon futures provides a volatility curve,which enables the creation of options and structured products.
Our marketing of one structured product, ‘CARE’ Notes, which provide exposure to the CER price, provided insight into current and potential investor appetite for these products. We identified a strong desire by institutions to invest in this asset class; however, we saw two distinct camps. The first, like ABN AMRO, were already in the market, with a lot of experience and thus capable of doing it themselves. The second – the majority – were very interested but did not yet have enough knowledge to feel comfortable with the sector. Moreover, their internal processes and risk approval were not yet developed for this asset.
However, we also became aware of increasing pressure on funds to allocate certain percentages to the emissions sector, in a similar way to microfinance commitments. Two thirds of the investment in a recent €800m carbon fund from Climate Change Capital came from Dutch pension funds ABP and PGGM, which bears this theory out. It also gives a clear indication of the potential of this market.
So, as carbon begins to mature as an asset class and investors become willing and able to invest substantial sums into the sector, what is the risk/return profile?
In terms of the EU ETS, we are unlikely to see a repeat of Phase 1 for the reasons outlined above. However, Phase 2 will require ongoing commitment and vigilance from governments to ensure it performs effectively. The UNCCC meeting in Bali this month should provide clear insight into EU ETS Phase 3 but importantly also

on the current state of opinion about further global trading schemes. The greatest upside price potential for CDM credits is the potential for it to form the single fungible element across several global emissions schemes.
Downside risk comes from over-allocation of credits (now avoided for EU ETS Phase 2) and also from the possible over-supply of joint implementation credits from the former Soviet bloc. Known as ‘hot air’, these are surplus credits resulting from a contraction in their economies since the 1990 Kyoto base year, against which targets are measured. How they bring this surplus to market (if they are able to) could have a huge impact.
Similarly, countries such as Brazil are looking into ways to monetise the prevented emissions resultingfrom avoided deforestation programmes.
The effort to combat climate change through the Kyoto Protocol and related initiatives has given birth to a new and fast-growing asset class. Carbon credits provide significant potential for investment, both in terms of direct investment and through a rapidly maturing market for innovative secondary products. Investors can also benefit from portfolio diversification due to a low correlation with other asset classes. As with any new market, there are risks to be aware of. However, many market makers have several years of experience, which, when combined with a broad understanding of the eco-sector, can help investors take their first steps.

Charles Longden is Global Head of Credit Trading and Eco-Markets at ABN AMRO