Greenhouse gases opportunity
In June this year, AgCert, a company that installs equipment to capture methane from pig farms in developing countries, raised £60.8m (e89.5m) on the London Stock Exchange. Two months earlier, investors put £135m into an investment vehicle called Trading Emissions, via the exchange’s Alternative Investment Market. And at the end of last year, Fortis Bank and CDC Ixis closed their €120m European Carbon Fund (ECF).
Investors in these three vehicles all believe the same thing: that a new asset - the right to emit a quantity of greenhouse gas - is set to increase dramatically in value, and that investments in AgCert, Trading Emissions, or the ECF put them on the ground floor of an exciting new market.
This new asset was created, in principle at least, in Japan in 1997, when the members of the United Nations signed the Kyoto Protocol on climate change. The treaty sets binding national greenhouse gas targets, from 2008 to 2012, on industrialised countries.
It also creates a global market in transferable ‘allowances’– the right to emit one tonne of carbon dioxide, or equivalent. These will be allocated by governments who, in turn, will dole them out to companies or other organisations who, through burning fossil fuels, for example, pump greenhouse gases into the atmosphere. They will also set reduction targets on these entities.
The principle is that companies that emit less than their targets can sell their surplus allowances to those who are likely to miss theirs – because they have increased production, for example. This gives a value to reducing emissions, flushing out the most cost-effective reductions, which can then be translated into hard cash.
The Kyoto Protocol came into force in February, despite the US (and Australia) pulling out of the treaty in 2001. Although its targets only apply from 2008, some forward trading in carbon has already begun. But what really kick-started the market was the launch, in January of this year, of the European Union Emissions Trading Scheme (EU ETS).
The scheme is designed to put the EU on course for its Kyoto targets. It covers around 11,500 factories and power plants across the EU, collectively responsible for around 45% of the bloc’s carbon dioxide (CO2) emissions. They have been set reduction targets by their national governments for the scheme’s first phase (2005-07) which are backed by significant financial penalties – companies have to pay e40/tonne of CO2, and make up the shortfall, for failing to meet them.
“For the first time, carbon has become an item on the balance sheet, and - like any other asset or liability - it needs to be managed,” says Louis Redshaw, head of the environmental products desk at Barclays Bank in London. “We’re seeing companies covered by the scheme coming into the market to buy and sell allowances, and we’re seeing more and more speculators adding to liquidity. Carbon is fast becoming a major new financial instrument.”
The scheme has become big business. More than 6.6bn allowances have been issued. The market often sees daily volumes in the millions of allowances, with that figure rising steadily. Despite complaints from environmentalists that governments were too generous to companies in setting targets, the price of carbon rose dramatically in the first months of the scheme – from less than e7/tonne on 1 January, to a high of €30/tonne in July, before slipping back over the summer to €22.50 by 17 August.
So how can investors get exposure to this new market? For those able to trade in futures, several exchanges have listed contracts referenced to EU allowances (EUAs). At the head of the pack is the European Climate Exchange (ECX), which lists its contracts via London’s International Petroleum Exchange.
Albert de Haan, the ECX’s Amsterdam-based commercial director, has been in discussions with a number of large Dutch pension funds, such as ABP, with the size and sophistication to trade in novel markets like carbon. “There’s interest in investing in carbon as an alternative investment – it’s completely uncorrelated with traditional investments,” he says.
At the moment, the ECX offers futures contracts, which require the delivery of EUAs at settlement. While this may be attractive to, say, a utility with a natural position in the market, financial players have less interest in receiving physical allowances, and little appetite in setting up the necessary registry account with the national regulator. To overcome this, the ECX is planning to launch cash-settled contracts, offering purely financial exposure to the price of carbon.
But for other investors, there is safety in numbers. The last couple of years have seen the emergence of carbon funds - such as the ECF - which invest in a portfolio of emissions reduction projects. Most repay their investors in credits, which can be used towards emissions reduction targets. A few, such as the ECF, are basically out to make a buck.
“We take the risk of buying credits now, and selling them later,” says Claire Byers, manager of environmental products at Fortis Bank in Amsterdam. “It’s obviously not that simple – we use structured products, to lock in margins, and we share risk by using a portfolio approach.”
Part of the fund’s appeal among the institutional investors that came on board - including AGF Allianz, Dexia, Groupe Caisse d’Epargne and Société Générale - was that “they know the carbon_market is going to be big. Emissions have been cited as the first new global commodity in a very long time,” Byers say. But she adds that were also attracted by “doing something environmentally attractive”.
London’s stock exchanges, too, provide carbon plays. AIM-listed Trading Emissions, for example, is essentially a listed carbon investment vehicle. Its main investment strategy is to take “a long position in carbon assets”, and its major investors include Credit Suisse, HSBC, Société Générale, F&C Unit Management, Gartmore and Jupiter Asset Management.
AgCert, meanwhile, is to the carbon market what a gold mining company is to the gold bullion market. Its business model involves commercialising a process by which methane from farms is captured, and destroyed. This process is likely to be eligible to earn ‘certified emission reductions’ (CERs) – carbon ‘offsets’ or credits – that will be valid for use against Kyoto Protocol carbon targets.
A number of major companies, such as Dutch utility Nuon, and French electricity giant EdF, have contracted to buy some of the tens of millions of credits that AgCert stands to generate – if it process is approved by the regulatory body that oversees the protocol.
And this delivery uncertainty - and the likelihood that carbon prices will rise - effectively offers a leveraged play on the carbon market. “An investment in AgCert is essentially buying an option on the development of the CER market, and on carbon prices in the future,” says Paul D’Alton, the firm’s chief financial officer.
Investors have responded enthusiastically. Shares in the company, whose flotation valued it at £215m, had risen 55% by mid-August.
Alternatively, there are a number of companies which provide a second-order exposure to carbon. Another AIM-listed company, Climate Exchange Plc - established by US environmental markets guru Richard Sandor - has invested e5m in the European Climate Exchange, and owns 40% of the Chicago Climate Exchange, its (voluntary) US forbear.
It is, however, early days for carbon as an asset, says Will Oulton, socially responsible investment adviser to the FTSE Group. “We’d need to see a number of developments around carbon as an asset class before many institutional investors get involved,” he says.
He cites the construction of more structured products, allowing pension funds - many of which cannot invest in derivatives - to gain exposure to the price of carbon. He also believes that needs to be more analysis of the how the market operates, and more performance history. “It also needs to appear on the consultants’ agenda,” he adds.
“But it’s a very positive development that recognised exchanges have created products around carbon,” he adds. “That, in turn, creates legitimacy for the asset.”
Mark Nicholls is the editor of Environmental Finance, based in London