Investors Eye Opportunities In Carbon Market

The growing carbon trading market is piquing the interest of private equity funds and hedge funds, which see opportunity to profit from increased demand for carbon credits next year when the Kyoto Protocol kicks into its second phase.

The nascent market has been in a test phase thus far but will enter formal trading next year. Already growing by leaps and bounds, trading will increase even more as compliance toughens up and more products come online. What's more, the growing carbon trade is expected to be geared in favor of credits from China, India and other developing Asian countries. Credits from Asia, called "Certified Emissions Reduction" credits or CERs, will start trading on the European exchange next year. Currently swapped only on an over-the-counter basis, or between companies, the credits should be well-received because they are cheaper than credits from Europe, called "European Union Allowance" or EUAs. Increased demand for CERs is, in turn, expected to drive more private equity investment into Asian companies with carbon reduction projects. "At present, CERs are not issued or sold, they're not available (to most investors)," said Emmanuel Fages, analyst at Societe Generale in Paris. The start of CER trading in Europe "will dampen the price of the EUA for sure." Since the Kyoto Protocol came into force in 2005, companies in France, Germany and other countries that signed the agreement have had to meet greenhouse gas emissions targets by implementing certain measures and funding "Clean Development Mechanism," or CDM, projects in developing nations such as China. Companies get carbon "credits" in return that help them meet emissions targets. From this mandate sprang a fast-growing cottage industry. The carbon trading market tripled last year to $30 billion, according to the World Bank. Trading volume is expected to double this year and double again in 2008. Market participants expect the worldwide market to grow to $250 billion by 2010. Carbon credits, which represent one ton of carbon that's been saved from emission, can come from companies in any part of the world. But it is cheaper for companies in developing countries to come up with credits because they're dealing with less efficient technologies. That's why EUAs, from Europe, are generally more expensive than CERs from Asia. EUAs have been trading at about 20 euros, while CERs generally trade at about a 20% to 30% discount to EUAs. Market watchers say the prices of carbon credits in general could rise next year amid increased demand, and some see CER prices poised to grow faster. Miles Austin, senior carbon analyst at EcoSecurities, sees the price gap between the two credits narrowing to 10% to 20% next year. Fages, who is bullish on CERs, sees their price reaching EUR21 to EUR22 next year. Low liquidity and high political risk have kept carbon credit prices volatile but liquidity is expected to improve. Hedge funds and some large financial institutions are already starting to trade carbon credits, seeing opportunity to profit from pricing inefficiencies.

Hedge Funds Move In

Most carbon trading is still done by electricity groups or cement producers - companies with a stake in carbon-reduction plans - but that's changing. Morgan Stanley (MS), Societe Generale and Fortis Bank all recently added carbon trading desks, while funds focused on carbon trading are popping up. Global investment in carbon-focused funds jumped 66% to $11.8 billion between November and April, according to New Carbon Finance, a carbon research firm. Hedge fund Man Group PLC is also looking to jump in. "We think that soon it will be at a stage where we have some actual money invested in these sectors," said Thomas Della Casa, Man's head of research. Carbon credits trade much like commodities. Firms can hold carbon certificates long or hedge against price changes by shorting. Many funds are seeing opportunity to ride the expected increase in credit prices, said Societe Generale's Fages. Hedge funds have seen opportunity in this pricing gap with some selling EUAs to buy CERs at a low price directly from the source, generally between EUR8 and EUR12, said Dinesh Babu, director of carbon trading at Asia Carbon Exchange in Singapore. "Funds can play around with credits and comply with the European carbon emissions targets at the same time," he said. Despite the rewards, carbon trading is not for the faint hearted. Hedge funds will hold positions for a month at most, whereas they'll hold other commodities, such as oil, for several months. In addition to political risks, carbon prices are subject to weather and energy prices. Just last week, the price of EUA futures dropped to the lowest level in two months because cool weather in Europe led to less energy consumption and thus, less emissions by power producers. "We've already seen the price of CERs go up and down like nobody's business," said Babu. Hedge fund participation has also added volatility. In February, the price of EUAs shot up to EUR25 from EUR11 before inching back to EUR22. Government decisions about credit allotments drove most of the movement, but hedge funds amplified the move, said Fages.

Private Equity Bets On Asia

The focus on CERs is encouraging private investment in carbon reduction projects, particularly in China, which sold 61% of the world's carbon credits last year. Private investment now outpaces public sector investments, says New Carbon Finance, with Asia the primary beneficiary of the investment. Chemical companies have been among the first to catch on to the opportunity because many needed relatively little investment and yielded lots of credits. Selling carbon credits can be quite lucrative and sometimes companies may make more money selling carbon credits than from their core business, said Le Chen, head of China operations at EcoSecurities. Baring Private Equity Asia made a $47.2 million investment for a 27.3% stake in Dongyue Group, a Chinese chemical company that makes refrigerants. A leading refrigerants producer, the company also has a side business selling credits for capture and incineration of HFC 23, one of the six different greenhouse gases targeted by the Kyoto Protocol. Still, selling carbon credits is more of an additional bonus, said Gordon Shaw, a managing director at Baring. "Baring will not be comfortable investing on the basis of CDM alone." That'll continue to be the case as industry observers say that early investors have already picked off the low-hanging fruit. Easy projects that yield a large amount of carbon credits are getting harder to come by. "The size of the projects is getting smaller compared to earlier days," said Seng Heng Yap, director for energy services in Asia Pacific for Rhodia, a chemical company in a joint venture with Societe Generale. More industries are now looking into projects that yield fewer credits. New projects tend to involve landfills as well as renewable energy sources such as hydrowind and biomass that are beckoning to a wider variety of investors.