Banks are at the heart of the carbon business, originating and funding emission reduction projects, trading allowances and offsets, and creating structured products. But just as many projects become more capital intensive, will financial meltdown and recession put the brakes on the business? Writer Geraldine Lambe.

When Goldman Sachs entered the carbon emission reduction sector, via a 10% stake in Blue Source in October and the acquisition of the majority of E+Co’s carbon offset portfolio in November, it signalled a rare thing: Goldman arriving a little late to a market. It may be tardy, but Goldman has spotted how much opportunity there is in the carbon emissions value chain.

The US bank had already made a significant investment in the Chicago Climate Exchange (CCX), but the investment into emission storage specialist Blue Source gives Goldman a toe-hold in the so-called primary market, through which it can invest in carbon reduction projects and earn offsets that clients can use to manage their carbon risk.

Banks have emerged as the fulcrum on which the emission reduction lever pivots. Their businesses touch virtually every point of the carbon/emission value chain. They help to finance clean development mechanisms (CDMs) – projects in developing countries that under the Kyoto Protocol earn UN-validated credits (certified emission reductions, or CERs) which regulated industries can use to offset their carbon emissions. They finance renewable energy and other clean technology businesses.

They trade the emission allowances handed out by governments to affected industries; they make markets in and trade futures on the CERs that will be delivered when clean development mechanism projects come to fruition; they provide carbon risk management services to clients that are heavily affected by emerging emission limits; and they are creating climate change-based structured products to appeal to investors.

For banks that can build the right platform, a bit of joined-up thinking has the potential to unlock a wealth of opportunity. Like others, Goldman Sachs is attempting to close this virtuous circle.

Rising trade volumes

The carbon business is based on the Kyoto framework’s cap and trade system. The Kyoto Protocol designed the market so that participants – the industries whose emissions are capped – are “structurally short” of government-issued allowances; this ensures that they have to invest in cleaner technologies via the CDM, in order to earn CERs to meet emissions targets.

Banks’ trading desks take proprietary positions on allowance and CER futures, and trade around those in the market. Volumes have been rising rapidly. On the European Trading Scheme (ETS), trading volumes more than doubled in 2007. On the European Climate Exchange – about 85% of ETS trading – in the year to September, volumes in EU allowance futures and CER options were already more than double those of full-year 2007.

The ETS is currently the only mandated cap and trade system, but further schemes are getting ready for launch: Australia and New Zealand look possible by 2010; perhaps Canada by 2011; in September, Japan launched a government-led voluntary trading scheme. In the US – one of the world’s biggest polluters – many believe that Barack Obama’s election will usher in a mandatory system; maybe by 2013. Until then, it has several voluntary schemes – including the CCX.

But because of the political priorities of host governments, systems are riddled with idiosyncrasies. Sponsoring governments decide which industries will have their emissions capped, they decide the allocation and price of domestic emission allowances; and they decide what percentage of CERs will be eligible within the system. This means that one country’s allowances cannot be traded on another country’s platform.

It is CERs – which will be fungible between systems – that will be the international ‘currency’. It is therefore the banks that finance CDMs and make markets in CERs that will play a pivotal role in glueing together the global framework, and ­pro­viding global carbon risk management for companies.

Much to play for

There is a growing amount to play for. According to New Energy Finance, in the year to September, the combined carbon markets were worth $84bn, up from $67bn in 2007. The World Bank’s 2008 report on trends in the carbon market revealed that more than $13bn flowed from Organisation for Economic Co-operation and Development (OECD) countries to developing nations via the primary and secondary CDM markets in 2007.

Secondary market trading revenues are also growing. Banks do not break out emission trading revenues, but according to Simon Dent, head of European gas and power trading and marketing at BNP Paribas, revenues from the bank’s carbon trading, a business that is barely three years old, are already commensurate with other commodities desks.

According to market analyst Point Carbon, current figures will be dwarfed by 2020. It believes that by then, global carbon markets could be worth almost $3100bn, with total transaction volume forecast at 38 billion tonnes of carbon dioxide equivalent.

Abyd Karmali, global head of emissions at Merrill Lynch, says the markets are assuming that in the next phase of the cap and trade system (post-2012, when Kyoto comes to an end), about 1.8 billion tonnes of emissions allowances (CO2 equivalent) will be issued per year by European governments to affected industries. On average, European countries in the ETS allow companies to offset about 10% of their emissions using CERs, meaning that the European market will need about 180 million tonnes of offsets per year.

The Japanese system is likely to call for a similar figure, while the prediction for the much larger US market is for about 15% of offsets to about $5.5bn of allowances, meaning the US market will need about 775 million tonnes of CERs. When all the markets are up and running, Mr Karmali believes there will be demand for about one billion tonnes per year of carbon offsets.

What does that mean in terms of revenues for a bank that is financing CDM projects?

“A good medium-sized CDM project earns about 100,000 tonnes of offset credits,” says Mr Karmali, “and a bank would be reasonably happy with a spread of up to €5 [$6.26] per tonne, depending on the level of risk being taken.”

There are costs; for example, the cost of off-taking the project could mean putting €10 to €15 per tonne of capital at risk, but at €5 per tonne, that equates to a €5bn pool of margin per year just from the primary CDM market; and if a bank gets involved with a CDM project at an earlier stage – for example when the project is first being developed – the spread can be as much as e8 per tonne to reflect the greater risk being taken.

Project finance limits

There are other potential revenue streams. At first glance, project finance seems like the likeliest candidate, not least because it does so many deals in the energy and power sector. But, in fact, says Chris Leeds, head of environmental market sales at Barclays Capital, so far the CDM space has had little need of the sort of lumpy up-front financing that project finance provides.

“The easiest projects got picked off first, so the earlier projects did not require a large amount of capital investment; they stood up without too much up-front finance or could be financed simply against the cash-flow on CERs,” says Mr Leeds.

Equally, the CDM marketplace poses some obvious problems. For one thing, project finance is a conservative discipline which does not yet sit comfortably with the developing regulatory environment of CDM. Timeframes are another issue: with no political clarity about what will happen when Kyoto expires in 2012, CDM’s short horizon does not work well with the longer tenor typical of project finance.

“If you implement a project today, you need to extract your financial return on it before 2012,” says Garth Edward, head of emissions markets at Citigroup, “but if you’re building a wind farm today, it will be implemented and registered [with the UN] by mid-2009, which means its first issuance will be early 2011. This means you will have only two years of flow [from CERs] on which to get a return, so the pay-back period is very short.”

Synergies exist

But that does not mean that there is no interplay between the emissions business and project finance. “The CDM business has applied a lot of the techniques and disciplines common to project finance to create a full-service product that enables banks to develop projects, walk clients through the project design document process, arrange the financing and to commercialise CER flows,” says Mr Leeds.

In some cases, CER revenue has helped to sweeten project finance deals – by pushing up the internal rate of return to the point that will make a project feasible – but BNP Paribas is further leveraging its project finance business by pursuing additive CDM deals with existing project finance clients.

It recently did a wind farm transaction with a client in Korea, whereby BNPP did an off-take agreement for the carbon credits. The CER flow was not part of the financing, but it provided an incremental income to the client, independent of the project financing.

“Because you are doing the existing project financing, you’ve done all the due diligence both on the client and the project; you understand all the dynamics of the project’s performance,” says BNPP’s Mr Dent. “This gives the bank and the client a higher level of comfort. More importantly, this kind of joined-up transaction leverages the bank’s franchise and client base, and adds real value to our project finance business. There will be a lot more deals like this.”

However, we may be approaching a point when project financing becomes a more pertinent tool. “The easy projects have been exhausted and people are moving into more capital-intensive projects, so there will be more demand for project finance or other kinds of up-front finance,” says Mr Edward.

Financial products

What has real potential for banks is a nascent climate change-based structured products business. At one end is the regulatory driven market, where compliance players want CERs shorn of their delivery and project risks. Firms such as EcoSecurities and Credit Suisse have securitised a portfolio of CDM projects, segmented the risk return profile and sold it in tranches: hedge funds and boutiques with significant risk appetite take the riskier tranches while compliance players take the senior notes.

But Mr Edward believes another important product space will be the financial product area. Here, banks can create financial instruments from the physical commodities, such as exchange-traded funds, and medium-term, or principal protected notes.

For a medium-term note, for example, a bank creates a vehicle that holds a flow of primary CERs. Investors buy into that vehicle and receive a euribor coupon, say. At maturity, on top of that coupon, they could receive whatever mark-to-market differential there was between their entry price and the price upon maturity or exit. In a simple principal-protected structure the buyer would, in effect, deposit cash and receive a coupon. Essentially they would buy a put and get long the underlying; so the principal would be largely protected and the upside capped out.

“These kinds of products really open the market up because they can be accessed by pension funds or retail investors,” says Mr Edward.

Challenges are mounting

But just as this virtuous circle began to yield significant results for banks, the financial meltdown and slowdown have begun to put the brakes on just about every area of the business.

In CDM terms, the credit crunch comes at the worst time. The low-hanging fruit have been picked off so that more capital-intensive projects are looking for capital at the exact moment when access to that capital is more difficult and costly.

There is clearly less appetite among the institutional investor market for structured financial products at the moment. Does appetite exist within the hedge fund community for the riskier tranches of structured CERs? Anecdotal evidence suggests that the volume of CER transactions has diminished in the past month. Some financial institutions that were active in the market have disappeared, some are less active and some are now trying to de-risk their portfolios.

Moreover, we are again at the point in the policy cycle when the market really needs investors with a higher risk appetite such as hedge funds and boutiques, says Mr Karmali. “At the beginning of this market, aside from the World Bank, it was hedge funds and boutiques that, despite the project risks and policy uncertainty, went long because of the potential upside. Because of the uncertainty about what policy will be beyond the end of Kyoto in 2012, we are back at that stage again. As some mainstream financial institutions de-risk or withdraw from the market, we really need hedge fund participation or there will be a hiatus in capital.”

But it is not all doom and gloom, says Mr Dent. Whatever the policy uncertainty, the EU is committed to emission reduction and the ETS; despite signs from its voluntary schemes that the US will initially price allowances so low that it undermines the incentive to invest in CDMs, at least it is increasingly likely that this huge carbon market will emerge as an official cap and trade system.

Equally, Mr Dent is less sure that the credit crunch will seriously derail the carbon business. It may even ensure that it does not go on to suffer the same over-exuberance that has brought the credit market to its knees.

“There is still a lot of money looking to invest in this type of business,” says Mr Dent. “The credit crunch will have an effect; there will be more scrutiny and more due diligence over CDM projects, and people will look to structure deals more intelligently. But utilities and other industries within the EU scheme are structurally short: they have to participate. And carbon funds have a lot of money that they need to mobilise and monetise in quite a short time frame. These sorts of market dynamics will keep it going.”

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