What price saving the planet?

The launch on March 17 of carbon-linked derivatives contracts on the Green Exchange, a joint venture between the New York Mercantile Exchange and a group of US brokers, is further evidence that market mechanisms and financial products are now a central component of the global fight to slow global warming.

What began as a trickle of funds aimed at a marginal group of ethically minded retail investors has swelled into a river that is engulfing wholesale markets and global corporates. And where there is appetite, there are banks willing to satisfy it.

Even the chaos surrounding the subprime meltdown has not prevented banks from announcing a raft of green-tinged products and initiatives. In ­February, three big lenders, Citi, ­JPMorgan Chase and Morgan Stanley, announced the Carbon Principles, which they say will guide the terms for financing carbon-intensive projects; in April, Bank of America also signed up.

Evaluating risks

Although the Carbon Principles may lack binding commitments, they do pledge enhanced diligence in evaluating the carbon risks of coal-fired power plants – which includes the potential liability for future carbon regulation – the requirements for carbon storage and sequestration, and to prioritise zero/ low-carbon projects. With the demand for infrastructure finance exploding in the world’s ­developing economies and many banks thirsty for revenues, this level of commitment by some of the biggest project financiers is not to be laughed at.

Carbon has also made its way into the advisory business. When Goldman Sachs advised the private equity consortium buying out energy giant TXU last year, the transaction was praised for being structured in such a way that the utility could scale back its building programme for coal plants. UBS has an environmental risk group which works across all of the investment bank’s transactions to ensure that its environmental risk guidelines are applied from the start.

Merrill Lynch has taken the idea a step further and created a dedicated advisory business. In April it partnered with consultancy firm ICF International to launch Merrill Lynch Green & Gold, a climate change advisory service. It ­is aimed at companies that do not ­currently face a regulatory requirement to reduce carbon emissions but who wish to proactively develop a carbon strategy that identifies financial opportunities and, in light of growing public awareness, enhances their brand.

All of this bodes well. But not everyone is happy that the market has been given the task of cleaning up the environment. Banks and the broader carbon industry have faced criticism that some initiatives are little more than green-washing, and other developments are accused of being an expensive waste of time because they have marginal impact on emission levels and do little to change the behaviour of the biggest polluters. Do the market mechanisms created under Kyoto and the plethora of investment banking products and services actually do any good?

Indices focus

In the early stages of the carbon reduction industry, most investment bank activity was focused on indices. Themes such as UBS’s global warming index, ABN AMRO’s global eco index (with ­Standard & Poor’s), Merrill’s carbon leaders index, and many more, proved fertile ground for launching eco-themed funds and notes.

In the wholesale markets, activity was largely focused on trading carbon credits on behalf of corporates who had to comply with regulatory caps. But as carbon has matured into an asset class in its own right, products have rapidly grown in sophistication. Just as credit derivatives evolved in the credit markets, so have derivatives blossomed in the carbon markets.

Therefore, what began as a compliance market changed with the entry of banks and brokers as arbitragers and hedge funds as speculators. Their combined activity began to generate enough flow business to justify the development of options and other derivatives, and an explosion of exchange activity followed.

Last year, the European Climate Exchange (ECX) alone traded more than one billion tonnes of EU All­owances (the emission permits allotted each year to companies by their government) – more than double the levels of 2006. More products are being added to the ECX suite. In April it launched futures and options based on certified emission reductions (CERs). These are tradable emission credits earned under the UN-backed clean development mechanism – a framework which oversees projects in developing countries specifically designed to reduce carbon emissions – which can be traded within the EU emissions trading scheme.

More exchanges are coming online. In February, the Multi Commodity Exchange of India launched futures trading in carbon instruments and is looking to develop a platform for CERs. Hong Kong Exchanges and Clearing is looking to partner with an overseas exchange to create a trading platform for carbon credits or other emissions-related products. The New Zealand Stock Exchange has also announced plans to develop carbon trading ­capability.

Product development

Increasing maturity inevitably leads to greater product sophistication and banks have wasted no time in applying to carbon the structuring technologies used in other parts of their business. Last year, ABN AMRO’s principal trading group launched its ‘CARE’ note that repackages CERs for sale to financial institutions. It utilises exactly the same special purpose vehicle (SPV) structure that has been at heart of the subprime meltdown.

The structure works like this. CARE notes – issued against a pool of CERs and aimed at investors such as pension funds – are secured on a total return swap entered into between the SPV and ABN AMRO. Payments due to note holders are achieved by the sale of CER certificates through a market polling mechanism (through which ABN AMRO gets a range of broker quotes) to establish what the market price will be at the point of maturity. The payments made under the notes – both principal and interest – can be modified to accommodate different tenors, currencies and coupon structures.

“CARE notes enable financial institutions to gain exposure to CERs without the administrative burden of having to buy them,” says Gavin Tait, global head of carbon trading at ABN AMRO.

Moreover, the notes eliminate a type of delivery risk specific to CERs. Because the calculation of emission reductions that will be generated by a project is not an exact science, some projects do not produce as many reductions as expected. For an investor, this would be like discovering that their bond portfolio does not contain as many bonds as they had bought.

“CARE notes eliminate this risk by focusing on already existing CERs,” says Mr Tait.

Slow take-up

Sales figures are not public but Mr Tait admits that take-up has so far been relatively slow; he stresses, however, that this is the price you pay for being a first mover.

“This is typical of a new market,” he says. “We were the first to come to the market with this kind of product, and if you look at product development in the credit markets, [a product] only really takes off when several banks put their weight behind it. This market will definitely take off as investors become more comfortable with CERs as an asset.”

Mr Tait is convinced that by taking ­a more lateral approach to ­commodities and energy (which led the bank to establish a cross-division superstructure, Ecomarkets, at the end of 2005) the list of potential capital markets applications is almost limitless. “You could see the securitisation of wind farm or other green technology revenue streams,” he says.

Credit Suisse has taken a different approach to structuring CERs and eliminating risk. Through its partnership with EcoSecurities, one of the world’s largest developers of clean development mechanism (CDM) projects and in which Credit Suisse is an investor, the bank is directly involved in the primary CDM market. Last December, the pair completed the first sale of structured CERs representing more than five million tonnes of carbon dioxide ­savings.

Originate and distribute

In a novel twist on the originate and ­distribute model, and combining elements of securitisation technology, Eco­Securities and Credit Suisse have jointly developed a structure which holds the rights to credits from a diverse pool of CDM projects, all of which have been developed by EcoSecurities. The key to the transaction is that buyers gain access to a geographically and technologically diverse portfolio of ­projects, without exposure to a whole host of unwanted risks – ranging from project and implementation risk, to country risk, to delivery and regulatory risk.

The price is right

A simple example demonstrates the risks Credit Suisse is promising to mitigate. Compliance players – such as large utilities in Europe – may need to use CERs in order to meet their EU emissions targets. This could mean buying the CERs generated by a methane capture project in China, for example. To do this directly would mean the ­company entering into a contract with a Chinese counterparty to buy 100 tonnes of carbon emissions, say; 20 tonnes for every remaining year of phase two of Kyoto.

Worth the savings?

By dealing directly with the Chinese project, the utility will get cheaper CERs; but to achieve those cost savings the firm has to find the project, monitor its development, manage the CER verification process and take all the delivery risk. What if, after signing the contract, the CDM project comes under UN review and it is discovered that the methodology has overestimated CER output by a few per cent? What if the project is disrupted for any length of time – by a plant breakdown or an industrial dispute – and emission reduction is therefore lessened?

These issues may simply be a function of unusual or complex projects in emerging markets, but that offers no comfort to the utility: it has already signed on the dotted line. So, in spite of the additional management headaches that it took on, it may not get the full amount of CERs it needs for compliance with EU regulations and will be forced to buy more credits in the carbon market.

Risk removal

The structure developed by Credit Suisse and EcoSecurities strips out those risks and, for a premium, guarantees delivery of CERs to those that need it. Credit Suisse has applied the same approach to slicing up risk that is used in a classic securitisation transaction, but instead of a portfolio of 100 loans, say, it is a portfolio of 100 diversified CDM projects; and instead of tranching credit risk, it tranches delivery risk.

So, just as a mortgage securitisation creates an AAA layer at the top, Credit Suisse has created a senior CER tranche by guaranteeing delivery of the top 25% of CERs, for example. The second tranche, effectively the BBB notes, have fewer guarantees, but the notes are cheaper; and the equivalent of the equity tranche at the bottom has no guarantees but the most upside if the CDM projects deliver as expected.

“In this way, compliance buyers get the certainty that they need, but investors who want to take on risk – and take the potential upside – can do so,” says Mr Ezekiel.

In a market where the reputation of CDOs has been tainted by the subprime crisis, the idea of creating more structured products may strike fear into the hearts of regulators and investors alike, but Mr Ezekiel argues that we should not allow the subprime turmoil to undermine the fundamental technology, which remains sound.

“Despite the turmoil in the mortgage markets, the concept of tranching out different types of risk that can be sold to different types of buyers still makes an enormous amount of sense,” he says.

But are there hidden risks that have not been taken into account? The recent crisis revealed that products and assets have turned out to be correlated in all sorts of ways that financial modelling had not calculated: can buyers of CERs be certain that their assets will not suffer the same fate?

Mr Ezekiel maintains that the diversification offered by the structure will prevent any such hidden correlations. “Buyers are not exposed to the risks of a single landfill project with variable yields; they are backed by a portfolio of different projects diversified across country, across project methodology, across operator and across counterparties,” he says.

In the pipeline

So far, this has been the only transaction of its kind. Although Mr Ezekiel says that Credit Suisse and ­Eco-Securities have another such deal in the pipeline, he admits that the market remains very small; but the potential for growth is huge, he says. “The EU emissions trading scheme only represents about 16% of global emissions and the market is already worth about €70bn. Given the unilateral nature of the EU commitment with respect to the rest of the world, the reductions in emissions required under the EU emissions trading scheme remain relatively modest. As required emission reductions are red­uced year on year, it is expected that there will be greater demand for CERs.”

The new tree-huggers

The potential for packaging carbon credits in ways that are both good for the environment and lucrative for arrangers is also apparent outside of the official Kyoto mechanisms. In April, Merrill Lynch invested $9m in a so-called ‘avoided deforestation’ scheme in Aceh, Indonesia.

Essentially, the investment bank is paying villagers in Aceh not to log the rainforest, which, as well as playing a crucial role in trapping CO2, is home to rare Sumatran tigers, clouded leopards and orang-utans. In return, Merrill will get the carbon credits judged to be earned (in return for the carbon that is trapped by the forest which, if it were cut down, would escape into the atmosphere). The process is monitored and verified by an independent auditor, the Climate, Community and ­Biodiversity Alliance.

Merrill will pay about $4 a credit for 500,000 credits a year during the next four years, at a cost of $8m. The remaining $1m pays for an option to acquire more credits. For Merrill, this is not just about saving the rainforest; it is about the ability to create packaged products for institutional clients who want to offer ethical products to their retail customers using ‘voluntary’ ­credits.

Market demand

Although it is estimated that deforestation accounts for about 20% of all global greenhouse gas emissions, such avoided deforestation schemes – also know as REDD (reducing emissions from deforestation and degradation) – are not yet eligible for trading within the Kyoto Protocol mechanisms. However, Mr Karmali, who believes that REDD credits will eventually become fungible with other carbon credits, says that the voluntary market is still a valuable one.

“There is a great deal of optionality in these kind of credits; it is only a matter of time before avoided deforestation schemes are recognised under Kyoto, and therefore the value of the credits will rise over time,” he says. “In any case, we believe that there is enough appetite and value in the voluntary credit sector to make investments like these very viable.”

Shifting attitudes

It is far too early to say that the initiatives surrounding the Kyoto Protocol have worked; but there is some evidence that they have contributed to a shift in the way that consumers and companies alike view their carbon emissions. Investment patterns at an institutional as well as at a retail level are changing. In the US – not yet a signatory to Kyoto – Mr Karmali says that the plans to build 53 coal-fired power stations have been shelved.

If China is still building more coal-fired plants than it is wind farms, it is also developing so-called supercritical – and super-efficient – coal-based technology, which is at least a step in the right direction.

Some find it unpalatable that financial markets are at the centre of efforts to stop the world overheating. Others may find it worrying that the structured technologies which have contributed to one crisis should be mooted as one solution for another. But financial markets are nothing if not inventive, so if financial institutions cannot find market-based solutions to help cure the world’s environmental woes, it will not be for want of trying. And if the world has recently grown wary of arcane financial technology, we must be careful not throw out the baby with the bath water.

CARBON JARGON

• Kyoto Protocol: international treaty to reduce greenhouse gas (GHG) emissions. It provides three market mechanisms to monetise the environmental benefits of reducing GHGs.

• EU Emissions Trading Scheme (ETS): example of the first Kyoto mechanism: ‘cap and trade’. The EU ETS enables companies and governments that reduce GHG levels to below their caps to sell the resulting emissions ‘credits’ to businesses and governments in developed countries that are close to exceeding their GHG emission quotas.

• Clean Development Mechanism (CDM): second Kyoto mechanism, which allows industrialised countries with GHG caps to invest in emission reduction projects in developing countries as an alternative to more expensive emission reductions in their own countries.

• Joint Implementation (JI): third mechanism to enable countries with binding emission targets (Annex 1 countries) to invest in emission reduction projects in any other Annex 1 country.

• Certified Emission Reductions (CERs): carbon credits earned by a CDM. Each CER unit represents the reduction of one metric tonne of CO2 equivalent.

• Emission Reduction Units (ERUs): carbon credits earned under the JI, where each ERU represents an emission reduction equal to one metric tonne of CO2 equivalent.

• Additionality: a concept at the heart of the CDM. It aims to ensure that a project reduces emissions more than would have occurred in the absence of the project. There is also an economic element: i.e. a project is deemed additional if it is only viable as a direct result of CDM revenues.

• Designated Operational Entities (DOEs): third-party agencies that ­validate a CDM project and ensure that it results in real, me­asurable and long-term emission reductions.

IN DEFENCE OF MARKETS?

The use of market mechanisms to encourage polluters to clean up their act has not been universally popular. Some environmentalists argue that buying credits from a CDM in the developing world will do nothing to encourage big polluters elsewhere to cut emissions; moreover they argue that the system of emission allocation in the EU trading scheme is vulnerable to political gerrymandering, with allocations too high to do any real good. Supporters of the market approach point to the tightening of emission allocations by European governments (and caps will get tighter each year that Kyoto is in place) as a sign that the new market is doing what it was designed to do.

“It is a question of whether you believe in markets, but we see evidence that it is proving a powerful mechanism to enable companies to cut emissions cost effectively and encourage them to incorporate carbon calculations into their business strategies,” says Owen Lomas, partner and head of the global environmental law group at Allen & Overy.

Other critics argue that the CDM mechanism is proving better at creating work for intermediaries than it is at cutting emissions. Mr Owens maintains that this is simply a result of the nature and complexity of what the scheme is trying to achieve. “This market is unique in that what is trading is a kind of ‘fiction’ which is borne out of a regulatory structure,” says Mr Owens. “Aside from the risks inherent to any project, there is an onerous due diligence process around project approval, as well as the usual licensing and consents, local law, and tax rules.”

Trust in the rigour of UN-policed mechanisms is absolutely critical to the notion of market-based solutions but this has recently been called into question. A story in the Wall Street Journal, for example, stated that there had been an increase in the number of rejected projects and cited it as a sign that a lot of projects that have been approved should have been rejected. The story claimed that the UN has since “clamped down”.

Kai Uwe Barani Schmidt, secretary to the CDM executive board and manager of the United Nations framework ­convention on climate change, says that this is not the case. First, he says, there have not been more rejections (which still amount to less than 7% or 8% of total applications) but an increase in the number of “requests for review”; this could be something as simple as a request for more information about a project.

Further, says Mr Schmidt, the CDM process is still new and all parties are “learning by doing”; it was a decision, more than a year ago, to apply a more systematised approach to validating CDM projects which led to the increase. “Much of the process requires interpretation of the UN standard, and that can sometimes lead to misinterpretation. However, the system has already stabilised and there has not been a further increase in the number of requests for review,” says Mr Schmidt. Moreover, to avoid such misinterpretation, he says that an official validation manual is currently being written: “This will guide applicants at those times when value judgements are required.”

Perhaps more damningly, the Wall Street Journal article claimed that CDM project developers had been “gaming the system by putting a green imprimatur on some projects that would have happened anyway”. Bruce Usher, CEO of major CDM developer ­EcoSecurities refutes any idea of gaming and says the process is extremely rigorous. “I have never seen evidence of fraud in this system. Even when a project has been registered by the UN, it does not automatically get carbon credits. Emission reductions must be independently verified by a designated operational entity (DOE); and it must be a different DOE to the one which validated the CDM in the first place,” he says.

It could be argued, of course, that any increase in the number of rejections or requests for review demonstrates that the system is working, not that it is failing. “Kyoto involves many new methodologies and so it has to be a learning process,” says ABN AMRO’s global head of carbon trading, Gavin Tait. “I would be concerned if the number of requests for review did not go up. It is a sign that the UN and other participants are feeding back into the process what they learn from each new ­project.”