The battle towards the reduction of greenhouse gas (GHG) emissions will enter a new stage at the beginning of next year, as Phase II of the EU Emissions Trading Scheme (EU ETS) comes into force. Phase I, introduced in 2005, has generally been seen as a taster of things to come, allowing companies to get used to the concept of measuring their carbon emissions. Phase II – that will run from 2008 to 2012 to coincide with the first Kyoto Commitment Period – will be much tougher, bringing in tighter restrictions and allowances and also higher penalties for those failing to meet their carbon reduction requirements.
Although the debate around socially responsible investment (SRI) and institutional investors is not new, regulation around carbon emissions has put a price tag on unsustainable industrial practices. As a consequence, fund managers and institutional investors are becoming more aware of the carbon risk of the companies they invest in.
Ranking system
In the UK, for instance, environmental research firm Trucost, has recently published a carbon footprint ranking of UK investment funds, to allow investors to take environmental issues into account when choosing an investment vehicle. Trucost’s CEO, Simon Thomas says that even though carbon emissions are increasingly being seen as a source of portfolio risk and cost by fund managers, only a minority of companies publicly disclose their GHG emissions – and fewer do it in a quantitative or comparable basis.
He explains his firm has been able to calculate emissions by analysing companies on a segmental basis and applying standard emissions profiles for over 130 different business activities. The data used has been obtained from different sources including national pollution and emission registries and environmental accounts. Their research ranks the carbon footprints of 44 of the largest investment funds in the UK, managed by 28 different asset managers and representing assets of around £45bn (€66.2bn) (see table download file).
“We need to express environmental damage in financial terms. The environment is not an ethical problem but an economic one,” Mr Thomas says. “If as an investor you own 1 per cent of a company, you own 1 per cent of its emissions.”
Looking at the ranking, Mr Thomas says that when it comes to carbon footprint socially responsible investment funds tend to do better than mainstream funds, although there are some exceptions. More importantly the survey found there is no correlation between the financial performance of the funds and their carbon footprint.
Trucost is now planning to release a ranking looking at the carbon footprints of European funds.
Regulation around carbon emissions have resulted in a growing carbon trading market, this is the trading of allowances for companies to emit carbon or other GHG, calculated in tonnes of carbon dioxide equivalent (tCO2e). According to the latest report by the World Bank’s Carbon Finance Unit, the overall value of the global aggregated carbon markets was over $10bn (€7.45bn) in 2005. During the first quarter of 2006, overall transactions worth $7.5bn led many to predict that this market would be valued at somewhere between $25bn and $30bn at the end of last year. However, the reports highlight that these values had been driven by soaring prices in the EU ETS market for European Union Allowances (EUAs). In 2005, EUAs traded $8.2bn, representing 322 million tonnes of carbon dioxide equivalent, almost a forty-fold increase over the previous year’s volumes.
“Carbon trading is a fast developing market and this is due simply to the fact that global warming is happening and public opinion is more aware of this,” says Emmanuel Fages, commodities analyst at Société Générale Corporate & Investment Banking (SGCIB). “Once you have this awareness you look at the tools you have to address this and the carbon market, at least in Europe, is one of the main tools available to reduce emissions.”
“It is a market that is worth around €20bn worldwide and we anticipate that in 2007 we will see an increase again to some €25bn,” he says. “This is a significant amount of money and we are seeing more and more participants in the market.”
Mr Fages comments that unlike the commodity markets, that are driven by demand, the carbon market is driven by regulation. “You have people producing oil and people that need to put it into their engine and the regulation comes afterwards to rule the way the exchange is done and make sure there is no manipulation.”
Approaching with caution
He adds: “However, there is no need for carbon reduction in terms of pure market initiatives. It is a constraint that is being imposed on industrial players that is being converted into a market mechanism.” Because of this some participants in the carbon market, such as hedge funds, are being very cautious when approaching the sector. “They think it is a risky market because political decisions might change but it is true we are seeing some [hedge funds] in the market.” As long as climate change continues being an issue and as more and more countries join the fight, carbon can become an asset class as much as gold has. “There are many hedge funds playing in oil because it’s an asset they can invest in and then sell or keep according to their risk aversion and return objectives.”
The World Bank’s report highlights how this new market has driven different players to develop clever carbon-based securities and hedge instruments aimed at hedging carbon price risk against price volatility in other commodity markets. Brokers, consultants, carbon procurement funds and hedge fund managers have been trying to identify opportunities to buy credits associated with different types of projects targeting reduction of emissions in developing countries. These include Clean Development Mechanism (CDM) projects – focused on the reduction of GHG emissions in developing countries by promoting sustainable and environmentally friendly development – and Joint Implementation (JI) projects.
“CDM projects generate what we call certified emission reductions that may be imported to help meet targets in Europe,” says Jihad Al-Chaer, project manager, commodities, at financial software provider Sophis. Under the terms of the Kyoto Protocol, the companies that generate such products can then sell these carbon credits to other market participants. “These types of players are looking for STP [straight through processing] systems that can reduce their operational risk,” Mr Al-Chaer explains. “They want a single and global system that allows them to manage their projects, and also allows them to easily generate reports for their portfolio and their financial positions.” He adds market participants want to be able to use a platform that can capture and price all carbon credit instruments and derivatives and, most importantly, they don’t want their potential growth to be limited by the system they use.
Mr Al-Chaer is confident that the arrival of Phase II will see an increase in market participants. “First of all there will be new players including hedge funds and banks. What they are seeking is to boost their returns and they are watching the market to understand how other players behave,” he says. “Corporates, of course, will also be interested in having the right system to manage their carbon risk because prices or penalties are going to get higher and higher.”
The future growth in the emission trading market and the emergence of carbon as an asset class will continue depending on further regulation and other regions following the steps taking by the EU. “This market has been looked at very closely by other countries that would like to somehow replicate this system,” says Mr Fages. Australia and Canada are also looking at implementing domestic systems similar to the European one. “The US is not there as yet but if they do something it will probably be a replication, or even an enhancement of what is happening in Europe,” he adds.
