How to get cool profits from global warming

1 January 2005 was supposed to be a great day for the environment it was the day that the power of the market was unleashed to save the world from global warming. In the biggest scheme of its kind, the 15 members of the European Union (EU) pledged to cut carbon dioxide (a key greenhouse gas) emissions by 20% by no later than 2020. They would do this by capping the amount of carbon produced by the most polluting industries using a vast carbon-trading scheme. It was the "most important piece of climate change legislation anywhere in the world to date", says Friends of the Earth.

Sounds great. But three years later, emissions are actually up. In 2007 alone they rose by 0.68% across Europe and 2.2% in Britain. It may not seem like much, but it's hardly contributing to saving the environment. Where carbon trading was supposed to encourage the development of wind and solar farms to replace coal-hungry power plants, we've seen even more of the latter. Firms have been able to increase their emissions, rather than cutting them, partly because permits have been too cheap. So what went wrong and how can investors profit from the drive to make the system work?

The birth of carbon trading

The EU Emissions Trading Scheme (EU ETS) has so far, by most accounts, been a complete mess. Indeed, "in private there is a lot of unease amongst the architects of the scheme because it is not doing what it was supposed to do decrease carbon", says Kevin Smith, a researcher with Carbon Trade Watch.

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The original idea came out of the ratification of the Kyoto Protocol in 2004, which saw most countries agree that global warming was a reality and needed to be tackled by cutting carbon emissions. There were different views on how this could be achieved, from imposing taxes to instituting even more regulation on the most polluting sectors of the economy. But in 2005, the EU settled on carbon trading and so the EU ETS was born.

The idea behind carbon trading, broadly speaking, is that each European government gets an annual emissions allocation, which it then divides up to issue polluting firms with a set number of carbon credits (effectively licences to emit CO2). If a company's emissions end up being lower than their allowance, they can sell the spare credits to those firms who have breached their allowance. So you have the carrot of being able to make money by polluting less, and the stick of being charged more if you do breach your allowance.

The concept behind trading pollution permits has a successful precedent in the form of the United States' acid rain programme, a market-based initiative established under the 1990 Clean Air Act. Its aim was to cut emissions of sulphur dioxide (SO2) and nitrogen oxide (NO), the causes of acid rain. And since the 1990s, SO2 emissions have dropped 40%, according to the Pacific Research Institute, while acid rain levels have fallen by 65% since 1976. So this kind of market-based solution to tackling environmental problems can work.

But it only works if the permits are actually worth anything. And that depends on getting the supply and demand right. Here's where the EU ETS hit a snag. Under the first phase of the scheme (2005-2007), a highly effective business lobby petitioned governments to offer a surplus of free permits after overstating the amount of CO2 they emitted. When it became apparent to the market that there were more credits on the market than there were emissions oversupply was estimated to be about 6% to 7% the carbon price collapsed from €25 a tonne to €4.

However, the first phase was always expected to run into problems, and it looks as though European governments have learned their lesson. Under the second phase of EU ETS, running from 2008 to 2012, fewer permits have been issued, leading to a tightening in the market. Meanwhile, demand has been rising as more industries have been included in the scheme and now need carbon credits in order to offset the amount of carbon they emit. Hence the price has bounced back up from €4 to €23 today. And demand is likely to keep rising. From 2010, it is expected that the aviation sector will be included in the scheme, while many expect that a new administration in the White House would push for the involvement of American industries in a similar scheme.

The value of carbon trading, meanwhile a business that is centred in London has risen to €38bn (£30bn) in the first half of this year, almost double the total for the whole of 2007, according to consulting group Point Carbon. By 2020, it could rise to as much as €3,000bn, the group reckons, with almost every large investment bank in the city setting up trading desks to profit from this burgeoning industry.

So why invest now?

There's another reason why the supply of credits looks set to fall. The obvious problem with the EU ETS is that it only covers Europe. A vast swathe of the world is industrialising, making efforts to trim carbon emissions in the UK, for example, seems pretty pointless if China and India keep knocking up new coal power stations and building motorways for all those new petrol-powered cars to drive on. At the same time, emerging nations weren't prepared to submit to having their emissions capped. After all, why should they have to disrupt their industrial revolutions to save the planet for developed nations?

So to encourage the involvement of the developing world, they are allowed to create Certified Emission Reductions (CERs), which are just another form of carbon credit, through a United Nations certified scheme called the Clean Development Mechanism (CDM). The CDM aims to get rich countries to fund clean energy projects in developing nations by rubber-stamping ventures such as Brazilian wind farms for CDM status. These 'clean' ventures earn CERs, which they can then sell on to polluters in the developed world. Currently, 1,000 of these projects have been given the rubber stamp by the UN, with another 2,000 or so making their way through the vetting process.

But again, there have been some teething problems with the process. For example, environmentally filthy projects such as Indian conglomerate Tata's huge coal-fired electricity plant in Gujarat is in the process of seeking a rubber stamp (just as similar Chinese projects have been able to do), even though it will emit an average of 26.7 million tons of carbon dioxide a year. Tata's argument is that this is 2.8 million fewer tons than the plant would release if it used the less-efficient coal-fired technology now common throughout the rest of the country. As a result, Tata would be able to sell 2.8 million carbon credits a year. At a price of €23 a tonne, that means an extra 64.4m for Tata at current values. Not a bad subsidy for building a power plant that ultimately adds to the amount of CO2 in the atmosphere.

It's not just the fact that projects like Tata's are receiving money from the scheme. Perhaps an even bigger problem is that, according to a new working paper from two Stanford University academics, the majority of CDM projects in the developing world would be built anyway without assistance from the UN scheme. In fact, "it looks like between one- and two-thirds of all the total CDM offsets do not represent actual emission cuts", says David Victor, law professor at the Californian university. In other words, the UN is dishing out a huge number of credits for nothing which then make their way back to the developed world and allow polluters to stoke up their emissions.

Again, however, all this criticism has been taken on board, and the UN is now expected to cut the number of projects being given approval. As a result, there will be a lot fewer CERs on the market, which means the price of carbon is heading in only one direction: up.

Analysts at Point Carbon predict that the average price of credits will rise to €32 a tonne by 2012 as higher oil prices and the lower-than-expected supply of carbon credits under the CDM drive up the price of carbon allowances. "We see €32 per tonne as a fair price for phase II European Union Allowances." That's €2 per tonne more than the group had expected only in March this year, explained Kjersti Ulset, manager of Point Carbon's EU ETS team in a recent report. They believe the price could even go as high as €39. That's a tidy potential profit for investors, given the current price stands at €23 a tonne particularly as there are currently very few other asset classes out there that look attractive over the long term.

There are risks, of course. There's the danger that if a global recession leads to a severe slump in industrial activity, then there may be less need for the permits, and thus a drop-off in the price of carbon credits. However, if this was the case, it seems likely that the number of credits available in the future would be cut back again.

Perhaps more importantly, unlike lean hogs or oil, a carbon credit is an imaginary commodity, a legal construct put together by governments. As such if governments lose interest in cutting emissions, or stop co-operating with one another to do so the whole market could be wiped away as easily as it was originally created at the stroke of a pen in Brussels.

However, for the moment that looks pretty unlikely. The global annual rate of growth of CO2 emissions was 3.2% in the five years to 2005, compared to 0.8% in the period 1990 to 1999, but the evidence so far is that carbon trading is beginning to work to cut emissions. A report from Point Carbon says that emissions in the power and heat sector in the EU ETS have been cut by 20 million tonnes as a result of carbon prices so far in 2008.

And it doesn't look like world leaders are going to change their minds about the dangers of climate change any time soon. Regardless of your point of view on the science of climate change (we aren't scientists here at MoneyWeek, so debating the exact number of degrees the earth may or may not warm by and whether it's all our fault or not, isn't really within our remit), the fact is that the consensus is now treating it as a reality. Last Tuesday's meeting of the leaders of the G8 merely confirmed this, when they set a goal of cutting emissions by 50% by 2050. With this kind of backing, emission trading looks too good an idea to consign to the dustbin just yet.

How to play the carbon trading market

Just as the carbon trading market looks ripe for buying into, Barclays Capital has launched one of the easiest means of doing so. The iPath Global Carbon ETN (NYSE:GRN)is an exchange-traded investment that came onto the market last month, with the aim of tracking the Barclays Capital Global Carbon Index (BCGCI). The BCGCI tracks the performance of carbon credits associated with the EU Emissions Trading Scheme and the Clean Development Mechanism (CDM), so the expectation is that when they rise in value, so too will GRN.

The good news is that on a historical return basis, over the year to the end of April 2008, the index has returned 28.93%, against a 4.68% drop for the S&P 500. As this suggests, the BCGCI has a low correlation to equities, with a 0.59 correlation to the S&P 500, and 0.56 to the MSCI Emerging Markets Index. (The closer the correlation is to one, then the stronger the relationship between the indices. The closer to zero, the weaker.) So, as equities fall, the BCGCI shouldn't follow it in tandem. But it's also barely correlated to the current commodities boom, with a correlation of 0.25 to the Dow Jones-AAIG Commodity Index. And with an annual fee of 0.75%, it's a pretty cheap way of getting access to the market.

It should be noted, however, that GRN is an exchange-traded note, which, unlike an exchange-traded fund, has a specific maturity date. In the case of GRN, that date is 2038 meaning once the ETN approaches maturity its price could well drop. More importantly, though, the carbon ETN is an unsecured promise of Barclays PLC, meaning if the bank goes bust, so too will the ETN. That does seem unlikely, even given the current state of the banking sector.

Another way to access the market is through one of the carbon project developers. However, delays in winning accreditation for projects from the UN's CDM have led to cash-flow problems. For example, Irish firm Agcert went into receivership after it ran short of cash. That's hurt sector peers such as EcoSecurities (Aim:ECON) and Camco (Aim:CAO). But EcoSecurities already has 126 projects registered with the CDM executive board, and those companies that can survive until cash flows pick up should see their share price appreciate, says Agustin Hochschild at Kreis Consulting.

Another option is Climate Exchange (LSE:CLE), which runs the European Climate Exchange and the Chicago Climate Exchange. The firm accounts for over 80% of all carbon trading in Europe, and if carbon trading continues to grow at its current rate and growth forecasts for the market are correct, volumes should rise too. For the first half of 2008, trading volumes were up 250.14% on the first half of 2007, while they soared 389% on its Chicago exchange during the same period.

The trouble is, any good news is priced in for now the stock trades on a 2009 p/e of 116. There are hopes that one of the bigger commodity exchanges, such as NYMEX, will launch a takeover bid. But as Ben Bland puts it in The Daily Telegraph, "any predators are unlikely to move at this kind of valuation, especially in this troubled market". So for now, the best way to bet directly on the carbon market looks to be the Barclays ETN.

If you're looking for a more general means of profiting from global warming, methane production projects are gaining popularity among governments aiming to switch from coal-based electricity plants to gas and methane ones. A much cleaner form of fuel than coal, methane is now being drawn from sites such as landfills, wastewater and coal deposits.

Waste Management Inc. (US:WMI) is the largest waste services firm in America, and plans to build gas to electricity plants at over 60 facilities across the country. It has a p/e of 16. As for funds, the Wilderhill Clean Energy Index tracks the performance of clean energy stocks in sectors such as semiconductors and electrical components. It can be tracked with PowerShares WilderHill Clean Energy ETF (US:PBW). It trades on a p/e of 13.63 and is up 16.77% since launch in 2005.