This article was originally published in MoneyWeek on 27/10/06
For the last 50 years, scientists have been issuing dire warnings about climate change and the havoc it would soon bring to the world. But for most of us, global warming has long remained, as BusinessWeek puts it, "merely a matter of numbers from a computer model" and as a result, we have taken little notice. That's changed. Today it seems as though we can see global warming all around us. The five months from May to September this year were the hottest since records began and July was the warmest month ever. Primroses are blooming on the Channel lslands; yellow slugs in Northamptonshire, confused by the warmth, are reproducing three months early; all over the UK irritated gardeners are cutting their lawns weekly long after they have usually put their mowers away for the winter; and in the South Pacific the president of Kiribati, an archipelago just 6ft above sea level, says his nation may be submerged within a decade.
More startling evidence of the reality of global warming appears to come from Antarctica: new research from the British Antarctic Survey in Cambridge has found that the collapse of the Larsen B shelf four years ago when an entire ice shelf the size of a small country disintegrated was not an act of God, but the direct result of dramatic warming' on the eastern side of the Antarctic peninsula. It is, says the study, 2.94C warmer today than it was in 1951.
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This is terrifying, says The Independent. Disintegrating shelves in themselves aren't that big a deal they float on the sea and don't actually raise sea levels when they melt. However, their disappearance has "ominous knock on effects": glaciers once held back by ice shelves are now moving towards the sea eight times faster than they were before. And when glaciers melt, they do raise sea levels. The sea is already rising by 2mm a year, but if the entire west Antarctica sheet were to melt, water would rise by six metres around the globe, "submerging the world's coastal cities, including much of London".
But it isn't just Notting Hill turning into a seaside resort that we have to worry about. There are massive changes in weather patterns, which could lead to drought across the rest of the world (the unsubmerged bits, that is); there's the fact that climate change is happening faster than evolution and so knocking out species as it goes (the Monteverde Harlequin frog is already a goner, says Newsweek); and, worst of all, the claim this week from Margaret Beckett that climate change is a threat to world peace. The added stresses it brings, she says, "increase the risk of fragile states dropping over the precipice into civil war and chaos". It is all a story "worthy of Greek drama", says Fiona Harvey in the FT. We've created a world that has brought us unparalleled prosperity only to find the "potion" that allows it (fossil fuels) is poisoned (in that it creates the carbon emissions responsible for global warming). However, there is a "small voice of hope". We have "both the knowledge and the power" to make all well. All that is needed is "for the world's peoples to put aside their differences and to work for a common goal": the global reduction of carbon emissions.
So what does all this mean for investors?
The answer is not straightforward. If we knew for certain that global warming was real, we know exactly what we'd do with our money. We'd sell all our low-lying London property and buy a ranch with a good fresh water supply in Argentina. That way, we'd be safe from drought and have exposure to the soft commodities market (if everything we're told is going to happen does, the prices of all agricultural produce will be forced up by the rising cost of irrigation and the weird weather events around the globe).
But we aren't scientists and can't be sure that what the WWF calls a "large scale eco-system collapse" is coming. There are dissenting voices Professor Philip Scott of the University of London insists the collapse of Larsen B had nothing to do with global warming and says that "simplistic apocalyptic statements about global warming' have more to do with myth than reality". But there's one thing we do know for sure: the majority of people and governments now accept climate change is real and that "something must be done" David Cameron's entire political strategy appears to centre on green' issues, and Margaret Beckett says that "achieving climate security has to be at the core of foreign policy". We also know there is a way to make money out of everyone else's climate convictions and the actions they want to take to cut emissions.
The key to this opportunity is the fact that very few people can ever be persuaded to do anything for the greater good however much they say they believe in it unless there is something in it for them. So just as householders won't put in solar heating unless they get a grant to do so, big companies (the main villains when it comes to emissions) won't make any effort to cut their carbon emissions unless there is a financial penalty for not doing so. With this in mind, and in the aftermath of the ratification of the Kyoto Protocol in 2004 which institutionalised the assumption of global warming the EU created a system under which member states agree to cap their emissions and which helps them to do so by allowing them to trade carbon emission allowances via the Emissions Trading Scheme (ETS).
How does carbon trading work?
It works like this. Each member state gets an annual emissions allocation that it then divvies up among its worst emission-producing firms. Each company in turn is then obliged to produce no more emissions than its allocation allows.
If it comes in under target, it can sell its excess allowance as carbon credits' to other firms that have overshot their targets. (Credits are measured in units of emissions reductions, each one being the equivalent to the reduction of one tonne of carbon dioxide). But if it comes in over target, it has to pay a penalty and then go to the market to buy credits to make up the difference.
Right now the market is in its first phase (2005-2007), and buying credits isn't hard. They have been generously issued, the market is thought by traders to be 6%-7% in surplus (thanks mainly to exaggerated emissions forecasts before allocations were set). It is also possible for Western firms to buy credits from the developing world: while they have no emissions limits of their own, firms in developing markets are able to create credits (known as Certificates in Emission Reductions, or CERs) by using cleaner production methods (see box, right). The result? Prices are low. At the beginning of the year a tonne of carbon cost around $30, but when details of the surplus emerged in April, it fell to around $9 and is now $12-$14. But this may not be the case for long. In the next phase of the EU scheme 2008-2012 the level of credits allocated to each country, and hence to each individual polluter, should be cut sharply (on the basis that under Kyoto, emissions in Europe must be cut to 8% below their 1990 levels by 2012), making it tough to meet targets and pushing demand for credits, and hence the price of credits, up fast.
How to invest in carbon trading
What does all this means for us? First, that carbon trading is about to become big business (even in 2005 the World Bank estimates around $10bn worth of carbon was traded, and I am told that, although the market, being young, is still relatively illiquid, two to three million tonnes are now being traded a day). Second, it makes sense for those who want to make money out of the market to stockpile and create CERs that can be sold on when prices rise (only CERs can be banked and carried over to future phases of the Emissions Trading Scheme). This has not escaped the attention of the City: carbon trading, being a complicated way to exploit a problem that few people understand and that may or may not exist, is right up its street. Its solution? Carbon funds: funds set up not just to trade, but also to create credits in emerging markets (with a view to selling them on when the price rises).
Climate Change Capital, one of the biggest names in the new game, has just raised nearly $1bn for a carbon fund that will do just that.
Its CEO, Mark Woodall, tells me that his lucky investors (not me, sadly the minimum investment is e25m) should make returns "commensurate with a venture capital or infrastructure investment in emerging markets". I would guess that means 15%-20%, but he wouldn't be drawn on the details. He is, however, planning to launch what he calls a "consumer-facing investment product" (a retail fund) some time next year. And for those who can't wait, there are a variety of funds and companies dealing in carbon in various ways see below for details.
Carbon credits: what are the risks?
This is not risk-free investing. A carbon credit is not a real, deliverable commodity. It is a legal construct that will continue to exist only for as long as governments want it to: if they lose interest in capping emissions, or stop co-operating to do so, the market will collapse. Those running carbon funds assume that when the European Commission next rules on allocation plans (in the next few months), it will slash them it should, if it wants its system to work but there's no guarantee that it will. Note that, according to environment commissioner Stavros Dimas, the requests for allocations he has already received from EU states are too high: if he were to let them through, he says, the scheme "would become pointless". It's also possible that, if it looks like there is good money to be made in carbon, there will be emissions reduction projects in every factory in China. That might be good for the planet, but it won't be good for investors if a rising supply of credits drives down their market value in the medium term. Likewise, as alternative energies, such as biofuels, become more viable, emissions will reduce naturally and so will the price of credits. Carbon bulls say that, in ten years, carbon will be a major and globally traded commodity, just like oil, but that is no more certain than the suggestion that Kiribati will be under water by then.
Still, caveats aside, I like the look of carbon trading. With the entire political world and most voters in the West convinced that cutting emissions is the only way to ensure the survival of civilisation, I can't see even the EU worming out of having a really good go at making the whole thing work. Dimas himself, speaking this week, says he will be sending back requests for generous allowances to member states and demanding they cut them. And when discussing the fact that too high allowances would ruin the scheme, he said, in a manner more direct than one usually expects from an EU official, "I cannot let that happen". Assuming he's true to his word, while the carbon market is bound to remain volatile, the long-term trend price of a credit can only go up, something that means that the funds getting in on the game now could end up doing very well indeed over the next decade.
The best ways into the carbon market
The carbon market is a new one, so investing in it is not as easy as it could be. There are still doubts about its long-term sustainability and there is no such thing as an experienced manager or trader in the sector: everyone is learning as they go. The market is also extremely volatile and very illiquid, to say nothing of being at the mercy of the whims of politicians. This means that shares in the companies that are active in the carbon market are not for those who cannot afford to take risks.
Anyone in doubt need only look at the share price chart of Trading Emissions (TRE), an Aim-listed firm that runs carbon funds that invest in CERs. The firm's fair value is, as Numis Securities points out, "very heavily dependent" on the carbon price. So when that price collapsed in April, as data from 2005 made it clear that there were more credits floating around than there were emissions, so did Trading Emissions shares (see chart).
Still, that doesn't mean it isn't worth buying the shares now. Despite the surplus in the market, the price of a carbon credit is holding up pretty well, something that reflects both the illiquidity of the market (much of the surplus supply never makes it to the market) and the general view that over the next two years (before the next phase of allocation cuts kicks in) demand for emissions might rise. A very cold winter or a very hot summer would, for example, mean more energy used and more carbon emitted, points out Gareth Hughes of CCC. Trading Emissions is currently paying around e7 for a CER and expects to be able to sell them on after 2008 for an average of e15. Numis thinks the shares are undervalued at 114p and has a target price for them of 156p.
Also in the business of creating carbon credits is Oxford-based and Aim-listed EcoSecurities (ECO), tipped by Brian O'Connor in the Daily Mail earlier in 2006. The company's broker, ABN Amro, expects it to make a loss this year, but to pull in revenues of £38m next year and make a profit of £6m in the process. In 2008, however, it forecasts that things will improve exponentially: ABN sees revenues shooting to £96m and profits to £52m. As with Trading Emissions, the company's value is entirely dependent on the price of carbon and, as O'Connor points out, "having almost doubled and halved in eight months", the shares aren't going to offer a smooth ride. They are, however, "worth a punt" if you can cope with the risk.
A third company working in the sector is Agcert (AGC). The company mainly makes its credits by setting up emission reducing systems on farms in the developing world (removing the methane given off by animal dung). It has had a tough time getting this technology sorted out, but nonetheless has over 400 sites up and running in South America. Shares magazine rates it a "high risk punt."
Next up is Econergy International (ECG). Econergy is not as pure a play on carbon trading as the other firms mentioned here. Its main aim is to generate electricity from setting up clean power projects in Latin America, and it is from this that most of its value comes. The fact that it should also be able to create CERs from its projects and that it acts as a broker for other carbon deals is, says Numis, just the "icing on the cake". Numis notes (quite rightly) that this is a long-term business to be in, but says that, "assuming the group executes to plan, we think that the shares could double in a four or five year view". Investors Chronicle is also a fan, rating the stock a buy and quoting chief executive Tom Stoner on the company's clean energy projects: "Once you've invested and have financed these projects you basically have a cash machine."
Those interested in getting a small amount of exposure to the carbon market via a generalist fund might look to the Scottish Widows Investment Partnership's UK Opportunities fund, run by David Urch. Urch, says the FT, is a fan of carbon trading and holds both Trading Emissions and Econergy in his fund.
Carbon trading and emerging markets
A problem soon emerged after Kyoto: developing countries were not prepared to have their emissions capped. As far as they were concerned, it would not be fair for rich countries who had developed in a dirty world to insist that they did so in a clean world. Hence it was decided that countries such as India and China would receive no specific reduction targets. But to encourage them to develop cleanly, under a scheme called the Clean Development Mechanism, they would be allowed to create credits to sell abroad by reducing their own emissions or developing so as to keep them low.
CCC, along with Deutsche Bank, has recently invested in carbon credits generated by Zhejiang Co, a Chinese chemical firm. It produces a nasty greenhouse gas that it will now incinerate to neutralise it, hence creating credits that can be sold in Europe. Western firms are initiating similar projects all over Asia and South America (so far, 365 projects have been registered) and are managing to create credits at a cost of around e7 each. This cost will rise as all the easy projects are completed and harder ones tackled (it is cheaper to clean up chemicals than to build a wind farm), but with credits selling for more like e14 in Europe, there is clearly money to be made.
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