Why you must play the carbon markets

"This is a green revolution in the making it will be a tenfold increase in our deployment of renewable energy!" Of all the unlikely statistics to have surfaced during the recession, Gordon Brown's target for 15% of our energy to come from renewables looks like one of the most pie-in-the-sky.

The government is introducing a scheme to make 20,000 struggling British firms buy energy allowances in an effort to realise his target. But is now really the time to worry about offsetting our carbon emissions?

French energy group EDF thinks so. EDF made a shock 60p-a-share offer for Irish carbon-offset group Ecosecurities last week, sparking a bidding war as Dutch firm Guanabara Holdings scrambled to outdo the bid.

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Ecosecurities makes its money by investing in projects that are eligible to be awarded carbon credits (anything from a hydroelectric power plant in Honduras to a pig farm in the Philippines) and then selling the credits which are essentially permits to pollute to utilities and governments via climate exchanges in Europe and Australia.

But trading hasn't been going too well recently. As global industry wound down, carbon prices in February fell to near-record lows on the European Climate Exchange, resulting in sales prices falling to similar levels "to purchase prices in China, the biggest supply market", reported Gerard Wynn on Reuters earlier this year.

With margins "too low" for most developers, they were left sitting on their holdings of carbon credits, and had to depend on cash reserves and forward sales made last year. Carbon prices have since ticked up somewhat, but still remain too low to encourage the development of many new offset projects.

And governments aren't helping. Brown and his ilk might make headline-grabbing promises for renewable energy, but the carbon trading market has repeatedly been hit by delays as the UN deliberates on which emissions projects are eligible for credits and which are not.

And it's hard to see how carbon prices will recover much before 2010. The economy has a very long way to go before it's back to full strength and demand for licences to emit carbon isn't likely to recover until some time after industrial output does.

But while times are tough for carbon offset groups now, those forward sales have put them in a good position to wait for a recovery, with healthy cash piles. For example, Ecosecurities has sold forward some 42.4 million tonnes at an average price of €13.70, says Wynn. That compares with an average purchase price for these credits of €7.50.

So why is EDF swooping now? As these groups have been hammered by the falling carbon price, they look like a very cost-effective way to snap up a portfolio of carbon credits. And EDF isn't the only big firm trying to elbow its way into the game. Morgan Stanley, JP Morgan and Goldman Sachs have all recently bought stakes in carbon-offsetting projects, says Mark Scott in BusinessWeek. It seems the financial sector has spotted a nice little sideline in advising industry on how it has to adjust to a similar system the Obama administration looks set to introduce.

The banks are already getting plenty of business. They collect an estimated $2m-$3m per client for the trouble, says financial consultancy TowerGroup. Last year, voluntary trading in the US amounted to less than $400m, but analysts reckon rules for a full-blown US scheme will be in place by 2013, and carbon trading could top $1trn a year by 2020, says research firm New Carbon Finance.

There is plenty of risk here, but huge commitments to carbon trading have already been made. Just last week Canada said it will follow Europe and America's lead. Everyone, from banks to to Filipino pig farmers, is staking their claim. You should do the same. We have a look at the best ways to do so below.

The best bet in the sector

If you don't want to go to the trouble of buying a pig farm in southeast Asia for the carbon-credit windfall, you might consider Aim-listed Trading Emissions (LSE: TRE).

This carbon project developer, which invests in everything from wind farms to biodiesel, posted a pre-tax loss of £126.7m for the six months through December 2008 amid delays in winning UN accreditation for projects and the collapse in the carbon price.

It currently trades on a p/e of 1.22. But the company still has a strong cash position, says Paul Hoskins on Reuters, with £202.6m in cash, up from £139m at the end of June last year. It has also sold forward about nine million tonnes of an expected 50 million tonnes offset pipeline, at an average price of €20 compared with average costs of €7.50.

The firm is a potential takeover target too, says Agustin Hochschild of Mirabaud, who has a price target of 127p on the stock. But those with more appetite for risk might want to look at smaller rival Camco (LSE: CAO), which would see more benefit from any carbon price recovery. Mirabaud has a price target of 53p.