How you can profit from climate change

The EU has had nothing but bad press in Britain this week, so the investment I'm going to suggest might seem a little odd.

Why? Because it's a bet on Europe finally getting something right and doing something that is responsible, good for the environment and also possibly profitable.

The bet is that in the next few months, when the environment commissioner Stravros Dimas gets round to fixing the carbon-emissions allowances for EU member states, he cuts them sharply from their current levels.

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Carbon trading: the basics

Let me explain. After the Kyoto protocol was ratified in 2004 (which committed participants to reduce carbon emissions by 5% from 1990 levels by 2012), the EU set up the Emissions Trading Scheme (ETS) to help member states cut and manage their emissions.

It works like this. Each state gets a set annual allowance of the number of tonnes of greenhouse gases they are allowed to emit (known as their AAU assigned amount unit). They then divide the allowance up among their polluting companies and institutions, which are obliged to produce no more emissions than they are allocated.

If they produce less they may sell their remaining allowance as "carbon credits", with one credit being equal to one tonne of carbon emitted. If they produce more they must buy credits elsewhere (and pay a fine). This creates a market in carbon credits: high polluters need to buy, low ones can sell.

The developing world does not have emissions targets but its countries can create credits known as certified emission reductions (CERs) by using cleaner production methods, and can sell these to the West.

The key to making money in the carbon market

CERs are the key to making money out of the ETS. At the moment there are plenty of credits around: they were generously allocated to member states in 2005 and the market appears to be in a short-term surplus.

But that might not be the case for long. In the next few months the European Commission has to decide on the AAUs for 2008-12. If it cuts them back and creates a shortage, the price of a CER should rise.

That would be good news for the many firms and funds that have sprung up to invest in the market. They are creating credits in the emerging world, by doing things like financing projects to neutralise chemical by-products from industrial plants in China, for about €7 (£4.70). Right now the market price in Europe is €12 to €14.

So how can you get exposure to the potential of the carbon market? There are various companies to consider. AIM-listed Trading Emissions runs carbon funds that invest in CER creation, as do Eco Securities and Agcert.

These are all high-risk investments. Their value is almost entirely dependent on the price of a CER and that depends on exactly how much political will Europe really has to address climate change.

First published in The Sunday Times 29/10/2006

For a more in-depth look at the sector, click here: How to profit from carbon trading