Carbon Funds, How They Work

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Courtesy of Blackstone Global Ventures a.s.

It could be said that when the average man on the street hears about a new Environmental Fund or Climate Change Funds its easy to imaging the observer visualizing a member of Greenpeace flogging and IPO prospectus on Wall Street. Perhaps destined to be a most undersubscribed offering.

In reality many of these carbon fund raisings are employing tried-and-true investment principals such as: origination of new stock, arbitration of differing instruments, the capture of significant discounts, all to ultimately return a capital gain to the investor. But how could this possible considering Climate Change-Global Warming is a greenie issue? Hardly the type of thing that would interest the professional financial markets community, an observer might opine.

In reality it is not too far fetched to imagine the near future where even investors lacking a renewable energy brief (or an environmental conscience) might consider the world of carbon trading simply a new commodities type market where variables such as the supply of the existing underlying, new origination efforts, and even a tight relation to the energy markets, will be enough to consider before investing.

But wait, did someone just explain the carbon market without spending multiple paragraphs on the issues causing Global Warming, the long process of negotiations between green house gas emitting countries and the acceptance of many said governments to curtail their harmful emissions to the detriment of their gross national product? Isn't that a bit too brief?

Well, that is why it is, for many, still in unexplored and unfathomable territory. Many would-be investors never read through those paragraphs because, while the basis for this new market is a paradigm of inter-governmental coordination and mother of all surprises - an 'agreement' between the majority of nations (the Kyoto Protocol) - the concepts employed tend to be explained in excruciatingly painful detail.

If however, the market of carbon instruments is explained from a different approach, an inside-out approach, perhaps investors would see how it works first and learn the why’s later.

The European market (yes, there are many locality based variables) market can be explained as a place where the right to emit greenhouse gases is securitized into ‘permissions’ or ‘allowances’ to emit, where less of these allowance credits are issued over time in a concept not unlike musical chairs, a simple concept for a serious issue whereby fewer emission allowance credits in circulation means less greenhouse gases actually emitted into the atmosphere. To police this, the participants “governments and companies face severe fines for ‘non-compliance’. These participants can, however, buy cheaper, newly created credits.

This next concept of newly created or ‘originated’ credits is the one that forms the basis for the lion’s share of new carbon funds and unfortunately becomes a bit wordier. This involves the principal of originating new credits based on causing the reductions of GHG emissions in places around the world were it would be much less expensive.

After all, implementing reductions, (cleaning up, capturing), elsewhere in the world benefits the globe as a whole. And the agent implementing the reduction is then awarded a carbon credit that is usually shared with the site where the emissions were reduced (the factory, the installation, etc).

This is quite frankly not unlike a new IPO offering or the mining of a new commodity. And the effort and expertise expended to bring the new security to market is recouped by the agent because the origination might take place at prices much lower than where the agent can sell them on the world market. Now it should be clear that with the capture of sizeable discounts, there is in fact room for larger financing. And with the growing surge of climate change understanding, the resultant political willpower, the sheer power of the financial market is brought to the cause. This power should be compared to other attempts at taxation where the application is usually up to individual governments and subject to changes as governments change, not nearly as affective as the financial incentive.

It must be made clear, however, that an investor to a fund that captures discounts in the generation of greenhouse gas emissions must be cognizant of important issues such as the risks involved in the creation of new credits: the lengthy and tedious administrative processes to establishing a carbon credit-worthy project, the verification and validation of real emission reductions, as well as the more obvious macro components affecting the supply and demand and ultimately the prices of credits. And also the investor must critically judge the fund manager (agent) to navigate the by-ways of the new credit approval process.

Indeed, perhaps it is here that the investor might best value a the fund since profitability mostly relies on the abilities of the manager to source discounted projects, manage the extraction process from the identification up to perhaps 5 years later when credits are issued: the fund manager must be a master of the carbon credit origination process.

Of course there is criticism. A cynic might say that with all those financial types involved, banks that need to earn large margins to stay afloat, it seems that the real greenhouse gas reductions may take a lesser import. On the other hand, many other previous attempts to apply environmental remedies have fallen short of their goals because the free market was not involved.

The carbon market now however, seems to have surpassed this criticism and is now firmly established as its own financial market. The carbon market and pricing is related closely to energy movements, subject to international acceptance (USA and Australia have not signed the Kyoto Protocol), and even another important factor when it comes to industrial prices. It is nevertheless a growing market confirmed by the appetite for growing fund investment.

*These less expensive locations (countries where emissions reductions are cheaper to implement, might have accepted emissions limits such as the Ukraine or Romania, or possess no limits at all such as in India or China, they benefit in the long run since the creation of new credits benefit the installation ‘host’ and host government implicitly, since they share in the sale of new credits.

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