International carbon markets, created to reduce greenhouse gas (GHG) emissions, have spurred innovation and efficiency across a range of industries, particularly those that are energy and GHG intensive. By creating price signals, carbon markets enhance the relative attractiveness of efficient, low carbon technologies.

Creation and management of carbon assets

Broadly speaking, any project, investment, or measure which reduces greenhouse gas emissions can generate a ?carbon asset?. Regulated companies falling under a cap-and-trade system ? such as the European Union Emissions Trading Scheme (EU ETS) ? which reduce their overall, company-wide emissions below their regulatory requirements can sell the excess reductions in the form of avoided carbon allowances on comparatively liquid open markets. Alternatively, companies or third-party investors can finance specific projects (such as a methane capture facility at a municipal landfill) which reduce emissions beyond any particular requirement or business-as-usual-scenario. The resulting carbon credits may have value in certain carbon markets, yielding a financial return on the investment. Our focus here will be on the latter opportunity, carbon assets generated by emission reduction projects.

In an ideal world, carbon assets would have intrinsic value, but in practice they must be monetized through a specific legal framework and market mechanism. The monetization process depends on the particular carbon market in which a company or project operates, but typically involves at a minimum:

An assessment of the emissions boundaries around a particular activity that reduces emissions;
An evaluation of specific options and motivations to undertake an emission reduction activity [i.e. establishing the ?baseline? or business-as-usual scenario];
A rigorous calculation methodology to quantify those reductions of emissions in tons of CO2eq;
Independent verification that the reductions occurred as stated by experienced 3rd party verifiers / environmental auditors;
Additional steps depending on the particular market mechanism employed (e.g. host government approval and additionality under the Clean Development Mechanism);
Contractual management of the legal title to the emissions reductions.

The actual asset at hand is intangible, simply represented as the legal ownership of the rights to the emissions reductions, as well as an independent verification/certification statement that the reductions are fairly represented. In best practice, the asset is ?registered? on an independent or government-backed registry which tracks the transactional flow and end uses of the credits. This ensures the proper accounting for a financial instrument which is otherwise not based on any underlying hard asset.

Examples of projects which can create carbon assets include clean / renewable energy generation facilities, switching to less carbon intensive fuel sources, energy efficiency measures, capturing fugitive methane emissions from landfills, coal mines, and oil and gas production and transmission systems. Certain ?sinks? projects which remove carbon dioxide from the atmosphere may also be able to create credits, for example large-scale reforestation or avoided deforestation projects.

The main existing mechanisms which have been created to recognize such project-based carbon assets are the Clean Development Mechanism [CDM] and the Joint Implementation [JI] markets of the Kyoto Protocol. The CDM in particular has experienced rapid growth over the past few years, with over US$ 12 billion in public and private capital being invested into a pipeline of over 2000 projects in Asia, Latin America, and Africa, representing emissions reductions in excess of two billion tons of greenhouse gases by the year 2012. Other, smaller regulatory markets also exist, as well as an emerging voluntary market for emission reduction projects which exists outside of any particular legal framework.

Putting Carbon Finance to Work: Use of Carbon Assets

Carbon assets ultimately derive their value as they can be used by companies and entities to comply with mandatory emissions reduction requirements. Currently these requirements apply only to companies with facilities covered by the European Union Emissions Trading Scheme [EU ETS], and governments which accepted binding reduction targets under the Kyoto Protocol (i.e. the EU-25 nations, Japan, and New Zealand). However, the spread of market-based policies to reduce GHG emissions is likely to expand the regulatory demand for carbon credits to new markets, regions, and sectors around the world, particularly in North America. Those corporations which have carbon intensive operations or assets in jurisdictions with such compliance obligations can either invest directly in projects which reduce emissions and take ownership of those reductions, or purchase credits from the open market.

Once management understands the cost implications of emerging carbon regulations on their companies, the decision of when and how to enter the carbon markets is best informed by a comprehensive carbon management plan. This exercise begins with an inventory of the company?s emissions and reduction obligations, followed by an investment analysis of the set of direct measures to reduce emissions internally. These steps could range from complex efficiency improvements such as upgrading to more efficient production equipment or substituting less carbon-intensive input materials, to simple steps such as minimizing employee air travel and installing on-site renewable energy generation. Each realistic measure available to management should be ?priced? by determining its marginal cost of reducing each ton of emissions (a technique known as ?marginal abatement cost analysis? which is simply a discounted cash flow analysis of an emission reduction project to determine the cost of reducing a ton of carbon emissions).

Undertaking this analysis helps management understand the internal cost of reducing emissions, compared to purchasing emissions credits on the open market. Internal measures which are more cost effective to implement ? and suitably aligned with corporate strategy as discussed above ? should be green-lighted, thus reducing the company?s emissions footprint when implemented. The remaining reductions required for compliance could then be achieved by purchasing credits in the open market.

As emissions credits are a tradable financial instrument, companies need not have regulatory obligations to benefit from carbon finance. Those companies with unregulated operations in regions covered by the CDM or JI can often derive an additional revenue stream or incremental boost to their returns by funding projects which reduce emissions at their facilities (such as an energy efficiency upgrade or fuel switch) or on their properties (e.g. on-site windfarms or clean energy generation), and selling the resulting credits to the market. Independent investors seeking new capital deployment opportunities and uncorrelated returns can also finance emission reduction projects or provide liquidity to the market through a growing number of investment vehicles and carbon funds.

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