The World Bank says that carbon funds are the leading providers of liquidity for Clean Development Mechanism (CDM) offset projects around the world—but what exactly is a carbon fund, and how are they evolving? The Ecosystem Marketplace examines the issues. When Laurent Segalen launched the European Carbon Fund in 2005, he wasn't really sure what to expect. "We just wanted to see if big banks would be willing to risk a bit of their money on this innovative concept," he recalls. Back then, most carbon funds were run by government development banks under the auspices of the World Bank, and existed purely to buy up carbon credits from abroad for sale to carbon emitters within their own countries. Under that model, investors received carbon credits, which they could use to offset their emissions. But the ECF was part of a new brand of carbon fund whose investors received profits or absorbed losses just like investors in a hedge fund. ECF's strategy was to harvest the vast network of contacts that backers Natixis Environment & Infrastructures, Fortis Bank, and Caisse des Depots had built up across Asia to buy high-quality credits before reductions were generated, with the goal of selling the reduction certificates on the secondary market and remitting the difference to investors. But how do you market an investment vehicle employing untested methods in an untested market that many doubted would ever even materialize? Segalen not only had to market the concept, but also had to come up with a projected rate of return worthy of the perceived risk. "We announced a return of 15% per year," he recalls, "but that was more of a mantra than a strategy." The figure, he says, is "magic" to private equity investors. "If we came up with 5%, people would say it wasn't worth the risk; and if we came up with 40%, no one would believe us." So far, they've managed to return more than 20% per year, and last year they laid claim to nine percent of all CDM projects worldwide, including two of the top ten transactions. The industry, however, is evolving quickly, and new players are tumbling in every other week. "In 2007, you really need to come with an asset management strategy," he says, "and not just something simple like, 'I buy now and sell later and it goes up because climate change is such a big issue.'"
A Fund is a Fund is…?
As of June, ICF International has registered 54 carbon funds managing more than 12 billion euros—and 14 of those have opened in the last six months. "This time last year, we thought the number of funds would stabilize because of the crash of the EU ETS price," says ICF Senior Consultant Natalia Gorina, who co-authored the group's recently published Carbon Procurement Vehicles: Investor's Guide 2007. Different tracking agencies have different numbers, in part because of different ways of defining a fund. Gorina—without consulting a cue card – offers this precise definition: "A vehicle that collects money from different investors and then disburses this money to buy carbon credits or to invest equity or provide loans to emission reduction projects in order to provide returns either in carbon credits or in cash to the investor." That includes government-sponsored and World Bank funds that accept money from private investors, but excludes governmental tenders, which only accept money from governments—a vehicle she places in the broader category of "carbon procurement vehicle." She adds that most of the 14 funds that have launched this year are "speculative" funds like ECF, which is bad news for emitters looking to diversify their risk by buying offsets via funds. "We've had calls from several companies covered by the EU ETS looking to buy carbon credits for compliance purposes," she says. "But many of the newly launched funds return to their investors in cash instead of carbon credits." The result: tons of new money in search of credits that can be bought cheap and sold high, but huge uncertainty over the price those credits will fetch a few years down the road, and a growing number of funds tripping over each other in an effort to get low-priced projects. "The low-hanging fruit has been picked up," says Gorina. "New funds have to either go into countries or technologies that are more risky, or that don't have margins like the ones we've seen in China."
Equity Stakes and the Voluntary Frontier
To get a jump on the competition, many funds are taking equity stakes in the projects from which they buy credits—a trend Gorina says she first noticed as early as 2005. "They realized that by doing so they can get credits at the lowest cost possible and control risks better, because they become part-owners of the project," she says. "This allows them to move to the sell side—becoming the seller rather than the buyer." But Segalen isn't among those pursuing that strategy. "We are not taking equity in projects," he says, "but we are more and more providing debt to project developers and making collateralized agreements, or otherwise sharing the risk of a project." He says ECF also absorbs a lot of up-front expenses, such as certification costs, which could evaporate if the project fails to deliver credits. "The main reason we don't take equity in projects is time to market," he says. "If you want an equity stake, you need three years to get financing, raise debt, and get equipment, start operations, and monitor the project. During those three years, you get zero carbon, while market price plays the roller coaster." Still other funds have moved into the voluntary markets—a segment Segalen says he's open to, but not particularly enthusiastic about. "If you asked me six months ago, I would have said voluntary projects were for fools," he says, "but now you have real demand." You also have huge quality concerns—leaving such projects with more warning signs than a pack of cigarettes. "When we do them, it's usually people we know and have done business with," he says. "Maybe we will do a voluntary project when someone has additional credits that cannot make it from a compliance standpoint, but can make it from a voluntary standpoint. In a case like that, if we know and trust the people, and know the emission reductions are legit, we will do the deal." But voluntary credits amount to less than two percent of ECF's business.
As the market grows, so does the sophistication of investors. "Carbon is now much more sophisticated and mainstream than it used to be, and investors now ask now about track record, pipeline, exit strategy, hedging, value at risk, leverage, etc.," says Segalen. "When we launched the fund, 50,000 tons of CO2 were traded every month—now it's 50,000 tons per minute!" And funds are competing on all fronts. "The main challenge for new guys is to find the right people in their management team," says Gorina. "You need people with language skills of developing countries; who understand CDM and JI; who understand project risks; who have experience with projects they've done before, and who can do due diligence. These people aren't easy to find." And everyone, it seems, is getting into the act. "You have trading houses like Mitsubishi and Noble launching carbon funds," says Segalen. "You have banks that are going it on their own like Credit Suisse or Deutsche, or boutiques which are more like consultancies than like funds, and Utilities like EDF or RWE – it's a very diverse crowd." But Bjí¶rn Udal, senior energy analyst for Sustainable Asset Management in Zurich, says that diverse crowd is largely following a uniform approach. "They're typically investing in renewable energy projects, methane capture, and so forth," he says. "The theory and philosophy behind the CDM idea was to bring high tech to developing countries, and we don't really see that." He believes the next wave will focus on technology transfer, and that companies that deliver that transfer will not only do more to promote sustainable development, but will come out ahead. Gorina says there is also a trend towards niche funds. "RNK Capital, for example, is famous for being welcome to risk and underwriting contracts that were the first of their kind," she says. "They were the first to buy post-2012 credits, while Cheyne Carbon Fund in London is focusing exclusively on voluntary projects." She points out that funds also differentiate among each other not only by the way they treat sellers of credits—such as the trend towards taking equity stakes – but also in the conditions they offer investors. "Some allow investors to take part in the investment decisions of the fund, and others say, 'Give me your money and forget about it for a year,'" she says. For her, the challenge is evaluating and ranking funds based on current performance and future prospects. "To really do that effectively, you have to look at how many carbon credits they have secured per year and how many they have to sell in case they return their investors in cash," she says. But unless they are a listed company or a World Bank fund, most funds don't publish this data." That could change, with Standard & Poor's beginning to evaluate the creditworthiness of carbon funds—a procedure that will force a good chunk of most funds' pipelines into the open.
Hedging and Risk Management
With so many bankers involved in carbon trading, it's no surprise that creative risk management ideas abound. Segalen, for example, says that collateralized carbon obligations (CCOs) are being used to collateralize future deals so that buyers can leverage their purchases and sellers can get funding up front. He also uses futures on the European Climate Exchange (ECX) extensively to hedge simple price risk, and he uses the exchange's spot and futures products as a benchmark for purchases. The most basic risk management tool is diversification, and despite the quest to carve out a niche, most carbon funds have clear diversification criteria. "They will not invest more than a set amount or percentage of their portfolio in any single project, country, region, or technology," says Gorina. In theory, fund managers could specialize in one technology but still diversify their risk by swapping a portion of their portfolio risk with a portion of another manager's risk, but EcoSecurities' Director of Commercialization Bill Collins says that's still a ways off. "To effectively swap geographical risk, you'd need something like an index for CDM China delivery vs CDM India delivery," he says. "This is a vehicle that could conceptually exist in the future, but doesn't now, so instead you'd more than likely be swapping actual contracts, and the element of risk in that is that someone who has a project in his portfolio knows more about it as seller than you do as buyer." Segalen agrees. "Applying hedge fund techniques to carbon is exciting, but it is recipe for disaster if you don't manage the underlying portfolio," he says, adding that the bigger risks exist far away from the trading room and out in the field where he spends the bulk of his time. "You have to stay close to the projects at the factory level." And, he adds, you have to keep focused on the big picture. "If you forget that the goal of all this emission trading is to foster clean energy and promote energy efficiency projects around the world, then you end up trading hot air, and this whole business becomes a farce," he says. "To paraphrase Bill Clinton: It's the Environment, Stupid!" Steve Zwick is a regular contributor to the Ecosystem Marketplace. He may be reached at steve.zwick at gmail.com. First published: June 25, 2007 Please see our Reprint Guidelines for details on republishing our articles. According to ICF International, the funds that move beyond Emission Reduction Purchase Agreements and that put money (either equity or loans) directly into projects are: * Trading Emissions PLC (TEP) * Merzbach Mezzanine Carbon Fund 1 * Climate Change Capital Carbon Fund I & II (CCC) * Carbon Assets Fund by Carbon Capital Markets * RNK Capital LCC * Sindicatum Carbon Fund * 3c Climate Change Investment I S.A. * Care Brazil Social Carbon Fund * The Bunge Emissions Fund * Proposed EcoWay Carbon Fund * Luso Carbon Fund SOURCE: ICF International