Carbon trade: To invest or not to invest?
Business Times 24 Mar 08;
It's unclear what form carbon markets will take after Kyoto Protocol expires in 2012, but many are convinced that carbon will have a price even after that, writes MATTHEW PHAN
THE carbon markets, whether you choose to praise or vilify them, have grown over the last two years, and today form a critical part of the Kyoto Protocol's mechanisms.
According to the United Nations, abatement projects in the developing world have prevented more than 100 million tonnes of carbon dioxide equivalent from entering the atmosphere.
And at least another 2.4 billion tonnes worth are expected to be avoided by 2012, from the nearly 2,900 projects registered with the UN so far.
But with Kyoto expiring after 2012, it is unclear what form the markets will take.
While most industry players believe carbon trading will continue until the rules are officially fixed, investors will hold back from financing projects.
'The question is, from an external financier's point of view, what would the risk coefficient of the project be?' says Mark Leslie, vice-president for South-east and East Asia at AES Agriverde, a project developer.
Since firms cannot guarantee that credits will have value after 2012, an investor may only partially fund a project. And as projects take time to register and construct, as the clock ticks away, they have a shorter and shorter period in which to earn back the money. If you believe that CERs (certified emissions reductions) will have no value after 2012, then a significant percentage of a project's value disappears with each passing month, says Mr Leslie.
Beyond the existential question are other pressing issues. The first of these is the balance in global demand and supply of carbon credits.
If countries do not commit to cutting emissions, demand for carbon credits will evaporate and the carbon price will collapse. Without a carbon price, it is not only project developers that will lose money - the financial incentive for companies to slash emissions will disappear and emissions will soar.
That is why industry players and environmentalists alike cheered Australia's promise to abide by Kyoto, and will intensely watch negotiations between the United States and China - the world's two largest emitters - over the next two years.
At the Carbon Asia Forum in Singapore last November, analyst Guy Turner of New Carbon Finance said that if the supply of CERs from Latin America and Asia accelerates, demand from Europe, Japan and Canada may prove insufficient. 'North American demand will then be essential,' he said.
Other factors could affect demand. One of them is how far developed nations will allow the use of CERs to offset their emissions.
If all the CERs can be used, then even without the US there will be a large market, says Mr Leslie.
At EcoSecurities, the world's largest buyer of credits, co-founder Marc Stuart expects no oversupply. Most of the low-hanging fruit - like large-scale, low capital projects to cut intensely pollutive HFCs (hydro-fluorocarbons) in China - are done, and the next wave of projects will be smaller and more complex, he said.
Projects in energy efficiency or renewables have multiple revenue streams and 'all the complexities of energy projects', said Mr Stuart. They take more time, involve performance issues, and require developers to form long-term relationships with technology vendors in order 'to advance the low-carbon infrastructure'.
Leaving aside demand and supply, another pressing issue is how to improve the current system.
Only 49 countries have registered carbon projects so far, with Brazil, China and India supplying about three-fifths of all credits. Contribution from Africa is minimal. Kyoto critics want to extend the geographical reach of the Clean Development Mechanism (CDM) and allow different kinds of projects, so more poor countries can benefit.
One way to do this is to validate 'programatic' projects. This approach speeds up the approval of similar small-scale projects and could help finance things like the widespread use of energy efficient lightbulbs in rural villages. Approving each light bulb change one-by-one - as the current process requires - would simply make no sense.
But only one 'programatic' method has so far been given the nod by the United Nations Framework Convention on Climate Change's (UNFCCC) executive board. Narrow in scope, it cannot apply to many asset types. 'We need more tools to make it work. Right now, we've got one,' said EcoSecurities' Mr Stuart.
One problem developers face is that the exec board is 'incredibly focused on being exact, rather than conservative', he said.
The market must be bigger if it is to address the underlying environmental issue. So while the board is appropriately cautious, it needs to balance efficiency against precision.
'Everybody is willing to take an appropriate discount on tonnes issued by the UN, if there is some uncertainty about exact performance', if the result is a more efficient and predictable process, he said.
Meanwhile, market uncertainty, poor liquidity and a worsening economic climate could lead to industry consolidation in coming years.
While some project developers are large and diversified, or part of a strong parent, like a bank or power generator, many are small firms with limited balance sheets.
At last November's forum, Laurent Segalen, head of the carbon group at Lehman Brothers, said only 40 per cent of firms which deal in primary CERs are investment grade.
In a presentation, titled 'Carbon Credit Crunch?', he said many independent carbon consultants decided to go beyond advisory services and take on the risk of owning projects.
In a sample of six firms, the value of their CER portfolios was between 14 and an incredible 168 times the value of shareholders' equity; in one case, the shareholders' equity was negative, according to Mr Segalen. Choose your counter-party carefully, he warned.
For the strong and patient, payoffs will be high. Political moves, scientific conviction and growing public awareness of global warming have convinced many that carbon will have a price beyond 2012. As Mr Leslie said, 'It depends on the company's cash flows, but if a company can afford to wait to sell the CERs, there will be a time in the future when CERs will see higher values.'
