Carbon Trading: The rise of a new asset class

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Concerns about climate change and the subsequent growth in emission trading schemes is giving rise to a new asset class – carbon.

There is widespread agreement among governments that climate change, if left unchecked, will have a material impact on the environment and, potentially, the global economy.

Although the global financial crisis has diverted some attention away from this issue in the short term, the practice of placing a price on carbon emissions will spread across countries and industries. This will occur despite the uncertainty surrounding the way in which carbon reduction policies will develop.

Existing schemes
Since the ratification of the Kyoto Protocol in 2007, a number of emissions trading schemes have been established with the aim of achieving reductions in carbon emissions.

Most of the existing schemes employ a cap and trade system, meaning emitters must either limit carbon emissions to the level of their allocation, purchase additional carbon emissions permits in the market or pay a fine for exceeding their emission limits.

This has effectively created a new commodity – carbon (or more accurately, carbon emission permits).

The pricing and trading of carbon is well underway.

The volume and value of transactions in the European Union Emission Trading Scheme (EU ETS), which is by far the largest emissions trading scheme in the world, has grown strongly since its launch in 2005.

This scheme has also been an important pioneer in overcoming some of the problems associated with the early days of carbon trading.

The EU ETS Phase II (2008-2012) is now an excellent model for other countries that are set to follow suit, which includes Australia, where a cap and trade scheme is expected to commence in 2010. The Australian Government has maintained its commitment to policy rollout and mandating company reporting on carbon emissions.

However, while carbon trading is underway, overall the market is in its infancy and the global framework is still developing.

Investors, therefore, need to exercise caution when responding to carbon and related issues.

Truly understanding the risks and developing effective strategies will require rigorous analysis and due diligence.

Understanding the risks
The first step for investors should be to investigate how carbon issues could impact their investments and reflect this in both the investment policy and the risk management plan.

Investors should also understand where risks are embedded in their existing portfolio, as well as where opportunities for additional returns lie – for example, specialist carbon-related strategies.

New tools are emerging to help investors monitor carbon and its implications for investments and to understand the carbon exposure of their investments. For example, there are now tools available that allow investors to measure the ‘carbon footprint’ of their portfolio at a portfolio, sector and company level.

This type of analysis allows clients to compare their portfolio’s carbon intensity with that of a chosen index. It can help investors raise these issues with their investment managers and gauge the impact of carbon emissions on investments.

The rationale is that companies with ‘carbon footprints’ in excess of their peers may have higher carbon dioxide emissions-related risks.

Other factors, both on the cost and revenue side, are also relevant to assessing the total impact of carbon risk on a particular company.

Importantly, the ability to measure carbon exposure, provides a performance monitoring tool for institutional investors to monitor manager portfolio and total fund level risk exposures.

Background to carbon trading: The Kyoto Protocol
The Kyoto Protocol was established in 1997 and came into effect in 2005 to help address climate change and reduce greenhouse gas emissions. So far, about 180 countries have signed up to the protocol and about 40 Annex I countries are committed to
meeting their emissions targets. Annex I countries include Organisation for Economic Co-operation and Development countries and economies in transition (most EIT are Eastern European countries). Countries such as China and India are non-Annex I
countries; they have ratified the protocol but are not yet required to meet any emission reduction targets.

Carbon is a central issue to investing
The growth of emissions trading schemes will increase the need for investors to assess how material carbon is and how it might impact the bottom line of companies.

Companies are increasingly evaluating the impact of carbon pricing in their operations, risk management plans and broader corporate strategies.

By the same token, institutional investors also need to review the potential carbon exposure in their investment portfolios.

Carbon may also present opportunities for investors, such as alpha generation – for example, exploiting pricing inefficiencies in the trading of carbon emission permits – and investment in carbon-related projects and new ‘clean’ technologies.

Capturing investment returns from these opportunities should become easier as research providing insight into the environmental, social and governance (ESG) practices of investment managers is more readily available.

So, while the carbon issue continues to heat up, investors would do well to know what their investments are really exposed to.