To say that Jack MacDonald’s company sells hot air would be wrong. In fact, EcoSecurities, where MacDonald is CFO, sells the absence of hot air.
The Dublin-based, London-listed firm is one of many companies which develop projects to cut greenhouse gases in China, India and other developing countries, generating emission-reduction credits that companies in Europe can use to offset their obligations under the EU’s CO2 cap-and-trade scheme. The trade in developing-world credits will be worth €4.6 billion ($6.1 billion) this year, double the total two years ago, according to consultancy Point Carbon.
In February, the Intergovernmental Panel on Climate Change, a group of scientists and government officials gathered by the UN, issued the fourth of a series of much-anticipated reports on global warming. The panel concluded that human activity is exacerbating climate change, leading to more frequent heat waves, heavy precipitation and severe tropical cyclones. In response, a host of new markets are emerging for financial instruments to help companies offset their emissions, bolster operations against increasingly capricious weather, or simply burnish their green credentials. What follows is CFO Europe‘s forecast of the key developments for climate-conscious finance chiefs.
Kyoto Flexible Mechanisms
The EU’s mandatory CO2 trading scheme, covering some 6,000 companies in the heaviest polluting industries, accounts for 60 percent of the volume, and 80 percent of the value, of global emissions trading. Most of the remaining trade is in credits generated by the “flexible mechanisms” of the Kyoto protocol, which are expected to increase in the coming years. (See chart below.)
Under the EU’s system, a portion of a company’s emissions allowance, generally between 10 percent and 20 percent, can be covered by UN-certified credits generated by projects that reduce pollution in the developing world, under a program known as the Clean Development Mechanism (CDM). Because achieving reductions in emissions in countries such as China and India is usually cheaper and easier than in western Europe, companies are expected to maximize their use of developing-world credits in the future in those parts of the world.
Analysts at JPMorgan recently estimated that companies will experience an annual credit shortfall of 150 million to 220 million between 2008 and 2012. (Each credit covers the emission of one ton of CO2.) The analysts reckon that around half of this shortfall can be met by using Kyoto credits.
Last year, prices for CDM credits ranged from around €6 to €17 per ton, according to Point Carbon. Energy companies and other large emitters often manage projects directly, securing credits at the low end of the price range, but also bearing the risks of project failure, registration delays and the like.
Insurers now offer “credit-delivery guarantees,” policies covering many of the risks inherent with CDM projects, which usually take one to three years from launch to certification by the UN.
EcoSecurities and other firms of its kind represent the growing influence of specialist carbon financiers in the CDM market. (Others include AgCert, Camco, CantorCO2e and Climate Change Capital.) These speculative investors seek the arbitrage opportunity of generating cheap credits in poor countries to sell to the developed world, primarily Europe, where the benchmark price for domestic CO2 credits in 2008 and beyond currently trades at around €15. More than €1.2 billion has been raised by private carbon funds to date, according to Sonia Labatt and Rodney White in Carbon Finance (John Wiley, 2007).
EcoSecurities has contracted more than 350 CDM projects, employing 18 different emissions-reducing technologies, in 36 countries. This spreads project risks, allowing the company to sell credits forward on a guaranteed basis, says CFO MacDonald. “Buyers don’t have to worry about insurance—that’s our problem.”
Credits from its portfolio have been selling for between €12 and €17, says MacDonald. Last year, the company sold forward 22m credits, expecting to fetch revenues of €287m with a trading margin of €151m. With that sort of projected profitability, it’s no wonder that the Kyoto credit market is attracting an increasingly broad array of players. “As the market matures, it’s becoming more and more like any other commodity market,” MacDonald notes.
Voluntary Carbon Offsets
Companies covered by the EU’s CO2 trading scheme aren’t the only ones offsetting their emissions by investing in climate-friendly projects abroad. It’s hard to find a bank, media company or retailer that hasn’t pledged in the past few years to go “carbon neutral”, despite a lack of regulation compelling them to do so.
A vibrant, but fragmented, market for voluntary emission-reduction credits is meeting this demand. In the absence of the same regulatory rigor as the mandatory cap-and-trade market, however, the standards and efficacy of voluntary projects vary widely. The price of voluntary offsets is also much lower than in regulated markets, at around €7.50 per ton of CO2 last year, according to the World Bank.
The size of the voluntary market is also smaller than mandatory schemes, in part because the companies active in the market already emit relatively few greenhouse gases. Still, US-based consultancy ICF International predicts that the global market for voluntary carbon offsets will grow from 10 million tons of CO2 in 2005 to 400 million tons annually by 2010.
There are several factors driving this bullish forecast, according to Abyd Karmali, ICF’s European managing director. First, with climate change a growing public concern, firms can use offsets to enhance their reputations. “Many companies realize that their carbon footprint isn’t so bad, so going carbon neutral comes at little cost while the upside can be fairly significant,” says Karmali. Second, some industries, such as aviation, expect eventually to be subject to mandatory cap-and-trade schemes, so companies in those sectors are gaining experience by dabbling in voluntary markets. Third, some companies are using greenery to differentiate themselves from competitors, as in the travel groups that now bundle offsets as part of their holiday packages.
Leading offset providers in Europe include 500 PPM and Atmosfair in Germany, ClimateNeutral Group in the Netherlands, and Climate Care and The CarbonNeutral Company in the UK.
According to Karmali, there are two nascent standards that companies should look for in voluntary offsetting projects. Last year, the World Wildlife Fund modified its Gold Standard methodology for validating CDM projects to suit the voluntary market, while a final version of the Voluntary Carbon Standard, developed by nonprofit the Climate Group and the International Emissions Trading Association, will be published later this year. More rigorous verification and accreditation will invariably push up costs, but “given that some of the offsets available are of dubious quality, companies which really value their reputation and brand will naturally migrate towards the higher end of the market,” Karmali predicts.
Another group migrating towards the voluntary offset market is hedge funds, following the lead of Cheyne Capital Management, which launched the first fund focused on voluntary credits in 2005. Last summer, the Bank of New York launched the first centralized registry for voluntary credits, hoping that standardized terms and contracts will drive liquidity and attract a broader range of market participants, as it has for mandatory trading schemes.
“Everybody talks about the weather, but nobody does anything about it,” said 19th-century American novelist Charles Dudley Warner. Today, as experts predict that climate change will make weather systems more volatile, capital markets are spawning innovative financial instruments to hedge these risks.
Last year, the number of trades on the Chicago Mercantile Exchange (CME), where most weather-risk products are traded, increased by a factor of four, while their value rose by a factor of eight. (See chart below.) Several new products have been launched recently which track phenomena beyond traditional temperature-based instruments, spurred by the increasing unpredictability and severity of storms.
In 2006, risks of typhoons and earthquakes in Australia, earthquakes in Mexico, and tornadoes and hail in the US were securitized for the first time. Last month, reinsurer Carvill opened trading in derivatives tied to the size and wind velocity of hurricanes on the Atlantic coast of the US.
“The CME is doing a good job of handling basic, bulk weather,” says Steve Smith, senior vice-president at ReAdvisory, Carvill’s analytical arm. “With the hurricane index, we’re adding in the extreme, shock weather. With instant pricing and fast settlement, it has all of the things you expect from a mature financial product, providing a broader appeal beyond just the insurance industry.”
Another trend in weather-risk markets, according to Barney Brown, a consultant in the financial markets practice of Detica, is the growing use of hybrid instruments which package together multiple weather factors. In November, for example, ABN Amro and underwriter Catlin sold tranches of a collaterized debt obligation-style security which covers nine different catastrophic risks—earthquakes, hurricanes and windstorms in Europe, Japan and the US. “The only thing that’s missing is thunder and lightning, but I’m not quite sure how you can trade that,” says Brown.
To date, no insurer offers explicit coverage for climate change. The potential damages associated with it, however, are influencing all varieties of corporate policies, boosting premiums for weather-related risks, expanding exclusions for losses associated with climate change and increasing deductibles for weather-related losses.
In these times of heightened sensitivity to an increasingly unstable climate, companies should tell their brokers about all or any improvements, however small, to their properties, says Tom Roche, engineering manager at insurer FM Global. In fact, it’s often the seemingly small measures that make a big difference in protecting a building from storm damage. “We talk with clients about putting an extra line of bricks around a property, or building a plant a little bit higher,” Roche says. “From a financial point of view, these things are quite simple.”
Environmental concerns also factor in to insurance contracts in less obvious ways, according to Warren Diogo, a climate-change specialist in the risk consulting practice of Marsh. For companies covered by the EU’s emissions-trading scheme, for example, business interruption insurance could be expanded to take account of CO2 allowances on their balance sheets. So if a power company loses the use of a gas-fired plant, requiring it to ramp up a more carbon-intensive coal plant, the unforeseen additional CO2 allowances needed to offset the event could be covered by insurance, he says.
Finally, although climate change is often thought of as a vague, looming threat, it has the potential to affect corporate directors in a personal way. Investors have filed 47 resolutions related to climate change at US-listed companies so far this proxy season, according to shareholder watchdog ISS. Institutional investors are also agitating for greater disclosure of climate-related risks. In February, the Carbon Disclosure Project, a group of nearly 300 investment groups managing €30 trillion of assets, sent questionnaires to the 2,400 largest listed companies in the world. Insurers will be scrutinizing responses to the flagship project to evaluate D&O exposure, says Diogo. “There is definitely the potential for liability against directors and officers for a lack of—or ineffective—action on climate change.”
Inevitably, US courts are now dealing with the first batch of lawsuits against companies accused of contributing to climate change. “Some lawyers say it’s legally impossible to make the connection between global warming and corporate liability,” notes Dan Anderson, a professor of risk management and insurance at the University of Wisconsin. He heard the same sort of arguments, he adds ominously, in the early stages of the asbestos cases.
Additional reporting by John Goff.