The Kyoto Protocol of 1997 was an historic response by the world’s governments – excluding the USA – to counter the effects of global warming. While it was a major development in mankind’s attempts to preserve the Earth, one of the outcomes of that Protocol was the creation of a market in which hedge fund managers and various other trading parties will play a key role.

At the heart of this new market was a legally binding commitment by the 37 industrialised member nations to an averaged 5.2% reduction in their greenhouse gas (GHG) emissions from 1990 levels by 2008-2012. Crucially for the carbon market, the Kyoto agreement also acknowledged that countries that produce more CO2 than their accepted targets would be able to purchase an “absorption ability” from another nation. Hence the birth of the “Carbon Credit” currency. One carbon credit is an allowance to emit one metric tonne of CO2 and is called a CO2e (or CO2 equivalent).

The Clean Development Mechanism (CDM), allows industrialised countries with GHG reduction commitments to invest in emission-reducing projects in developing countries as an alternative to more costly emission reductions in their own countries. The CDM is managed and run by the United Nations Framework Convention on Climate Change (UNFCCC).

A CDM project issues carbon offsets, also known as CERs (Certified Emission Reductions) every time a UNFCCC registered and audited project prevents one tonne of CO2e being emitted. A good example would be a project replacing coal-fired electricity with clean technology or methane capture from landfill sites. The ultimate objective for issuing CERs is to help developed countries meet their emission targets at relatively affordable costs by investing in cleaner energy projects in developing nations.

Europe was developing its own method to help combat emissions at the same time: the European Union Emission Trading System (EU ETS). The EU ‘cap and trade’ plan identified around 12,000 physical installations in six major industrial sectors within the 27 member states that were large emitters of carbon dioxide. All 12,000 sites were obliged by law to submit accurate annual estimates of their carbon emissions to the EU-ETS. Based on the initial 2005 figures, each installation was then given an emission allowance of carbon permits, allowing them to emit a specified, ever decreasing amount of CO2e annually without penalty. These permits are known as EUAs (or EU allowances). Emitters incapable of achieving their emission targets must buy permits on the free market, from their sovereign government or via the recently introduced EU auction forum. Conversely, if emitters are able to reduce their CO2 emissions below the specified allowable amount, they may sell their spare allowances to anybody in the marketplace. Allowance auctions will progressively replace the (controversial) free distribution as the default method of allocating allowances to businesses from 2013. Over half of all allowances are expected to be auctioned by 2013, and thereafter there will be no more free allocation to electricity generators (the major emitters in the EU), apart from a few limited exceptions.

The leading trading platform for the EU carbon market is the European Climate Exchange (ECX), which handles over 95% of the derivative trade on the ETS. There has been a massive increase in volumes since 2005 (the inception of the ETS), with 2009 volumes 20 times greater than those of 2005.

The jargon surrounding the industry can be daunting. A carbon offset is a UN-issued allowance called a CER. A carbon permit is an EU-issued allowance called an EUA. Both permits and offsets are allowances for one metric tonne of CO2, so in theory they carry the same value and could be traded and offset against each other. Many traders are positioned long or short of the EUA-CER spread, a correlation which has spawned its own spread contract on the ECX. Fig.1 shows daily closing prices of the rolling daily CER and EUA futures since early 2009. CERs have always traded at a discount to their EUA counterparts, due to differences in their associated risks: while EUAs are issued by the EU, and might be regarded as a “currency” with no underlying issuer risk, the same cannot be said for CERs.

Each CER is linked to a specific UN-registered project. Whether it is a biomass project in Brazil producing electricity from waste, or a wind farm in South Africa, many CDM projects rely heavily on initial funding by raising capital through the discounted forward-selling of CERs, which may only be certified by the UN up to five years from the date of issuance. The added associated risk of these unregistered CERs at project level can only be quantified by associating a “certainty factor” (similar to the delta of an option) to each project, and applying this factor during portfolio valuation.

Some CERs are ‘cleaner’ than others, and legislative changes can have huge effects on the market. The proposed EU legislation to exclude credits created by the controversial industrial gas projects (HFC-23 etc.) from 2013 is a case in point. These supply issues provide wonderful volatility plays for hedge funds strong in option trading capabilities, and software such as Ozone3 caters for it perfectly by managing all the Greeks of the derivative book as well as including a high-level exposure report on any investments in forward-trading spot CERs.

The EU ETS was activated to help European countries to meet their Kyoto Protocol obligations, and remains the domain of the emitters, energy-traders, and associated speculators.

Market participation has increased rapidly over the years, despite – and in certain cases because of – illegal practices such as the VAT carousel, which increased turnover in the spot market by huge percentages in 2008. Other blows to market confidence have included phishing attacks, the trade in already retired credits, as well as the massive theft in January 2011 of Czech EUAs, which shut down the whole EU spot-trading system for two weeks. The need for a centralised registry is paramount. In 2010 the EU ETS made up 81% of globalcarbon trade, and the fact that a major player like the International Clearing Exchange (ICE), has joined the fray (it bought a majority shareholding in the European Climate Exchange last year), adds gravitas to the market. Today one of the leading London independent emissions brokers describes the broad list of participants like this:

• The 11,000 – 12,000 EU compliance companies who must be involved
• Other small spot market players
• Asset managers
• Private wealth managers
• Banks
• Pension funds
• Hedge funds

One immediately assumes that these players are EU-based – but they go on to remark that they see a lot of active interest from these types of institutions in the USA as well, and see the area as offering growth potential in the coming year.

There is very little to be gained for a socially responsible fund manager by holding a portfolio of EUAs. CERs are a different game entirely. With asset managers worldwide being asked to hold anything up to 15% of their portfolios in socially-responsible and environmentally friendly assets, we have seen a marked trend towards a two-tier approach of investment. Firstly, investing in the equity of companies making the plant to be used by the UN-approved project, whether it be a wind-turbine manufacturer, or a company manufacturing biomass converters. This is the easy step to take, because the manager normally has access to high quality research about the company, which makes his stock-picking much easier. Secondly, investing in the CDM project itself, which is much harder to do because:

1. Many projects use cutting-edge technology out of the realm of the normal research analyst.
2. Investment is required before the foundations have even been dug, and there are little or no hard figures to back up the decision when facing an investment committee.
3. Most CDM projects are based in developing countries, which makes it hard for a busy fund manager to at least do an on-site inspection of their investment.
4. The lack of suitable portfolio management software to handle the complexities of valuing CERs.

Given the above, investment in physical projects has been slow, but as market knowledge increases, and software products like Ozone3 come on stream, we are already seeing more confidence in direct CDM project investment.

The investment industry’s approach to the carbon market has also been polarised by climate-change “believer/non-believer” syndrome, much of it fuelled by ignorance, and slick PR from companies with vested interests in its failure.

Whether you believe in the theory or not, all one needs to do is stand back, and take a rational look at the amount of pollution we are creating today compared to 100 years ago, to conclude that it must be having an impact on our fragile planet.

The carbon market remains a new market, and it is characterised by illiquid contracts and high volatility. It is still subject to surprise announcements, like the January forced closures of European registries (national custodians of issued, traded and retired carbon credits), and the ban on all spot trade after the theft of an estimated €28m worth of CERs. But the other thing that goes with a nascent market is wide margins, and hedge funds are well placed to take advantage of the wild price swings and broad bid-offer doubles that an illiquid market offers.

Trading strategies include playing – and then ignoring – any correlations with the energy complex, as the two markets couple and then disengage, depending on extraneous events such as an added supply of CERs into the market. (Ozone3 calculates the vanilla beta correlation between these markets at 0.1357% for 2010). Fig.2 does not conclude a strong correlation. It examines the 21 day rolling correlation between the Brent crude near contract against the ICEDEUA daily future.

Each type of participant has a different axe to grind: the compliance companies are always leveraging their internal emission numbers (and the consequent number of credits they must retire) against the EUAs they have been awarded, as well as pricing at the regular auctions. All players are mindful of the fact that the aviation industry will join the cap and trade scheme in 2012, followed by the petrochemicals, ammonia and aluminium industries in 2013. Many players perceive a net increase in demand for credits in the next few years, and are buying in advance of these fundamental changes.

A strong area of growth in the carbon markets has proved to be exchange traded options. Initially constituting a very small percentage of annual trade, the number of options traded in 2010 (415,567 contracts) was very nearly double that traded in 2009, and made up about 14.5% of the total contracts traded on the ECX in 2010.

Hedge fund managers are in the game to make a return for their investors, no matter how warm and fuzzy the investment might look: as CDM projects increase both in number and size we have seen a new industry of financiers helping to package CDM projects to fund managers and private equity players.

The forward selling of CERs to raise initial capital is just one example: many new packages include two-way options which allow both the project-owner and the investor to share in greater-than-forecast profits. All of these sophisticated offerings are helping to make CDM investment more attractive to the fund manager, irrespective of the socially-responsible aspect.

With all of the above in mind, there is a strong future for the carbon markets, especially as the level of both the sophistication of the projects and the way they are financed starts to make good investment sense. This, together with a solid and well-administered trading exchange platform and clearing process will underpin the growth we have seen, and expect to continue to see, in the carbon derivative markets.