Mining a New Source of Carbon Credits

Man Investments backs carbon emissions project in China

Originally published in the October 2007 issue

Much has already been made of the fact that some major hedge fund groups are looking at the emerging market for carbon credits as a potential source of new fund strategies. Part of the appeal here is credits’ lack of correlation to mainstream markets, particularly in light of recent market events which have shaken investor confidence in some strategies. There is also the ‘green’ factor that allows institutional investors to demonstrate to stake-holders that they are taking ecological issues seriously by deploying capital into socially-responsible schemes. Indeed, ‘green’ funds represent one of the fastest growing areas of retail investment in continental Europe, particularly in Germany, France and the Scandinavian countries.

Many existing carbon funds tend to be long on carbon credits. The skill of the manager is rooted in his ability to access streams of credits, and aggregate these into a pool. From an investor’s perspective, such a fund would make sense if you held the view that credits would appreciate in value over the medium to long term. But more can be done via a proactive approach in the carbon emissions area.

Man Investments, already a firm with a strong grasp of the need for asset management houses to have an established ecological policy (it is, after all, avowedly carbon-neutral itself), has gone a step further with the launch of its latest fund, the China Methane Recovery Fund. Rather than be a buyer of credits, this fund is going to be a manufacturer. Working with joint venture partners in China, the fund will help to finance new, ecologically sound methane emissions reduction technologies for the mining sector, a notorious source of methane gas escaping into the atmosphere. Methane is more than 20 times more potent as a greenhouse gas than carbon dioxide, a very damaging gas in its own right, according to climate change experts.

Projects that are approved under the Clean Development Mechanism, part of the Kyoto Protocol, will generate credits. These can then be sold into the growing market for such instruments. Under the protocol, industrialised countries with a greenhouse gas reduction commitment, can invest inprojects to reduce emissions in developing countries as an alternative to more expensive projects in their own. Eligible carbon projects have to establish that they would not have occurred without the incentive of emissions reduction credits. Emissions Reduction Purchase Agreements (ERPAs) are the mechanism by which a seller makes money from the sale of credits awarded to them for reducing carbon emissions, and are of increasing interest to major corporations in the developed world (and a source of cash for governments and business in the developing world addressing their own carbon emission problems).

According to Nick Wood, head of a group developing environmental strategies and products at Man: “There are a number of underlying investment propositions, but the high level one from an investor’s perspective is that this is a return stream whose returns are not going to be correlated with anything else you’ve got in your portfolio, unless you happen to be very long carbon credits. From an institutional perspective, fitting alongside equities, bonds, and other hedge funds, it will be a very uncorrelated asset.”

Such an approach to the carbon credits market leaves the manager running a fund that combines aspects of a hedge fund with that of private equity and infrastructure, a trio of alternative asset classes that have been attracting increasing investor attention in the past five years. The fund’s actual manager is MTM Capital Partners, a boutique asset manager specialising in environmental projects, in which Man owns a majority stake.

China’s mining boom

China’s rapid industrialisation has led to a boom in its mining sector, as the massive nation seeks out raw materials under its own soil. Mining engineers have to vent methane out of seams in the rock before work can commence, in order to avoid underground explosions. Traditionally, the methane is simply expelled out of the mine and into the atmosphere where it can disperse harmlessly. However, with so much mining activity going on around the planet these days, ecologists have isolated mining work as a major source of harmful methane generation for the world’s climate.

Man is using its fund to purchase and install cutting-edge technology in Chinese mines that will allow mines to burn up the methane gas instead, generating useful additional electricity for the national grid, and reducing the harm the mine is doing to the planet in general. On top of this, of course, the fund gains the carbon credits it can then sell on into the market.

The fund’s projects should generate CER (Carbon Emissions Reduction) credits under the CDM, which are to a degree fungible into the European Trading Scheme, currently the main market for carbon credits. According to Wood, “The ETS is designed to reward people who invest in reducing their emissions, and that is done by putting a price upon a ton of carbon, allowing those that effectively produce a surplus to trade it, and those that are unable to do so, to buy the allowance out. The CDM is designed…to allow capital flow from developed countries to developing countries, encouraging them to invest in emission reduction projects. The theory behind that is that greenhouse gases are a global problem – no matter where they are emitted, they will go into the atmosphere and contribute to global warming. Reducing emissions in developing economies is going to be cheaper than doing it in developed economies. What we’re doing with our fund is exactly what the Clean Development Mechanism envisaged.”

Why China?

But why China? Obviously the country is industrialising at a breakneck pace, and its mining sector is expanding rapidly. China is in fact the world’s largest coal producer, and by a good way (the US comes in at second place). In addition, historically China’s environmental credentials have left a lot of be desired.

But a fund which looked at tackling mines around the world would just be too difficult to implement. The investment that Man had to make to be able to operate in China, with a number of joint venture partners and the blessing of the authorities, was difficult enough without having to replicate it for other emerging nations. China’s mining sector is huge, and the opportunity set there was deemed sufficient to allow a fund to be able to operate within it for some time without needing to shop around elsewhere in the world. “We decided to concentrate our expertise on a large market where we have an edge,” Wood explains. “MTM Capital Partners has nearly 20 years of experience in putting together joint venture companies and deals within China.”

Being China, the fund has had to develop joint ventures with a number of local partners and acquire the specialist knowledge of the mining sector within China which is needed to install the new technology. Getting the fund off the ground has required putting in place the right relationships with specialist firms on the ground who can implement the strategy. It is the first fund of this kind to be established, and as such enjoys the first mover advantage this brings with it.

China itself is changing, with broader recognition of the environmental threat posed by rapid industrialisation. Both at a political level, and at a business level, there is now a much greater urgency to the country’s approach to green issues. For example, the Chinese government said in March it would help fund 2.6 million household methane pits to help reduce emissions from the residential sector. Environmental protection laws are now on the books (and being enforced with vigour), and Man has found a ready understanding of the clean development mechanism on the part of joint venture partners and the government officials it has dealt with.

“We find a very well-informed and receptive government in all its different aspects in China,” says Wood. “They completely understand the CDM, and the most developed infrastructure for supporting it is in those countries that implement the CDM. China is very aware of the environmental pressures on its air quality, water quality, and land use, as well as of the bigger issue of climate change.

From their perspective, they have implemented a number of environmental protection laws, although real implementation on the ground has been patchy. They’d admit that. They have carried out a series of crackdowns recently to try to correct non-compliance, particularly on water quality and land use. I think that is just a long term problem that a country like China, particularly one that is industrialising rapidly, will have to deal with.”

Where the CDM has been particularly appreciated is in its power generation capabilities. China currently has a dearth of power generating capacity, and any scheme that can help to put more power into its grid cheaply and cleanly gets a ready hearing. This is helped by China’s renewable energy laws, which incentivise businesses to generate energy more cleanly. “They desperately need electricity generating capacity,” says Wood. “Their economy is growing by 10% per year; they are the workshop of the world; all that runs on electricity. The renewable energy story is a significant indicator of their pragmatism.”

Although the fund is mainly focused on reducing methane emissions in the mining sector, it does have the option within its mandate of also working on landfill projects should attractive opportunities occur. The World Bank signed the first greenhouse gas reduction project based on a landfill site in China in July, and Wood is right to be keeping an eye on an alternative growth area within the fund’s mandate.

The potential volumes involved in Chinese methane emission reduction schemes should not be underestimated either, given the size of the country and its industry. In June Fortis Bank estimated that China’s contribution alone to the carbon credits market would be between $40 and $50 billion this year, up from $30 billion in 2006. This figure looks set to continue to grow going forward.

Man estimates it will be closing the fund at €400 million, probably by the end of the year. It is now seeing interest in the fund from a broad range of investors, not simply those with specialist SRI expertise. Wood puts it down to a sudden appetite for non-correlated assets in the wake of August’s credit meltdown. Many institutional investors have been putting a lot of thought towards how they can source new, non-correlated investment strategies which can be intelligently implemented.

“We have found that many investors are extremely well-informed already,” he says. “Many have put teams of researchers on this whole area already, looking at the credit areas and other areas of environmental finance, credit aggregator funds, projects like ours, and potential long/short strategies in environmental mutual funds. There are one or two hedge funds managing long/short strategies in this area, and then of course there’s the whole clean tech venture capital industry as well.”

In the case of the China Methane Recovery Fund, one of its private equity characteristics is its limited lifespan (estimated at five years or so). Man has launched the fund because it feels it has recognised an opportunity that combines two major macro themes: a rapidly industrialising economy, and a new market for quantifiable emissions reductions. Cap that off with the increased demand for non-correlated assets, and one can appreciate the timing of this launch.

Leading edge of the trend

Man is not ruling out the possibility of further carbon credit-generation schemes of this nature, but is monitoring the take-up for the fund before launching other vehicles. But the investment has been made in terms of time and energy, and a second such fund, perhaps focusing on South America for example, would be a slightly easier exercise in implementation. “There are other strategies we are looking at, not necessarily in methane capture, where we can offer our investors the opportunity to invest in funds that have a return linked to an environmental impact like credit trading and generation of credits, or other aspects of renewable energy trading,” Wood says. “There are potential projects outside the CDM countries where it is possible to offer attractive returns from renewable energy generation where governments and regulators are offering incentives.”

Man has just expanded its green credentials in the hedge funds space with a fund of funds project, overseen by its specialist seeding subsidiary RMF, investing in green hedge fund strategies. Apart from the non-correlated appeal for the investment community, it reflects Man’s canny grasp of how ecological issues are quickly moving up the agenda in the finance and business worlds generally. Other funds with an environmental angle are also on the drawing board. The products are designed to provide investors with attractive, non-correlated returns, and are not simply being marketed under what Wood calls “a purely SRI” pitch.

“We think it’s a great opportunity for our investors to invest in something we believe is going to impact just about every area of investment over the years ahead, some areas positively, some areas negatively,” says Wood. “Although there’s a defined concept of environmental finance and climate change investing, this is the leading edge of a trend that is going to impact all portfolios in one form or another.”