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CARBON FUNDS

Managers under the spotlight

18 August, 2008

Carbon Finance’s latest survey of the carbon fund market shows solid growth, medium-term confidence – and the continuing dominance of China as a source of carbon. Mark Nicholls reports

Depending on which metric you use, the growth of assets in carbon funds is either trailing the equivalent growth in the carbon market, or outpacing it. Research by Environmental Finance Publications for the latest edition of the Carbon Funds Directory has identified 80 carbon funds, buyers’ pools or government carbon procurement vehicles that are either operational, or are actively raising funds – up from 56 last year. These funds collectively manage, or have commitments for, $12.87 billion – and, if those still raising money all reach their stated fund-raising goals, they will amass an additional $5.49 billion. This compares with $7.9 billion under management last year – a 63% rise.

Meanwhile, according to figures from the World Bank, the value of carbon transactions doubled between 2006 and 2007, to reach $64 billion – and it is forecast to exceed $100 billion by the end of 2008. However, growth in volumes in the Kyoto Protocol’s project-based markets – the Clean Development Mechanism (CDM) and Joint Implementation (JI) – grew more modestly. That figure, including both primary and secondary trading, was 832 million tonnes of carbon dioxide equivalent in 2007, up 44% on 2006. However, the 109% growth in the value of transactions, to $13.4 billion, was in line with the overall market.

This is not entirely surprising. The carbon asset management market was driven strongly by something of a ‘gold rush’, as forward-looking investors rushed into the market after Kyoto’s entry into force in 2005. Also, governments which anticipated missing their Kyoto targets were encouraged into the market early by the World Bank.

Furthermore, conditions over the last 12 months have not been ideal for raising new money – in addition to the credit crunch, and a wholesale repricing of risk across financial markets, it’s been a tough time in the carbon markets. Problems with the market infrastructure which has prevented CDM developers selling credits into the EU Emissions Trading Scheme (ETS), and uncertainty over a post-2012 climate regime have made project investments riskier than ever.

However, the survey of fund managers that we conducted to accompany the directory paints a more optimistic picture. Of the 64 fund management companies or government-run purchasing agencies polled, 33 fund managers responded, via an online survey conducted in June and July 2008. The survey – which repeated a similar exercise in 2007 – covered future fund-raising plans, current and future portfolio construction, pricing expectations and general views of the market.

Most responses were directed at the CDM market, and the certified emission reductions (CERs) that these projects generate – reflecting the buying interest of most carbon fund managers. However, some responses also covered emission reduction units (ERUs) from JI projects, and the voluntary market.

Fund raising
Despite growing fears of a global economic slowdown, and uncertainty about the nature – or even existence – of an international climate change regime after 2012, this year’s survey reveals a greater expectation of growth than last year. Then, 11 of the 22 fund managers responding to the survey planned to raise more money into existing vehicles, and 13 planned to launch additional funds.

This year, those figures have risen to 22 and 16 respectively. The former are collectively hoping to raise $2.8 billion of additional capital for existing funds, while the target for the new funds is smaller, at $1.4 billion. Last year, the comparable figures were $530 million and $2.4 billion. Of course, these figures have to be treated with caution – they are aspirational and anecdotal. However, they do give an indication of fund managers’ perceptions of capital availability and demand for carbon assets.

Carbon asset availability
In terms of the supply of carbon assets available to the market, this year’s survey reflects growing concerns that the approach of the 2012 ‘cliff’ is likely to depress volumes. In mid-2007, only one respondent expected supply from the primary side of the market – that is, directly from projects – to fall compared with the previous 12 months. This year, that figure has risen to eight – representing almost a third of those who answered that question. However, 11 respondents expect supply to continue to rise.

Similarly, the survey shows this concern reflected – to a limited extent – in the secondary market. This year, as last, fund managers express confidence that the growing maturity of the carbon market will be reflected in growing volumes in the secondary market over the next 12 months. However, while more than 80% expected growth 12 months ago, that figure has now fallen to two-thirds.

Pricing
The prices at which fund managers are sourcing carbon assets are – not surprisingly – going up. When we carried out the 2007 survey, prices in the secondary CER market were around €14/tonne ($20.60/t) of carbon dioxide equivalent (CO₂e) but, in early June this year, they went past €20 for the first time.

Last year, only eight respondents disclosed the price they were paying for primary CERs, of which half were in the €8–13 range (this year, as last, most respondents gave a price range, rather than a single average figure). The remainder were sourcing at lower prices.

Of the 15 respondents who answered the question this year, 11 said they were buying in the €8–15 price range. Of the remaining four, two gave ranges of €6–11 and €7–12, while one Japanese buyer gave a surprisingly low range of €3.15–9.50.

While these prices are still significantly below the secondary market price, reflecting the risk of projects failing to deliver which is assumed by those buying directly from projects, they are clearly edging upwards. While only one respondent claims to be paying more than the €13 ceiling cited last year, the distribution has shifted towards the higher end of the range.

Beyond 2012
While uncertainty over the international climate change negotiations risks reducing short-term supply of project-based credits, the survey showed continuing confidence that the carbon market in general, and the CDM in particular, will survive beyond 2012. As with last year’s survey, the respondents overwhelmingly agreed that the CDM would survive in some form post-2012. Last year, one respondent thought otherwise – this year, there was unanimity.

Moreover, a growing proportion of fund managers are buying carbon credits for delivery post-2012. Last year, the sample split more or less down the middle. This year, two thirds of those who answered the question said they are buying credits that will be generated after 2012.

Supply and demand
Survey respondents were asked what factors they expect to have the greatest bearing on supply and demand over the coming year and, not surprisingly, their responses covered a wide range of issues of concern to the market. But three topics dominate: the development of carbon markets in the US; the degree to which the EU will allow the import of CERs/ERUs after 2012; and the nature of a post-2012 climate regime.

On the first issue, most analysts would expect the US to provide a potentially enormous source of demand for project-based credits, given the size and carbon-intensity of its economy. However, some proposed cap-and-trade legislation has included tight limits on the import of credits from overseas, as a consequence of concerns (often ideologically motivated) over the robustness of the CDM system and an unwillingness to pay Chinese companies for carbon credits. Nonetheless, it is likely that US companies will lobby hard for access to potentially low-cost overseas carbon credits.

On the second, there are growing concerns that the EU ETS – which has until now generated the lions’ share of demand for CDM credits – may be substantially closed to CERs and ERUs after 2012. As part of its negotiating position in the UN climate talks, the European Commission is proposing a virtual freeze on imports of CERs and ERUs after 2012 if no successor agreement to the Kyoto Protocol has been agreed by that point. In that case, it has committed itself to a 20% reduction in GHG emissions below 1990 levels by 2020.

But it is also suggesting that it will raise this reduction target to 30% if other developed economies agree to comparable reduction goals – and, in this case, half of the additional emissions reduction effort could be met with imported credits. However, analysts suggest that the volume of CERs that this would draw into the EU ETS would be significantly lower than will have been imported between 2008 and 2012. EcoSecurities, for example, puts the figures at just 72 million tonnes (Mt) of CO₂e a year under a 30% target, compared with an expected 267Mt CO₂e/year over 2008–12.

Fund managers also voiced concerns about the processes for bringing projects through the UN approval system – both for JI and the CDM. Supply from JI countries – particularly Russia and Ukraine – is seen as a key issue by a couple of respondents, but continuing uncertainty persists over the extent to which the institutional set-up, especially in Russia, will allow significant supply.

A number of respondents raised concerns about the capacity of Designated Operational Entities (DOEs) – the private sector verification companies sanctioned by the UN to validate and verify CDM projects (they are known as Accredited Independent Entities in the JI process). Over the past 12 months, a serious bottleneck has emerged among these DOEs, significantly increasing project approval times.

“The major factor [affecting] primary supply is the speed of project verification,” says one respondent.

Geographical distribution
The predictions of many fund managers last year that China would become a less significant source of their carbon credits – or at least would not increase its share – were not reflected in its changing share of the global market. According to World Bank figures released this May, it rose from 61% of supply in 2006 to 73% last year. India, which was tipped to increase by almost half of respondents (with the rest expecting it to hold its own) actually slipped, from 12% to 6%.

This year, as many fund managers (just over a quarter) expect to reduce their exposure to China as to increase it. Once more, there is a bias towards increasing purchases from India. Fund managers are also extremely bullish on the rest of Asia – all of them expect to increase purchases from countries which, it is broadly agreed, have been somewhat slow in attracting carbon finance.

Brazil also seems to be finding more favour this year than last. Then, just over a third were planning to increase their percentage exposure to the third-largest single supplier of CDM credits, with a similar number planning to cut back. This year, the bias is firmly towards greater supply. Patterns of interest in the rest of Latin America are similar to those reported last year.

So too with the former Soviet states. More than half the fund managers polled plan to increase the proportion of their portfolios dedicated to JI projects, slightly down on last year. However, as noted above, the development of the institutional infrastructure in both Russia and Ukraine is still wanting, and the JI Supervisory Committee – the JI equivalent of the CDM Executive Board – is still relatively untested.

Conclusion
Few participants in the carbon markets, carbon fund managers included, doubt that they are poised for substantial growth. The establishment of carbon markets in the US and the successful conclusion of negotiations on a post-2012 regime would both take carbon trading and finance to the next level. However, there are undoubtedly numerous challenges facing the markets, and significant risks to which participants are exposed. While most expect market mechanisms to play a growing role in tackling climate change, there are likely to be plenty of pitfalls and upsets along the way.

Note: This is an abridged version of the survey results. The full report is available in the Carbon Funds Directory 2008/09. Click here for more information.

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