Greenhouse Gas Emission Credits Funds - Caveat Emptor
Any alternative investment - which usually means taking a risk in a somewhat exotic asset class - deserves careful scrutiny sometimes on moral as well as economic grounds. One such class is an investment in a green house gas emission credit fund.
To understand these funds we need to back track to the Kyoto Protocol on global warming.
The Kyoto Protocol (“Kyoto”) proposed a commercial mechanism for regulating greenhouse gas emissions known as “cap and trade”. Kyoto establishes binding caps on emissions for developed nation parties and parties with economies in transition (“Annex I parties” or “Annex I nations”). These caps are limits on emissions of green house gases ("GHGs") during the 2008-2012 period. The caps are set as reductions below each party’s 1990 emission level of six GHGs: CO2, methane (“CH4”), nitrous oxide (“N2O”), hydrofluorocarbons (“HFCs”), perfluorocarbons (“PFCs”), and sulfur hexafluoride (“SF6”). Emissions reduction commitments specified by Kyoto are typically 5-8% below the emissions baseline, although some parties successfully negotiated a commitment of no reduction below the baseline or even an increase above it. Additionally, different levels of economic growth or stagnation since 1990 mean that while some Annex 1 nations face steep cuts, others actually have excess allocations.
So far, only the European Union (“EU”) has established the Kyoto accord principles in the form of a mandated emissions trading program. In the EU program’s first phase, carbon emissions licenses called assigned allowance units (“AAU’s) were granted free of charge to established corporations. The people administering the EU plan were often forced to rely on emissions estimates prepared by the firms themselves. Not unexpectedly, these figures gave the corporations generous leeway.
The result was massive over-allocation of AAU’s, which in some areas of industry exceeded actual emissions by as much as 50%. In May 2006, after the scale of this over-allocation became a well known fact, the market in AAU’s collapsed.
Also included in Kyoto are provisions allowing Annex-1 parties to pay for emissions reductions additional to what otherwise would have occurred within other Annex I parties and then credit these reductions against their own assigned amount units. This is known as Joint Implementation (“JI”).
Another part of the Kyoto Protocol that needs to be understood by way of background is the Clean Development Mechanism (“CDM”). Annex I parties may pay for emissions reductions that are additional to those that otherwise would have occurred within a developing (“Non-Annex I”) nation that is a party to the protocol. The purchasing Annex I nation may then credit these emissions reductions against its AAU’s.
The CDM is an attempt at a market-based solution for addressing the problem of global warming. CDM is not a cap and trade system because the host nations of CDM projects are developing countries that have no binding cap limit to the mass of GHGs that they may emit under the Kyoto Protocol. An approved CDM project generates Certified Emission Reductions (“CERs”), the currency of the CDM system, which are in essence tradable emission credits generated by “offset” projects.
The CDM is a project-based system. This means that it accomplishes its objectives at the scale of individual projects that are validated by designated entities and registered with the CDM Executive Board the mechanism’s governing body, rather than at an industry or sector-wide scale. Each project wishing to participate in the CDM must prepare a Project Design Document that explains in detail how its future emissions reductions will be real, additional, and not induce leakage. It must also prepare a monitoring methodology that explains in detail how it will monitor emissions reductions made by the project.
Although the United States declined to join the Kyoto Protocol, market mechanisms to control carbon emissions are currently being developed by a coalition of 7 northeastern States (the Regional Greenhouse Gashouse Initiative – “RGGI”)) and by California. The RGGI does contain provisions for offset projects.
With that history out of the way, let us return to the greenhouse gas emission credit fund. The greenhouse gas emission credit funds generally have as their goal emissions reduction or avoidance projects in underdeveloped economies to generate saleable “credits” for the investors. The fund manager (the following language is from a manager of projects intended to produce EU CER’s) will claim to have needed expertise:
“It must be made clear, however, that an investor to a fund that captures [underdeveloped country] discounts in the generation of greenhouse gas emissions must be cognizant of important issues such as the risks involved in the creation of new credits: the lengthy and tedious administrative processes to establishing a carbon credit-worthy project, the verification and validation of real emission reductions, as well as the more obvious macro components affecting the supply and demand and ultimately the prices of credits. And also the investor must critically judge the fund manager (agent) to navigate the by-ways of the new credit approval process.
Indeed, perhaps it is here that the investor might best value the fund since profitability mostly relies on the abilities of the manager to source discounted projects, manage the extraction process from the identification up to perhaps 5 years later when credits are issued: the fund manager must be a master of the carbon credit origination process.”
There are a number of market/regulatory factors that should be considered in such an EU project. First, the shorter the interval before the end of the initial Kyoto compliance period in 2012, the less money to be made from CERs, so the larger the transaction costs associated with registration and monitoring become. Second, without certainty about the shape of any future Kyoto based trading program or subsidy, financial incentives to invest with post-2012 in mind are absent. Finally, even for the 2008-2012 market, there is significant demand (and hence price) uncertainty because of the possible competition of CDM with both JI project based reductions and outright purchases of AAUs from Russia, Ukraine, and the remainder of Eastern Europe. Whether these other alternatives are sought out by Annex I parties in turn depends, on the costs of domestic compliance, the price of CERs, and other political considerations.
CERs will eventually be transferable to a buyer who establishes an account with the International Transaction Log, a yet to be constructed database of Kyoto accounts. This requires that, for the time being, a fund which merely wants to acquire CER's from developers be designated as a “project participant” by the Kyoto project entity generating the CER’s. However, a fund which merely wants to purchase CER's to trade may not be able to be granted such status.
Moreover, not all methodologies that on their face would seem to be ways to reduce greenhouse gas and hence generate credits work out so well in practice. A prime example, is developing countries’ forests — both the old-growth forests now being eyed for carbon absorption as “carbon sinks”, and new tree plantations.
However, forests as carbon offsets are a questionable proposition for a long list of reasons. How much carbon dioxide a forest will absorb over a given period is at best an educated guess. Forests can burn, releasing their carbon. Old-growth forests absorb much less carbon dioxide than new plantations, which enhances the temptation to clear-fell the former in order to plant the latter.
The problems are multiplied wherever regulation is lax and officials corrupt. Tropical forests, it can be expected, will at times both be logged and claimed as carbon sinks. Where such forests are protected with any vigor, the “protection” is often likely to be aimed at indigenous people who practice a sustainable shifting agriculture. The increased incentives for plantation forestry threaten to cost tenant farmers their land. Perhaps on account of these issues, I know of no confirmed CDM project resulting in CER’s to be obtained from reducing CO2 by planting trees.
The moral of course is to think very heavily about an investment in any greenhouse gas offset project or credit participation fund. As the European market experience shows even in a somewhat broad market situation the market price for carbon credits (albeit there in the AAU context) is hardly stable. The US experience, really limited so far on any major scale to sulphur emissions allowances (i.e. credits), has shown sizeable price volatility. In the developed countries future environmental legislative uncertainty adds another major risk to the mix. Advances in science also mean that the projected "credit" worth of an emission project today may not be realized tomorrow on account of a change in emission metric and analysis methodologies or the development of scientifically "better" reduction programs. Thus, for example, expected credits for carbon sinks like forest programs might not even exist or the status might be questionable as is seemingly the current case with such programs under the EU version of the Kyoto regimen. And when you start getting into emission reduction projects in underdeveloped countries, the financial (and moral) risks multiply enormously.
In short, caveat emptor.
