Asset Class – September 2008

The drive to reduce carbon emissions is bringing about profound change in the business world. Sam Richardson argues that alternative assets will not be immune from the effects.

The world is producing more hot air and global warming is by definition a global problem. The Kyoto Protocol, the international agreement to tackle the issue, has attempted to create a free market solution with the establishment of the Clean Development Mechanism (CDM), a market for tradable credits that developed world companies can buy to meet their pollution requirements. The trade in these credits was worth €40 billion ($60 billion) last year and according to Point Carbon, the specialist research group, it will be worth an estimated €63 billion this year. According to New Carbon Finance, the global trade in carbon emissions could hit $2 trillion by 2020 which is two-thirds the present $3 trillion value of global oil markets.

An emerging commodity market in carbon appears to be gaining some sort of momentum. If you dismiss the recently invented focus on being“carbon neutral” as a fad, perhaps you need to think again. Among those companies which have fully bought into the idea is SwissRe, one of the world’s largest institutional investors, which has been carbon neutral since 2003.

Scepticism is rife regarding carbon markets: much like the Catholic confession box, offset trading is seen by some as a rather reactive way to combat the sins of greenhouse gas emissions. The spectre of “greenwash” has also come into view, in which corporate marketing and PR campaigns quickly jump on the environmental bandwagon. Outside the world of FMCG brands, does this have any relevance to the financial asset management industry?

What has changed since the original introduction of Kyoto and the CDM is that commodity prices have hit levels never before seen. Global energy prices are now above those at the height of the OPEC-induced oil crises. Carbon auditing, once seen as merely a pillar of a business’ corporate and social responsibility (CSR) programme, is now becoming a potential tool to analyse cost inefficiencies in the service and manufacturing sectors. This recent “carbon and cost convergence” has been driven by oil prices of more than $100 a barrel.

An early supply chain carbon audit performed by The Carbon Trust for food company Walkers Crisps identified inefficiencies which not only could reduce the company’s carbon footprint but also reduce its production costs. Companies are realising that what was once seen as paying lip service to their carbon impact could now be a tool to improve overall operational expenditure savings.

For venture capital investors, the growth of this market will present a raft of opportunities that will emerge as the sector matures. Pure consultancy businesses focussing on carbon audit and consultancy are beginning to mushroom as more and more corporates look to pursue an “audit, abate and offset” process in relation to their carbon and greenhouse gas emissions.

Consultancy companies have not been fertile investment ground for VCs to date, but as the carbon services sector develops, innovative companies will leverage their expertise and build their own toolkits.

Is it possible to contemplate a time when your carbon audit will be as important as an S&P rating on your corporate debt?

This will create a technology-driven service sector which could provide the risk equity investor with some interesting returns. Carbon consultancy businesses which overlap into the offset trading market are already attracting the interest of investment banks, evidenced by JPMorgan’s purchase of carbon reduction firm Climate Care and Macquarie’s recent purchase of an equity stake in climate change company Climate Friendly. However, with doubts remaining over the forward price of carbon, investors with exposure to companies with large amounts of carbon assets on the balance sheet need to beware.

For some time now, private equity and infrastructure funds have been cottoning on to the importance of monetising their carbon offsets with particular reference to the large renewable energy schemes that have been funded over the last few years. Whether it is by straightforward trading of credits or through various regional subsidy programmes such as the Renewable Obligation Certificates (ROCs) in the UK, many a project finance model has depended on the added value of this intangible commodity.

In time, buyout opportunities will emerge as the large consultancy, audit and trading houses see teams spinout to develop franchises with a pure focus on carbon. 3C, a spin off from Dresdner/Allianz recently combined with Factor AG to form First Climate, a leading carbon asset advisory firm in Germany. Although few carbon-specific funds have been raised to date, the Natixis-advised European Carbon Fund, and Al Gore’s Climate Solutions Fund being notable exceptions, it is further up the institutional LP food chain where we may see carbon having a noticeable impact.

While much of the private sector investment community is still in “wait and see” territory on carbon, at the vanguard is the wealth of capital with roots in the public sector. The California Public Employees Retirement System’s (CalPERS) recent highly publicised commitment to cleantech has been mirrored by the French state’s Caisse des Depots investment group and the Australian civil service Superannuation Funds. In fact one of our fund LPs, Rotterdam-based Robeco, has invested funds on behalf of one their large clients, the UK Environment Agency’s pension fund. It is these public sector pension fund investors which are putting low carbon strategies very firmly near the top of their agenda.

With greater carbon accountability coming into focus across asset management as a whole, some companies are looking at emerging tools to demonstrate the low carbon credentials of their portfolios. Trucost, an environmental analysis company, has developed its own Carbon Footprint Ranking of UK investment funds, which, whether or not you buy into its “proprietary methodology” for calculating results, does show some startling outcomes which will be of growing interest to pension trustees and other gatekeepers of institutional funds. Their survey of 185 UK investment funds, for example, showed up to ten-fold variances in estimated carbon footprints of investment portfolios. Is it possible to contemplate a time when your carbon audit will be as important as an S&P rating on your corporate debt?

Even in the US, institutional investors are pushing for carbon disclosure. In July this year pressure from asset managers controlling over $1.8 trillion on the SEC enabled a part-ratification of the Financial Services Bill, which calls for better climate change disclosure by publicly traded companies. It is only a matter of time before this is adopted by the alternative asset classes and LPs start asking questions of GPs about their carbon transparency policy.

Undoubtedly the recent economic travails across global capital markets will influence the priority that investors and businesses alike place on their carbon asset strategy. While the convergence of carbon and cost efficiencies will continue to be sustained against a backdrop of rising energy costs, the more interesting medium-term developments surround how fully institutional investors embrace low carbon and sustainable portfolios as an asset management priority. For now it represents a small, if growing, sector of the market -but one that could force a reappraisal of how portfolio risk is addressed in the future.

Sam Richardson is investment director of the Sustainable Technology Fund, a UK-based venture capital fund investing in cleantech and sustainable companies.