Where there's no muck, there's still brass

The EU's attempts to clean up industrial air polluters has seen the emergence of the CO2 emissions trading market and a new opportunity for hedge fund managers

EU carbon dioxide (CO2) emissions trading started experimentally in the middle of 2004, with the official market opening in January 2005.

Since then, one CO2 emissions trading fund from Ixis has launched, another is running in Japan, and many hedge fund managers are eyeing an immature and less crowded marketplace than established equity, fixed-income and other traditional marketplaces.

Paul Dawson, director of environmental regulation at Barclays Capital, says that since the start of 2005, "liquidity and the number of traders have increased exponentially, buy and sell spreads are coming down. Volume has picked up to the extent that in the OTC market over 30m tonnes of CO2 have been traded."

Laurent Segalen, lead manager on Ixis Corporate and Investment Bank's European Carbon Fund (ECF) Sicav, claims that according to his calculations there is a 90% chance of European firms that need carbon emissions credits running short in the next eight years - one of the reasons that ECF is an eight-year vehicle - but that this shortage is less certain over the next three, opening up a buy and hold opportunity for those managers who can afford to wait.

Buy and hold

ECF's strategy is simple: buy carbon emission credits until 2007, hold them, and then start selling them as shortages appear.

"It's very simple because whatever the regulation, there will be a shortage," he notes. "It takes a lot of time to emit less (CO2), and you need to redraw plans and change fuels, it requires a lot of time. If you take the big picture, in five or eight years' time there will not be enough certificates inside Europe to go round."

Segalen says in the five-year period between 2008 and 2012, European corporations will have a shortage of CO2 of between 300-500m tonnes.

But Dawson feels "it's a brave person who thinks the prices are only going up. There are a number of drivers, in terms of the tightness of the emissions constraints going forward, on the value of the allowances."

Segalen could buy any credits left over from the €20bn-worth the EU issued preceding Europe's carbon market's 1 January debut (equivalent to 2.3bn tonnes of CO2 at €8 per tonne).

However, he says about 80% of the fund's credits will come from environmentally friendly projects in countries such as Brazil, India, China, South Africa and Mexico.

Segalen, who contributed to writing the EU's and the World Bank's laws and views on carbon trading, says these can be bought more cheaply (though counterparty risk must still be monitored).

Dawson notes that such countries' projects could lead to a fall in the price of allowances. Russia, likely to have a significant number of free credits since its fall in industrial output has restrained emissions, will also be crucial, he adds.

The price of gas and coal will be a major variable. It's "less the price of the imported clean development mechanism as the constraint on supply and to what extent these projects qualify," says Dawson.

Volumes

"Clearly, if they come on in huge volumes, they might depress prices. If there are constraints that limit the amount coming on stream, you'll still see prices driven by underlying fundamentals."

These will not just be profit-driven traders in the market, adds Segalen.

"We have participants coming from very different horizons, some from the project finance background, others from asset management and others from an energy trading background."

While buyers of credits will not just be Europe's utilities, Segalen calculates they will drive 60% of the market, with 10% by refineries and other CO2 producers. These players want largely to hedge against or cancel out CO2 emissions, but six, including RWE, Eon and EDF, do have internal trading desks. Traders from asset managers and investment banks - trading off their own books and clients' - will also make up a small proportion.

Complex instruments

However, the traders will have an increasingly complex array of instruments to profit by: straight credits, of course, but also derivatives traded on Easdaq, linking elements such as CO2 credits, coal and gas and the weather.

Weather can be included because, when it rains, dams fill, less environmentally damaging hydropower can be used, and utilities can save on their credits.

There has also been talk of parallel schemes, such as one in North America involving Canada and some individual US states. "The key is to ensure you're not diluting the EU scheme by having credits generated on a different basis," says Dawson.

KEY POINTS

Although the EU trading market only officially launched this year, trading volumes have already grown and spreads closed.

A buy-and-hold strategy may work for managers as shortages of credits are expected, at least within the next eight years.