Carbon Finance

The information contained in this primer is of value to almost any business but is especially important to point source emitters of carbon dioxide such as producers of alternative fuels.

To a degree that is possibly unique among emerging technologies, carbon mitigation has become the province of fund managers and financiers rather than technology developers per se. Such a state of affairs is, we believe, temporary, and is largely a consequence of the unique history behind the international efforts to control emissions of carbon dioxide into the atmosphere, a history we will discuss in some detail below.

Why Carbon Finance is Vital to Your Business

Why should you concern yourself about carbon finance and trading? Mandated limits on CO2 emissions are already in force in most of the nations of the world and are very likely to be imposed in the United States, one of the last major holdouts. If you are doing business internationally, and especially if you are operating plants overseas, you may already be subject to such limits. And even if you are confined to domestic operations, you almost certainly will be subject to such limits eventually. Carbon funds constitute one option for meeting your obligation to reduce your carbon output. They also represent a way to avoid costly retrofits to your industrial operation, because you are in effect hiring someone somewhere else, presumably at a low rate, to minimize the problems you have created.

What follows is the most basic discussion of how the funds work. The details of project certification, trading, and complex financial instruments are covered in separate sections.

The Nature of Carbon Funds and Finance

Carbon funds are in a sense investment funds, but they differ fundamentally in their operation from the usual type of equity or debt financing associated with angel investor groups, venture finance institutions, and investment banks. Ordinarily the contributors to an investment fund of whatever sort expect to profit from their investments and to get back more money than they put into the fund. Carbon funds and related entities called ecosystem funds generally don't work that way. Instead the investor, if that's really the proper term for the individual or firm providing money to the fund, purchases what are known as carbon offsets or carbon credits from the fund, or, more rarely, carbon allowances. The money provided to the fund for the purchase of these offsets or credits is not returned, nor is any interest or dividends allocated to the purchaser of these offsets subsequently. Furthermore, the purchaser of credits does not receive equity in the carbon mitigation projects being financed with his contribution nor is the fund manager or the project manager in debt to the contributor. All obligations to the contributor cease upon the delivery of the documentation establishing the existence of the offset which will usually include some sort of certification from a recognized body.

So why bother to purchase such offsets in the first place?

There are essentially two reasons for doing so: to obtain regulatory relief when one is conducting business operations within the jurisdiction of a government mandating limits on carbon emissions, or to make a statement concerning the public spiritedness of the organization and its determination to avoid adverse environmental impacts in the course of its normal operations.

In this sense the purchase of carbon offsets constitutes a form of overhead rather than an investment, although in some cases offsets can be resold or traded.

How Offsets Work

The basic idea behind offsets is that the atmosphere of earth is a commons and that any carbon dioxide either added to the atmosphere or taken from it will affect the total balance and will be felt pervasively. Thus if I am doing business in one place and emitting carbon dioxide in the normal course of business operations, I can mitigate the impact of my actions by inducing someone else to remove carbon dioxide from the atmosphere in the same amount that I am producing it. That someone else is in effect offsetting the CO2 that I produce, thus rendering my business activities carbon neutral.

So how might CO2 be removed from the atmosphere? Green plants consume carbon dioxide in the course of performing photosynthesis, and so theoretically by increasing the photosynthetic biomass of the planet one is offsetting the CO2 produced by burning fossil fuels. Planting a forest where none previously existed could be said to contribute to such useful biomass. One could also capture the CO2 at its source and sequester it, that is, store it in some sort of geological formation where it is not apt to escape. Other CO2 elimination methods exist as well, and we will discuss these in our section on carbon mitigation and management.

One can also claim offsets for schemes that merely reduce emissions for some activity rather than actively eliminating CO2 from the atmosphere. Arguably, such reductions would have the same net effect upon the volume of CO2 in the atmosphere, that is, they would reduce it, or, at any rate slow its growth.

Why Offset in the First Place?

The justification for offsets and offset programs is that they are less onerous for businesses than are carbon taxes, and that they will encourage the development of a carbon market, a trade in emissions, as it were. According to this argument, which at this point is more a matter of faith than any readily demonstrable economic truth, market mechanisms will conduce to the greatest efficiencies in addressing the problem of greenhouse gases, and will be embraced rather than resisted by industry as would be a carbon tax, considered below. Certainly carbon market mechanisms have been embraced by the financial industry and by certain brokers of carbon mitigation projects, though the response of emitters themselves, at least here in the U.S., has been somewhat less enthusiastic.

Nevertheless, there is one very good reason why offsets might in fact be more attractive to industry than a straight tax on emissions or internal programs for reducing emissions at the place of business. That reason is that the cost of mitigating emissions is not uniform from place to place or from industry to industry, and thus one entity may be able to make reductions at a lower cost than another or at no cost at all. This salient fact forms the basis for what is known as cap and trade in the jargon of the carbon business.

The cap refers to limits assigned to individual emitters for a given year. As an emitter I am allowed to release however many tons of CO2 the government has determined for my type of business at my level of industrial output, and this is my carbon allowance. Allowances themselves are calibrated to meet overall reduction goals under the terms of the Kyoto Treaty.

If I exceed my allowance, I have a problem and I may be subject to various penalties. If, on the other hand, I emit less than my allowance, then I am assigned carbon credits which have real monetary value, albeit a value that is determined by the market rather than the government setting the limits. Such credits are generally expressed as dollars or euros per ton of carbon, and are said to determine the price of carbon on the world market, though, interestingly, they have almost no relationship to the price of carbon or carbon dioxide as an industrial commodity.

Carbon credits form the basis for the trade in emissions as it's called. You see, a company that is below its allowable limits for carbon emissions can sell its credits to another company that is above its limits. I may be such a company, and it may cost me far more to bring my plant into compliance by physically reducing my own output than it would cost me to buy enough credits from you to offset my excess emissions. So I buy from you, or, more likely, I buy from a fund or broker that has already paid you for your credits and effectively taken them off the open market.

Cap and trade is enshrined in the Kyoto Protocol and in the European Union's Emissions Trading Scheme. Caps are being put in place in a number of states and coalitions of states in the U.S. as well, but the legitimacy of such legislation under the U.S. Constitution awaits determination.

Tradable carbon allowances arising from a firm exceeding its emissions reductions obligations are easily definable and verifiable and thus comprise a readily negotiable carbon currency. This is not the case with offsets involving activities intended to reduce greenhouse gases but not to meet individual emissions mandates, these constituting the second type of tradable emissions credit. It is to this second type that we will turn our attention now.

A concrete example of the latter will best illustrate the difference.

Let us suppose that a rural cooperative in a developing country is restoring a forest that is intended to become an ecotourism attraction. The cooperative has not been previously engaged in any activities that are highly productive of greenhouse gases, and thus has not been assigned emissions limits by the government (even when the governments of developing nations are Kyoto signatories, they generally have not set in place a bureaucracy for implementing Kyoto goals and lack carbon registries indicating individual liabilities). So in essence the cooperative has no government assigned allowances to trade, and thus no pre-existing documentation regarding the carbon intensity of its activities.

In order for that cooperative's greenhouse gas reducing activities to be recognized as such and to be assigned a value in the carbon marketplace, that cooperative will need to have a certification body assess its program and make a determination as to the GHG reduction that it will provide. The certification body in turn will apply a recognized certification standard to the certification process, providing a measure of transparency.

In most cases such a cooperative would not undertake the certification and sale of its own offsets. Instead it would form a relationship with a carbon fund or with a broker or aggregator of offset projects. The fund or broker would actually take the offset credits to market.

Offsets of this nature may be sold and resold though as yet there is no common carbon currency in force in global financial markets. In the present scheme of things, major international carbon funds attempt to acquire offsets cheaply in local markets and then sell them at considerable profits to corporations abroad. The money from the initial sale of the offsets by the group actually running the project will enable the project to go forward and will also provide an income for the members of that group. Normally it does not provide the carbon fund with either equity in the project nor does it saddle the project managers with debt. The money provided to the project managers only applies to the offset itself it and does not result in transfer of ownership of the actual project.

The arbitrage opportunities for the fund managers have been considerable in this regard, and 1,000% profits are not unknown. That's why major financial houses have set up carbon practices. It has been a business with legs, as they say.

We should point out that emissions trading can take place even in the absence of caps within what is known as the voluntary carbon market. This market is so different and distinct from emissions trading under the Kyoto Protocol that it merits a section of its own.

How Trading Came to Be

The emissions offset concept was first legislated into existence in the United States with respect to sulfur dioxide emissions which constituted a serious problem in the early nineteen nineties. Federal mandates resulted in cap and trade and the appearance of some of the first greenhouse gas funds. The resulting emissions trading captured the attention of those seeking to limit CO2 emissions on an international basis, and the same principle was adopted as a key part of the Kyoto Protocol, and was deemed to represent the "magic of the market" rather than a heavy handed command economy approach that was likely to be resisted by business leaders.

It must be said, however, that while the American scheme for limiting sulfur dioxide has been a solid success, Kyoto objectives have generally not been met, in other words, the market has failed to work its magic on the international stage. The reasons behind this troubling discrepancy are various, but the lack of international enforcement bodies having the clout of national regulatory agencies must surely be a major factor. Clearly national will is stronger than international will.

The Voluntary Carbon Market

Emissions trading taking place within the voluntary carbon market is much smaller in scope than cap and trade transactions. It is nonetheless a market that is rapidly growing, though its long term future is unclear.

Within the voluntary carbon market the companies purchasing offsets face no government mandates compelling them to do so, hence the term voluntary. Instead they strive to reduce their emissions profiles either as a public relations ploy or because they anticipate the coming of carbon caps, and wish to be compliant ahead of the fact.

Voluntary carbon markets chiefly flourish in countries that are not Kyoto signatories, most notably, the U.S. and Australia. The largest voluntary carbon market, not surprisingly, is in the U.S.

Because such markets do not reflect legal mandates, and because the trade itself is almost entirely unregulated, the voluntary carbon market tends towards considerable diversity. There are, however, a number of general trends discernible within it.

In the case of at least one trading scheme, that overseen by the Chicago Climate Exchange, the organization purchasing credits must agree to a legally binding contract that stipulates emissions limits and reductions. Furthermore, offsets purchased must adhere to a given certification standard, and adherence must be established by a third party certification authority. The aim here is to replicate as much as possible the sort of regularity present in the Kyoto mechanisms.

In other cases, the offset purchaser incurs no binding obligations and participates in the trading scheme merely as a gesture of good will. Nevertheless, most funds will take it upon themselves to certify offsets according to some widely recognized standard, absent any legal obligation to do so, and will encourage their clients to measure their own carbon footprints according to standardized procedures associated with the offset certification standards.

Where the voluntary programs differ most significantly from the Kyoto Protocol, apart from the fact that they are voluntary, is in the range of activities deemed worthy of the carbon negative designation. Voluntary carbon funds have been associated with renewable energy projects, efforts to preserve existing forests rather than plant new ones, and with no till agriculture that releases less greenhouse gases from the soil.

The details of the various voluntary carbon trading schemes are discussed in sections devoted to the major exchanges, certification standards, and funds.

Carbon Taxes

We can't complete a basic overview of carbon finance without making mention of carbon taxes. Carbon taxes are not in fact directly related to cap and trade, but they are very much a part of carbon finance in that they represent an alternative method for managing emissions through financial disincentives.

A carbon tax is government levy on CO2 emitted into the atmosphere in amounts beyond the maximum permissible for an individual organization. Carbon taxes are generally associated with caps of one sort or another but no assumption is made as to the existence of offsets that would reduce an organization's carbon tax liability per a given level of emissions. Instead the tax might be seen as a stimulus for directly reducing emissions.

As is the case with credits and offsets, a tax assumes a price for carbon, but in this instance it is a set price assigned by the government in question, not a market price. That price will generally be expressed as so many dollars or euros per ton, just as is the case with cap and trade schemes.

Most advocates of carbon trading are vehemently opposed to taxes, claiming that such exactions will subvert market mechanisms and will be less effective in achieving carbon reduction goals inasmuch as there is no guarantee that money collected as carbon taxes will go into carbon mitigation projects. In the case of tradable offsets of course the linkage is direct and irrevocable. Money spent on offsets can only be used for the purpose of carbon mitigation—that and for paying transaction fees.

We, for our part, are not prepared to enter into this particular policy discussion, and, in any case, we doubt its relevance to the business community. Either way money is being taken from the operating capital of the emitter and given to someone else in the pursuit of a larger policy objective having little to do with the emitter's own corporate mission.

We will allow that we understand the position of the traders. If the carbon tax is set lower than the market rate for carbon, which has been the case with all taxes enacted thus far, then the emitter has no incentive to buy offsets and the trading system would indeed be undercut. Whether or not that is bad thing is another issue.

There is, however, another dimension to the issue, that of enforcement in regard to caps, a dimension that, as it happens, many traders would prefer to ignore. Unless there is some penalty in place for those who exceed their assigned limits, then those limits will be exceeded on a massive scale simply because it will be financially advantageous for the emitter to do so. There has to be in place a financial disincentive to discourage the flouting of cap regulations, or some other form of disincentive—though we doubt that many governments would be inclined to jail emitters who exceed their limits. The levy on the part of the government may be construed as fine or as a tax but its impact will be the same.

To date enforcement mechanisms have been few and lax throughout the world. No government official is eager to confront large point source emitters of carbon dioxide who are providing essential services and products to the public and who are operating the basic infrastructure and manufacturing facilities that underlie an industrial economy. But in the future, when increasingly more stringent limitations are imposed upon industries, enforcement will become crucial, with what financial impacts, we can scarcely speculate today.