Reducing Gains

There's plenty of money to be made in the fight against global warming, but the risks can be as big as the potential profits.

Thanks to powerful incentives created under the United Nations-sponsored Kyoto protocol, investment is surging in companies that specialize in reducing emissions of carbon dioxide, methane and other gases believed to cause global warming.

Under Kyoto, a polluter in a developing country that reduces its emissions can receive allowances from the U.N. that can then be sold to polluters elsewhere, mostly in the European Union, Japan and Canada. rights to a portion of these allowances, project developers are paying polluters, mainly in China, India, Brazil and Mexico, to build emissions-reduction projects at their facilities.

Analysts predict investment in the sector will continue to grow as the need to reduce dangerous emissions becomes more pressing. AES Corp., the Arlington, Va.-based global power company, last year paid about $55 million for a 9% stake in AgCert International PLC, a Dublin-based company that specializes in cutting greenhouse-gas emissions from farms around the world. Morgan Stanley recently bought a 38% stake in MGM International, a Miami-based project developer, and Credit Suisse Group said in June it would pay $59 million for a 10% stake in the London-based carbon finance firm EcoSecurities Group PLC.

But few if any of these developers are turning a profit. Most of their projects are still awaiting approval by the national governments where the projects are based, as well as rulings by a key U.N. board that measures the emissions reductions and determines whether projects qualify for allowances.
Indeed, the U.N.'s impact on this sector is huge. AgCert shares, which are traded on the London Stock Exchange, lost about three-quarters of their value over the past year after the U.N. changed how it calculates gas reductions at animal farms. The change cut in half the amount of methane, a potent heat-trapping gas, project developers could claim they prevented from escaping into the atmosphere. Thus, investors feared AgCert would fall short on its goals of cutting greenhouse gases and earning allowances.

"It's not for the faint of heart," AgCert Chief Executive Bill Haskell says of this sector. "There's a lot of scar tissue that those of us in the business a long time have endured."
Despite such uncertainty, the market in emissions allowances is growing quickly and many in government and industry expect it could be worth hundreds of billions of dollars annually. 

Companies bought $5.5 billion worth of allowances generated by offset projects in 2006, up from $2.9 billion in 2005, according to the Worldbank, which helps finance emissions-reduction projects. The total value of all allowances traded in carbon markets world-wide tripled to $30 billion in 2006 from the previous year, the World Bank reported. Most of that activity comes from a thriving EU secondary market that has been tapped by hedge funds and the world's largest banks. Carbon-reduction projects appeal to investors because the cost of generating the allowances is much lower than the price those allowances fetch in the European carbon market. Projects often cost less than $5 a ton of carbon reduction, yet the allowances for delivery in 2008 can sell in Europe or other markets for more than $20 a ton. But, as the change in calculations for farm emissions shows, it's tough to predict how many allowances a project will yield. 

"We won't get 100% delivery of allowances and that's a risk we have to bear," says Paul Ezekiel, head of Credit Suisse's global carbon-trading business. "That's the reason we buy carbon allowances without a guarantee at a much lower price: We take a lot more delivery risk."

Operating in developing countries such as Brazil, Mexico, India and China, as most projects do, adds uncertainty and delays, say industry participants. National governments that must approve the projects are often slow to act. But the biggest problem seems to be the regulatory obstacles put up by the U.N.'s CDM (Clean Development Mechanism) Executive Board in Bonn. It determines the number of tons of emissions a project has eliminated, and certifies allowances in recognition of those reductions.
The methodology used in the approval process "can be burdensome, and there's not a lot of clarity around what's going to be approved or not," says John Mackle, chief financial officer of MGM International. The main hurdle is proving to the board that the emissions-reduction project would not have been undertaken without the prospect of obtaining and selling the emissions allowance. The board thoroughly investigates each polluter's incentives for reducing emissions. In cases where it finds
that other antipollution regulations are the driving force behind reductions, the board will deny the allowance credits. The board also looks at whether the project holds economic advantages for the polluter without the sale of the allowance. If it does, the allowance is denied.  The board will also deny allowances if an emissions-reduction project relies just on estimates and not on actual measurements. It was an issue like this that cost AgCert so dearly: AgCert and other emissions reducers that focus on agricultural projects previously calculated the emissions of an animal farm by counting the number of animals and extrapolating the amount of methane produced. But the U.N. now has ruled that developers must measure the emissions produced by an animal farm using gas meters to determine how many credits they can claim. This almost always produces a figure lower than when an estimate is based solely on the number of animals present.
The U.N. says it has taken a number of steps to speed its review of projects and provide more clarity for project developers. "We're seeing some very strong signs that the measures put in place by the executive board are working quite well," says Grant Kirkman, team leader for methodologies at the CDM office in Bonn. AgCert, for its part, says it doesn't expect to encounter similar problems with reduction methodologies as the regulatory process develops. The company is expanding into other kinds of projects, such as reforestation and other methane-recovery techniques at farms, that will lower its risk from relying too heavily on one methodology, he says. AgCert does still face some daunting challenges, however. For 2008 it has commitments to deliver 7.2 million "certified emission reductions," or
allowances produced under the CDM program, and 4.1 million for 2009. But after the U.N.'s methane ruling, AgCert projects it will be able to generate only 1.76 million CERs in 2008. AgCert says it will try to cover the shortfall by providing consulting services in exchange for receiving CERs at below-market prices.

That strategy has risks, too, the company says. In a May prospectus filed with the Irish Financial Services Regulatory Authority, AgCert warned that it may not meet its obligations because the company has little experience "sourcing and entering into [consulting] relationships with third parties." Nevertheless, Mr. Haskell is optimistic that AgCert eventually will realize the large profit margins it set as goals. "Cutting emissions is not as easy as it looks," he says. "But it is a lucrative business."

By: Matthew Dalton

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