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Pooling Carbon Risks…and Benefits

Amanda Hawn

Just two weeks after Kyoto was put into force, Natsource Asset Management Corp. (NAM Corp), a subsidiary of New York based Natsource LLC, announced the world's first private sector mechanism for managing European Union Emissions Trading Scheme (EU ETS) and Kyoto Protocol (KP) Greenhouse Gas (GHG) compliance requirements. A month on, The Ecosystem Marketplace looks at what makes the mechanism unique and considers, more generally, the significance of private-sector players in the newly-minted global carbon market.

Just two weeks after Kyoto was put into force, Natsource Asset Management Corp. (NAM Corp), a subsidiary of New York based Natsource LLC, announced the world's first private sector mechanism for managing European Union Emissions Trading Scheme (EU ETS) and Kyoto Protocol (KP) Greenhouse Gas (GHG) compliance requirements. A month on, The Ecosystem Marketplace looks at what makes the mechanism unique and considers, more generally, the significance of private-sector players in the newly-minted global carbon market. In the mid-twentieth century, Ludwig Mies van der Rohe, the famous architect, popularized the notion of "Less is More." In the late-twentieth century, Sam Walton, the famous capitalist, popularized the notion of "More for Less." Now, in the early-twenty-first century, the two ideologies are converging in the emerging private sector of the global carbon market. On February 28, Natsource Asset Management Corp. (NAM Corp), a subsidiary of New York based Natsource LLC, launched the world's first privately owned trading mechanism for managing carbon compliances. The mechanism — dubbed the Greenhouse Gas Credit Aggregation Pool (GG-CAP) — will pool contributions from companies and governments in Canada, Japan and Europe, and then invest in a portfolio of projects aimed at reducing greenhouse gases around the world. While a number of similar carbon funds have been created through public-private partnerships, GG-CAP represents the first strictly private-sector tool designed to help companies comply with European Union and Kyoto Protocol emissions requirements. The private sector nature of the mechanism is important, say its architects, because it allows GG-CAP's managers to best serve their customers by taking a Mies van der Rohe meets Walton approach to the carbon market.

Less is More

Based on current emissions trends, Natsource estimates that the 35 countries bound by the Kyoto Protocol will fall short of their reduction requirements for 2008-2012 by 3.5 billion tons. If this projection is right, considerable amounts of carbon will need to be purchased from externally managed projects. GG-CAP hopes to supply this demand. The pool, of course, will not be the only market player looking to sell emissions reductions credits to buyers in need, but, at the moment, it is one of the few pitching its ability to do so in purely utilitarian terms. The World Bank, for instance, sponsors eight carbon funds, towards which 60 companies and governments have committed over $800 million. Two of these pools — the Community Development Carbon Fund (CDCF) and the BioCarbon Fund (BCF) — target projects that not only reduce emissions, but also further specific social and environment/development aims. Likewise, most government and NGO-backed pools are bound by specific procurement rules when it comes to selecting the portfolio of projects in which they will invest. GG-CAP, say those at NAM Corp., has one aim only — to focus on the needs of its investors. Will this "less is more" approach work? Richard Rosenzweig, the firm's Managing Director, is betting the answer is, yes. Specifically, Rosenzweig says he believes that GG-CAP's narrow focus will make the tool more flexible than similar public-private mechanisms, providing buyers with increased cost-efficiency and decreased risk. "We have a global team of experts who possess unparalleled expertise in the policies that created the greenhouse gas market, and significant commercial experience in contracting for such reductions," says Jack Cogen, President of Natsource. "This expertise will be utilized to provide highly valued asset management services to our clients to assist them in managing their emissions liabilities cost-effectively." By combining private sector experience with a concentrated focus on cost-efficient investments in emission reductions, NAM Corp. hopes to streamline the compliance process for buyers in GG-CAP. Specifically, GG-CAP's managers stress that they will be actively involved in managing the pool's portfolio at every step, from project discovery through to project delivery. "We would like to get GG-CAP to a point where it is almost a turnkey project for buyers," says Rosenzweig. To date, buyers have responded well to this funding pitch. At first close last month, GG-CAP had already signed up six firms from Japan, Canada and Europe — Electricity Supply Board (Ireland), The Chugoku Electric Power Company, Inc., Hokkaido Electric Power Company, Inc., Osaka Gas Company, Ltd., Tokyo Gas Company, Ltd., and an undisclosed sixth company from Canada. Cosmo Oil Co., a Japanese oil refiner, made it a circle of seven this month, and Rosenzweig says his company hopes to make more announcements soon. From the current group of seven, GG-CAP already has over US$100 million to invest in projects that will generate emission reduction credits (ERs). Capitalization of the pool is expected to rise to US$130 million by the end of the month and then jump again before a final close which has not yet been announced.

More for Less

Streamlined investment management services, however, mean little to potential buyers unless the investments themselves are sound. GG-CAP's managers thus claim that, in addition to offering investors a less is more take on the carbon market, they can also put together a portfolio that will offer their buyers more for less. One of the primary reasons companies or governments might choose to invest in a mechanism like GG-CAP — or indeed any carbon fund — is that by pooling their resources with those of other buyers, they are better able to access economies of scale. Rosenzweig attests that, as GG-CAP's managers have begun shopping for emissions reductions projects in which to invest, the bargaining power brought by the pool's size has been important, "without a doubt." But there are bigger pools, or carbon funds, out there (the World Bank, alone, boasts several, click here for a story on other carbon funds), so in order to pursue their more for less strategy from a competitive standpoint, NAM Corp. needs to prove that GG-CAP is set to be an innovative pool, not just a big one. Toward this end, the company says it has developed a unique tool called a Delivery Risk Model (DRM) that will help to direct the pool's investments towards the most cost-efficient projects and management options. "We spent several years developing a model in conjunction with about 8 companies and a whole series of outside experts," says Rosenzweig. "This model now allows us to quantify how many tons of carbon reduction we should expect from any given project." In theory, at least, the model's projections, then, will help GG-CAP's managers get more bang per investment buck by informing risk management options and increasing project delivery. Specifically, the DRM calculates the projected delivery of ERs for any given project by weighing risk factors in five categories: counterparty risk; carbon regulatory risk; country investment risk; technology performance risk; and, last but not least, carbon performance risk. "You never want to say that you are the only one doing something because someone else could certainly be out there, but we are confident, at least, that DRM is one of the few tools of its kind out on the market today," says Rosenzweig.

Compare and Contrast

GG-CAP's private-sector approach to the carbon market looks to be, at least on paper, both lean and innovative. That is not to say, however, that there might not be trade-offs associated with throwing in with the private sector in the evolving game of global carbon finance. For instance, while de-linking carbon investments from explicit social or environmental aims can make mechanisms like GG-CAP more flexible, it can also reduce the "green" or "socially-responsible" branding opportunities that have buyers flocking to World Bank ventures like the Community Development Carbon Fund (CDCF). Indeed, when announcing that the CDCF was over-subscribed at US$128 million at first close earlier this month (March, 2005), Ken Newcombe, Senior Manager of the World Bank's Carbon Finance Business, turned the idea that "less is more" when it comes to carbon neatly on its ear. "The CDCF responds to the World Bank's strategy to expand the frontiers of the carbon market beyond the boundaries of risk currently acceptable to the private sector," he said. "For many parties the CDCF is a safe harbor in an uncertain regulatory environment, and benefits from simplified procedures. The higher cost of emission reductions is justified by the knowledge that these kinds of projects have wide support due to their direct contribution to host communities." Likewise, the notion that bigger is better can cut both ways given that some of the biggest investment pools are still captained by public-private partnerships. And, last but not least, models are only as good as their latest corroborated projection. GG-CAP's DRM tool has not yet been tested in the post-Kyoto carbon market, so the proof, as they say, will be in the pudding.

Healthy Competition

The real take away on the GG-CAP, however, may not lie in comparing the relative merits of private and public sector approaches to carbon finance, but rather in celebrating that both now exist. If global carbon trading schemes are to continue to grow and, hopefully, to succeed in achieving reductions, then the marketplace of ideas concerning carbon finance will need to be an active one. GG-CAP's launch, through its introduction of a private-sector approach to managing carbon compliances, has, at the very least, enriched the marketplace of ideas in the fast-evolving world of carbon finance. And that should be good news to carbon players of all stripes, of all sizes. Amanda Hawn is the Assistant Editor of The Ecosystem Marketplace. She may be reached at athawn@alumni.princeton.edu. Last Modified: 3/22/05

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