Cashing in on Pollution

Climate change capital has positioned itself at the epicenter of the burgeoning global market in greenhouse gases.

By Stephanie Baker-Said
Bloomberg Markets December 2007

One early October day in London, a financier named James Cameron was poring over a poster-size map of China inside his offices near the River Thames.

Dotting the map were 20 or so sticky labels, similar to small Post-it notes. There were pink ones, blue ones, green ones, yellow ones--each marking a spot where Cameron's company, Climate Change Capital, is wagering tens of millions of dollars.

Cameron doesn't invest in stocks or bonds. What he invests in is carbon dioxide (CO2), the principal cause of global warming. In return for curbing emissions in, say, China, Cameron can sell the right to pump CO2 into the air in Europe. The going price: about 6 euros ($23) per metric ton.

Since co-founding Climate Change Capital in 2003, Cameron and his business partner, Mark Woodall, have turned their company into a powerhouse in the burgeoning global trade in greenhouse gases. Driven by the Kyoto Protocol on global warming, an accord Cameron helped write, this corner of the derivatives market is growing as never before.

Global warming may present the greatest challenge humans have ever faced. For Cameron, part of a new breed of climate-change capitalists, it also offers something else: a chance to make money. Whether this quest for profit will avert the potentially catastrophic consequences of a warming Earth is, at this point, unknowable. One possible alternative to trading would be to tax emissions, thereby making it costly for companies to keep polluting.

Al Gore, who won the Nobel Peace Prize on Oct. 12 for his work on climate change, has championed trading as one way to curb emissions of CO2, whose molecular structure traps heat near the Earth's surface. These markets enable power companies, refineries and factories to buy and sell the right to pollute once regulators cap emissions levels. Supporters of trading point to the success of the 12-year-old U.S. market for sulfur dioxide (SO2), a primary cause of acid rain. Since this system began, SO2 emissions from power plants have dropped 41 percent below 1980 levels.

The U.S. has fallen behind Europe in trading CO2 allowances- "carbon," in trader speak--because U.S. President George W. Bush has opted out of the Kyoto Protocol, saying its strict limits on emissions would prove too costly to U.S. companies.

As a result, London rather than New York has become the world capital of carbon finance. As part of the Kyoto accord, the European Union created a single market for CO2 rights on Jan. 1, 2005. Trading has exploded. Last year, the carbon market worldwide grew threefold to $30 billion, according to the World Bank. Investors have poured about $12 billion into funds devoted to pollution, according to London-based research firm New Carbon Finance. Half of that money is managed from the British capital.

In the U.S., where polluters can trade CO2 rights among themselves if they choose, California Governor Arnold Schwarzenegger is pushing to create a market that could one day dwarf Europe's. (See "Pumping Green," also in this issue.) By 2020, the global carbon market could swell to $565 billion, according to Oslo-based research firm Point Carbon.

So the great carbon rush is on. In January, Morgan Stanley bought 38 percent of MGM International, a Miami-based company that invests in emissions-reduction projects, as part of a $3 billion push into the carbon market. In June, Credit Suisse Group bought 10 percent of Dublin-based EcoSecurities Group Plc and said it may lend that company €1 billion for pollution investments. In August, a unit of London-based hedge fund giant Man Group Plc raised $382 million for a fund specializing in greenhouse gases at Chinese coal plants. And Salt Lake City-based Blue Source LLC, a startup run by two Utah entrepreneurs, has quietly amassed the biggest bank of pollution credits in the U.S. (See "CO2 Wildcatters," also in this issue.)

So much money is pouring into this arena that some investors may not make as much profit as they think, says Martin Whittaker, a director at MissionPoint Capital Partners, a Norwalk, Connecticut- based private equity firm that manages a $335 million growth fund aimed at clean energy and the environment. "A lot of investors have piled in expecting big returns in a nascent market," Whittaker says. "As in any investment, you get a lot of capital chasing returns and it tends to depress the margins."

Cameron, 46, and Woodall, 45, run Climate Change Capital out of a glass office tower near the south bank of the Thames, next to the headquarters of London Mayor Ken Livingstone. The company, which has about 120 employees, projects an eco-friendly image. The walls are covered with bamboo and the floors are blanketed with gray carpet made from recycled fabric. The coffee machine is full of fair trade beans. Tables and worktops are made from recycled plastic yogurt containers. A series of multicolor tiles use English words and Chinese characters to proclaim the company's motto: "Wealth Worth Having."

Cameron, who is vice chairman, and Woodall, chief executive officer, have big plans for their company. Climate Change Capital is already financing projects that it says will eliminate 70 million metric tons of greenhouse gases. That's roughly equivalent to the amount of CO2 Denmark sends into the sky each year. Cameron and Woodall predict that assets under management will swell to $10 billion within five years. They've pushed Climate Change Capital to manage money, finance clean-air projects and advise on mergers and acquisitions--in other words, to become a sort of Goldman Sachs of carbon.

In September, the duo flew to New York, where the UN was holding a meeting on global warming, to rub elbows with Gore, former U.S. President Bill Clinton and Hollywood star Brad Pitt. Their latest project is to raise $1 billion for a fund that will invest in low- energy buildings. "We're just babies," Cameron says. "We've just begun."

Climate Change Capital has already lured deep-pocketed investors. In 2005, New York-based Och-Ziff Capital Management LLC, the hedge fund firm founded by former Goldman Sachs Group Inc. trader Daniel Och, bought 20 percent of the company, Woodall says. A unit of Man Group has bought 10 percent. MSM Capital Partners, part of an investment firm started by Priceline.com Inc. co-founder Jesse Fink, also bought in. MSM sold its shares earlier this year, more than doubling its initial investment, says Whittaker of MissionPoint, which was started by Fink and Mark Schwartz, a former CEO of Soros Fund Management LLC. "It was a tremendously successful investment," Whittaker says, declining to elaborate.

The money keeps pouring in. In 2006, Climate Change Capital raised more than €800 million for a new carbon investment fund. More than two-thirds of that came from the Dutch pension giants ABP and PGGM, which together manage more than $425 billion. Otto van der Wyck, the founder of BC Partners Ltd., one of Europe's biggest buyout firms, became chairman of Climate Change Capital in 2004 and has helped raise the firm's profile.

For now, Climate Change Capital has the edge in carbon investing, says PGGM money manager Jelle Beenen. "They represented the first serious strategy in emission rights," he says.

There's big money at stake--for everyone. Nicholas Stern, former chief economist of the World Bank, last year forecast that climate change might cost the global economy $9.6 trillion by 2100. A rise of just 2-3 degrees Celsius in the average world temperature might displace 200 million people, devastate food crops and shave 3 percent off the global economic output, Stern concluded in an October 2006 report prepared for the U.K. Treasury.

Whatever the scope of the problem, trading in pollution permits may or may not be the solution. So far, trading CO2 rights has done little to curb emissions in Europe, according to Open Europe, a London-based think tank. The group is backed by U.K. executives such as Michael Spencer, CEO of broker-dealer ICAP Plc, and Brian Williamson, former chairman of the London International Financial Futures Exchange, which is now part of Euronext NV. European emissions rose 0.8 percent from 2005 to '06, according to Open Europe, which has urged the EU to let member countries decide how to reduce emissions on their own.

Europe has adopted a so-called cap-and-trade market similar to the one the U.S. Environmental Protection Agency created in 1995 for SO2. For each year through 2007, EU governments granted about 12,000 factories and power plants the right to emit a total of about 2.2 billion tons of CO2--the cap in cap and trade. The EU also permitted the companies to buy and sell allowances--the trade in cap and trade. If companies think they might exceed their annual CO2 allowance, they can buy rights from companies that pollute less. Under the Kyoto accord, the UN has issued similar credits from emission-reduction projects in 49 countries that produce similar results.

This dual system enables European corporations to buy indulgences from those in developing countries rather than mend their polluting ways, up to varying limits. It's simply cheaper to reduce emissions in, say, China, than it is in Europe. The EU has allowed European companies to import too many cheap credits, according to the World Wildlife Fund. The result is that some of these companies are doing less than they could to reduce emissions, according to a June WWF report.

"You're sending a signal to companies in Europe that they can carry on investing in high-carbon infrastructure by offsetting reductions," says Kirsty Clough, a climate-change policy analyst at the WWF in London. "That locks us onto a high-carbon path for decades." A better approach would be to prevent European companies from using so many credits from developing countries, Clough says. Cameron says the system is helping to put China's fast-growing economy on a lower carbon path. "A ton of carbon is a ton of carbon," he says. "It doesn't matter if you reduce it in Birmingham or Beijing."

European CO2 trading has enriched big utilities. At recent prices, the allowances that EU governments have granted to companies largely for free for 2008 carried a combined market value of €44.5 billion.

For investors such as Climate Change Capital, the potential rewards--and risks--have been enormous. The price of 2007 CO2 rights plummeted after traders concluded that the EU had flooded the market with allowances. The plunge prompted the EU to tighten emissions caps from 2008 to '12 and reduce the number of allowances it issues. Carbon investors and traders applaud that decision, and with reason: Fewer credits mean higher prices. Allowances for 2008 were trading at about €21 on Oct. 10. Some EU members, including the Czech Republic and Poland, have threatened to sue the European Commission, saying their pollution caps are too stringent.

The question is, where do prices go from here?

Oslo-based Point Carbon predicts that prices will rise to as much as €30 in 2008 and '09 as more utilities start buying allowances in order to comply with Kyoto rules.

Catrinus Jepma, professor of energy and sustainability at the University of Groningen in the Netherlands, says they'll plummet as credits from developing countries deluge the European market. Since 2005, the United Nations Clean Development Mechanism has issued about 84 million Kyoto credits. That number is likely to surge to 2.2 billion by 2012, according to the UN agency. So far, the European market has been a costly mistake, Jepma says. "The Kyoto Protocol period is almost a lost decade," he says. The idea behind Kyoto credits was to place a high price on polluting. Instead, an oversupply of credits means the price to pollute could stay low, he says.

Back at Climate Change Capital, Cameron points to a yellow tab affixed to his map of China. The sticker marks chemical maker China Fluoro Technology Co., located in Shandong Province. China Fluoro Technology exemplifies the potential for profit--and controversy--in the pollution market. The Chinese company makes refrigerant gases. One byproduct of that process is a potent greenhouse gas called trifluromethane, or HFC-23. Pound for pound, HFC-23 traps 11,700 times more solar heat in the atmosphere than CO2. Because China doesn't regulate HFC-23 emissions, China Fluoro can belch countless tons of gas into the air with impunity. (The U.S. doesn't regulate HFC-23 emissions, either.)

That's where Climate Change Capital comes in. Cameron and Woodall have helped devise and finance a system that captures the gas and prevents it from swirling into the atmosphere. In return, Climate Change Capital takes a cut of the emissions credits that the UN awards China Fluoro Technology under the Kyoto Protocol. The project will generate credits for 23.5 million tons. At current prices, China Fluoro credits are worth as much as €376 million of carbon equivalent credits over six years. The result is that China Fluoro stands to make more money selling its pollution credits than it does selling its refrigerants. And factories in Europe and Japan can buy the credits from China rather than curbing pollution themselves.

"This is supposed to be about clean development," says Lionel Fretz, who co-founded Climate Change Capital and now runs London rival Carbon Capital Markets. "It's not meant to be a subsidy to refrigerant factories in China."

Cameron says that, over time, the invisible hand of the marketplace will reduce greenhouse gas levels and help head off climate change.

"Right now the market is doing exactly what it should do--it's going after as many tons as possible at the lowest possible cost and taking them out," Cameron says. "We have a global problem, and national boundaries are virtually irrelevant."

Cameron and Woodall came to the carbon market from different corners. Cameron is the policy brain, Woodall the financial brain. A lanky man who's half English and half Australian, Cameron grew up in Lebanon and Singapore. He studied international law at Cambridge University in the 1980s. In 1986, he became interested in environmental law after seeing plumes of radioactive smoke billowing across borders from the Chernobyl nuclear accident in Ukraine. That prompted him to help set up the Center for International Environmental Law based in Washington. He used the nonprofit organization to make a name for himself negotiating the Kyoto Protocol on behalf of the Alliance of Small Island States, a 39-nation coalition he helped to build pro bono. He later started the climate change practice at international law firm Baker & McKenzie in London.

In 2002, Cameron made his first stab at setting up a business to implement Kyoto. He tried to form a sustainable investment group, a coalition of different companies and organizations that would manage funds to invest in the emerging low-carbon economy. He thought he had the European Investment Bank on board to fund his dream. Instead, one of its senior bankers shot down the idea, saying it would be like asking a fish to ride a bicycle.

Cameron didn't give up. At the end of 2002, he bumped into Woodall on the sidelines of the UN's sustainable development summit in Johannesburg. The idea for Climate Change Capital was born.

When he met Cameron, Woodall was a serial entrepreneur who was integrating a technology investment company he founded into Pi Capital, a London private equity firm. Woodall, whose grandfather was the chairman of British Steel during World War II, stumbled onto environmental causes by accident back in the 1980s, when he set up his first company selling products to help factories clean up oil and chemicals. A former British Army officer educated at the elite U.K. boarding school Wellington College, Woodall put his first company into administration when the pound crashed in 1992. "I thought hedging was something you did in your garden," he says.

After earning a Master of Business Administration from the U.K.'s Cranfield University School of Management, Woodall tried to get a job at a venture capital company. No one would hire him, he says. He decided instead to start what would become Impax Capital Corp., which invested in renewable energy. Woodall exited the business in 2000 when Impax went public. Nowadays, he drives to the office in an electric G-Wiz car, made in India by Reva Electric Car Co., from his home in the south London neighborhood of Stockwell.

From the start, Woodall and Cameron saw opportunity in climate change. They raised 1 million pounds ($2 million) from what Woodall describes as "friends." Cameron remortgaged his house to invest in the venture, and Woodall also dug into his own pockets. They were joined by Gareth Hughes and Anthony White, fellow founding partners who run the firm's corporate development and advisory businesses. "I put my entire life and guts in the business, terrified it was going to go belly up," Cameron says.

The pair soon raised more than $100 million for their first carbon fund to invest in rights to emit greenhouse gases. By 2006, Climate Change Capital was readying a fund 10 times that size. "They've raised the money very swiftly," says Nick Wood, head of Man Investments' environmental strategies group in London. "They've been around the longest in a high-profile sense." Cameron says the firm is breaking even. Climate Change Holdings Ltd. reported a loss of £426,100 in the year ended on Aug. 31, 2006, compared with a loss of £1.6 million the previous year, according to the most-recent filings with Companies House.

In September, the firm announced it had raised €200 million more for a new private equity fund targeting clean technology, energy efficiency and waste recovery across Europe. Investors included AlpInvest Partners NV, the Dutch private equity firm with €35 billion under management, and HSBC Holdings Plc.

The bulk of Climate Change Capital's funds are still invested in China, which last year surpassed the U.S. as the biggest emitter of CO2. The firm has been a big player in the market to check HFC- 23 emissions.

HFC-23 projects accounted for almost half the credits issued by the UN Clean Development Mechanism through mid-October. Money flowing from the sale of these credits could be up to 10 times higher than the cost to curb the emissions, according to an August UN report.

It would cost about €100 million to install incinerators at the 17 refrigerant producers in the developing world, says Michael Wara, a San Francisco-based lawyer at U.S. law firm Holland & Knight LLP, who studied credit trading at Stanford University. Yet, at current prices, the 40 million credits issued for HFC-23 projects are worth about €880 million. "These projects have distorted the market," Wara says.

Cameron and Woodall defend their work. China taxes profits from HFC-23 projects at 65 percent and puts the receipts into a special fund to finance clean energy, Woodall says. Besides, without Climate Change Capital, the greenhouse gas at China Fluoro Technology would just end up in the atmosphere. These days, Climate Change Capital is expanding into wind farms, biomass power plants and other sorts of green projects. The challenge will be to keep on delivering high returns. "There can be no trade-off," Cameron says. "None of this, 'We're terribly nice people trying to save the world; therefore, we can perform averagely.'" Cameron and Woodall say they want to do good. They just want to make sure they do well, too.

STEPHANIE BAKER-SAID is a senior writer at Bloomberg News in London. ssaid@bloomberg.net

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