The Big Money Pouring into Carbon Trading

The Kyoto Protocol has led to countries working to limit greenhouse emissions. And, it's sparking a hot business in trading carbon emissions credits

As concern mounts over the problem of global warming, the trading of carbon credits—or the right to emit specified amounts of greenhouse gases—has become a hot business. It reached a new pitch in the past week, after Morgan Stanley (MS) said Oct. 26 that it would plow $3 billion into beefing up its position in global carbon-trading markets. The New York-based brokerage will expand existing trading activities launched in 2004 by its commodities division and pour funds into projects related to emissions reduction.

Five days later, more than a dozen investment banks, including Barclays Capital (BCS) and Deutsche Bank (DB) teamed up with five organizations involved in carbon trading to create a new pan-European association for emissions trading, called European Carbon Investors and Services (ECIS), whose goal is to spur standardization and internationalization of carbon trading.

Little wonder financiers are keen to get in on the act. As politicians and businesses become increasingly concerned about global climate change, they're also realizing that government regulation is only one part of the solution. Europe's experiment with adding market-based incentives to the mix has had its share of critics, but the idea is clearly catching on. On Oct. 16, for instance, California Governor Arnold Schwarzenegger announced a program to trade greenhouse gas emission credits with other U.S. states.

EU Leading the Way

Industry experts caution that the carbon-trading market is still in its very early stages and suffers from fragmentation. But projects such as California's "…demonstrate the scope for a long-term international market to emerge," said Kate Hampton, of Climate Change Capital in London, in a statement announcing the formation of the ECIS trade group.

The European Union is still at the vanguard. To meet the demands of the Kyoto Protocol, the 25-nation bloc enacted a formal emissions trading scheme (ETS) at the start of 2005 that set limits on the total amount of carbon dioxide (CO2) that can be produced. Carbon-trading volumes have exploded from just 10 million tons in 2004 to more than 600 million tons so far this year. Over the period from 2008 to 2012, says consultancy ICF International, the market for carbon credits will be worth some $45 billion annually, about double what it is now.

To serve the demand, exchanges have sprung up across the Continent that give polluters the ability to trade and hedge carbon emissions credit. Now, big-time commodities brokers are getting into the act. In September, for instance, Goldman Sachs (GS) shelled out $23 million for a 10.1% stake in London-based Climate Exchange, the biggest carbon marketplace in Europe.

Apples to Apples

The launch of the ECIS is just one sign that financial heavyweights want to see their involvement in the market pay off. Although commissions from trading on EU exchanges may not be more than 1%, over-the-counter trading of higher-risk CDM carbon credits, which allow investment in emission-reducing projects in developing countries, can bring returns of up to 7%. With non-standard OTC carbon-credit instruments, banks have the potential to make even more substantial gains, industry experts say.

To realize the full potential of the market, though, carbon traders are eager to see the lowering of potential legislative and technological hurdles. A key factor in this will be the standardization of Kyoto-compliant emissions contracts so that they are fungible and tradable on a global basis.

Currently, for example, so-called Certified Emissions Reduction units (CERs) can trade OTC in Europe but not on any of the carbon exchanges because the so-called International Transaction Log software to register transactions won't be online until next spring.

Thinking Globally

Another stumbling block: few countries have been approved to trade emissions under the Kyoto Protocol's Article 17. Only 4 of the 35 nations that fall under the Kyoto umbrella have applied so far to the United Nations for certification; the rest have until January.

This is mainly a matter of working out the kinks in the system. But for carbon trading to address global warming—which, after all, isn't a regional problem—new projects such as the California plan also will have to be brought into a uniform exchange mechanism. Currently, carbon trades made with region-specific exchanges have no value for compliance purposes in the EU.

"The more areas that come under carbon caps, the bigger the markets for a variety of carbon instruments," says Abyd Karmali, managing director of ICF International. "If you can use the market mechanism it will expand the carbon markets and the development of asset classes." And, if the arrival of financial heavyweights is any indication, create a lot of new wealth in brokering pollution credits.

Before it's here, it's on the Bloomberg Terminal.