IFR Environmental Finance 2008

For those on the inside, the carbon market is functioning pretty well. Lionel Fretz, chief executive of broker and fund manager Carbon Capital Markets, likens the growth of the market – in terms of liquidity and the emergence of risk management products – to the early growth of the electricity market.The EU ETS was divided into three chronological phases, allowing the project to be expanded over time and giving the Commission the opportunity to modify regulations between phases where appropriate.Since the onset of phase II of the EU ETS on January 1 2008, the price of carbon has remained within a band between €20 and €30 per tonne of CO2, meaning EU technocrats can claim success on their goal of maintaining a fair price for carbon. “It is a good price for carbon at this stage,” said Trevor Sikorski, a carbon analyst at Barclays Capital in London.There is some debate as to exactly how much correlation carbon – represented by EU Allowances (EUA) and Carbon Emission Reductions (CER) – displays with other asset classes. According to Emmanuel Fages, senior carbon and coal analyst at SG, research conducted by SG demonstrates the constantly changing nature of carbon’s relationship with other asset classes: at times it displays some limited correlation with oil, for example, while at others there is no correlation at all. “We were looking to see if it could be an effective hedge for our gas or other exposures but we couldn’t find any correlations that held up for any period of time – and they were certainly insufficient for cross hedging,” said Fages.This, he said, is a product of the diverse influences on, and the enormous complexity of, the price of carbon. In the short term – and influencing daily price movements, are oil and gas prices, and the weather. Over longer periods of time, economic growth clearly has an impact, implying companies are emitting more carbon, though GDP figures seem to have no impact on daily movements, said Fages.For Sikorski, carbon’s correlation with oil is a little closer. “Oil is a lead indicator for carbon,” he said, citing a definite positive correlation between EUAs and gas – being the preferable source of energy, relative to coal.Either way, its distinct properties make carbon very attractive at a time when other asset classes – for example, equities and oil – are becoming increasingly linked, with major indexes like the FTSE hosting a large number of oil companies.Not a baby anymoreThe market has shown fairly significant volatility this year, though this is in itself a symptom of a normal market. With the market short EUAs, traders started the summer buying the spread between EUAs and selling CERs – which pushed up the price of EUAs. Direction was given from both the Commission policy proposals and the upward trend in oil at the time. Yet a mild summer has ensured demand for carbon credits has been muted, which has facilitated some selling, as has the recent dip in oil prices. “Over the summer there has not been much compliance buying, but quite a lot of position taking,” said Sikorski.Just as significant a victory for carbon-philles has been the rapid expansion of liquidity in the market. Orbeo, a joint venture between SG and Rhodia which helps companies manage their carbon exposures, traded around 2m–3m tonnes of CO2 a day in 2006, said Fages, compared to around 12m a day now. Carbon Capital Markets (CCM), another significant carbon trading institution, trades 0.5m tonnes of CO2 a day now, up from a mere 10,000 tonnes in 2005.The carbon market has displayed other symptoms of its maturity. A broad range of structured products has emerged in recent months tracking EUAs and CER markets, including capital guarantee products, barrier options and investable indexes.It is all so different to a year ago, when prohibition of bankability – the ability to carry credits between ETS phases – caused the value of credits to tank. But according to Fages the chances of that reoccurring are remote-to-nonexistent.In

HSBC has created the Global Climate Change Index, a fully investable index, providing another way for investors to get exposure to companies that will be positively affected by climate change. The index is fully quantitative, and includes companies that derive more than 10% their revenues from one or more of 19 investment themes identified by HSBC, within four broader groups: low carbon energy production; energy efficiency; adaptation (i.e. companies that help to adapt to the physical changes of global warming); and financing. Looking at global companies of a market capitalisation of US$10m or more, HSBC identified 1,000 companies that qualified for inclusion on the index. The investable version of the index comprises only companies with capitalisations of more than US$500m, which comes to 332 companies worth an aggregate US$1.4trn and equal to 2.5% of global market cap, said Kevin Bourne, head of electronic equities at HSBC. Companies that derive 10%–25% of their revenues from the given investment themes have a weighting of 25% of their market cap in the index; generating 25%–50% of their revenues from them gets a 50% weighting; and above 50% gives a 100% weighting.The index is not “green” or SRI, said Bourne. It includes, for example, nuclear power companies, which, for better or worse, are likely to benefit from the drive to the low carbon economy, regardless of other environmental factors. Bourne said that the index has aroused significant interest from pension funds, hedge funds and others who can use the index as a starting-off point but can overlay their own investment parameters, for example focusing on certain regions, excluding certain sectors or shuffling the weightings. “It is not just an index, it’s a toolkit,” said Bourne.

Increasing interest in the carbon market is unlikely to come at the expense of the equity or fixed income markets, according to Martin Schulte, director carbon investment advisory at First Climate, a carbon asset manager. Institutional investors have entered the market as an asset allocation decision, in recognition of the growing importance of the market, while private investors see it as an alternative investment, and come looking for high returns. For both sets of investors it is still seen as a niche investment.Carbon investment vehicles can be crudely divided into hedge funds – though many are long-only – and private equity funds. The former have lockups of one or two years, and tend to be more active in the secondary market, trading carbon credits, where the liquidity on offer enables them to offer investors redemptions at shorter notice. Private equity funds have longer tie-ins of up to 10 years and tend to operate in the primary market: the illiquidity associated with environmental infrastructure investments means assets need to be locked in for longer periods.David Love, managing director at placement agent C.P. Eaton Partners in La Jolla, California, likens the current clean energy market to technology in the late 1990s. Just as with the technology bubble, he cautions that there are plenty of opportunities but also dangers. Fund managers have a large and rapidly expanding investment universe from which to pick, with many duds among the real diamonds.Of the private equity funds on offer, venture capital funds offer investors with a higher risk appetite exposure to the sector through carbon efficiency technologies. As with VCs generally, the chance of a “home run” investment is offset to a certain extent by the probability of a relatively high proportion of non-performing investments. C.P. Eaton works primarily with later stage funds, with US$500m–$3bn in assets. Investing in technologies that have cleared the first hurdle offers reduced risk, although sometimes at the expense of upside potential. Its clean energy division has a bias towards funds dedicated wind and solar power, currently the most developed sectors. The best add value by helping create a strong management structure; early stage businesses are often run by entrepreneurs and ideas people, not necessarily those with strong operational backgrounds. C.P. Eaton’s target funds look to exit their investment by selling a strong and fully functioning business, sometimes to one of the energy majors. It is striking that although these companies were originally among the strongest opponents of carbon trading and moves to stimulate the growth of alternative energies, many now show signs of embracing it, according to Love. Masdar, the carbon neutral city being proposed in Abu Dhabi, is a good example of the change of approach: the emirate hopes that it will provide a hedge to its reliance on the oil market. Carbon is a good hedge, displaying very little correlation with other asset classes – although Love admitted that a global recession would be likely to have an adverse impact on the sector. It “would slow down the rate of change by reducing the upward pressure on the price of oil,” Love explained. “But this would just be a hiccough – a temporary slowdown in a longer term trend.” The best fund managers recognise that there are significant differences – regulatory, scientific and financial – between the various sub-sectors of the alternative energy universe, and are dividing them into different silos. Some are putting teams in place with expertise in various fields, even in those in which they are not currently active, anticipating new sectors being opened up by innovative technologies. Things can change very quickly: there is currently little momentum behind biofuels, for example, but a simple change of policy in the US to reduce tariffs on Brazilian ethanol imports might be enough to transform the economics of such technologies overnight. Fortis recently launched

In 2004, when Tom Whitehouse, CEO of London-based Carbon International, first launched his environmental investor relations/public relations consultancy, most private sector investors had little or no interest in committing money to environmental projects or renewable energy undertakings.“They viewed the entire field of environmental finance as ethical, and therefore not profitable for them,” Whitehouse said. “Private sector investors – venture capital, hedge funds, institutional investors and even private wealth – have dropped their prejudice and realised that you can make money in environmental finance,” Whitehouse said. “Even large corporations that had no track record of acting ethically are realising they have to invest in clean energy technologies if they want to be profitable in the future.”In some markets wind project financing can prove to be something of a trip down memory lane, with old elements of project finance being revived to solve problems which rarely arise in more developed sectors – especially absent or unclear regulation and high political risk associated with the likely lack of continuity between changing governments. This sometimes forces bankers to be creative or bring back elements they used in project finance deals in the early 1990s, when several sizeable emerging market power projects were funded with project finance, said Clara Alvarez, group head of ING’s utilities and power finance team in London. The tenors on alternative energy projects also tend to be longer than those on traditional power deals: 15-16 years, on average, for traditional projects, compared to up to 20 years for wind and 22 years for solar projects, said Alvarez.What is really driving the money into environmental initiatives of all kinds is the universal realisation that there is simply no other way forward. Even as the high price of oil and gas is forcing companies to look at alternative ways of generating energy, renewables are a political priority in just about every part of the world, said Lionel Fretz, CEO of London-based Carbon Capital Markets, a fund manager and trader specialising in carbon and clean energy markets. At this stage in the game, Fretz said, the dynamic looks irreversible.“Oil may be king but even if prices do trend down again, there is still a huge supply/demand imbalance,” Fretz said. “The high price of oil has got everyone to think more deeply about alternative energy, which is what we need in the long-term.”Of course, the uptake is still relatively slow and alternative energy is not high on the list of most banks’ or investment funds’ priorities. The private sector still prefers to invest in alternative energy sectors that have been around for a while, such as wind and solar power, because investors are looking to deploy funds quickly, said Connor McCoole, head of project finance for Asia at Standard Chartered Bank. Therefore existing projects in developed countries are an obvious attraction. FragmentationCertainly, Europe is ahead of the curve when it comes wind and solar energy – not just in terms of the number of projects that are ongoing in Spain, Italy, the UK and elsewhere, but also with respect to the regulation that supports these. The markets are very different either side of the Atlantic, in terms of tenors, structures and pricing – with Europe being less demanding than the US, both in terms of margins and fees. “Before the credit crunch the US was approximately twice as expensive for these kinds of deals,” said Alvarez. However, “markets are also quite different within Europe,” Alvarez said. “Each country is a different market, with different financing parameters and different regulation.”However, the sheer size and scale of projects in a country such as China, together with the will to get them done, means that it is catching up rapidly with the west, both in wind and solar energy technology as well as in other areas.Standard Chartered, in fact, recently closed two biomass and waste-to-energy

Deal pipelines are looking pallid but the renewable energy sector is regarded as a niche where ECM transactions are still possible in certain conditions. With Frankfurt as the world's hub for renewable energy listings and its companies dominating the sector, Germany could emerge as a rare ECM bright spot amid the gloom that has descended over the rest of Europe.German companies are world leaders in renewable energy; there is little doubt that its renewable energy infrastructure is better developed than anywhere else in the world. The proportion of electricity generated from renewable sources in Germany has almost doubled since 2000, from 6% to more than 12% in 2006. A government target for renewables to account for 27% of energy by 2020 far exceeds a European Union requirement of member states to reach 20% over the same period. The country is also the world's largest producer of wind power, which accounts for 5% of the total energy generated in the country.According to the German Wind Energy Association, installed capacity in wind energy is 20,622 megawatts, nearly double the amount in Spain which is widely regarded as a possible rival for Germany's renewables crown.Surprisingly enough, figures from Germany's Federal Ministry of Economics and Technology show the country produces 39% of all the solar power generated globally, slightly ahead of its nearest rival Japan, which accounts for 38%.Demand for additional capital among issuers remains robust, driven by projected growth in the industry, as well as a desire to have the upper hand in any future wave of consolidation. Meanwhile, investor demand has also emerged relatively unscathed from recent turmoil and the virtual shutdown in equity issuance.Performing in tough timesThough broadly down overall, renewable energy stocks have posted a noticeable outperformance compared with the broader market over the past 12 months. The European Renewable Energy Index is 14% lower over the year to March 16 while the DJ Eurostoxx declined 21.5% (see chart).Deals are still challenging in the current climate and in spite of their relative outperformance, renewable stocks are prone to high levels of volatility (see chart), the result of a combination of uncertainty about the regulatory environment and the viability of new technologies. ECM deals in the sector are therefore characterised by relatively deep discounts as bankers push to attract investment.Equities bankers pushing deals have also adopted a hands-on approach to pricing, introducing greater flexibility to the bookbuilding process to better respond to market volatility. Schott Solar, which began roadshows for its €500m IPO on September 8, delayed setting a price range, choosing instead to arrange a series of face-to-face meeting between investors and managers. Bookrunners Commerzbank, Deutsche Bank and JPMorgan believe that this could earn them a 50 cent boost to the eventual price. Few investors have encountered the concentrated solar power technology employed by the company, bankers argued, so a meeting with management would help educate them. Premarketing also coincided with a week of exceptionally shaky markets in early September, and a pro-active approach would doubtless ease jitters.Bankers working on German equity capital deals for renewables companies have developed a habit of waiting until a week or more into the subscription period until setting the price. The measure appears to work, with a series of successful transactions pushed past the post in defiance of unprecedented market volatility, including a €315m, multiple times covered IPO from SMA Solar Technology and a €112m rights issue from Manz Automation, both in June, and a €54.3m rights issue by Solar Millennium in March. In each instance lead managers played the market by ear, waiting well into the subscription period before fixing a price towards the lower end of initial expectations.But while weak markets required an active approach, bankers involved in these deals