At a recent biomass conference in San Francisco, one institutional investor with capital exposure to carbon transactions lamented the “crowds of unemployed bankers” roaming around looking to create carbon “deals” and launch funds based on credits that have a tenuous value.
“Even the people trading carbon since it’s been around don’t know what they’re doing,” he said. “It’s a lot of risk to take in.”
It's a common refrain in investment circles these days.
Carbon may be a dynamic new investment opportunity but the classic risk/reward dynamic still applies--even with game-changing, cap-and-trade legislation on the horizon.
“Capital in the U.S. is beginning to be mobilized into carbon funds, ready to be deployed once the President signs into law the requisite legislation,” wrote Environmental Finance editor Mark Nicholls, in his firm’s just-released 2009/2010 carbon fund survey.
The survey counts 89 carbon-related investment vehicles with assets under management of $16 billion. That's ten more funds and $3 billion more in capital than a year ago.
Though private equity and hedge funds have already begun placing their bets in the carbon space, its unclear at this point whether the old investment models are best suited to play a market that could hit $2 trillion in a few years times.
At this point. private funds are “emerging as the method of choice” for access, says Scott Furman, head of the environmental law group at the New York-based firm of Tannenbaum Helpern Syracuse and Hirschtritt, because it "enables the investor to share risk, diversify and rely on professional management,” he says.
The ideal carbon fund structure, however, may borrow some aspects from both private equity and hedge funds, creating a hybrid that could require some rethinking of asset allocation models that typically divide alternatives managers into private equity, real estate or hedge fund portfolios.
Because of the way carbon offsets projects are developed, most investors now approach carbon from a project finance perspective—often a private equity approach, with the closest model being a closed-end partnership to develop oil fields—versus creating a fund buying and trading the carbon commodity itself, a more typical hedge fund strategy.
For example, a project financing pool may approach a dairy farmer, help him build and manage an anaerobic digester to capture methane from his herd’s manure and turn that methane into green energy. The farmer sells the power to a utility for profit and generates carbon offsets as an additional revenue stream in the process.
Adding more farmers creates a portfolio of carbon offsets projects and the resulting carbon credits could then be traded.
Greg Arnold, managing partner at CE2 Capital Partners, says his firm now does both of these things, although not through one investment vehicle.
Founded in 2005, the firm’s first funds focused on environmental commodities, including European Union Emissions Trading Scheme carbon credits, renewable energy certificates produced by clean energy generation in many US states and carbon credits from a regional greenhouse gas organization, as well as nitrogen- and sulfur-oxide-related credits under the old acid rain mitigation cap-and-trade program.
“In these funds, we looked at everything that was investable,” he says.
But in their latest vehicle, CE2 Carbon Capital LLC, Arnold says they’re taking an asset management approach. “It’s a perpetual investment vehicle,” he says, adding that it’s not really a fund in the usual sense. “Think of it as an ‘extremely long-dated hedge fund."
CE2 Carbon Capital, for example, recently closed a $12 million carbon offset transaction with GoldmanSachs and Utah-based emissions project firm Blue Source, the largest single offset transaction to date in the U.S.
“We’re kind of that hybrid. We’ll off-take (carbon credits from) other people’s projects, buy projects, and develop our own projects. We’re control-oriented.”
Arnold sees challenges in bringing the trading and project development together into one vehicle, at least while the market is in its infancy.
Beyond the unique structuring required to complete transactions effectively, some big issues still need to be ironed out.
One is tax treatment of carbon trading which can be “difficult to pigeonhole as either passive investment or business activity”, says Tannenbaum’s Furman, which can make for an unforeseen tax liability.
Another issue is the usual “2/20” management/performance fee structure of a hedge fund if you apply it to a portfolio of carbon credits or other environmental commodities that depend mainly on political will for their value. Furman says it’s tough to determine your fund’s value to calculate your fees when the portfolio can change a whim.
“If you take a fee based on NAV [net asset value], you could have three values (for carbon) that can be valued differently,” says Furman, adding that the real payoff for fund managers will be at liquidation, with some management fees for structuring the offset project deals. “(Fees) will probably move to be more private-equity-like.”
Because of this political risk, he sees a bigger role for reinsurance firms. “We’ll go out and see a project and see that they have (credits),” he says, taking on the role of a hypothetical fund manager. “We have a discount due to duration of regulations. We’ll aggregate carbon projects and enhance them (via reinsurance). Then I wait until a buyer needs credits and sell them at a higher price.”
Whatever the fund structure and tax issues, it’s not an easy thing to bring together the right team of people with the right experience—engineers, utilities’ professionals, commodities brokers and policy wonks—to make these deals happen, says CE2’s Arnold.
“You shouldn’t expect to have everything tied up with a bow. There’s a lot of heavy lifting,” he says about new market entrants. “We feel it’s about a combination of expertise and capital, finding a solution the opportunity dictates.”