Carbon Trading Market? Build It And They Will Invest

Ahead-of-the-curve retail investors looking to play carbon as a commodity may want to bone up on the facts while they are waiting for the nascent market to scale up.

“Trying to understand the global carbon market opportunity is still a daunting task for individual investors, because there are very few sources for clear information,” says Richard Domaleski, CEO of World Energy Solutions, a firm building online carbon-credit auctioning platforms. “Even the experts are learning as they go. At the end of the day, carbon is a commodity and an opaque one at that.”

What's more, even if everything comes together perfectly—proposed cap-and-trade legislation passes in the U.S. by year-end and a new international framework is achieved at the upcoming Copenhagen global climate change summit in December—politicians, lobbyists and regulators will still need to sort out a lot of details to enable the launch of a fully functional and highly liquid carbon commodity market.

“The way the political system works, they won’t get it right, right away,” says Garvin Jabusch, co-founder and chief investment officer of Colorado-based green investment advisory firm, Green Alpha Advisors, about the emissions policy process.

A look at the four-year-old compliance emissions market in Europe is a helpful guide. Among other things, it shows there are relatively few ways to play carbon as a commodity at this point.

Barclays Capital launched the world's first carbon exchange-traded note, ETN, in July 2008, the iPath Global Carbon ETN  , which is linked to their own carbon emissions index, the Barclays Capital Global Carbon Index .

The index tracks the two largest carbon emissions markets: the European Union Emissions Trading Scheme, EU ETS, and the UN’s Kyoto-agreement-based Clean Development Mechanism, CDM. As of June 2009, the index had a market cap of about $4 million—a drop in the global $8-billion ETN bucket.

Richard Couzens, who heads product origination in Barclays' investor solutions group, admits the ETN is small but “with moderate trading volumes it's certainly attracted quite a bit of interest, especially since it represents an alternative, uncorrelated investment solution and references a sector that that we believe will continue to grow.”

Small, but nevertheless, a sign of the times and a glimpse into the future.

“We acknowledge these markets are in their growth stage, but you can track a global carbon price with (this) index,” says Jigna Gibb, who works in the commodities investor structuring group at Barclays Capital.  “We recognize that it's a policy- and legislation-driven market. It's not going to get hot overnight. It'll take time to develop.”

And at this point, it’s still too soon for the index to include US entities, most notably, the only existing compliance market, the Regional Greenhouse Gas Initiative—which regulates and auctions emissions from some northeastern US power plants—and the Chicago Climate Exchange, where voluntary credits are bought and sold.

"The depth of market liquidity hasn't taken off just yet, says Gibbs. “When we look at [potential new sources of carbon credits] with respect to the BGCI, we need to see viable futures contracts,”

Investors may also want to look at other carbon futures indices. There's the Dow Jones/CCX European Carbon and CER indices—that could lead to other ETNs or other index-linked funds down the road. Another listed product, the AirShares EU Carbon Allowances Fund , is a commodity pool that tracks a basket of exchange-traded futures contracts for EU ETS emissions.

You can also gain carbon emissions exposure through equity-linked, carbon-themed indices that track companies aggressively tackling their carbon footprints, or those that offer the products and services that will help other firms mitigate their carbon exposure.

For example, Standard & Poor's, offers a U.S. Carbon Efficient Index, measuring the performance of large-cap, US companies with lower carbon emissions, relative to their S&P 500 benchmark. Merrill Lynch, a unit of Bank of America  , also offers a similar index, the MLCX Global CO2 Emissions Index.

Some money managers say this equity approach may be the best way to dampen the policy risk issue surrounding the carbon commodity.

“Who cares about playing carbon directly?” says Green Alpha’s Jabusch, whose firm offers the Green Alpha Next Economy Index, or GANEX, which focuses on investing in corporations offering products or services that tackle climate change and other environmental issues. “You need to get your arms around the guys who are going to save civilization.” ”

Jabusch points out that enough of Corporate America is already convinced of the need to act on climate change that there will be a climate change market, if not a carbon commodity one.

Regardless of what shape the market takes, growing pains could be sizable and investors of jumping in just because it’s “the new new thing,” says World Energy Solutions’ Domaleski. “The energy and carbon landscape is littered with companies that sold the sizzle and forgot the steak.”

© 2009 CNBC.com