Wednesday, April 11, 2007

Cleantech investors and carbon and RECs (pt 2)

In the last post, we described the differences between carbon offsets and RECs: How the former are financial instruments based upon physical commodities, and the latter are more of a bundled concept.

But what impacts do these differences have in the burgeoning markets for these somewhat competitive products?

Regulations and restrictions (whether governmental or self-imposed) are having a significant impact on the early evolution of the markets for carbon offsets and RECs.

In Europe, where they are operating under the requirements of the Kyoto Protocol and other climate change-focused mandates, an EU Emissions Trading Scheme has been implemented. This is essentially a region-wide "cap and trade" carbon emissions scheme, with specific requirements as to what kinds of emissions credits can be traded, and with limits as to the total amount of region-wide emissions. Thus, in the EU carbon emissions rights are a scarce commodity. As Charles Morand at AltEnergyStocks has described in this very helpful column, the EU ETS market was estimated to be about $27B in 2007.

In the U.S. the major mandates made to date are on utilities, and are geared around "green energy" generation requirements. Most states are adopting Renewable Portfolio Standards (RPS) which require local utilities to source up to 25% of the electricity they sell from renewable sources by certain dates ("20 by '20" appears to be a popular political phrase in state legislatures right now). As utilities scramble to find those sources, the market for RECs has taken off.

In terms of carbon markets, on the other hand, the U.S. still remains at a very early stage of development. The Chicago Climate Exchange has been making headway, and efforts like the Regional Greenhouse Gas Initiative (RGGI) are starting to come together. But in the absence of commonly-acknowledged definitions of acceptable carbon emissions reductions projects, not to mention the absence of a national limit on carbon emissions, offset credits are not a scarce commodity. Thus, the price remains significantly lower for a ton-reduction of carbon emissions in the U.S. versus much the same ton-reduction in the EU ETS. That seems strange, given the fact that carbon is a global pollutant, but as the experts at last week's NEEIC event pointed out, it's not really an apples-to-apples asset comparison, since there are different standards/ definitions/ certifications/ etc.

So does this mean that in the US investors should pay more attention to RECs, while in the EU they should pay more attention to carbon emissions credits? There are several reasons to believe that the long-term end point for both regions is a vibrant carbon emissions credits market and a less trafficked market for RECs.

First of all, RECs are subject to a lot more subjective definitions than are carbon emissions credits. Granted, right now definitions vary widely for both. But in the end, a ton of carbon is a ton of carbon -- it's a physically-defined commodity. Whereas RECs bundle together a lot of other factors. Therefore it will be harder for large-scale stakeholder negotiations to arrive at commonly held definitions of RECs (say, at a national level) than for carbon. While regional carbon emissions trading schemes are coming together even in the US, RECs remain a state-by-state defined market, dependent upon the specifics of each state's RPS definitions. For example, in some markets waste coal is counted as a legitimate source of RECs, whereas for other states that's not allowed. Such fragmented markets stymie efforts to create a large, liquid market. Europe helps prove this point -- there are national RPS schemes there and a variety of REC markets that all pale in comparison to the EU ETS.

Secondly, carbon emissions are easier to offset (yes, an offset of an offset) against all existing forms of electricity generation. Heat rate, utilization and fuel mix are all well-understood factors by energy traders, and when a viable consistent financial product which can be geographically arbitraged against transmission-constrained generation assets is available to these traders, they will jump on such assets and drive up the liquidity in such markets. It's tougher to think about such traders being able to trade off a solar REC against utilization of a coal-fired plant. Liquid fuels markets are also easier to integrate into a carbon market than a REC market, further lending potential liquidity to a future carbon market. And the thing about financial markets is that liquidity drives even more liquidity, due to positive network externalities.

Thirdly, given all the emphasis now being put on climate change at a federal level, it's becoming more likely that industry will soon have to operate under some form of cap-and-trade scheme or other limitations on carbon emissions, whether it's a national mandate, a region-level mandate, or even voluntary schemes within certain industries. As these limitations gain more teeth, carbon emissions will become a scarce commodity in the U.S. as it has been in Europe.

Finally, RECs have a hard time dealing with energy efficiency "sources" of carbon emissions reductions. So-called "white tags" have been established in some RPS systems that would allow for a separate set of products for negawatts via energy efficiency projects, but it's tough to gel these different green tags and white tags, etc., into a single viable market (is there going to be an exchange rate for green tags versus white tags?). But again, a ton of carbon emissions reduction is a ton of carbon emissions reduction. And energy efficiency is perhaps the most feasible form of carbon emissions reductions, so it can't be an ignored factor.

So it would appear that, given the increasing concerns about climate change and the resulting political pressures, we can start to plan for a long-term market for carbon emissions credits that will grow more quickly than the market for RECs. Maybe. Of course, this is all based on assumptions that might change -- a national RPS with federal-level definitions for RECs, for example, could change a lot of the analysis from above. But you can see why investors are paying close attention to the development of the carbon market in particular, even if RPS schemes and other incentives have driven adoption of green generation technologies to date.

In the next post, we'll see what all this means for investors.

Also in the news:
  • VentureWire reported that hybrid vehicle manufacturer Aptera has raised "under $20mm" in a new round of financing from Idealab and an undisclosed angel investor. Nifty-looking car, expected to be available sometime in 2008...
Other news and notes: Interesting thoughts from Paul Holland of Foundation Capital... Interesting thoughts from David Hochschild on the solar market... And interesting thoughts from Xzibit and the Governator... Finally, a Fortune article on the "green bubble".


Anonymous Anastasia O'Rourke said...

People might be interested to know that there is a certification scheme being devised for providers of retail GHG offsets - under the Green-e program. The idea is to bring coherency, transparency and credibility to offset schemes for consumers.

The draft standard is still open for public comment.


Anastasia O'Rourke
(PhD Candidate, Yale U)

11:12 AM  

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