On 11 May 2010, Gerry Rocchi and Phil Schmitt, principals with Green Power Action Inc. presented a seminar at Toronto CFA Society on the impact carbon markets and credits may have on investment and risk management decision-making in the years to come. The following summarizes the event.

The creation of carbon markets has a far-reaching impact on companies, non-profits and governments throughout the world. Carbon affects everything from insurance rates to supply chain to human capital development.

Understanding carbon credits

Carbon credits are the ultimate “fiat instrument”, defined by regulation. Without government or self-imposed rules, they have no monetary value. At the moment, most carbon finance is voluntary. This voluntary market has high standards, as the vendors are basically “selling reputation”. Companies that buy credits ahead of regulation are expressing a desire to reduce their carbon footprint, build their reputation as a responsible corporate citizen and mitigate future risk under a regulated system.

Regulated carbon markets occur when governments create a “carbon allowance”, which is a limit on the amount of carbon a company may emit. These allowances can also be auctioned to emitters and become a tradable instrument with an after-market. The secondary markets that have emerged have been primarily exchange-based, with negligible OTC.

Organizations that generate credits do so by engaging in projects that reduce carbon, such as planting trees. Many of the carbon credits are generated by non-profits and represent a source of fundraising. Data quality is the main issue in valuing credits. Project data must be quantifiable, verifiable and reliable.

Credits are sellable “rights” at any point during or after the project. They are realized once created, once the carbon reduction occurs. An incomplete project will result in a discounted credit, to allow for the risk of non-completion of the project and non-certification of the credits. Typically, credits are counted and verified on an annual basis.

The United Nations is the official creator of carbon credits, which are a serialized metric of CO₂ equivalent. Credits must be unique (cannot be used twice), verified (3rd party) and have “additionality”. Additionality refers to the concept that the project financed by carbon credits would not have happened otherwise, that these projects are created with carbon credits as the catalyst.

Disclosure requirements for risks associated with carbon emissions are increasing. The United States now requires all insurance companies to report on climate change risk and carbon is the leading risk for property insurance companies. Canadian securities administrators require continuous disclosure on environmental matters.

Is regulation coming to North America?

Several initiatives are underway that may create carbon emission regulation in North America. The “Western Climate Initiative” targets 2013 as its first year of compliance and the U.S. Federal system expects legislation in 2010 or 2011 with compliance in 2014. There is also potential for a global deal on carbon at the UN conference in Cancun, scheduled for December 2010.

Managing risk

Tracking risk The tracking of carbon emissions also creates risk for the emitting company. Regulated companies have their emissions measured and compared to the allowance. An emitter doesn’t know until their approval after the end of the year if they are compliant. Some emitters will pay a premium (currently $15/tonne vs. $12/tonne) to avoid this risk. Companies that emit less than the allowance receive a credit.

Skills shortage Another risk associated with carbon is embedded in the implementation of carbon management for regulated companies. Carbon trading will increase competition for skilled human capital – there is already a shortage of carbon finance related skills/knowledge. This will increase dramatically if carbon pricing becomes regulated.

Supply chain management It is also important to note that carbon costs impact companies that aren’t directly affected by the carbon regulations. Carbon emitting companies that have increased costs to achieve compliance may push these costs through the supply chain by raising prices.

Risk mitigation There are several ways to mitigate risks associated with carbon. Companies should follow and understand the regulations as they are being developed, as various carbon systems affect companies differently. Factors such as: measurement, validation/verification and after-markets can all impact how a company deals with carbon issues and risk management. It is also crucial to develop human capital ahead of carbon market implementation. Once systems are in place, skills and experience related to carbon management becomes scarce and people with relevant expertise become scarce and expensive.

Seeing opportunities

Carbon finance also creates opportunities. Organizations that initiate the carbon-reducing projects that will be sold to emitting companies will have a new source of revenue. Innovators who create technology and methodology to reduce carbon emissions will have a market for their products and individuals with carbon management expertise will be in high demand.

Like any fundamental shift in business practices, carbon finance will create both risks and opportunity. Smart companies will plan for both.