Carbon Finance

Praise for Carbon Finance

"A timely, objective, and informative analysis of the financial opportunities and challenges presented by climate change, including a thorough description of adaptive measures and insurance products for managing risk in a carbon constrained economy."
—James R. Evans, M. Eng. P. Geo., Senior Manager, Environmental Risk Management, RBC Financial Group

"Climate change will have enormous financial implications in the years to come. How businesses and investors respond to the risks and opportunities from this issue will have an enormous rippling effect in the global economy. Sonia Labatt and Rodney White's insights and thoughtful analysis should be read by all who want to successfully navigate this global business issue."
—Andrea Moffat, Director, Corporate Programs, Ceres

"In Carbon Finance, Labatt and White present a clear and accessible description of the climate change debate and the carbon market that is developing. Climate change is becoming an important factor for many financial sector participants. The authors illustrate how challenges and opportunities will arise within the carbon market for banking, insurance, and investment activities as well as for the regulated and energy sector of the economy."
—Charles E. Kennedy, Director and Portfolio Manager, MacDougall, MacDougall & MacTier Inc.

"Climate change is the greatest environmental challenge of our generation. Its impact on the energy sector has implications for productivity and competitiveness. At the same time, environmental risk has emerged as a major challenge for corporations in the age of full disclosure. Carbon Finance explains how these disparate forces have spawned a range of financial products designed to help manage the inherent risk. It is necessary reading for corporate executives facing challenges that are unique in their business experience."
—Skip Willis, Managing Director Canadian Operations, ICF International

"In this timely publication, Labatt and White succeed in communicating the workings of carbon markets, providing simple examples and invaluable context to the new and changing mechanisms that underpin our transformation to a carbon-constrained world. Carbon Finance will be the definitive guide to this field for years to come."
—Susan McGeachie, Director, Innovest Strategic Value Advisors, Graduate Faculty Member, University of Toronto; and Jane Ambachtsheer, Principal, Mercer Investment Consulting, Graduate Faculty Member, University of Toronto

Foreword iii

About the Authors xiii

Acknowledgments xv

List of Acronyms xvii

Chapter 1

Introduction 1

Introduction 1

The Changing Climate 3

The Scientific Context of Climate Change 5

The Political Context of Climate Change 8

Corporate Climate Risk 11

Regulatory Risk 11

Physical Risks 13

Business Risks 14

Climate Policies 15

Mitigation Policies 15

Adaptation Measures 19

Role of the Financial Services Sector 21

Conclusion 23

Chapter 2

The Energy Chain 27

Introduction 27

The Energy Chain and the Value Chain 28

Carbon Policies 32

Policy Approaches 32

The Broader Policy Context 33

National and Local Self-Sufficiency 33

Impacts of Different Users and Uses on Climate Change 34

Users: Business, Households, and Government 34

Uses: Manufacturing, Transportation, Heating, Water, and Solid Waste 34

Sources of Energy: Fossil Fuels 36

Coal 36

Oil 37

Gas 38

Sources of Energy: Nuclear Energy 39

Sources of Energy: Hydroelectric Power 41

Sources of Energy: Renewables 42

Traditional Biomass 44

Wind Energy 44

Solar Energy 46

Tidal Energy and Wave Energy 47

Modern Biomass and Biofuels 48

Geothermal Energy 50

Key Issues 50

A Hydrogen Economy Based on Fuel Cells? 51

Carbon Sequestration 52

Unintended Discharges 53

Financing the Transformation of the Energy Chain: The Role of Venture Capital 53

Conclusion 55

Chapter 3

Regulated and Energy-Intensive Sectors 57

Introduction 57

Power Industry 57

Integrated Oil and Gas Industry 65

Government Mandates 65

Physical Capital 66

Restricted Access to Oil and Gas Reserves 66

The Coming Age of Gas, and Beyond 68

Global Concerns Regarding Energy Security 70

Transportation 71

Automotive Industry 72

Factors Affecting Auto Manufacturers’ Carbon Profile 76

Aviation 80

Cement 82

Competitive Implications of Climate Risk in Regulated and Energy-Intensive Sectors 84

Conclusion 87

Chapter 4

The Physical Impacts of Climate Change on the Evolution of Carbon Finance 89

Introduction 89

Physical Impacts on Unregulated Sectors 90

Water Supply and Treatment 90

Agriculture 92

Forestry 94

Fisheries 96

Real Property and Production Facilities 96

Transportation 97

Tourism 97

Municipalities 98

The Built Environment 100

Physical Impacts on Carbon-Regulated Sectors 103

Electric Power 103

Oil and Gas Producers 104

Financial Services 105

Banking 105

Investment 106

Insurance 106

Conclusion 108

Chapter 5

Institutional Investors and Climate Change 111

Introduction 111

Institutional Investors: Size and Global Reach 112

Environmental Reporting 112

Corporations 112

Institutional Investors 113

Corporate Environmental Reporting 113

New Era of Fiduciary Responsibility for Institutional Investors 116

Investment Decision Making 117

Active Engagement 118

Shareholder Resolutions and Proxy Voting 120

Mutual Funds 122

New Momentum in the Corporate World 125

Barriers to the Financial Consideration of Climate Change 127

Institutional Investors and Climate Change 130

Institutional Investors’ Group on Climate Change (IIGCC) 131

Carbon Disclosure Project (CDP) 131

The Equator Principles 134

Investor Network on Climate Risk (INCR) 135

Conclusion 135

Chapter 6

Emissions Trading in Theory and Practice 137

Introduction 137

How Carbon Is Traded Now 140

The Kyoto Protocol 140

The Chicago Climate Exchange 143

The European Union Emission Trading Scheme 143

The Price of Carbon in the EU ETS 148

Countries outside Europe with Kyoto Caps 150

Carbon Markets in the United States and Australia 151

Setting up the Clean Development Mechanism and Joint Implementation 153

The Role of Carbon Funds, Carbon Brokers, and Exchanges 156

Key Issues 159

Verification—Protocols for Measuring Emission Reductions 159

Controlling the Sale of ‘‘Hot Air’’ 160

The Quality and Price of Carbon Credits 161

Enforcing Compliance 161

Integrating the Various Trading Platforms 162

The CDM Bottleneck 162

Extending the Time Horizon beyond 2012 163

Extending Carbon Caps to Uncapped Parties 163

The Carbon Offset Market 164

The Role of Insurance in Emissions Trading 165

Issues for Dispute Resolution 166

Conclusion 166

Chapter 7

Climate Change and Environmental Security: Individuals, Communities, Nations 169

Introduction 169

Direct Effect of Extreme Weather Events 170

Health Effects of Climate Change 173

Direct Effects of Temperature Extremes: Heat Waves and Cold Spells 174

Indirect Effects of Climate Change: Vector-Borne Infectious Diseases 175

Polar Regions 179

Climate Systems and National Sovereignty 181

The Gulf Stream and the Thermohaline Current 181

The El Niño/Southern Oscillation (ENSO) 183

Conclusion 185

Chapter 8

Adapting to Adverse and Severe Weather 187

Introduction 187

Adverse Weather: The Role of Weather Derivatives 188

Weather Derivative Instruments 191

Examples of Weather Derivative Contracts 192

Current Status of Weather Markets 193

Constraints on the Weather Derivatives Market 196

Severe Weather: The Role of Catastrophe Bonds 198

The Structure of a Catastrophe Bond 199

Catastrophe Bonds and Carbon Finance 200

Conclusion 201

Chapter 9

Key Players in the Carbon Markets by Martin Whittaker, guest author 205

Introduction 205

Basic Elements of the Market 206

EU ETS Trading 206

Clean Development Mechanism (CDM) and Joint Implementation (JI) Projects 207

Intermediaries, Speculators, and Professional Services 208

Key Private-Sector Players 210

Compliance Participants 210

Commercial Banks 210

Carbon Funds 211

Speculative Investors 211

Project Developers and Aggregators, Consultants 213

Equity Research 213

Carbon Brokers 215

Exchanges 216

Credit Rating Agencies 217

Insurers 217

Key Players from the Public Sector 218

National Governments 218

National Business Associations 219

Multilateral Banks 219

Information Services 220

Professional Services 221

Accounting 221

Legal 221

New Horizons for the Carbon Market 222

Carbon as an Asset Class 222

Mainstreaming into Project Finance 222

Conclusion 223

Chapter 10

Carbon Finance: Present Status and Future Prospects 225

Introduction 225

Trading Volumes in Carbon and Weather Markets 227

Carbon Markets 227

Weather Derivatives 228

What Can Be Traded Where? (and What Cannot?) 229

Price Discovery 230

The Evolution of Products for Carbon Finance 231

Litigation over Responsibility for Climate Change 232

Is Carbon Finance Likely to Help Us Avert Dangerous Levels of Climate Change? 234

Carbon Finance within the Broader Field of Environmental Finance 235

Conclusion 237

Endnotes 241

Web Sites 245

References 247

Index 263

"A clear assessment of the carbon market and financial products being developed to help address the threat of climate change." (Ethical Corporation Magazine, May 2007)

SONIA LABATT is an associate faculty member at the Centre for Environment, University of Toronto. She has been engaged in the academic world of environmental finance through her graduate-level courses at the university, and in the financial services world as an active investor. Dr. Labatt broadens her environmental concerns, experience, and commitment through her association with World Wildlife (Canada).

RODNEY R. WHITE, Professor of Geography at the University of Toronto, was director of the university’s Institute for Environmental Studies from 1994 to 1999 and 2000 to 2005. He is an Associate Fellow of the Environmental Change Institute at the University of Oxford and a Senior Fellow at Massey College, University of Toronto. White’s recent books include Building the Ecological City, Planning in Cities (with Roger Zetter), and Environmental Finance (with Sonia Labatt), which was also published by Wiley.

For more than a decade now, environmental concerns in general, and issues regarding climate change in particular, have quietly captured the attention of financial institutions, individual investors, and a variety of businesses. This is because certain environmental conditions pose a credible threat to the global economy—affecting the wealth of societies, the availability of resources, the price of energy, and the value of companies.

Environmental finance experts Sonia Labatt and Rodney White understand the difficulties facing companies that need to manage their greenhouse gas emissions and are well aware of the challenges that equity and debt analysts monitoring climate liabilities must overcome. That’s why they’ve created Carbon Finance, a comprehensive guide that explores the financial implications of living in a carbon-constrained world—a world in which emissions of carbon dioxide and other greenhouse gases can sometimes carry a hefty price.

Opening with a brief introduction to the Kyoto Protocol and the policies that shape a carbon- constrained society, this book quickly moves on to:

• Outline the carbon finance market place, and explain the speed with which it has developed and the complexity of its growth
• Explore specific products—designed to cover environmental risks associated with climate change—for Alternative Risk Transfer
• Take a closer look at the entire energy chain and its relationship to today’s value chain
• Examine the fiduciary duty of institutional investors as they assess the financial effects of climate change within the investment community
• Detail key mechanisms created through the Kyoto Protocol and the experience of the EU Emissions Trading Scheme
• And much more

Written in a straightforward and accessible style, Carbon Finance will help you understand the metrics of carbon, carbon dioxide, and equivalents. It develops some of the themes presented in the authors’ previous book Environmental Finance, and features the latest information on risk transfer measures, the Kyoto Protocol, and the role that carbon finance will play in the analysis of corporate climate risks and opportunities—as well as in company valuations.

Filled with in-depth insight and expert advice, Carbon Finance provides you with the information you need—from discussions of new markets in carbon currencies to details on the interrelationship between weather and energy markets—to succeed in this dynamic field.