The World Bank’s Prototype Carbon Fund (PCF), launched in April 2000, was the first carbon fund ever established.

The PCF is structured as a close-ended, multi-donor, international trust fund comprising:

The PCF receives contributions from the Participants, which it uses to source carbon credits from CDM and/or JI projects by signing Emissions Reduction Purchase Agreements (ERPAs) with the project proponents or sponsors.

An ERPA is an agreement governing the sale and purchase of project-based emission reduction credits (the unit of currency that the projects generate). ERPAs have become the standard contractual mechanism for the direct acquisition of carbon credits from overseas projects (for a sample standard ERPA, see International Emissions Trading Association (IETA), Emissions Reduction Purchase Agreement, version 3.0 (2006)).

The fund then distributes the CERs and ERUs generated by the projects it invests in to the Participants pro rata to their original contributions.

Since its creation, the PCF has invested in 24 projects ranging from biomass to conservation. On 23 March 2007, the fund closed its portfolio to new projects having fully committed its US$180 (EUR124.9) million capital.

The World Bank remains a significant player in the carbon market. As of January 2009, the World Bank, through its specialised Carbon Finance Unit (CFU), managed 13% of all carbon funds (see ICF International, Report, Carbon Funds Outlook, January 2009 ).

The bank has also launched several pioneering carbon facilities, such as the BioCarbon Fund, which invests in “land use, land-use change, and forestry” (LULUCF) projects not currently eligible for CDM or JI credits under the Kyoto Protocol.

Other multilateral organisations, such as the European Investment Bank (EIB), also administer carbon funds, primarily on behalf of investors who need the resulting credits for compliance purposes.

Government carbon funds are managed by different entities depending on the policy framework under which they are created. These policies can consist of:

Some governments, such as The Netherlands, use a combination of the above methods as part of their national emissions reduction programme. The UK government has taken a policy to meet its Kyoto targets mainly via domestic action rather than buying credits although it encourages the private sector to do so both for compliance and, to boost the development of the secondary market in carbon, onward trading purposes. Had the UK government chosen to buy credits, it would have probably relied on one or more of the above methods.

The development of the European Union Emissions Trading Scheme (EU ETS), a ‘cap and trade’ system which aims to reduce the emissions of heavy industries across the EU, created an additional compliance need for allowances and hence laid the foundations for the market for privately-owned and managed carbon funds (see PLC Environment, Practice Note, EU Emissions Trading Scheme).

According to Andreas Gunst, a lawyer in DLA Piper's Energy and Water group, “The EU ETS has become the driving force behind the international carbon market”. Gunst further notes that “The establishment of the EU ETS led to the rise of secondary and structured carbon transactions, thus attracting a new class of speculative carbon fund manager, which is not interested in the carbon credits themselves, but the financial returns that these credits can generate for their investors”.

As Gavin Tait, a carbon trading expert most recently Head of Carbon Trading at ABN AMRO, notes, the development of a secondary market attracted other primary investors such as banks, hedge funds and commodity speculators, which began investing in projects in order to sell the resulting credits in the secondary market and exploit the price differentials between primary and secondary. This kind of carbon investor behaves very differently from carbon funds that invest in projects because their investors have compliance obligations.

According to the ICF International report, over 50% of carbon funds are privately managed. The 2009-2010 edition of the Carbon Funds Directory further notes that ten out of the 12 carbon funds raised between 2008 and 2009 were private sector-administered, compared to just two governmental or development bank-managed initiatives.

Private carbon funds have rapidly evolved into sophisticated entities. Private carbon fund managers are also involved in a wider range of investment activities across the carbon credit value chain than their development bank or government-managed counterparts. Some private carbon funds operate as carbon asset management companies dealing with all matters relating to carbon investing”.

For instance, First Climate operates as an “integrated carbon asset management company”. First Climate’s activities include:

Although there is a little publicly available data on the financial performance of private carbon funds, there is some evidence to suggest that it can be strong. For instance, the European Carbon Fund, managed by Natixis, has reported annual returns of 27.8% since its establishment in 2005.

According to the 2009/2010 edition of the Carbon Funds Directory, as of October 2009 there were:

Out of the 30 funds that took part in the Directory’s survey:

These figures underscore the continuing growth of carbon funds despite the crisis but also indicate a decline in fundraising compared to previous years.

Some investment managers are avoiding carbon funds altogether. In October 2009, Robeco, a private equity investor focusing on sustainability and clean technology, stated its decision not to invest in carbon funds due to the unwarranted influence that political developments can have on their financial performance. Tait also notes an emerging gathering consensus towards direct action and away from carbon offsetting.

Although the United Nations Framework Convention on Climate Change (UNFCCC) conference that took place in Bali during December 2007 (Bali Conference) confirmed that project-based mechanisms would continue when the first commitment period under the Kyoto Protocol expires in 2012 (see PLC Environment, Legal Update, What, if anything, was decided at Bali?, 18 December 2007), practitioners expect the CDM and JI mechanisms to be modified in the near future (see below, Copenhagen and beyond).

New revenue streams. Despite the uncertainty surrounding the CDM and JI mechanisms, fund managers continued to raise CDM and JI funds during 2008 and 2009, including funds targeting post-2012 CDM/JI credits (such as the EIB’s Post 2012 Carbon Credit Fund, which signed two ERPAs for the off-take of 2013-2020 credits in June 2009).

However, practitioners have noted that the diminished appetite for raising new carbon funds has been particularly marked among those funds with a focus on CDM/JI projects. Gunst explains that “Many early market movers have closed their funds to the extent that their capital is fully invested” due to a number of reasons including:

Martijn Wilder, who heads Baker & McKenzie's Global Environmental Markets Practice, notes that “Although funds are still investing in CDM projects, some fund managers are broadening their portfolios to generate additional revenue streams by providing development capital or project finance other types of GHG reduction projects”. For example Masdar , renewable energy company backed by the government of Abu Dhabi, recently abandoned plans to launch a carbon fund in favour of a joint venture with a utility company to invest in carbon abatement projects “as owners and operators”.

According to Wilder “There is no doubt that the downturn has impacted on global carbon fundraising; several funds have stalled in their fundraising due to the economic climate”.

The financial crisis, and the possible adoption of a post-2012 agreement on climate change during 2010, could result in increased consolidation among carbon funds. JP Morgan’s £129 (US$211) million acquisition of EcoSecurities and the ongoing merger talks between UK-based Trading Emissions and Leaf Clean Energy provide early evidence of a possible wave of merger activity among carbon funds.

The growth of secondary trading has been partly driven by the steep rise in derivatives linked to carbon assets, notably:

The increasing volume of trading in derivatives linked to carbon assets has prompted regulators such as the UK’s Financial Services Authority (FSA) to investigate their potential risks (see box, Emissions-linked derivatives: the regulatory response so far).

The initial aim of COP15 was to reach an international agreement to tackle climate change when the first compliance period under Kyoto Protocol ends in 2012. In the end, COP15 only produced a brief, non-binding, political declaration (Copenhagen Accord) (see PLC Environment, Legal Update, Outcome of the Copenhagen negotiations: a brief summary, 22 December 2009).

The Copenhagen Accord sets out a framework for the negotiation of a new global agreement over the coming years. Specific policy proposals include:

Reform of the CDM system. COP 15 examined several proposals to streamline the CDM project cycle and improve developing country access to CERs. The following changes to CDM are still under discussion:

Forestry credits. The current CDM mechanism only allows afforestation or reforestation projects to generate credits, but does not include deforestation, which accounts for almost 20% of GHG emissions.

There are proposals to extend the scope of CDM credits to LULUCF activities, such as sustainable forest management and restoration of wetlands.

A further proposal advocates extending the scope of LULUCF to include projects reducing emissions from deforestation and forest degradation (REDD) and REDD+ (which includes conservation and the enhancement of carbon stocks in existing forests). The extension of the CDM network to REDD and REDD+ could create opportunities for developing countries to increase their participation in the carbon market.

According to a recent Norton Rose survey which examined the business community’s hopes and expectations for Copenhagen (Norton Rose survey), business leaders support reform of the CDM and the development of new market mechanisms. 70.6% of the respondents believe that climate change cannot be effectively combated without new flexible mechanisms that can mobilise both public and private sector finance (see Hopes for Copenhagen, a Norton Rose Group Survey).

Although the Copenhagen Accord acknowledged the pivotal importance of reducing emissions from deforestation and the immediate need for an incentive, it set out no detail or timetable for achieving this (see PLC Environment, Practice Note, Copenhagen conference: post Kyoto Protocol).

Technology transfer. The climate change negotiations discussed the need to devise a framework for transferring clean technologies to developing nations, which could involve:

The Accord contains an agreement to establish a Transparency Mechanism to speed up the transfer of technology on mitigation and adaptation but provides no detail on this.

Initial conclusions from Copenhagen. Although the Copenhagen Accord is merely a political declaration without binding force that does not even set a timetable for achieving a legally binding agreement, practitioners hope that a legally binding agreement that will emerge in due course.

While carbon investors would have welcomed a legally binding agreement at this stage, Tim Baines, a senior advisor on climate and clean energy at Norton Rose LLP’s climate change and clean energy team, argues that “The market is moving regardless, partly as a result of the proliferation of new emissions trading schemes beyond the EU’s borders” (see below). Private sector companies, under pressure from a number of external stakeholders, have also set up several initiatives aimed at enhancing their environmental governance (see box, Stakeholder pressure to improve companies’ environmental governance).

On 26 June 2009, the House of Representatives passed the American Clean Energy and Security Act of 2009 (the Waxman-Markey bill).

At the time of writing, the US Senate is considering two further proposals, the Clean Energy Jobs and American Power Act (the Kerry-Boxer bill) and a bipartisan proposal unveiled by Senators John Kerry, Lindsay O. Graham and Joseph I. Lieberman (Kerry-Graham-Lieberman proposal) (http://kerry.senate.gov/cleanenergyjobsandamericanpower/intro.cfm). As Jeff Gracer, a leading environment lawyer at Sive Paget & Riesel in New York notes, “The legislative scenario in the Senate is very fluid right now. There is a good chance that Congress will pass climate change legislation in 2010, because most companies strongly prefer that Congress steps in to create clear rules, but political opposition must be overcome before the necessary votes are obtained ”. If the Senate passes either proposal, it will then be combined with the Waxman-Markey bill. At the time of publication, adoption of the proposed legislation risked being delayed or even abandoned as a result of opposition from several prominent Democrat Senators.

The proposals’ common building block is the establishment of a cap-and-trade system (US ETS). As Gracer explains “There will be a regulatory cap on GHG emissions designed to achieve an emissions reduction of 17% below 2005 levels by 2020 and 83% by 2050. In order to meet this cap, the government will issue tradable allowances, which major emitters will either acquire for free or purchase from the Government”. There will also be approximately US$2 billion dollars in offset credits outside the cap for companies that implement emissions reduction projects that are not required by law”.

The bills propose the use of up to two billion credits for compliance purposes annually. Each entity covered by the ETS will be able to use offset credits to cover about 30% of their GHG emissions, half of which they can source from overseas projects (75% in some circumstances, during the legislation’s early years). However, this would be subject to a requirement that the host country be party to a bilateral or multilateral agreement with the US setting out criteria and standards for offset projects.

The bills intend to authorise the US Environmental Protection Agency (EPA) to recognise credits issued under the CDM (or any subsequent successor mechanism), subject to an agreement between the US and the host country. EUAs could also be traded in the US ETS, subject to a number of restrictions.

Other significant aspects in the proposals include:

Establishing a renewable electricity standard that would require States to produce 6% of total electricity from renewable sources by 2012 and 20% by 2020.

Commentators expect the climate change legislative proposal to encounter strong opposition in the Senate. Gracer believes that the votes of Senators from coal-mining States will be of pivotal importance. “Any successful proposal will need to mitigate the economic impact on coal-burning power plants and the economies of the states they’re based in”. A possible solution might be to allocate free GHG credits to a significant number of sources in the near term, with the expectation that, as technology develops, these credits will have to be purchased. Gracer also highlights the Kerry-Graham-Lieberman’s bill stronger emphasis on promoting nuclear power and domestic oil & gas development.

If Congress ultimately fails to enact climate change legislation, the EPA will regulate GHG under the Clean Air Act, following the US Supreme Court ruling in Massachusetts v EPA in 2007 and the recent findings by the EPA that GHGs endanger public health and welfare (see EPA, Press Release, EPA: Greenhouse Gases Threaten Public Health and the Environment / Science overwhelmingly shows greenhouse gas concentrations at unprecedented levels due to human activity, 12 December 2007). According to Gracer “If Congress fails to regulate GHG reductions, the EPA will do so under its existing authority, which gives it far less discretion to mitigate the impact of regulation on the economy. Moreover, any effort by the EPA to establish a cap-and-trade scheme without express legislative authorization could be challenged on its merits. In contrast, Congress is in a position to offer companies the certainty, flexibility and predictability that legislation brings”. Gracer also notes that US Courts have recently began to recognise that companies can be sued for climate change impact and, unless the Supreme Court reverses these decisions, there remains a litigation risk that only legislation can fully pre-empt.

The adoption of climate change legislation by the US Congress could have a major impact on the global carbon market:

It would formally bring the world’s largest economy and second-largest GHG emitter squarely into the international carbon market, creating an unprecedented number of investment opportunities.

It is generally accepted that the US will not support an international binding climate change agreement until it has clarified its domestic position. As Baines notes “It would have been very encouraging if the US had been able to commit to a single emissions reduction target at COP15 but we have to face the political reality that the major global emitters are not going to accept legally binding targets at this stage”.

Several other jurisdictions are considering or implementing national emissions trading schemes. According to Baines, “This evidences the way in which countries are recognising the importance of tackling climate change”. For many market participants, these national initiatives are as important as developments in the international arena. 96% of respondents to the Norton Rose survey believe that there are business opportunities in their jurisdictions as a result of the drive to reduce carbon emissions.

New Zealand. On 11 September 2008, the New Zealand parliament passed the Climate Change (Emissions Trading) Act, which established a national emissions trading scheme (NZ ETS). Some of the scheme’s key aspects are set out below:

Following a change of government combined with early criticism of the NZ ETS, on 25 November 2009, the New Zealand parliament passed the Climate Change Response (Moderated Emissions Trading) Amendment Act. This significantly reduced the ambition of the scheme and made several amendments to the legislation, such as:

Australia. Australia recently abandoned plans to establish an emissions trading scheme. On 2 December 2009, the Australian Senate rejected the Australian Climate Change Regulatory Authority Bill 2009 [No. 2], which would have established the biggest ETS outside of Europe, covering 75% of Australian emissions. Although Wilder laments this setback, he notes that “We are seeing a global pattern towards cap-and-trade schemes emerging, which could make the Australian Parliament reassess its position in the near future”.

Baines concludes that these nascent ETSs single out emissions trading as the business community’s preferred market-based option for combating climate change due to its cost, flexibility and ability to accommodate the needs of different business structures. However, he cautions that ETSs should not be viewed as the only panacea for combating climate change and are always to be complemented by other policies. The critical thing is that they put a price on carbon which is transparent"