From the October 2008 issue of Wealth Manager Web • Subscribe!

AN INCONVENIENT BETA

Carbon is many things. It's an element that's been known since antiquity and it's one of the most abundant substances in the universe. It is also the crucial ingredient in organic matter, which means that all life forms are based on carbon. But is it an asset class?

More precisely, is the market for carbon trading that's tied to controlling global warming worthy of a dedicated spot at the asset-allocation table? In a bid to motivate investors to think along those lines, Barclays launched the iPath Global Carbon Exchange Traded Note (NYSE Arca: GRN) in June.

As exchange-traded products go, GRN breaks new ground as the first publicly traded, index-focused security in the U.S. that passively targets the rapidly growing market for carbon-emissions credits. The catalyst for the trading is the global effort at reducing the output of greenhouse gases by the industrial sector.

Declaring a worldwide war on global warming is a grand plan by any standard. The iPath Global Carbon ETN's goal is modest by comparison: delivering the performance of Barclays Capital Global Carbon Index Total Return (BGCI). The index measures the performance of the most liquid carbon-related credit plans. According to a Barclays marketing brochure for the new ETN, BGCI is a "global industry benchmark for carbon-related investing."

It's debatable if trading carbon credits is an effective means of reducing global warming, although as investments go, it has clearly been a winner so far. BGCI has soared 94 percent through June 2008 from its October 31, 2006 inception (see Graph at end). That's a spectacular run compared with stock and bond markets over the same period. It's also double the rise of commodities generally (as per the Dow Jones-AIG Commodity Index) during that time span.

Expecting more of the same for BGCI is probably asking for too much--at least for the near term. Roaring bull markets can roll on for extended periods, of course, and perhaps for longer than the crowd expects. But assuming that's a forgone outcome is risky business, for any asset class. That doesn't mean that strategic-minded investors should ignore carbon trading in the long run. Dramatic growth for the business of carbon trading is widely expected in the years ahead. Meanwhile, Barclays reports that carbon trading returns have posted low and negative correlations with the conventional asset classes in the past. The implication: Adding the new ETN to conventional portfolios may enhance overall risk-adjusted returns (see Table at end).

Perhaps, although creating an index and building an investment product around it is one thing. Labeling the effort a new strategic opportunity--much less a new asset class--is something else. Many claims on that front are suspect, if not patently false. Might carbon trading be the exception?

Carbon credits are certainly a legitimate marketplace, not to mention a large one that is brewing with opportunity. Nonetheless, strategic-minded investors should tread carefully. Yes, fighting global warming looks like a growth industry. And for environmentally conscious investors, iPath Global Carbon is yet another way to support the cause. Still, the carbon credits market is a complicated beast and figuring out what's driving it isn't easy.

There are lots of twists and turns in carbon trading. Even the label "carbon trading" is a bit misleading. There's lots of trading going on here, in both listed securities and private transactions, and carbon is at the base of all the action. But the commodity that's changing hands--as far as iPath Global Carbon is concerned--is a credit, a carbon credit.

The lion's share of the market for exchange-listed carbon credits is in London, where European Union Allowances (EUAs) and Certified Emission Reductions (CERs) are traded. BGCI is comprised of both, with the majority weight (80 percent) in EUA futures contracts, the more liquid of the two and the larger by far in terms of market value.

Technically, carbon credits are commodities. There are no dividends or cash flow from the underlying securities, and so the listed carbon credits are in the same camp as derivatives based on crude oil, lumber and gold. Valuation, in other words, is almost exclusively a speculation about future supply and demand trends. Then again, this is no run-of-the-mill commodity. For good or ill, carbon trading owes its existence to government regulations. Conventional commodities, by contrast, exist independently of political mandates.

Carbon trading traces its roots to 1997, when several leading industrial nations hammered out the Kyoto Protocol. The agreement spells out the terms for cutting greenhouse gas emissions, which are made up mostly of carbon dioxide (CO2). To date, 175 countries have ratified the treaty, although the U.S. remains a conspicuous holdout.

To fulfill its commitment to the Kyoto Protocol, the European Union (EU) launched its emissions program in 2005. Participation is mandatory for EU member states by requiring that certain companies--mainly industrial and power-generating firms--in the union satisfy their allotted emissions ceilings through either 1) direct action (installing environmentally friendly technology that lowers carbon output, for instance); 2) buying carbon credits on exchanges or directly from other companies with credits to spare; or 3) a bit of both.

London is currently the center of gravity in the carbon-trading market. The city claims a rapidly expanding universe of boutique investment banks, research organizations and specialty shops targeting the marketplace. The main exchange-listed trading in carbon credits takes place on the Intercontinental Exchange (ICE), which lists carbon emissions futures and options contracts.

Because the U.S. has not ratified the Kyoto Protocol, participation in the carbon market in America is voluntary. Predictably, the volume of U.S. exchange-listed trading in carbon emissions is a fraction of London's. Nonetheless, the U.S. domestic market for carbon emissions trading is growing. Currently, there are two exchanges for trading carbon emissions here: the Chicago Climate Exchange (chicagoclimatex.com) and the Green Exchange (GreenFutures.com).

Globally, the value of carbon trading exceeded $64 billion last year. That's double the 2006 level and six-times the value of trading in 2005, according to the World Bank. By 2020, carbon trading will reach $1 trillion, predicts New Carbon Finance, a research firm in New York. For comparison, the annual total dollar value of trading in oil futures on NYMEX was recently running at roughly $10 trillion.

Percentage-wise, the market for carbon trading is certainly booming. But is it a new asset class? Although many reject the idea, some analysts think otherwise. Carbon credits "constitute a proper asset class," opines a 2007 report from the Centre of Geopolitics of Energy and Raw Materials at Dauphine University, Paris.

If carbon trading represents an independent beta, adding it to a conventional portfolio may bring the usual advantages that generally come from mixing uncorrelated asset classes. That includes enhanced risk-adjusted performance in a portfolio relative to excluding carbon permits. The numbers cited by Barclays in the Table (at end) certainly encourage such expectations.Yet the limited history of the data series suggests that it's too early to pronounce definitive conclusions about the nature of carbon trading and what it can--or cannot--provide investors. Indeed, there's a scant two years of market history for BGCI.

Meanwhile, no one should underestimate the potential for surprises in the market. The bouts of extreme volatility in the short history of the listed credits tell the story. For example, during the so-called first phase of EUA trading that ran for two years through 2007, there was a dramatic fall in prices in April and May of 2006. The front-end EUA futures contract price dropped by nearly two-thirds in a two-week stretch. The explanation is widely reported as a sudden recognition at the time that there was a larger-than-assumed supply of carbon credits in the market.

This high volatility is a reminder that there's lots of embedded risk in securities that are not yet widely understood. That leaves a number of questions about pricing theory in this space--and by extension, the outlook for diversification benefits.

Yes, supply and demand are the primary drivers of price, as they are for all commodities. But decomposing those factors into their component parts suggests multiple pricing drivers for carbon credits--including weather, energy costs, and regulatory decisions tied to carbon credits.

"I think a lot of [the carbon credit market] will be driven by the global economy," says Richard Ferri, CEO of Portfolio Solutions, a money manager with $1 billion under management that favors ETFs and index mutual funds for client portfolios. "If the global economy starts to weaken, the demand for carbon credits has to go down. It's got to be somewhat correlated with global economic activity. If the economy's booming, more people will need more credits because they're producing more goods, and vice versa."

Barclays' London-based carbon analyst Trevor Sikorski agrees, advising that general economic trends will play a key role in carbon credit pricing. That doesn't mean carbon credit analysis is simple. For example, carbon trading in the short run will take cues from the cost difference between natural gas-fired and coal-fired power generation in Europe, Sikorski says. Keep in mind that gas is a cleaner burning fuel than coal. If gas-fired costs increase relative to coal's, the pricing shift may boost demand for coal-fired power generation. In turn, a higher use of coal-based energy production can increase demand for carbon credits as power companies scramble to offset the higher greenhouse gas emissions.

At times, politics will also play a large role in the pricing of carbon credits. "The market will be driven by highly uncertain changes in the regulatory regime in parts of the world," says J?rgen Weiss, managing director at Point Carbon, an Oslo, Norway-based environmental research firm. Alas, predicting regulatory changes isn't any easier than predicting prices.

Yes, carbon trading is a new marketplace, and it may even be a new asset class. But the market will still face some very old challenges.

"There's a large uncertainty over price formation in the [carbon trading] market," Weiss concludes. "To the extent that there's a lot of uncertainty, whoever thinks they have a better insight into where things will be going on the regulatory front has a large 'inefficiency' to exploit."

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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