When former U.S. Vice President Al Gore and the U.N. Intergovernmental Panel on Climate Change won the 2007 Nobel Peace Prize for their focus on global warming, the Nobel committee said climate change “must be treated with the utmost seriousness.”

But it’s not just politicians and academics becoming involved with the issue. The global capital markets are having their say. Peony Capital Ltd., a €400 million ($590 million) Beijing-based carbon trading fund backed by Microsoft founder Bill Gates, said in August that it would buy 10 million tons of emission reductions by 2012 from projects in China.

Peony is just one of many. In their report on the “State and Trends of the Carbon Market 2007,” Karan Capoor and Philippe Ambrosi of the World Bank said an estimated $11.8 billion had been invested in 58 carbon funds as of March 2007, compared with $4.6 billion in 40 funds as of May 2006.

“It all starts from the Kyoto Protocol,” said Jeff Jiang, managing director of Renaissance Carbon Investment, the carbon investment and trading arm of Pivoton International, a U.S.-based private equity company. “According to the Protocol, industrial countries must reduce greenhouse gas emissions by 5.2% compared to 1990 levels in the period 2008 to 2012.”

The Kyoto Protocol, a multilateral accord under the U.N. Framework Convention on Climate Change, came into force in February 2005. In order to give parties to the Protocol flexibility in meeting their emissions reduction targets, the Protocol developed three mechanisms — Emissions Trading, Joint Implementation and the Clean Development Mechanism (CDM) — that allow developed Kyoto signatories to earn and trade emissions credits through projects implemented in other places.

The mechanisms were meant to identify lowest-cost opportunities for reducing emissions and to attract private sector participation. Developing nations would benefit through technology transfer and investment brought about through collaboration with industrialized nations under the CDM.

“It’s a complicated global process”, Jiang said. “Therefore there has to be a strictly defined system to ensure its implementation. One of them is the methodology.” So far, the Executive Board (EB) of the U.N. has issued 137 methodologies to rule explicitly on defining, measuring and valuating projects, Jiang said. “For example, on methane power generation, the EB has a detailed formula on how to process methane, how to measure the emission, etc.”

The U.N. has a Designated National Authority to register and approve all projects domestically. In China, the Designated National Authority is the National Development and Reform Committee (NDRC). Once projects are approved, the Executive Board, through its Designated Operational Entity, will determine whether the project receives U.N. registration. If a project is successful after a year’s trial, it will be reaudited on the way to earning a Certified Emission Reduction (CER) designation.

In short, Jiang explained, “CERs are emission reduction rights generated from CDM projects defined by the Kyoto Protocol. The CDM was created to allow transfer of emissions reduction rights from nonbinding countries of the Protocol to countries that have a binding interest to reduce greenhouse gas emissions by defined percentage quotas. And we believe there is a severe imbalance of demand and supply of the global emissions market under the Kyoto Protocol framework.”

The Biggest Market

The World Bank estimates total demand for greenhouse gas reductions at 5 billion to 5.5 billion tons of carbon dioxide equivalent (TCO2e) by 2012, half of which can be met by developed countries themselves, and the other half to be met through flexibility mechanisms. Contracted CDM projects to date on the supply side will generate less than 300 million tons of carbon dioxide by 2012. So the gap that purchasers of emissions permits can tap is substantial.

According to the World Bank report, the carbon market grew to an estimated $30 billion in 2006, three times greater than a year earlier. Project-based activities primarily through the CDM and Joint Implementation grew sharply, to more than $5.3 billion from about $2.7 billion in 2005.

According to the report, Asia continued to dominate the CDM market with about 80% of volumes transacted, led by China, which contracted to supply 61% of the CERs purchased by industrialized nations since 2002. According to the U.N.’s website, there are 2,883 CDM projects in the pipeline globally, with 2,137 in the Asia-Pacific region. China accounts for 961. China’s NDRC had approved 1,028 CDM projects through December 28, double the number as of mid-July.

The NDRC, at every provincial level, is facilitating CDM projects. Zhang Hanwen, chairman of the Hunan CDM Project Service Center and Hunan Xiangke Clean Development Co., has been developing CDM projects for more than two years. His company is backed by the science and technology office and the Development and Reform Committee of Hunan Province. “In the carbon market, China has a lot of opportunities because the country has relatively lower energy efficiency,” Zhang said. “In Hunan Province alone, the potential CDM projects to be developed up to 2012 are estimated at around a 4 billion RMB (US$ 556 million) trading value. We have now achieved total emission reduction at around 40 million TCO2e, which is worth 300 million to 400million RMB ($42 million to $56 million). So there is a lot of potential here.”

China’s Market Power

Through measures that took effect in October 2005, the Chinese government will take a percentage of the CER transfer benefit from CDM projects. The percentages are 2%, 30% and 65%, based on different emissions types.

According to the World Bank report, carbon-market prices remained strong throughout 2006. Project-based emission reductions attracted an average price of $10.90 per TC02e for CERs, a 52% increase over 2005 levels.

China sets a relatively stable price floor for the global supply of CERs, the report’s authors noted. “A major factor in this stability was the market power of China, which maintained an informal pricing policy by raising the minimum price floor in the $10.40 to $11.70 range. This policy was clearly acceptable to private European buyers who continued to show strong demand at that price range in 2006, although some Japanese buyers shied away at the top end of the range.”

Bjorn Odenbro, general manager of the Beijing office of Tricorona Carbon Asset Management, said it was difficult to predict how the market would develop over the next few years, even though China’s CDM market has grown rapidly as CER prices have risen. Tricorona, with headquarters in Stockholm, Sweden, is one of the world’s largest carbon trading companies.

Odenbro sees two main causes for the rising prices. One is an increasing awareness among Chinese project owners of the high prices at which CERs can be sold in Europe. The trend starts with the big electricity companies and trickles out into the provinces. The other is Chinese government intervention in the market, particularly through a minimum price mechanism. “They are working very actively to see to it that these emission reductions sell at the value which they perceive as being fair,” Odenbro said. Rumor has it that the minimum price may be raised further, he said. If prices do rise “considerably above” current levels, that will make it attractive for carbon buyers to start looking at other countries. “But China will continue to be the dominant market,” he predicted, probably continuing to account for more than half the world’s CER supply.

On Nov. 9, China’s government announced the start of the “China CDM Funds,” which it said would be a nonprofit state-owned fund. The major source of the funds is revenue collected from CDM projects as regulated in the October 2005 measures.

Xie Xuren, China’s finance minister, said in a news conference that the fund would cooperate with other countries and organizations to strengthen China’s capabilities in the climate change sector and provide services and support for related system building.

On January 23, the National Business Daily reported that China’s first carbon trade exchange could be set up in Beijing soon. Xiong Yan, president of Beijing Property Right Exchange, said that “China, as an important supplier in the global carbon market, hasn’t built any trading exchanges so far. And the domestic price is almost half of the secondary market’s. We are making a lot of efforts now to become a first carbon trading exchange center in China.”

If the goal is realized, the profit margin for CER buyers will be squeezed.

Strategy, Challenges for Developers

Tricorona’s Beijing portfolio has a heavy hydro emphasis in water-rich Hunan and Yunnan. Meanwhile, China’s steel and cement industries offer potential for projects in waste heat recovery. Tricorona’s largest registered project in this category is in Handan Iron & Steel in Hebei province, recovering heat from steel furnaces.

The Handan project, Odenbro said, provides an example of a strategy that has worked well. “We found this particular project through a consultant,” Odenbro explained. “They did much of the groundwork and much of the development of the project.” He gave credit for the company’s performance last year to its heavy reliance on consultants in the early stages. “Different carbon buyers operate different business models,” Odenbro noted.

While consultants provide “economies of scale,” he said, some can cause headaches. “They call themselves consultants but they are more like brokers,” Odenbro said. “They want to develop the project but they don’t really have what it takes.” Thanks to Tricorona’s in-house technical team, this isn’t a serious problem, Odenbro said. Having established an early foothold through extensive use of consultants, the company now places greater emphasis on reaching clients directly. “We do increase amounts of business development origination ourselves now,” he said. “We have our own guys traveling around and seeing potential owners.”

Jiang’s Renaissance Carbon Investment has developed a close partnership with a Beijing government-backed organization– Beijing Zhongzi Guo Yan Investment Consulting Center. “We are a one-door service provider for project owners,” Jiang said.

Gao, director of the Beijing Zhongzi Guo Yan Investment Consulting Center, is an experienced project director who has been working within the NDRC for more than a decade. He is now committed to CDM projects. “The CDM projects have a very good market in China due to the reason that some enterprises have to invest in emission reduction projects anyway, voluntarily or requested by the government, so we provide new and more incentives for factory owners. It suits well with the purpose of CDM projects, which is to improve the revenue of developing countries and at the same time to reduce emissions.”

As to the challenge of developing projects, Gao said some owners were more keen to focus on how much money they would get than to focus on how much effort they should put into project details. “The biggest risk for us is the auditing and approval risk. Once you have spent a lot of time and effort on developing one project, it will be a huge loss not only in labor but also in opportunities if it didn’t get approved by [the Designated Operational Entity] in the end.” 

Zhang, of the Hunan CDM Project Service Center, says the biggest challenge now comes from the U.N.-issued methodology. “Some methodologies are hard to implement in reality,” he said. “In China, some policies and rules are in conflict with [CDM Executive Board] rules.”

Another headache for Zhang is the number of unqualified brokers. Many don’t have the capability to develop projects but ask for generous commissions because of their project connections. “Worldwide, the carbon market attracts a lot of speculation,” Zhang said. “These brokers have increased our development cost, cut the price for the whole business, and their incomplete and unstable service has destroyed the reputation of the whole industry. Now the factory owners are bewildered on whom they should trust, because there are too many agencies. Sometimes there is just one single person promising them they could do the project for them. The market needs to be regulated further,” he said.

Though Odenbro says Tricorona has smooth processes in place, some glitches are inevitable. “With a portfolio our size, not everything can run smoothly,” he acknowledged. He pointed out that Tricorona’s largest competitor, Britain’s Ecosecurities, the largest global purchaser of CERs, wrote down the value of its portfolio in November, citing bottlenecks in the U.N. registration system. “There are a lot of bottlenecks in the process,” he said. “I think the U.N. has been overburdened by the sheer growth.” Additionally, a shortage of Designated Operational Entities, the UN-accredited CDM project validators, means a long backlog of projects awaiting validation. The European Union, among others, is working to boost the number of accredited DOEs.

“The major challenge right now, to be honest, is education,” Odenbro said. When he first arrived in China 15 months ago, awareness was negligible. “A lot of our time goes into some sort of informal capacity-building for CDM where we actually travel around and teach potential project owners about CDM and help them to recognize the potential.” Now, thanks to the efforts of carbon buyers, the United Nations, the European Union and the NDRC, awareness of CDM in China is increasing “very rapidly.”

The next challenge, Odenbro said, will be to find individual projects in Western China that might require education. “We are really looking with interest at Xinjiang, some projects in Gansu and Qinghai.” However, he is realistic about the West’s suitability for CDM. “CDM is, I think, in one way coupled with industrial growth,” he said. Western China, with its less developed power grids and industry, is a much smaller potential market.

Zhang said that improving energy efficiency in industrial projects had the biggest potential. “China, overall, has a 30% lower energy efficiency compared with industrial countries, which provides a huge potential in this respect, although methodology still plays an uncertain role in these projects.” As for his own company’s competitiveness, Zhang is fully confident: “We are very stable and we are very much local. If you are to fully understand and communicate with these CDM project owners, you have to have a lot of local knowledge.”

Odenbro noted the potential in China’s renewable energy scene. Wind and hydropower are big, he said, and are the focus for Tricorona’s business. Looking to the future, however, he pointed out that there can be only a limited number of wind farms and hydropower plants. “Solar is getting increasingly interesting,” he noted, thanks to the advent of more efficient sun panels and larger projects. But currently solar projects are small. Biofuels operations are similarly limited in scale, and do not form a significant component of China’s CDM market. Much will depend, Odenbro said, on how the technologies develop. “New methodologies for new renewable and more efficient energies—say, solar power—create new markets for us to get our reductions from.”

On top of the dynamics of China, politics plays a significant role in this environmental business.

Ni Jun, CDM director of Shanghai Yangtze Delta Investment Consulting Co., a Shanghai-based private consultancy on environmental business, said the biggest challenge for this business is political uncertainty. “The whole CDM idea is created by politics. If the international rules change, the whole industry will be reshaped. Now China has a lot of pressure to shoulder the climate responsibility too. However, I don’t see it as too big an impact on our business. Even i