Carbon Investment Funds:

Research Report n 12, November 2007 Ian Thomas Cochran Benoît Leguet +33 (0)1 58 50 41 77 +33 (0)1 58 50 98 18 ian.cochran@caissedesdepots.fr Carbon Investment Funds: The Influx of Private Capital benoit.leguet@caissedesdepots.fr Since the release of the Caisse des Dépôts Mission Climat s 2005 study on carbon funds, the investment field pioneered by the World Bank with the creation of the Prototype Carbon Fund in 1999 is now estimated at a total volume of 7 billion and has expanded with the involvement of new actors for a total of 58 vehicles. The past two years have been characterized by shifts in investment strategies and approaches, with a substantial increase in the number of funds seeking to provide cash returns to investors rather than credits to meet compliance needs. Investment vehicles are getting involved earlier in the project development process, taking larger risks through equity investment in expectation of larger returns. However, the demand for projects may be larger than the supply, with less than an estimated 50% of raised capital invested. Carbon procurement vehicles play an important role in the international carbon markets, currently financing an estimated 24% of all CERs and 31% of ERUs and will potentially lead to the avoidance of nearly 700 million tons CO 2 e. With a successor to the Kyoto Protocol yet to be negotiated, the future of the carbon market is uncertain. While onethird of vehicles indicate that they invest in post-2012 vintage credits, it is likely that the volume of capital invested remains minimal. In October 2007 the European Investment Bank launched the first dedicated post- 2012 carbon fund, indicating that some actors remain confident in the future of the carbon asset market. Private Capital 51% Figure 1 - Relative Volume of Carbon Investment Vehicles (Global Size = 7,0 Billion) Private Compliance 2% Climate Change Capital (Compliance) 1% Climate Change Capital (Capital Gains) 10% Natsource Asset Management (Capital Gains) 7% Private Voluntary (Japan) 2% The Netherlands 9% Japan 5% Austria 5% Portugal 4% Other Governments 4% Multi-Government 3% Public Capital 32% Private Capital Gains 29% World Bank Mixed Funds 10% Switzerland 2% Other Mixed Funds 7% Mixed Capital 17% Note: See Annex I for Methodology Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 Acknowledgements: The authors wish to thank everyone they interviewed during the preparation of this report, especially Philippe Ambrosi and Alexandre Kossoy (World Bank Carbon Finance Unit), Delphine Eyraud (Climate Change Capital), Oliver Wassbein (UNDP MDG Carbon Facility), and Gautier Queru (Natixis Environnement & Infrastructures). The authors bear sole responsibility for any mistakes or omissions.

Table of Contents I. Carbon Procurement Vehicles... 3 A. The Expected Demand for Carbon Assets (2008-2012) 3 B. The Supply of Carbon Assets 5 C. Sourcing Carbon Assets through Carbon Procurement Vehicles 6 D. Differentiation of Carbon Procurement Vehicles 7 II. The Growth of Carbon Procurement Vehicles... 8 A. A Rapidly Growing Investment Area 8 B. Public vs. Private Investment 10 C. Administration of Carbon Procurement Vehicles 13 III. Investment Strategy... 14 A. Investment Purpose 14 B. Risk Management and Diversification 16 C. Geographic Diversification and Project Type 18 D. Equity Investment 21 E. Post-2012 Investment 22 IV. Effects of Investment... 24 A. Environmental Impacts 24 B. Economic Impacts 25 V. Outlook for Carbon Procurement Vehicles... 26 Annex I - Methodology... 27 Annex II Table of Carbon Procurement Vehicles... 28 Annex III Table of Carbon Procurement Vehicles in Development... 30 Annex IV Other Carbon Asset Market Participants... 31 Glossary... 32 References... 33 Research Reports Published by the Caisse des Dépôts Mission Climat... 34 2

I. Carbon Procurement Vehicles A. The Expected Demand for Carbon Assets (2008-2012) The demand for carbon assets stems from the efforts of nations and industries to meet emission reduction objectives. The Kyoto Protocol, adopted in 1997 pursuant to the United Nations Framework Convention on Climate Change (UNFCCC), established binding emission reduction targets for the 38 developed nations party to the treaty, referred to as Annex B countries (see Glossary). The Protocol aims to reduce Annex B greenhouse emissions by a minimum of 5.2% below 1990 levels during the 2008-2012 period. Greenhouse gas emissions have a global effect: emission reductions in one country will have the same effect as in another. Further, some nations may be more readily able to curtail their emissions than others. As such, the Annex B nations agreed to take on differentiated emissions commitments during the 2008-2012 compliance period. Each nation will receive a given amount of greenhouse gas credits, or Assigned Amount Units (AAUs), equivalent to the total amount of emissions they will have the right to emit between 2008 and 2012. Nations may trade these AAUs with one another in an international carbon market. The International Carbon Market To facilitate the reductions of emissions where it is most economically efficient, the international carbon market links the Annex B countries together, allowing for the trading of credits between countries. The market equally allows participating countries to implement emission reduction projects beyond national territory through the Kyoto Protocol Project Mechanisms. These projects thus allow countries to benefit from returns in carbon credits that can be used to meet their reduction goals. Figure 2 Difference between 2005 Emissions and Yearly 2008-2012 Kyoto Objectives Canada Japan 174 184 Spain 108 Italy 97 Austria Portugal New Zealand Netherlands Denmark Belgium Ireland 25 18 15 13 9 8 6 Sweden France Germany -8-8 -8 UK -27-50 0 50 100 150 200 MtCO 2 éq. Sources: Caisse des Dépôts Mission Climat, UNFCCC 2007 3

Emissions data from 2005 indicates that a number of participating countries will be hard pressed to meet their reduction obligations without engaging in trade during the first period of the Kyoto trading period (2008-2012).. Figure 2, which presents the difference between observed emission levels in 2005 and Kyoto 2008-2012 obligations, suggests that there will be a substantial demand for tradable carbon credits due to continued high emission levels. It is clear that countries such as Canada, Japan, Spain and Italy will either have to take costly measures to drastically reduce emissions at home or will have to turn to the international carbon market in order to secure the carbon credits necessary. The European Union Emissions Trading Scheme To aid in achieving its objects under the Kyoto Protocol, the European Union has implemented a market-based emissions trading system (EU ETS). More than 45% of European CO 2 emissions and above 30% of all European GHG emissions are covered by the market created by directive in 2003, initiated in 2005 and entering into its second period in 2008. Following this system, each EU member country has established emissions restrictions applied directly on the industrial sectors with the highest levels of CO 2 emissions. As such, a portion of the allocation of national emissions has been divided between the different installations. The companies covered by the EU ETS are able to reduce their own emissions, purchase European emissions permits from other installations, secure carbon credits generated by the Kyoto Protocol Mechanisms to compensate their emissions, or pursue a mixed strategy of all three options. Today, the European Union, whether through the demand stemming from EU ETS-covered industries or from member countries seeking to meet their Kyoto obligations is the source of the largest demand in the international carbon market and is the primary financer of projects linked to the Kyoto Protocol. Japan: Voluntary Industry Compliance While Japan committed itself to a Kyoto target of 6% below 1990 levels by 2012, this goal is proving challenging to a nation home to some of the most efficient industries in the world. As Japan has made great strides in reducing its emissions before the Kyoto agreement, making further emission reductions is extremely costly for the nation. In 1997, the Keidanren Voluntary Action Plan was established by the industry association Nippon Keidanren, bringing together 36 industries and 137 entities in industry and energy production representing 44% of total emissions. As part of this action plan, each industry has committed itself to work to reduce emissions. In addition, the Japanese central government established a voluntary domestic emissions trading system through which companies chosen from a pool of applicants receive subsidies equivalent to 1/3 of the cost of reaching target emission reductions. While the system is voluntary, if the selected installations do not reach the established targets, they will be forced to refund the issued subsidies. The effectiveness of this program has proved limited as only around 30 companies participate in the system, none of which represent the largest national emitters (steel, etc.) except for a small number of electricity generation companies. While the City of Tokyo is also in the process of establishing a municipal trading system, few large industrial emitters are located within the covered zone. As a result, both the Japanese government and participating companies have turned to the international carbon markets to purchase the credits necessary to achieve reduction goals as emission levels continue to increase. Canada While a Canadian emissions trading system has long been in discussion, the central government has failed to reach consensus on how to reduce the country s greenhouse gas emissions. Due to the absence of an established national environmental policy, little action has been taken by either the public or private sectors to reduce emissions. 4

As a result, Canada s current emissions far exceed its Kyoto target. In order to fulfill its commitment, Canada will have to make drastic domestic reductions or purchase millions of credits on the international market. The Canadian Climate Fund reported in 2005 has yet to be allocated the necessary financing and may be cancelled altogether. In April 2007, the Canadian government indicated that while it would not purchase Kyoto carbon assets, individual companies may be allowed to use credits generated by Kyoto mechanisms to offset up to 10% of their emissions as part of the national Large Final Emitters scheme. Other Sources of Demand for Carbon Assets Two other significant sources of demand for carbon assets exist: voluntary offsets and the United States Regional Greenhouse Gas Initiative (RGGI). While personal and commercial voluntary offsets (outlined further below) frequently use assets developed outside of the Kyoto system, a small number of companies use Certified Emission Reductions (CERs) generated by Clean Development Mechanism projects described below. In addition, the Regional Greenhouse Gas Initiative (RGGI), an emissions trading partnership developed by a coalition of northeastern US states may lead to an estimated demand of around 30 Mt CO 2 per year. While neither voluntary offsets nor RGGI are expected to present substantial demand before 2012, it is important to note that the all purchasers of carbon assets are not necessarily part of the Kyoto system. Table 1 presents the estimate aggregate demand from each potential source from 2008-2012. Table 1 Estimate of Aggregate Demand for Carbon Assets Through 2012 Mt CO 2 Kyoto Annex I Countries 4 400 - UE* 2 130 - Canada** 1 100 - Japan 910 Non-Kyoto - USA*** 150 Total Demand 4 550 * Only countries with emissions exceeding Kyoto objectives. ** Reflects the potential demand if the Canadian government chooses to purchase credits for compliance. *** As reported by ICF International. Includes potential demand from the US Regional Greenhouse Gas Initiative (RGGI) Sources: Caisse des Dépôts Mission Climat Club Tendances Carbone 2007, UNFCCC 2007, ICF International 2007 B. The Supply of Carbon Assets The Kyoto Mechanisms To assist both countries and emitters in reaching their reduction objectives, the Kyoto Protocol includes two flexible mechanisms, the Clean Development Mechanism and Joint Implementation, to help nations reduce their emissions in an economically efficient manner. The Clean Development Mechanism The Clean Development Mechanism (CDM) allows for investment in emission reduction projects in developing countries party to the Kyoto Protocol. This mechanism is based on the premise that the cost of reducing greenhouse gas emissions can vary significantly between different countries and regions. Annex B countries and covered industries can therefore maximize the economic efficiency of emission reductions through projects in developing countries while at the same time sponsoring foreign direct investment and clean technology transfers. These projects result in the creation of Certified Emission Reductions (CERs), issued by the CDM Executive Board, the regulatory body that monitors the entire process. 5

Joint Implementation The second flexible mechanism, Joint Implementation (JI), functions similarly to CDM projects. It, however, allows for project development and investment in other Annex B or developed countries, primarily Eastern European and other former-soviet nations. These projects convert host country Assigned Amount Units (AAUs) to Emission Reduction Units (ERUs) which are delivered to investors. Other Sources Assigned Amount Units and Green Investment Schemes In addition to CDM and JI projects, which serve as the primary generators of carbon assets, AAUs can be secured through purchase from countries with large credit surpluses, including the many economies in transition that have experienced substantial emission reductions in emissions since 1990 due to diminished industrial production. The purchase of these so-called hot air carbon assets has, however, been questioned due to the lack of correlated real emission reductions. However, four factors, however, will limit the purchase of AAUs from nations with surplus credits. Firstly, AAUs can only be used by States for their Kyoto protocol compliance. Therefore industries subject to emission limits cannot use these credits for their compliance unless the credits are converted to ERUs though Joint Implementation projects. Secondly, the eligibility and oversight conditions for the sale of AAUs are complex and it is not yet sure when the economies in transition will be institutionally prepared. Third, the Kyoto Protocol requires nations to be in possession of at least 90% of their allotted AAUs or the equivalent of 5 times the emissions levels of the last national GHG inventory at all times, thus leaving approximately only 10% available for sale. Fourth and finally, many countries and investment vehicles have voluntarily chosen not to purchase hot air credits and are instead investing in Green Investment Schemes (GIS) in exchange from AAUs. While a legal framework has not yet been developed for GIS investment, the World Bank and other large investors have begun to explore this area through which investment in clean technologies and projects would be exchanged directly for AAU credits. Voluntary Emission Reductions There are additionally a range of different voluntary emission reduction credit types, such as Verified Emission Reductions, Emission Reductions, etc. As these credits cannot be used for compliance purposes and are not fungible against national Kyoto emission reduction commitments, investment by carbon procurement vehicles has been minimal.1 C. Sourcing Carbon Assets through Carbon Procurement Vehicles Carbon procurement vehicles, as defined for the purposes of this study, are those investment entities designed to pool public or private capital with the goal of securing carbon assets in the primary market. These vehicles primarily use the flexibility mechanisms established by the Kyoto Protocol to source carbon assets with the expectation that the price of these assets will increase over time. Whether investors are seeking to avoid paying higher prices to comply with emission reduction objectives in the future or to benefit from capital gains made through the later sale of assets, they pool investment capital to finance emissions reduction projects through a variety of contractual structures. 1 For a full analysis of the voluntary offset market, see the Caisse des Dépôts Mission Climat Research Report N 11. 6

This pooled capital serves a number of purposes: firstly, vehicles use pooled capital to develop large-scale projects, which often increase the efficiency of emissions reductions. Secondly, vehicles allow investors to take advantage of a fund manager s expertise in project selection and development. Thirdly, it allows for upfront project financing which in turn, on a scale correlated to the risk profile of the project, leads to for the purchase of credits at a discounted future price. Once projects have been approved and reductions have been verified, credits are delivered to vehicle managers and then either distributed among investors or sold on the secondary market. There is a broad range of actors involved in carbon finance (see Annex IV) which fall beyond the scope of this study. Carbon assets can be sourced through a number of different methods using either the primary market through investment vehicles or project owners, or the secondary market through project development companies or traders. Large companies often source credits directly through in-house divisions, the case of EDF Trading who invests in projects and purchases credits for EDF and its subsidiaries. Other actors including companies functioning as project developers and traders, such as EcoSecurities Group Plc. and AgCert, develop projects in order to sell the resulting carbon assets directly to clients or on the secondary market. Further, many large banks are becoming increasingly involved in carbon finance as the profitability of the sector becomes increasingly apparent. D. Differentiation of Carbon Procurement Vehicles While carbon procurement vehicles are generally referred to as carbon funds, there are in fact three different types of carbon investment vehicles: Carbon Funds, Project Facilities and Governmental Procurement Programs. All three types of vehicles share many characteristics and at times the difference between types can be blurred. Carbon Funds A Carbon Fund is an investment vehicle specializing in the financing of emission reduction projects through upfront payments, equity investment or forward purchase contracts, making returns to investors through either credits (compliance) or cash (capital gains). Carbon funds are normally open to private investment. The European Carbon Fund The European Carbon Fund is a prime example of a private, capital-gains driven, carbon fund. Launched in 2005 by the Caisse des Dépôts and Fortis Bank and managed by Natixis Environment and Infrastructure, the fund has secured 142,7 million in capital from 14 large financial institutions. The fund invests in CDM and JI projects eligible under the EU linking directive through the use of future contracts with project developers. Project Facilities A Project Facility is similar to a carbon fund in investment practices, however facilities specialize in using their expertise in the development and active management of emission reduction projects, playing a key role from start to finish. Project facilities equally tend to be open to private investment. 7

Japan Greenhouse Gas Reduction Fund Launched in 2004, the Japan Greenhouse Gas Reduction Fund is a project facility that pools over USD 100 million from Japanese companies to assist in the sourcing and development of emission reduction projects. While named a fund, the program functions as a facility, providing grants for initial documentation development and expertise on validation and certification processes. Government Procurement Programs Government Procurement Programs can take the form of aforementioned carbon funds and project facilities, as well as tender and purchasing programs. The key differentiating feature is that these programs are not open to private investment and are designed to help Annex B (primarily European) countries achieve their Kyoto obligations. ERUPT New Style The ERUPT program was launched in 2000 by the Dutch government to buy emission reduction credits from JI projects. Managed by SenterNovem, an agency of the Dutch Ministry of Economic Affairs, the program has successfully contracted over 100 million worth of emission reductions through multiple tender processes. The program was retooled in 2005 and renamed ERUPT New Style with the mission of filling gaps in the existing procurement program. II. The Growth of Carbon Procurement Vehicles A. A Rapidly Growing Investment Area With the creation of the Prototype Carbon Fund in 1999, the World Bank established itself as a pioneer in the carbon investment field, bringing together both public- and private-sector investment totaling USD 180 million. The World Bank s early involvement was followed by a number of innovative programs designed to explore opportunities for carbon asset investments in an uncertain environment. Since these early movers, the number of funds and their investment volume has continued to grow at an increasing pace: since 2003, more than 10 funds have been created yearly, and since 2004, more than 1 billion euros has been added to the total capital pool each year. In 2005, the Caisse des Dépôts Mission Climat reported that 34 carbon procurement vehicles had been created, representing over 3,4 billion euros in investment capital. Less than two years later in October 2007, more than 20 new vehicles have been launched, for a total of 58. If all funds reach or exceed their capitalization goals, the dedicated capital will have more than doubled to well over 7,0 billion. Further, if all vehicles announced but not yet active are developed, the capital pool could swell in early 2008 to over 9,4 billion distributed among 67 different funds. 2 2 As of publishing of this study, the following funds had been announced, but not yet become active: The Brasil Social Carbon Fund, the Fomecar - Mexican Carbon Fund, the Gold Carbon Capital Fund, the Irish Carbon Tender, the Ecoeye Korea Carbon Fund, the Natixis European Kyoto Fund, the World Bank Forest Carbon Partnership Facility and the World Bank Partnership Carbon Facility. 8

Figure 3 Evolution of Carbon Procurement Vehicles since 1999: Number and Size Number of Vehicles 10000 9000 67 80 70 Total Volume (Million ) 8000 7000 6000 5000 4000 3000 2000 1000 0 2 3 4 341 308 192 9 886 14 1458 24 2069 34 3565 45 5564 58 7041 9406 60 50 40 30 20 10 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Estimated 2008 Projected* Notes: (1) The volume of four investment vehicles was not disclosed and are therefore not included in financial calculations. (2) Values were adjusted to avoid instances of double counting; as such, the World Bank Umbrella Carbon Facility was not included in the financial calculation as it is primarily a fund of funds. (3) These figures assume that all vehicles will reach or surpass their stated investment goal. * The 2008 Estimate includes those announced, but not yet launched, vehicles listed in Annex III. Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 To date, carbon procurement vehicles have made great strides in reaching their capitalization goals. Fifty funds have reported that they have secured an aggregate total of over 5,4 billion. However the investment of this secured capital has progressed at a slower pace. For the 33 vehicles for which data was available, on average, half of their capital has been committed to reduction projects, excluding those funds launched in 2007. It is estimated that only 10 vehicles have fully committed all raised capital. While data is not complete due to confidentiality concerns, it appears that the percentage of raised capital invested is neither directly related to the year the vehicle was created nor the characteristics of the vehicles itself (public or private, investment strategy, etc.) This relatively low level of capital investment may be an indicator of a bottleneck in the project development market (see section IV). Table 2 Percentage of Capital Invested by Year Launched Year Launched* % of Capital Invested Number 2000-2002 56% 6 2003-2005 61% 12 2006-2007 25% 15 Total 41%** 33 Notes: * No information was made available concerning funds created in 1999. ** Average increases to 55% when those funds created in 2007 are excluded. Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 9

Evolution of Vehicles by Type As shown in Figure 4 below, carbon funds have come to dominate the investment market. In 2005, the capital invested in funds surpassed that invested in government programs for the first time. In October 2007, carbon funds accounted for over 50% of all procurement vehicles and were responsible for over two-thirds of the total capital pool (see Figure 5). The first project facility was created in 2004; since then only 7 project facilities have been created, controlling less than 5% of the total capital pool. Since 2006, the rate of capital investment in the government programs and facilities has decreased while investment in funds continues to remain steady. 8000 7000 Figure 4 Evolution of Investment Capital by Vehicle Type 6000 Project Facility Million 5000 4000 3000 2000 1000 Carbon Fund Government Procurement 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year Note: Financial information available for 53 of 58 vehicles. See Annex I Methodology for further information. Sources: Caisse des Dépôts Mission Climat 2007 Figure 5 Distribution of Vehicles and Investment Count (58 vehicles) Project Facility 12% Capital ( 7,0 billion) Project Facility 4% Government Procurement 30% Government Procurement 36% Carbon Fund 52% Carbon Fund 66% Sources: Caisse des Dépôts Mission Climat 2007 B. Public vs. Private Investment Capital from public and private sources is invested in carbon procurement vehicles that can be classified as purely-publicly funded, purely-privately funded vehicles and mixed-source vehicles. The entrance into the market by public and private investment falls into two broad periods divided by ratification of the Kyoto Protocol. 10

Figure 6 Evolution of Procurement Vehicles by Investor Type 70 60 Number of Vehicules 50 40 30 20 10 0 23 15 10 14 3 13 7 9 2 4 21 1 14 15 17 1 1 7 10 1 2 3 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year Private Mixed Public Sources: Caisse des Dépôts Mission Climat 2007 Public Investment and the Birth of the Market Before 2004, investment had occurred primarily through publicly-funded vehicles, with some private investment concentrated in mixed vehicles. Confident that emission reduction objectives would become a reality, many governments quickly realized that they would have to make full use of the established flexible mechanisms in order to meet their emission reduction objectives. Annex B countries recognized the carbon finance market as a key tool in meeting their Kyoto obligations. European countries felt the pressure before others with the development and implementation of the European Emissions Trading Scheme. As such, European governments, after the first tentative steps of the World Bank, were early active participants in carbon finance: in late 2004, governmental carbon investment programs accounted for well over 50% of total investment, not including participation in mixed funds. While public investment in the field continues to increase, the trends demonstrated in Figure 7 suggest that investment in purely-private vehicles is quickly outpacing investment in public programs. The Netherlands The Netherlands was one of the first countries to establish carbon procurement programs. Due to its highly efficient industry and historical commitment to environmental protection, the country s cost of emission reduction was estimated at close to double the European average. The Dutch government therefore announced that it would meet half of its Kyoto commitments (or 100 million metric tons of CO 2 emissions reductions) by purchasing CDM and JI assets. Shortly after the creation of the World Bank Prototype Carbon Fund, the Netherlands launched the ERUPT tender program to purchase credits from JI projects, followed shortly by a number of other investment schemes representing over 680 million in capital. 11

Figure 7 Evolution of Investment Capital by Investor Type 8000 7000 Million 6000 5000 4000 3000 Private Mixed Public 2000 1000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year Note: Financial information available for 53 of 58 vehicles. See Annex I Methodology for further information. Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 The Role of Private Sector Investment The number and volume of purely-private vehicles remained relatively minimal until the Kyoto Protocol was ratified in late 2004 by the Russian Federation. Before this date, uncertainty surrounding the implementation of the Protocol served to discourage widespread private involvement in the market. Those who were investing showed a general preference for investment in mixed investor funds which had been stabilized by government investment, and were thus perceived as more secure. This early investment of public funds in World Bank and other mixed vehicles played a key role in increasing private investor confidence, leading to the gradual increased participation of private capital up until 2004. With the announcement of the European Emissions Trading Scheme in 2003 and a clear indication that the Kyoto Protocol would enter into effect in late 2004, the floodgates were opened and investment in the market began in earnest. Since then, the number of private vehicles and the amount of private capital has increased substantially. This shift can be partially explained by the compliancerelated pressures placed on the private sector stemming from the quantified objectives established for individual companies by the EU ETS and other emission reduction programs. While in 2003 publicly-funded vehicles controlled over 70% of the capital pool, private investment surpassed public for the first time in 2005 and by number in 2007. It is likely that privatelyfunded vehicles control an even larger percentage of the capital pool total capitalization as the investment total is not regularly disclosed and therefore have not been included in financial calculations. In terms of mixed funds, it is not clear whether public or private capital makes up the larger portion due to a lack of disclosure of information. On average, among the 7 World Bank managed mixed funds, total capital is evenly split between public and private investors. Nevertheless, the percentage of private participation in mixed funds can range from 20% in the Carbon Fund for Europe to 78% in the Umbrella Carbon Facility. 3 3 World Bank, Carbon Finance for Sustainable Development, 2006. 12

C. Administration of Carbon Procurement Vehicles Administration Carbon procurement vehicles are managed by one of three types of agents: government agencies, development banks or private-sector asset managers. The investment in and development of emissions reduction projects is a technical and complex process, requiring a high level of both financial and technical expertise. Between 1999 and 2004, the World Bank, other development banks and public financial institutions were the dominant asset managers. The management landscape began to shift in 2003 with the increasing involvement of private asset management companies in the market. The creation of the Rabobank Dutch Government Carbon Facility marked the first entrance of the private sector in the management of a carbon procurement vehicle. Since then, the number of vehicles managed by the private sector has rapidly increased: by mid-2007, almost half of all vehicles were managed privately, representing at least 56% of the total capital pool. Figure 8 Evolution of Investment Capital by Vehicle Managing Agent 8000 7000 6000 Private Sector million 5000 4000 3000 Government Agency 2000 1000 Development Bank 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year Notes: (1) Financial information available for 53 of 58 vehicles. See Annex I Methodology for further information. (2) The category Development Bank includes those vehicles managed by the World Bank Carbon Finance Unit as well as other development-focused finance institutions. Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 The classification of managing agent tends to vary by the type of investor. Close to 60% of purely publicly-funded vehicles are managed by government agencies or public finance institutions, followed by development banks and a very small number by the private sector. More than 70% of mixed vehicles are managed by development banks, responsible for 60% of the mixed-investor capital pool. Only the mixed-investor KfW Fund places private money in the hands of a government agency, in this case, a German public finance institution. Purely privately-funded vehicles consistently entrust their funds to private managers. Table 3 presents the primary three managers of vehicles for public, private and mixed vehicles. 13

Table 3 Largest Management Agents by Investor Type Public Vehicles Mixed Vehicles Private Vehicles Overall 1. NEDO* (Japan) 1. World Bank Carbon Finance Unit 2. Kommunalkredit Public Consulting 3. World Bank Carbon Finance Unit 1. Climate Change Capital 2. KfW 2. NatSource Asset Management 1. World Bank Carbon Finance Unit 2. Climate Change Capital 3. FC2E Gestion SL 3. Trading Emissions 3. NatSource Asset Management Note: The volume of capital secured was used to rank management firms. * New Energy and Industrial Technology Development Organization Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 Zoom: The Giants of Carbon Procurement Vehicle Management The World Bank Carbon Finance Unit has been a recognized leader in carbon asset management, managing nine vehicles and over 800 million euros in investment capital from both public and private investors. It has played a key role in the development of the field since 1999 and continues to shape the market, most recently through the development of a post-2012 investment vehicle to be launched at the end of 2007. Climate Change Capital, a private niche investment bank based in London, follows close behind the World Bank with over 800 million euros in investment capital between its Carbon Funds I & II. Active in the carbon assets market since 2005, CCC is currently in the process of developing a third investment fund with an unreleased launch date. Its expertise in the field has been recognized by the Dutch pension funds ABP and PGGM, having both chosen to invest in its Carbon Fund II. III. Investment Strategy Since 2005, the carbon procurement market has seen innovations in investment strategy occurring in a number of areas including risk management, investment practices and post-2012 investment. Many of these developments have stemmed from efforts to reduce risk exposure associated with investment in carbon asset generating projects, often based on the premise of diversification. As such, a simple breakdown between public and private investment is not enough to understand the motivations behind investment. Over the last few years, financial investors have recognized that investment in emission reduction projects and the resale of the resulting credits on the secondary market to nations and industries can lead to substantial capital returns. In 2007, a number of different parties were involved in the carbon investment market for reasons ranging from compliance to capital returns, and most recently, humanitarian purposes. A. Investment Purpose The expectation that the price of carbon assets will increase over the 2008-2012 period is at the heart of all strategies employed by carbon procurement vehicles, whether driven by compliance or capital gains. Between 1999 and 2003, investment in the market was motivated primarily by compliance buyers who, under pressure from the variety of obligations described previously, began investing in carbon assets early to minimize compliance costs. 14

However, starting in 2004 and growing rapidly, financial investors seeking capital gains recognized the lucrative opportunities offered by carbon investment paired with the benefits of investment in the environment. Carbon assets have been recognized by traditional investors as a decorrelated asset, fluctuating independently from both the equity and non-energy commodity markets. As liquidity has increased and prices have become less volatile, asset-yielding emission reduction projects have become more attractive to large investors. Instead of presenting returns to investors in the form of credits as with compliance vehicles, capital gains vehicles invest in carbon assets with the expectation of selling them later at a higher price and delivering competitive monetary returns to investors. The number of private procurement vehicles developing projects to resell credits on the secondary market has increased rapidly. While in mid-2007 two-thirds of the 58 procurement vehicles covered in this study were compliance-driven, the 30% that were capital gains-driven managed close to 45% of the total capital pool. The capital returns offered by the market have been utilized primarily by private investors; only one purely publicly-funded vehicle invests for capital gains purposes in comparison with the two-thirds of purely privately-funded vehicles seeking capital gains. As shown in Figure 9 below, it is likely that if the current trend continues, capital gains vehicles will soon surpass compliance vehicles in terms of volume and number. Figure 9 Evolution of Investment Capital by Vehicle Strategy 8000 7000 6000 5000 Million 4000 3000 Capital Gains 2000 Compliance 1000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year Notes: Financial information available for 53 of 58 vehicles. See Annex I Methodology for further information. Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 Humanitarian Investment In addition to emission reductions, the Kyoto Protocol calls for the incorporation of the principles of sustainable development into its application. While some earlier vehicles such as the World Bank s Community Development Carbon Fund focused on the larger goals of sustainable development, new vehicles have emerged to harness the Kyoto mechanisms for humanitarian purposes. These investment funds and facilities sell CERs generated from projects in developing nations to fund sustainable development projects. While few in number and still in development, humanitarian-focused vehicles are nevertheless noteworthy departures from the dominant complianceand capital gains-focused approaches. 15

Harnessing the Kyoto Mechanisms for Human Development In 2006, the first vehicle managed by an NGO was announced: the Brasil Social Carbon Fund. This fund will be primarily managed by the international charity CARE and has contracted with CO2e, a private carbon trading company, for technical assistance. While still in development, the fund aims to develop within Brazil small-scale CDM emission reduction projects that promote sustainable development and support local communities. The CERs resulting from these projects will then be sold on the secondary market and proceeds will be used to either fund existing projects or establish additional ones, with a portion of the proceeds returned to the initial private or institutional investors. The United Nations Development Program has developed the UNDP MDG Carbon Facility in partnership with Fortis Bank to use the Kyoto mechanisms to assist in reaching the UN Millennium Development Goals. Aiming to generate 15 MtCO 2 equivalent of avoided emissions, the facility leverages carbon finance to aid in poverty reduction and help increase investment in emission reduction projects in under-represented countries. Projects tenders are evaluated and selected by the UNDP following criteria set to further the Millennium Development Goals. Initial project development, including the preparation of documentation for the CDM Executive Board, is overseen by the UNDP and underwritten by Fortis Bank. Fortis and the project developer agree on a set price for the CERs generated by projects, and the Bank recuperates its costs through the eventual sale of these carbon assets on the secondary market. In addition to strictly humanitarian-driven vehicles, some vehicles are putting a strong emphasis on sustainable development capacity of project development. When created in 2002, the Swedish government s CDM/JI program was not specifically designed to pursue humanitarian purposes. Nevertheless, in 2007 the program focuses its efforts primarily on fostering CDM projects in the least-developed and those countries the under-represented in the CDM market. As Sweden is on schedule to reach its Kyoto emission reduction objectives, it is stocking the generated CER credits until a decision is taken concerning their use (resale, cancellation, etc.). B. Risk Management and Diversification While the level of risk associated with investment in CDM, JI and other credit-generating projects has diminished as the market has grown, investment vehicles still take a number of measures to protect themselves, which are explored below. Project Investment and Asset Type To date, carbon asset investment has primarily focused upon Clean Development Mechanism and Joint Implementation projects, the primary tools developed by the Kyoto Protocol for the creation of tradable carbon credits. As shown in Figure 10, the majority of investment vehicles choose to spread their investment over both CDM and JI projects. However, many vehicles are electing to further diversify their portfolios through the investment in other assets. The Cheyne Carbon Fund has forgone investment in CDM and JI projects altogether, focusing on Verified Emission Reduction credits or VERs. This shift reflects the increasing demand among consumers for voluntary personal and small-scale commercial emission offsets. Other private funds, including RNK s Grey K Environmental Fund, the Bunge Emissions Fund and the Natsource Aeolus Onshore and Offshore Fund, have expanded their investment scope to include a mixture of SO 2 and NO x permits from the United States Acid Rain SO 2 Cap-and-Trade Program as well as European Allowances (EUAs) in addition to CDM and JI projects. 16

Figure 10 Distribution of Investment by Asset Type Count (58 Vehicles) Capital ( 7,0 billion) Neither 2% JI Only 7% CDM Only 26% JI Only 4% CDM Only 24% Both CDM & JI 65% Both CDM & JI 72% Note: The capitalization of the vehicle reporting investment in neither CDM nor JI projects is not included in the capital pie chart as no financial information was disclosed. Sources: Caisse des Dépôts Mission Climat, Environmental Finance 2007 Risk management products As the number of projects registered by the CDM Executive Board and approved by designated national authorities increases, the risk of non-approval is having a diminished effect on investment decisions. However, increasing fears of credit under-delivery remain, as projects deliver on average 85% of promised credits. Additionally, delays or failures in project registration and certification of CDM credits continue to make investment risky. This has led to the development of a number of secondary market products and services. In 2006, insurance firm Swiss Re offered coverage for CDM credit delivery for the first time. The World Bank s Multilateral Investment Guarantee Agency (MIGA) has also extended coverage for political risks posed by investment in certain countries (project nationalization, revoking of permission, etc.). Different forms of delivery insurance and guarantees have had an influence in making carbon investment much less of a risky venture. Funds of funds Further diversification has occurred as carbon procurement vehicles are investing in other vehicles. In doing so, investment funds are able not only to diversify their own portfolio, but also access projects potentially beyond their expertise and to avoid expending large amounts of capital on only a few large projects. The World Bank Umbrella Carbon Facility Launched in December of 2005, the World Bank Umbrella Carbon Facility (UCF) functions as an aggregating facility, pooling the capital of governmental programs, the existing World Bank carbon funds and new investors to sponsor large-scale projects. With a total of 776 million in secured capital, the facility focuses on large projects that will typically yield reductions of more than 10Mt of CO 2 e, beyond the scale of projects within the investment range of its individual investors. The majority of these funds have been invested in hydrofluorocarbon (HFC) destruction While the Umbrella Carbon Facility is the only dedicated fund of funds, some vehicles also accept investment from other vehicles, including the Asia-Pacific Carbon Fund, the Baltic Sea Region Testing Ground Facility, the Community Development Carbon Fund, the KfW Fund and the Multilateral Carbon Credit Fund. 17

C. Geographic Diversification and Project Type A key factor in ensuring the solvency of investment is the development of a broad portfolio of projects, including variety in geographic location and type. Of the 46 vehicles that disclosed information concerning diversification, two-thirds reported an established set of criteria for geographic diversification with three-fourths reporting set criteria for diversification by project type. The correlation of managing agents with the buyers listed in the UNEP Risoe Centre s CDM and JI Pipeline databases has allowed for the association with the majority of vehicles with projects in the pipeline. This information, analyzed below, should be taken as estimates due to the restrictions on the analysis listed in Annex I. Geographic Distribution Carbon procurement vehicles employ many strategies to determine which geographic areas to invest in. A number of vehicles have set restrictions, such as the CAF funds which focus only on Latin America and the Caribbean, and the Portuguese Carbon Fund and Luso Carbon Fund, which invest only in Brazil and other Portuguese-speaking countries. Two funds in development, the EcoEye Korea Carbon Fund and the Fomecar Mexican Carbon Fund, will only invest in Korea and Mexico respectively in order to further develop national CDM capacity. Figure 11 Number of Projects by Country (Estimate)* Indonesia 2% Sri Lanka 3% Philippines 3% 18 Chile 3% Other Countries 23% Brazil 6% CDM N = 288 JI N = 102 India 15% China 45% Estonia 6% Poland 9% Ukraine 12% Other** 11% Bulgaria 13% Czech Republic 18% Romania 14% Russia 17% * Data presented above is based on estimates drawn from the CDM/JI Pipeline analysis by the UNEP RISOE Centre concerning 50 vehicles. See Annex I for further information. ** Other includes: Lithuania, New Zealand, Slovakia, Germany and Hungary. Sources: Caisse des Dépôts Mission Climat, UNEP RISOE Centre 2007 When considering the geographic location of a project, vehicles take into consideration a number of risk factors that may influence the development of the project and thus carbon asset delivery. These factors range from geopolitical stability to the level of infrastructure development to the quality of the business environment. Further, Kyoto mechanisms projects require that host countries meet a set of institutional qualifications, including the establishment of the necessary oversight and approval bodies. While CDM projects make up the bulk of vehicle investment, it is not widely spread across countries and regions. As shown in Figure 11, three countries have received close to 70% of investment: China (45%), India (15%) and Brazil (6%), followed by Chile, the Philippines and Sri Lanka. When investment is broken down among regions, Asia and Latin America combined host over 90% of vehicle investment in CDM projects. These geographic trends hold true for private, public and mixed investor vehicles (see Table 4), although mixed-investor vehicles invest more evenly between India (22%) and China (20%) and private-investor vehicles have concentrated over 90% of investment in Asia.

Table 4 Regional Distribution of CDM Projects by Investor Type Mixed % Private % Public % Total % Asia 36 56% 123 92% 53 59% 211 73% Latin America 16 25% 8 6% 29 32% 53 18% Africa 8 13% 4 3% 3 3% 15 5% Other 4 6% 0 0% 5 6% 9 3% Total 64 134 90 288 Sources: Caisse des Dépôts Mission Climat, UNEP RISOE Centre 2007 JI projects are more evenly distributed among the eligible countries, with the Czech Republic and Russia receiving 18% and 17% of investment respectively. As indicated in Table 5, the concentration of projects in the Czech Republic are almost singularly funded by the mixed World Bank vehicles (16 of 19) while almost all Russia-hosted projects stem from public procurement vehicles (14 of 18). Information from the Risoe CDM / JI Pipeline indicates that private-investor vehicles have yet to invest in JI projects. Table 5 Distribution of JI Projects by Investor Type Host country Mixed % Public % Total % Czech Republic 16 55% 3 4% 19 19% Russia 4 14% 14 19% 18 18% Romania 1 3% 13 18% 14 14% Bulgaria 0 0% 13 18% 13 13% Ukraine 1 3% 11 15% 12 12% Poland 1 3% 8 11% 9 9% Estonia 3 10% 3 4% 6 6% Other* 3 10% 8 11% 11 11% Total 29 73 102 * Other includes: Lithuania, New Zealand, Slovakia, Germany and Hungary. Types of Projects Sources: Caisse des Dépôts Mission Climat, UNEP RISOE Centre 2007 The criteria for investment diversification by project type range substantially between carbon procurement vehicles. The FE Clean Energy funds focus specifically on renewable energy development while others, such as the Norwegian Carbon Tender, set upper or lower limits on the amount of emission reductions generated per year. Vehicles must also take into consideration limitations on CER use set by different authorities. Many vehicles with investors or potential secondary market buyers in the European Union do not invest in forestry projects as the EU ETS system does not recognize carbon assets from this source. In addition, a number of vehicles have specifically stated their intentions not to invest in a number of controversial project types, including HFC destruction, large hydroelectric projects and carbon-capture and storage. The diversification by project type is also dependent on the timeframe of returns. Investment in HFC destruction projects provides large emission reductions over a short period of time at a relatively low cost. Renewable energy projects, conversely, require larger capital investments with returns spread over a longer timeframe. These projects are exposed to further risks related to potential underperformance of reduction technologies and or delays in implementation due to the complexity of projects. All of these factors influence the timeline and reliability of carbon asset delivery. 19

Figure 12 Distribution of CDM Project Type (Estimate)* Coal bed/mine methane 3% Biogas 5% Landfill gas 12% HFCs 2% Wind 15% Count N = 288 CERs (Million) N = 544 Other Other 8% 7% Biomass energy 15% Hydro 24% Energy Efficiency 16% Fossil fuel switch 5% N2O 5% Coal bed/mine methane 7% Hydro 7% Wind 4% Energy Efficiency 8% Landfill gas 11% Note: * Data presented above is based on estimates drawn from the CDM/JI Pipeline analysis by the UNEP RISOE Centre concerning 51 vehicles. See Annex I: Methodology for further information. HFCs 46% Sources: Caisse des Dépôts Mission Climat, UNEP RISOE Centre 2007 As indicated in Figure 12, hydroelectric, biomass energy and wind projects make up over 50% of all projects, followed by energy efficiency own generation and landfill gas. In terms of the number of projects, this represents a broad diversification as no single project has a majority. However, when the number of CERs estimated to be generated by the project by 2012 is analyzed, over 46% of projected reductions come from HFC destruction projects, which represent only 2% of all projects implemented. While this follows the trends seen for all CDM projects in the pipeline, it indicates that even if the type of projects may be well diversified, the source of actual carbon assets may not be equally distributed. As evidenced in Table 6, project investment varies by investor type and there are significant differences between the sources of expected CERs. As to be expected due to the size and relative simplicity of the project type, it appears that all investors are heavily dependent on HFC destruction projects. Mixed-investor vehicles show the most evenly diversified CER portfolio, with roughly equal investment in HFC projects, landfill gas projects and hydroelectric projects. Reflecting an increased attention to the forward value of credits, private-investor vehicles are slightly more diversified in their investment in other project types showing a stronger interest in energy efficiency and coal bed and mine methane, The correlation indicates that government investors are the less diversified but appear to be more interested in wind generation projects. Table 6 Distribution of CDM Projects by Investor Type (CERs) Project Type Mixed Public Private HFCs 36% 51% 44% Landfill Gas 31% 10% 7% Hydro 20% 7% 4% Wind 2% 9% 3% Energy Efficiency 2% 2% 13% Coal Bed/Mine Methane 0% 3% 10% Total CERs (Millions) 89 136 318 Sources: Caisse des Dépôts Mission Climat, UNEP RISOE Centre 2007 Investment in JI projects by public-investor and mixed-investor vehicles is highly diversified, with no single project type capturing a majority of investment or providing the majority of the resulting carbon assets. As shown in Figure 14, hydroelectric, landfill gas and wind projects are the most numerous while energy efficiency, wind, and energy distribution generate the largest percentage of ERUs. There is little difference between the investment of public and mixed vehicles in projects, except for a higher incidence of investment in hydroelectric projects by mixed vehicles (55%). 20