Private equity's carbon play

Private equity and hedge funds have found a new plaything – trade in carbon credits and the targeting of companies that could generate them in large quantities.

Plays within the clean energy sector are estimated to have attracted some $15 billion in venture capital and private equity investments in the past year, double that of 2006, and are forecast to reach some $100 billion by 2010.

But the big development in 2008 could be a further evolution of the carbon investment market that will see mainstream buyout funds targeting established companies with hidden carbon credit assets.

In the past few years, private equity and hedge funds have been the early movers into the carbon credit market established under the auspices of the United Nations-sponsored CDM (clean development mechanism) scheme, particularly in China and India.

Here, the funds agree to invest in a project – such as energy efficiency or burning of methane – that allows an asset such as a power generator or coal mine to reduce its carbon emissions. The fund takes the carbon credits and sells them into a recognized carbon market.

This market will expand quickly. And soon those funds will be moving beyond India and China to assets in developed countries such as Australia that offer a similar leverage when Australia's own emissions trading scheme comes in effect.

Targeted companies might be those with technology or services that can help an industry reduce emissions, or highly inefficient emitters that offer huge potential for abatements and the generation of carbon credits. Buyout funds might be tempted to package these assets together and sell them at a later date.

The future price of carbon has already proved influential in two significant transactions in the past year: the $45 billion buyout of TXU by TPG and KKR, and with the $42 billion purchase of Alcan by Rio Tinto.

The Alcan deal, for instance, was only concluded after Alcan secured access to Canada’s river systems in perpetuity. Alcan’s Canadian smelters are driven entirely by hydro electricity. In a world that will price carbon at $30 to $150 a tonne, that will provide Rio with a massive competitive advantage.

The sale of the NSW electricity assets, which will only be finalized months before the introduction of a national emissions trading scheme, will also have to take into account the projected carbon price and the ability of the various assets to reduce their emissions.

Analysts are already talking about a new financial metric – carbon adjusted asset value, or CAAV, for short.

And look to the emergence of a generation of carbon aggregators – companies that offer to make a business more efficient in its energy use. The aggregator will bear the cost of the abatement. The customer reduces its energy expense, and the aggregator makes off with the carbon credits as payment.

It’s a model that is based on recent developments in Europe, where some utilities are no longer simply trying to sell as much energy as they can – they are offering services such as heating solutions. The utilities bear the cost of insulation and other efficiency measures and charge for a heating service. The utilities are finding they can generate bigger margins from the energy efficiency and the accumulation of carbon credits.

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