April 17, 2008: 4:39 AM EDT
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Carbon finance comes of age (p. 2)

By Marc Gunther, senior writer

Yes, you've got pigs, private jets, and investment bankers, all tied together by the oddest of commodities - the certified absence of a colorless, odorless gas.

The traders

For two centuries rum, molasses, and sugar were bought and sold at London's West India shipping docks. Today the gleaming office complex that towers over the docks, Canary Wharf, is the global nerve center of carbon finance. Barclays, Citibank, Credit Suisse, HSBC, Lehman Brothers, and Morgan Stanley all have trading desks here, and so here is where you find a pair of investment bankers - both 35, both alumni of Enron, both brainy and self-assured - who have emerged as two of the world's top carbon traders.

Louis Redshaw of Barclays Capital and Imtiaz Ahmad of Morgan Stanley (MS, Fortune 500) have risen above the crowd for several reasons. First, they were early movers: Redshaw started the desk at Barclays in 2004, before EU trading began, and Ahmad traded emissions credits for BHP Billiton, the giant mining company, before joining Morgan Stanley in 2005. Second, their banks have relationships with utilities and industrials whose emissions are regulated by the EU. Third, they can navigate a market that is opaque and highly regulated, and offer insight into where prices are going.

Redshaw and Ahmad say that the price of carbon credits, like that of other commodities, is driven by supply and demand. Here are just a few of the things that come into play: Economic growth in the EU and Japan - because more demand for energy means more demand for credits. The rain in Spain - because more water power means less demand for coal. Then there's so-called hot air in Russia and the Ukraine, which refers to what some experts believe to be a huge over allocation of credits to those countries that will flood the market and depress the carbon price. The countervailing view is that the Russians will not dump their hot air into the market because they want to keep carbon prices high to drive demand for natural gas, which emits less carbon than coal (Gazprom, the Russian gas giant, sells lots of natural gas to Europe). "The geopolitics of this market are fascinating," says Ahmad.

Some people describe the first phase of the EU trading scheme, which ran from 2005 to 2007, as a learning experience. Others call it a flop. National governments issued too many allocations to regulated companies; when traders realized that the market was oversupplied, prices crashed. Partly as a result, EU greenhouse gas emissions rose by about 1% a year during the period.

The next phase of the EU market began in January and runs through 2012. Redshaw and Ahmad believe that the market will be short of emissions credits during this phase, causing carbon prices to rise and giving companies an incentive to curb their pollution. The market is now attracting financial players like RNK Capital and Jane Street Capital, hedge funds based in New York, that are betting on short-term and long-term price fluctuations.

Paul Ezekiel, head of global carbon trading for Credit Suisse, is inventing new structured products to serve them. In December, Credit Suisse bundled a group of about 20 projects and then sliced the credits into a series of tranches according to their risk profile. Buyers pay more for a collection of low-risk credits, less for those that are chancier. If this sounds familiar, it should - it's the carbon finance version of those collateralized debt obligations that investment banks used to sell mortgages.

That's one risk of relying on global financial markets to curb climate change. We're counting on the people who brought us the subprime mortgage meltdown to get it right this time around.

The carbon cowboys

But don't despair. There's evidence to suggest that this business of swapping pollution permits may save us from an overheating orb. It comes from, of all places, the Bush administration (father, not son), which in the early 1990s established what's called a cap-and-trade program to control sulfur dioxide, a pollutant that causes acid rain and fouls lakes. The EPA-run program is still going strong. Coal-burning power plants are allocated emissions permits, albeit fewer each year. (That's the cap.) Utilities that cut their emissions by installing new equipment or burning cleaner fuels wind up with permits to sell. Others opt to buy them rather than adopt new practices. (That's the trade.) The goal is to harness market forces to figure out the most efficient ways to cut pollution, and it has worked very well. Which is why you don't hear about acid rain anymore.

So it's no wonder the U.S. insisted that a cap-and-trade approach be built into the Kyoto agreement. "The Europeans are implementing the American plans," says David Doniger, policy director of the climate center at the Natural Resources Defense Council. The U.S., however, rejected Kyoto because the treaty does not require rapidly developing countries such as China and India to curb their emissions. Poor nations argue that they didn't cause the global warming problem - their emissions are much lower, on a per capita basis, than those of Europe or the U.S. - and they need to grow, so they shouldn't be burdened by caps.

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