Merrill Lynch's carbon bet

(Fortune) -- The business of "carbon farming" is growing fast -- and Merrill Lynch is the latest big company to bet that it will become profitable.

What's carbon farming, you ask? It's a business designed to recognize the value created when trees store carbon dioxide and prevent global warming. So people who plant new trees or prevent existing trees from destruction can get paid for doing so.

That doesn't mean that the tree in your backyard or mine will help pay college tuition or fund a 401(k). For now, the payments are going to villagers in the developing world who agree to protect endangered forests. Starbucks (SBUX, Fortune 500), Marriott (MAR, Fortune 500) and Rio Tinto (RTP), among others, have all agreed to finance projects designed to deter deforestation.

This week, Merrill Lynch (MER, Fortune 500) announced that it will invest $9 million to help save a tropical forest in Aceh, Indonesia. It's the first time a Wall Street firm has invested in carbon farming, and let's be clear: this isn't philanthropy of public relations; it's strictly business.

In fact, the man who put the deal together to save the 1.9-million acre forest, called Ulu Masen, believes it could be a very big business. "It will be the biggest carbon project in the history of the world if we can pull it off," says Dorjee Sun, the 31-year-old founder of an Australian startup company called Carbon Conservation.

Here's how the deal will work: Merrill will pay villagers in Aceh, a province on the island of Sumatra, to stop logging their forests. Aceh, of course, is the place that was devastated by a tsunami in 2004 and, before that, wracked by civil unrest. It's also home to Sumatran tigers, clouded leopards and orangutans, and therefore of special interest to environmentalists. The money will be used to train the villagers in alternative livelihoods, like growing coffee, cocoa or palm trees for oil. I

In exchange, Merrill will get carbon credits, which are also known as carbon offsets -- that's the "crop" in carbon farming. The credits will meet quality standards set a group called the Climate, Community and Biodiversity Alliance (CCBA), whose members include environmental groups Conservation International, The Nature Conservancy and the Rainforest Alliance, and companies as BP, Intel and SC Johnson. The alliance functions as a regulator, albeit without legal clout.

Merrill will pay about $4 per credit for 500,000 credits per year over the next four years --$8 million in all. (The other $1 million buys an option to acquire more credits.) Merrill then hopes to sell them for a profit to companies that want to voluntarily offset their carbon emissions. Currently, these voluntary credits --each one represents a ton of CO2 that is prevented from entering the atmosphere -- sell from between $2 and $20 each, according to Andrew Ertel, the president and CEO of Evolution Markets, a leading broker of emissions credits.

The credits will be worth a lot more if they can be sold into regulated markets. Greenhouse gases are regulated in Europe and Japan, and laws to control them are being considered in the U.S. and Australia. So far, though, projects like this one -- called "avoided deforestation" or REDD projects, for Reducing Emissions from Deforestation and Degradation -- have not been approved for regulated markets. Deforestation is said to account for about 20% of all global greenhouse gas emissions.

"This is uncharted territory," says Abyd Karmali, global head of carbon emissions at Merrill Lynch. "That's part of the risk that Merrill is taking. How much appetite will there be for credits from projects of this type?"

Speaking by phone from Jakarta, Dorjee Sun says he has pitched large-scale avoided deforestation projects to more than 200 banks, hedge funds, pension funds and conservation groups. He's working with governors in Indonesia and Brazil, and came to the U.S. last fall where he pitch deforestation projects to Howard Schultz of Starbucks and investor George Soros.

Sun, a former Internet entrepreneur, is frank about his motives. "The more hectares we manage, the more land we 'farm' carbon on, the more money we make," he says. "Our goal is to be the amazon.com of the Amazon."