Risk managers face a number of challenges when their companies enter the fledgling carbon credit market
The passage of the Kyoto Protocol, which became effective in February 2005, signalled a growing consensus on the need to control and reduce greenhouse gas (GHG) emissions. One of the more interesting consequences of Kyoto has been the creation of an entirely new branch of international commerce -- the carbon credit trading market.
This is a serious, global market valued at US$60 billion in 2007. It is projected to be valued at US$200 billion by 2020. And while the financial and environmental gains associated with the carbon credit market can be significant, a number of risk management issues warrant consideration. That being said, currently available insurance products and new approaches in the development can help organizations address many of these risks.
CARBON CREDITS
Carbon credits are key components of various GHG emission-trading schemes nations have employed following the enactment of the Kyoto Protocol. Under Kyoto, based upon a number of factors, emission targets are allocated by country under the auspices of the United Nations. Some of these targets are challenging, reflecting a growing sense of urgency about global GHG emissions. Ideally, a nation will attempt to reduce directly its GHGs through the application of new technologies in power generation, industrial production, transportation and other key segments. However, countries may also mitigate challenging domestic carbon-reduction targets by investing in "clean development mechanisms" (CDMs) in developing nations. This means participating in carbon credit projects that would not have occurred in the absence of Kyoto. The UN must certify such projects as CDMs for the projects to qualify for Certified Emission Reduction (CER) credits. Examples of these projects include renewable energy power plants, waste-to-energy plants, re-forestation initiatives and other activities.
Carbon credits earned through investments in CDMs can be applied against a nation's or a company's own GHG reduction targets, ultimately contributing to aggregate reductions of emissions on a global scale. Investors participating in the carbon credit market will benefit from credits monetized by national governments and paid out as investment gains.
In today's global economy, any company with operations or business interests in countries that are signatories to the Kyoto Protocol must take into account regulations limiting GHG emissions. In some cases, companies will find emissions directly regulated, with legal and financial ramifications if targets are not met. Even companies that are not directly regulated under the Kyoto agreements must take to heart the marketing and public relations implications of non-compliance, given the widespread public support for Kyoto.
The benefits of the carbon credit market are many, but there are also a number of genuine risk management concerns. Chief among them is the political risk associated with projects in developing and potentially unstable parts of the world.
Investors could face expropriation, nationalization or confiscation of a project, its assets and the stream of carbon credits it would generate. Political violence or civil unrest could also damage a project or prevent it from operating effectively.
A related risk is the potential of contract frustration by a government ministry or agency with the responsibility to approve the issuance of carbon credits. The possibility exists that a controlling agency might deny the issuance of credits for purely political reasons, rather than bona fide commercial reasons, preventing investors from realizing anticipated returns. There may also be a need for more comprehensive credit insurance associated with the export of goods and services, which can include the sale of carbon credits.
Investors must also contend with the spectre of regulatory or legal risk. Since the carbon credit market would not exist in the absence of the Kyoto Protocol, any significant change in the international regulatory or legal framework related to Kyoto -- such as, for example, expiration and non-renewal of Kyoto -- would have an immediate and profound impact on the economic viability of carbon credit projects.
Finally, the global response to Kyoto is driving the development of many technological innovations. As is generally the case when new technologies are involved, there are risks that innovations may not perform as designed, with resultant financial loss to investors.
Insurance carriers with sufficient global capabilities and product portfolios will be important participants in the continued viability and growth of the carbon credit market. Political risk coverages of the types needed to insure CDMs have long been staples of multi-national risk management programs. Insurance products for emerging and alternative energy technologies are already available from forward-looking insurance carriers, with future products in the pipeline.
Whatever the rewards and risks of the carbon credit market, the most encouraging aspect is a recognition that the private sector can be a progressive force in achieving important environmental goals. The Canadian experience is an example.
Canada has always been a society with highly developed environmental sensibilities, due largely to the country's transcendent natural beauty. As a signatory to the Kyoto Protocol, those sensibilities are now codified in environmental regulation. However, many Canadian companies have long demonstrated genuine environmental awareness, even extending to the adoption of voluntary commitments to reduce their carbon footprints. For many Canadian companies, participation in the carbon credit marketplace is providing an important bridge to a greener future, while ensuring economic viability and competitiveness in the present.
Global insurers with the presence, knowledge and resources to support this effort will be challenged to deliver innovative products to help manage the risks of a shifting environmental paradigm. If history is any guide, we have no doubt the industry will be up to the challenge and will be a major contributor to the greener future that all of us hope to achieve.
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