South African financial services specialist Sterling Waterford Securities, 66% owned by previously disadvantaged individuals, is breaking new ground in the international investment field with the planned launch of environmentally linked derivatives.
Announcing the initiative on Wednesday, Sterling Waterford director Greg Paterson-Jones said the group’s upcoming carbon credit note (CCN) issue will be a world first, while also providing the first formal trading facility for environmental derivatives.
A CCN is a fully underwritten obligation (in the form of a note or bond) to deliver a carbon credit — a registered certified emission reduction (CER) — to a purchaser at a date in the future. It is deemed a derivative because its value derives from the underlying CER.
“Essentially the launch of the CCNs revolves around the Kyoto protocol, the global initiative to address the ever-increasing problem of greenhouse gas emissions around the globe and the effect these emissions have on climate, environment and economy,” explained Paterson-Jones.
“Guidelines set by the Kyoto protocol — using ‘cooperative mechanisms’ — either reward corporates for the reduction of industrial emissions or penalise individual companies failing to reach pre-determined targets.
“Companies that achieve targets earn emission-reducing ‘credits’, and once these carbon credits are registered they have a tradeable value and can be bought and sold. For instance, companies that do not adhere to emission levels can buy carbon notes to offset likely penalties.”
As an example, Paterson-Jones said that for French aluminium producer Pechiney, one of its aluminium smelters can use more electricity than a small European city, and this electricity mostly is created by burning coal or oil.
Pechiney will have to buy carbon credits to offset this huge emission problem if it cannot change its aluminium production process. Not only this, the company’s electricity suppliers will have the same obligation.
“If they don’t change to a lower emission electricity source, they will have to buy credits elsewhere. If they don’t buy them soon, they will be scrambling for credits when the deadline approaches. Their carbon liabilities are recognised as a balance sheet liability and will affect their net asset value and hence their stock valuation. It is a very real issue.”
Paterson-Jones said the market for CCNs is brand-new, and the group is looking at providing the first liquidity mechanism — thus facilitating trading.
Estimates show the market could be worth between $15-billion and $20-billion per year in the near future, a sizeable niche representing half the annual trade on the JSE Securities Exchange South Africa.
Sterling Waterford hedges the delivery of the carbon credit by contracting with individual projects in a variety of countries through established intermediaries in the emission reduction market for the delivery of an amount of CERs corresponding to the notes issued.
The group’s first foray into the CCN market will see the launch of a small zero coupon bond issue totalling about $10-million, with a 2008 maturity, in early June, Paterson-Jones said. Currently the group is in the pre-marketing stage of the issue, with the formal roadshow set to begin in about three weeks’ time.
The first issue will be an initial “test” of the market, he explained. If successful, the group will launch a second note issue totalling about $50-million in six months’ time.
The issue will be aimed at large South African institutions with international operations — those that might have clients with carbon liabilities, that would potentially be active in the secondary carbon market, he added.
The bond issue will see 100% of the capital exposed to the underlying value of carbon credits. Sterling Waterford does assume risk in the investment, but this is managed through a variety of individual project insurance policies to ensure full delivery of the CER on the effective date.
A CCN is fully transferable and saleable. The derivative is tradable on the open market and Sterling Waterford will facilitate transfer ownership of the CCN once a willing buyer is found.
Paterson-Jones said CCN pricing is not solely determined by supply and demand because carbon emissions are legislated, and specific penalties apply to failure to reduce carbon emissions. As a result, there will be a price floor under the instruments depending on the level of the penalties, as well as the marginal abatement costs incurred by a company — representing the cost to the company of changing its fuel sources and/or processes.
A second CCN offering by Sterling Waterford is planned for the third quarter of 2004 and could be followed by a variety of hybrid products based on CCNs. — I-Net Bridge