Db-climatechange Full Paper

Investing in Climate Change 2009 NECESSITY AND OPPORTUNITY IN TURBULENT TIMES OCTOBER 2008

http://dbadvisors.com/climatechange

Climate Change Investment Research

Mark Fulton Managing Director Global Head of Climate Change Investment Research: New York [email protected] +1(212) 454-7881

Bruce M. Kahn, PhD Director Senior Investment Analyst: New York [email protected] +1(212) 454-3017

Mark Dominik Vice President Senior Research Analyst: London [email protected] +44(20) 754-78943

Emily Soong Research Analyst New York [email protected] +1(212) 454-9227

Lucy Cotter Research Analyst London [email protected] +44(20) 754-75822

Jake Baker Research Analyst New York [email protected] +1(212) 454-2675

We would like to thank the following Deutsche Bank contributors: Jed Brawley, Paul Buchwitz, Loretta Dennett, Gem Dematas, Josh Feinman, Suleyman Gokcan, Theresa Gusman, Mark C. Lewis, Nektarios Kessidis, Michael Marcus, Sabine Miltner, Adam Sieminski, Michele Shehata, John Willis, Joe Wong, and Muttasif Zaidi. *Bar chart in cover image sourced from New Energy Finance.

Investing in Climate Change, One Year On Kevin Parker Member of the Group Executive Committee Global Head of Asset Management

The necessity: Tackling carbon. One year ago, we published Investing in Climate Change: An Asset Management Perspective. We argued that the growing investment opportunities in climate change were driven by long-term mega-trends that would continue into the foreseeable future. One year on, the absolute necessity to act now to mitigate and adapt to climate change is even more urgent, and the opportunities generated by the sector continue to increase. New evidence has established that carbon in the atmosphere has reached an 800,000 year high (see graph below). The leading scientific research shows that we are careening towards the tipping point where average global temperatures are likely to rise by 2°C or more. Beyond 450 ppm CO2e, it is increasingly likely that a series of macro-climatic shifts will set up a self-sustaining cycle of rapid global warming. Without significant and immediate action, or some unforeseen miracle, this tipping point stands no more than 15 to 20 years away. The research in this report is driven by these two imperatives of necessity and opportunity. We have a new challenge, however, added to the mix: how to find the financing to develop and deploy the technologies we need to mitigate and adapt to climate change. Trillions of dollars have already been wiped off the global balance sheet by falling asset values, and the world’s major economies are heading into recession. Investors understandably lack confidence at the moment and governments, who are dealing with the contingencies of the banking challenge, will be reluctant to commit further capital to the climate change sector for the foreseeable future. Today’s atmospheric CO2 concentrations are higher than they have been for at least 800,000 years

Atmospheric CO2 concentration, ppm

400

Concentration in 2008: 385 ppm

380 360 340 320 300 280 260 240 220 200 180 160 800,000

700,000

600,000

500,000

400,000

300,000

200,000

100,000

0

Years before present Source: D. Lüthi,“High-resolution carbon dioxide concentration record 650,000-800,000 years before present,” Nature, 15 May 2008.

i

Investing in Climate Change 2009

Continued on next page.

Governments around the world can, however, take a big step in the right direction by agreeing to price the carbon externality. This would mean a global carbon tax in one form or another, such as cap-andtrade. The aim must be to create a clear long-term regulatory regime that determines a market-driven cost of carbon while at the same time encouraging the development of alternatives. If governments recognize the necessity of creating the right regulatory environment, investors will recognize the opportunity and step in. There are numerous examples of governments already heading in the right direction. The recent renewal of the Production Tax Credit and Investment Tax Credit in the US assured solar and wind energy the regulatory certainty and proper incentives for continued development of the sector. And one need only look to Germany’s Renewable Energy Sources Act for an example of true commitment to climate change mitigation. Germany has created a friendly environment for renewable energies to power up and connect to the grid through its system of feed-in tariffs and transparent and enforceable policies for renewable development. Any successful regulatory frameworks must have these clear, comprehensive procedures to incentivize industry and create capital formation over the longer term. Achieving this kind of regulatory consistency on a global scale is a massive project, of course. But the world cannot wait. The potential economic, social and political upheavals that could result from a failure to tackle carbon emissions may be irrevocable. Severe though it is, the current financial crisis can eventually be fixed, and should not be used as an excuse for inaction.

ii

Investing in Climate Change 2009

Editorial

Mark Fulton Global Head of Climate Change Investment Research

The opportunity: Low carbon prosperity. As Kevin Parker points out in his opening letter, this is no time for governments to back away from climate change initiatives in the face of tough economic conditions. The necessity to encourage mitigation and adaptation remains urgent. For investors, this creates opportunity. Constructing the right regulatory environment is a long-term goal for governments. Over the short-term, however, there is an economic slowdown to contend with. If governments are going to stimulate their economies, as many almost certainly will over the next year or two, they should support a climate-friendly approach. There are numerous reasons for doing this. Organization for Economic Co-Operation and Development politicians are talking a lot about energy security, which can be made climate-friendly when focused on renewables and clean coal technologies. Energy efficiency technologies are obviously highly desirable in economies facing recession. Infrastructure stimulus can be tied directly to climate-sensitive sectors such as power grids, water, buildings and public transport. Climate change industries, in fact, present a vast new field for the creation of new technologies and jobs. The current economic downturn presents governments with a historic opportunity to “climate proof” their economies as they upgrade infrastructure as a core response to the economic downturn. This is just one of the reasons why we continue to expect a long-term secular growth trend in many climate change opportunities. In the energy sector alone, the International Energy Agency estimates that about $45 trillion will be needed to develop and deploy new, clean technologies between now and 2050. This represents nothing less than a low-carbon Industrial Revolution. Writers and policymakers from across the political and intellectual spectrum have recognized the potential this holds for long term job growth and industry creation. The debate around climate change is shifting away from cost and risk towards the question of how to capitalize on exciting opportunities. Here again, the financial disruption of the last few months is a potential distraction. One consistent theme to emerge from the market turmoil is that there are no safe havens just now. Climate change, like almost all other asset classes, has not been spared from the broader market downturn. So where is the new investment capital going to come from? We believe that for investors, climate change has a built-in advantage over most other sectors. Its regulated markets hold the promise of enormous secular growth. In the long-term, the earnings of companies and projects that are supported by governments for policy reasons are more trustworthy. There is, in short, a significant safety net effect here. In the first part of our report, we determine that climate change is well-suited for public equity markets and particularly private markets such as venture capital, private equity, infrastructure and timberland. In the second part of our report, we examine some of the technical aspects of how regulation interacts with the underlying dynamics of technology costs and energy prices. This compendium provides an analytical framework that investors can use to understand the climate change opportunity.

iii

Investing in Climate Change 2009

Table of Contents: Investing in Climate Change 2009

Complete whitepaper and individual chapters available online. http://dbadvisors.com/climatechange

List of exhibits and boxes

v

Part I. Necessity and Opportunity in Turbulent Times I.

Investor summary

1

II.

What is new in climate change investing?

6

III.

Low carbon prosperity

18

IV.

The credit crisis and climate change investing

26

V.

Investment attributes of the climate change universe

36

VI.

Market sizing: Scarce resources and the size of the markets

54

VII. Carbon and energy prices

68

Part II. An Analytical Perspective I.

Investor summary

92

II.

Government policies & regulation: An analytical framework

96

III.

The investor perspective: Risk & Return around commercial breakeven

116

IV.

Clean technologies: Deepening, broadening and developing

128

Appendix

iv

I.

Kevin Parker: Perspective on carbon prices

137

II.

The science of climate change

138

III.

Carbon Capture and Storage (CCS) & Forestry

143

IV.

Recent regulatory developments

149

V.

Critical factors for achieving commercial breakeven

152

Investing in Climate Change 2009

List of Exhibits & Boxes: Investing in Climate Change 2009 We draw from multiple sources to illustrate our thesis.

Part I. Necessity and Opportunity in Turbulent Times What is new in climate change investing?

Exhibit 2.1: Exhibit 2.2: Box 2.1: Exhibit 2.3: Exhibit 2.4: Exhibit 2.5: Box 2.2:

The Four Pillars of Climate Change Today’s CO2 concentrations are higher than they have been for at least 800,000 years The EPICA Project Oil price trends Trading Volumes on the EU-ETS are growing Phase-II EU Carbon Prices have been trading near or above €20 Geo-planetary Engineering – Looking for ‘silver bullet’ solutions to climate change?



Box 2.3:

Advances in solar storage technologies at MIT

Low carbon prosperity

Box 3.1: Exhibit 3.1:

Energy security A low carbon Industrial Revolution is urgently needed

The credit crisis and climate change investing

Exhibit 4.1: Exhibit 4.2: Exhibit 4.3: Exhibit 4.4: Exhibit 4.5: Exhibit 4.6: Exhibit 4.7: Exhibit 4.8: Exhibit 4.9: Exhibit 4.10: Exhibit 4.11:

The climate change universe has historically outperformed the world index The ratio of the climate change universe to the world index The climate change universe shows variable correlation to financial markets The correlation of the climate change universe to financial markets over different timeframes The correlation between energy and the solar sector Historical P/E of the DWS Climate Change Alpha Pool vs. the MSCI World Index Distribution of historical P/E of the DWS Climate Change Alpha Pool Leading wind companies’ P/E with one year forward earnings Leading solar companies’ P/E with one year forward earnings VC investment: Informatiom Technology vs. cleantech ($ billion) Sub-sector VC / PE investment by stage

Investment attributes of the climate change universe

v

Exhibit 5.1: Exhibit 5.2: Exhibit 5.3: Exhibit 5.4: Exhibit 5.5: Exhibit 5.6: Exhibit 5.7: Exhibit 5.8: Exhibit 5.9: Exhibit 5.10: Exhibit 5 11: Exhibit 5.12: Exhibit 5.13:

Climate change: An integrated framework of mitigation and adaptation The climate change investment universe The illustrative lifetime of an identifiable investment theme Economic correlations of climate change sectors Climate change sector correlations with real GDP growth Specific investment strategies for climate change The climate change universe asset class fit The performance of carbon beta leaders vs. laggards The spread of market cap weighted returns of the climate change universe The volatility of the climate change universe The investment spectrum for the private market climate change universe U.S. Private Equity Index® Compared to Other Market Indices for the One Year Ended December 31, 2007 What is infrastructure investing?

Investing in Climate Change 2009



Exhibit 5.14: Exhibit 5.15: Exhibit 5.16: Box 5.1: Exhibit 5.17: Exhibit 5.18 Exhibit 5.19: Exhibit 5.20:

The low volatility of infrastructure investing Infrastructure investing: Relative placement along risk return spectrum Timberland investing: Relative placement along risk return spectrum Efficient frontier: Balancing risk and return Inputs for efficient frontier analysis Efficient frontier: Adding climate change can potentially add benefits to portfolios Traditional portfolio 5% allocation of each climate change sector Comparison of traditional portfolios with climate change strategies

Market sizing of the clean tech universe

vi

Exhibit 6.1: Exhibit 6.2: Exhibit 6.3: Exhibit 6.4: Exhibit 6.5: Exhibit 6.6: Exhibit 6.7: Exhibit 6.8: Exhibit 6.9: Exhibit 6.10: Exhibit 6.11: Exhibit 6.12: Exhibit 6.13: Exhibit 6.14: Exhibit 6.15: Exhibit 6.16: Exhibit 6.17: Exhibit 6.18: Exhibit 6.19: Exhibit 6.20: Exhibit 6.21: Exhibit 6.22: Exhibit 6.23: Exhibit 6.24: Exhibit 6.25: Exhibit 6.26: Exhibit 6.27: Exhibit 6.28. Exhibit 6.29: Exhibit 6.30: Exhibit 6.31: Exhibit 6.32: Exhibit 6.33: Exhibit 6.34: Exhibit 6.35: Exhibit 6.36: Exhibit 6.37:

Low carbon projected growth of renewable power generation Water consumption and population growth Demand and production of cereal food balances by 2030 Wind, solar, biofuels and fuel cells expected to see $254.5bn of global revenue by 2017 Total solar PV installations by 2013, Global (MW) Total solar PV installations by technology by 2013, Global (MW) Crystalline silicon continues to lead by global market share through 2013 - $64.1bn Wind power installations, Global (MW) Wind penetration by 2030, % of total generating capacity (MW) Offshore wind projects Energy storage market size by sector, Global $bn Transportation energy storage market size, Global 2004 – 2012 Global sales of products incorporating nanotechnology by sector ($M) Biofuels produced, Global (Gallons) Ethanol production mostly from grain feedstocks except for Brazil, Global Biodiesel production, Global Global new nuclear capacity planned (GW) Planned carbon capture & storage (CCS) projects Annual worldwide cleantech investment is expected to reach $450bn by 2012 and $600bn by 2020 Global venture capital investments, 3Q 2008 Global venture capital investments by region, 3Q 2008 Total global new investment in clean energy 2007 & 1H 2008 Global new investment by technology 2007 & 1H 2008, $M New investment by region (VC/PE, Public Markets, Asset Finance), 2004 vs. 2007 Global PE/VC transactions in clean energy companies, $M VC/PE investment by technology, $M Global asset financing, $M Asset financing investment by technology, $M Global transactions on public markets, $M Public market investment by technology, $M Growth of carbon markets: reported transaction volumes from 2003-2008, Gt CO2e Potential total size of carbon markets in 2020 Sustainable energy funds by type and asset class, March 2008, $M Carbon funds, 2004 – 2007, $M Estimated number of climate change-related mutual funds/ETFs, March 2008 Estimated number of green hedge fund managers Estimated number of private equity funds, September 2007

Investing in Climate Change 2009

Carbon and energy prices Exhibit 7.1: Exhibit 7.2: Exhibit 7.3: Exhibit 7.4: Exhibit 7.5: Exhibit 7.6: Exhibit 7.7: Exhibit 7.8: Exhibit 7.9: Exhibit 7.10: Exhibit 7.11: Exhibit 7.12: Exhibit 7.13: Exhibit 7.14: Exhibit 7.15: Exhibit 7.16: Exhibit 7.17: Exhibit 7.18: Exhibit 7.19: Exhibit 7.20: Exhibit 7.21: Exhibit 7.22: Exhibit 7.23: Exhibit 7.24:

More than half of greenhouse gas emissions came from fossil fuel combustion in 2005 CO2 emissions from fossil fuel combustion have increased dramatically since the beginning of the Industrial Revolution Over time, the US has transitioned from dirty, inefficient fossil fuels to cleaner, more efficient fossil fuels Energy demand is expected to increase significantly by 2030 The West Texas Intermediate crude oil price has been volatile The majority of world oil reserves are concentrated in OPEC countries The finding costs for oil are increasing The finding costs of oil and oil price are related Market views on long-term oil prices as of September 2008 (real $) The Henry Hub natural gas price The global supply/demand balance for LNG The natural gas trade is increasingly global Market views on long-term natural gas prices as of September 2008 (real $) Newcastle coal price has recently spiked The rapid expansion of coal use is likely to continue Market views on long-term coal prices as of September 2008 (real $) Oil and gas prices have been correlated with EUA prices In the long-term, carbon and energy prices are likely to increase Supply and demand equilibrium for substitutable fuels The effect of carbon prices on equilibrium for substitutable fuels Scaling capacity leads to greater uptake of clean energy Supply shock: Constraints (peak oil scenario) Supply shock: Surplus (coal glut scenario) Demand expansion (emerging market growth scenario)

Part II. An Analytical Perspective Government policy & regulation Exhibit 2.1: Box 2.1: Exhibit 2.2: Exhibit 2.3: Exhibit 2.4: Exhibit 2.5: Exhibit 2.6: Box 2.2: Exhibit 2.7: Exhibit 2.8: Box 2.3: Exhibit 2.9: Exhibit 2.10: Exhibit 2.11:

vii

The longer the world waits before beginning significant mitigation, the more radical the cuts need to be Climate change: mitigation, abatement and cost Different regulatory policies impact different parts of the greenhouse gas mitigation policy curve There are three broad sets of policy options available Examples of carbon pricing in practice Looking for a global carbon price Examples of traditional regulation in practice Renewable Portfolio Standards (RPS) in the US 32 US states have Renewable Portfolio Standards Examples of innovation policy in practice Feed-in tariffs Uptake of regulatory policy in 60 countries As mitigation options reach commercial breakeven, carbon price can replace most other incentives Different regulatory policy sets impact different parts of the greenhouse gas mitigation policy curve

Investing in Climate Change 2009

From the policy curve to the commercial breakeven opportunity

Exhibit 2a.1: Building the commercially viable investor opportunity curve

The investor perspective: Risk & Return around commercial breakeven

Exhibit 3.1: Box 3.1: Exhibit 3.2: Box 3.2: Exhibit 3.3: Exhibit 3.4: Exhibit 3.5: Exhibit 3.6:

Dynamics of commercial breakeven Calculating LCOE Key drivers of LCOE for a specific technology Understanding electricity markets Developing the investor’s spreadsheet Using the investor’s spreadsheet to illustrate the risk/return drivers of alpha Energy price, carbon and regulatory risk/return are engaged in a dynamic interaction The curve shifts down if oil and energy prices increase



Exhibit 3.7:

Different mitigation opportunities have different sensitivities to changes in oil price

Clean technologies: deepening, broadening and development

Exhibit 4.1: Exhibit 4.2: Exhibit 4.3: Exhibit 4.4: Exhibit 4.5:

Understanding mitigation through the stabilization triangle and Pacala and Socolow’s ‘wedges’ Combining wedges to achieve mitigation targets The technology development pipeline Examples of technological developments Mapping the nanotechnology development pipeline



Exhibit 4.6:

Mapping the solar technology development pipeline

Appendix: The science of climate change

Exhibit A2.1: The anthropogenic greenhouse effect results from multiple sources. Exhibit A2.2: Atmospheric greenhouse gas concentrations are on the rise Exhibit A2.3: Range of warming scenarios



Exhibit A2.4: Examples of potential impacts of climate change

Appendix: Carbon Capture and Storage (CCS) & Forestry

viii

Exhibit A3.1: Mitigation measures below€€40/ton in forestry could save 7.9 GT CO2e by 2030 Exhibit A3.2: Economics of early commercial CCS projects Exhibit A3.3: BCG estimates that the costs of CCS will be significantly lower than those developed by McKinsey

Investing in Climate Change 2009

Part I. Necessity and Opportunity in Turbulent Times • Climate change is a large and growing investment opportunity. There have been significant and meaningful developments since we published Investing in Climate Change: An Asset Management Perspective last year. • Climate change sectors have been caught up in the volatility of the credit crisis. We believe that given their regulatory support, they should eventually recover well with value established in many sectors.



• We believe climate change when combined with energy security will play a role in government efforts to stimulate economies in 2009. We do not expect governments to back off the science and its implication for action, which remains a necessity. • The opportunity suits most asset classes. • Energy prices have been very volatile. In the long-term, we expect high oil and gas prices, weaker coal prices and we see carbon prices, as they are adopted, being the key backstop to ensuring clean energy is deployed. In this paper, we examine the climate change investment universe. This paper reviews the arguments we made last year in Investing in Climate Change: An Asset Management Perspective, and updates them, given the current market context. The components we examine in detail in this paper are:

II. What is new in climate change investing? The investment opportunity in climate change has become broader, deeper, and more complex since we published Investing in Climate Change: An Asset Management Perspective. In the last year: · Energy prices have experienced increased volatility; · Some renewables have moved closer to commercial breakeven with conventional energy as their costs have come down; · Some progress has been made negotiating the successor to the Kyoto Protocol; · Emissions trading regimes such as the EU-ETS have been strengthened; · Cap-and-trade is spreading to new geographies, such as New Zealand, Australia, and some US states (through the adoption of the Regional Greenhouse Gas Initiative); · The climate change policy response in the US is gathering momentum; · The climate change technology universe has grown leading to more opportunities for investors. As a result, we have expanded some of the definitions in our Four Pillars of Climate Change Investment, and looked at developments in the past year in this context (See Ex. 2.1) · Government policy in climate change remains active. Government priorities, such as energy security and providing a “green collar” economic stimulus are contributing to the climate change debate; · Carbon in Europe has been trading near or above €20s, new regions are establishing cap-and-trade regimes or discussing them, and international negotiations are cautiously moving forward towards a global agreement to succeed Kyoto. Commodity prices – particularly energy prices – have become more prominent in discussions of climate change investing; · Corporations have increased activity in climate change over the past year and the investment universe has expanded; · Climate change technologies have developed and broadened.

1

Investing in Climate Change 2009

The scientific debate over climate change · One of the most important scientific announcements in our view was the updating of the ice core history, now dating back 800,000 years, depicting the extraordinarily high and previously unseen levels of carbon that we are now facing; (See Ex. 2.2) · We believe that the credible scientific debate is over. Indeed, as more dynamic models of climate change are developed, we expect to see estimates of the danger of global warming increase.

III. Low carbon prosperity Low-carbon prosperity: an answer to the credit crisis and energy security? · Over the course of the past few months, there has been more discussion of the potential for stimulus in climate change-related sectors to contribute to lifting the economy out of the current morass. We believe this is a significant opportunity; · Energy security has also been a linked issue for policy makers in terms of long-term availability of energy and the economic implications of securing it. · Energy efficiency is also a key way to deliver climate change mitigation with a long-term payback. Political support for a “low-carbon Industrial Revolution” · Policymakers across the political spectrum have also emphasized the potential for low-carbon prosperity; · In the US, both Presidential candidates have talked about renewable energy in particular as a source of growth and job creation; · The UK Prime Minister has stated that a low-carbon economy can be a new engine of productivity and economic growth; · The German chancellor has argued that climate change can be a “win-win situation” if Germany invests in growing clean industries and creating new jobs; · Chinese officials have underscored the importance of environmental protection in China’s development; · The Indian Prime Minister has said that sustainable development can go hand-in-hand with India’s growth objectives. · In the very long-term, the underlying climate change sectors have the potential to grow to very large scale – in the multi-trillion dollar energy, automotive and industrial markets.

IV. The credit crisis and climate change investing The effect of the credit crisis on climate change investment sectors · After generally outperforming in 2006 – September, 2007, listed equity climate change sectors lost ground against the market when the more pronounced credit crisis correction took hold from May 2008 onwards; (See Ex. 4.1, 4.2) · In September 2008, many renewable stocks were aggressively sold off early in the month as liquidity considerations affected markets. Weaker energy prices led them lower as the regulatory support in the US for the Production Tax Credit (PTC) and the Investment Tax Credit (ITC) wavered in particular; · The Troubled Asset Relief Act of 2008 (TARP) package in the US did extend solar and wind regulatory support, but for now markets are not focusing on fundamental support factors for company earnings; · At a valuation level, the DWS climate change alpha pool P/E has only been marginally above the MSCI World, and is now looking more attractive following the correction; (See Ex. 4.6) · At a sector level, there have been signs of inflated valuations, with solar being the most noted example. That is now disappearing and the credit crisis correction looks to be delivering attractive valuations given strong regulatory support for earnings;

2

Investing in Climate Change 2009

Part I. Necessity and Opportunity in Turbulent Times · From a credit supply perspective, which will affect public and private markets, certainly some companies and projects will find it difficult to raise debt capital, increasing reliance on equity and having to price for that. We believe that the more dependable regulatory environment for climate change will continue to see money move towards climate change sectors in private markets.

V. Investment attributes of climate change Based on the key drivers in the climate change space, we have defined four broad sectors for climate change investment (See Ex. 5.2) ·Clean Energy: (Power Generation, Infrastructure, Power Storage, Transport and Biofuels); ·Environmental Resource Management: (Water, Agriculture, Waste Management); ·Energy and Material Efficiency: (Advanced Materials, Building Efficiency, Power Grid Efficiency); ·Environmental Services: (Environmental Protection, Business Services); ·Combined, these sectors represent a fast-growing multi-hundred billion dollar marketplace, which offers numerous and compelling investment opportunities. Investment Attributes ·We also looked at the arguments around whether climate change would persist over time or ultimately, simply become assimilated into markets. All Alpha factors will fade into the background eventually. (See Ex. 5.3) Therefore, it becomes a question of how long the trend can last. Given the 40-50 year investment horizon and the size of the problem – $45 trillion of investment needed in energy markets alone – we believe that climate change will remain the source of identifiable Alpha for many years ahead; ·Key climate change sectors exhibit low-moderate correlation to the general economy; ·Listed equity markets have shown high correlation to the MSCI World Index, industrial companies and depending on the composition of the index, to small cap companies. While water and agriculture might be expected to show low correlation over the long term, more recently they have been caught up with the general market correction; (See Ex. 5.4, 5.5) ·One correlation that has attracted investor attention is renewable energy with oil prices. There is reason to expect renewables to track on the upside as rising oil prices make renewables more attractive on a breakeven analysis. On the downside, so long as regulatory support is there, renewables should outperform traditional energy sources in the long-term. The investment attributes of climate change suit most asset classes: ·Venture capital, private equity, infrastructure and public equity; ·Hedge funds can create strategies across this space; ·The technology drivers of climate change are particularly suitable to venture capital (VC) and private equity (PE). (See Ex. 5.5) The effect of climate change sectors on asset classes and portfolios ·Looking at the investment attributes of climate change-related sectors, we can see that these are suited to the broad array of investment strategies. This includes listed equities, VC/PE for new technologies, and infrastructure for scaling up many areas of the climate change universe; ·As an example of how climate change affects portfolios, we have looked at the effect of an “efficient frontier” of including renewables, water and agriculture at different levels of asset allocation over the 2006-to-date timeframe. Given historic risk/return tradeoffs, the frontier shifts up by nearly 1% if 5% of funds are allocated into each of these sectors. (See Ex. 5.18)

3

Investing in Climate Change 2009

VI. Market sizing: Scarce resources and the size of the markets A number of factors are acting together to create the climate change opportunity. Global population and GDP are rising fast · The IEA calls for $45 trillion of investment in industry technologies by 2050; · The growing global population and increasing wealth of that population will lead to significant increases in demand for water, food and energy; · YTD 2008 VC/PE investment figures depict a continuously growing and healthy climate change sector; · As a result, from a ~$150 billion market in 2007, investment across capital markets is projected to reach $650 billion p.a. over the next 20 years; · All this has led to a deepening and broadening of the opportunities for investors.

VII. Carbon and energy prices Global coal, oil and gas use – and their contributions to anthropogenic greenhouse gas emissions · Three fossil fuels – coal, oil and gas – supply 88% of the world’s primary energy and are responsible for about 60% of global greenhouse gas emissions. Consumption is set to rise as the world’s population grows and wealth increases; · Over the past 200 years, as the world has gone through a series of energy transitions, the most notable energy quality improvements have been made in volumetric density: there is more energy in a given volume of oil than there is in a given volume of coal or wood; · Some aspects of energy quality have been harmed by the transitions in energy over the past 200 years, most notably spatial distribution, financial risk, risk to human health and amenability to mass storage; · While improvements have been made in emissions intensity of energy (emissions per Joule) over the past 200 years, renewable energy is the final phase of reducing emission intensity towards zero; · There are energy quality problems associated with renewables. Very large industries are expected to emerge to deal with problems associated with intermittency, gravimetric density, volumetric density and ease of transport of renewables. This will be a key area for investors as renewables grow to scale. Developments in coal, oil and gas prices · Fossil fuel prices have been trending up in the last few years, recently spiking but then collapsing; · In the long-run (beyond 2015), oil prices are expected to return to above $90 a barrel (in real terms), gas prices are expected to return to at least $9/MMBtu (in real terms), and coal prices are expected to fall back to a $50- $75/ton range (in real terms); · Coal prices in particular will have serious implications for greenhouse gas mitigation and carbon pricing. The dynamic interrelationship of coal, oil gas and carbon · Carbon price, the supply/demand balance of each of the three most important fossil fuels, and the scaling capacity of renewables are intricately linked in a dynamic relationship; · Currently, the market has tended to correlate carbon prices in Europe with oil and gas prices, because carbon is used primarily to motivate fuel switching in the EU ETS. In the long-run, we do not expect that to hold, especially as coal becomes more plentiful; · In the long-run, we expect coal prices to drop, while prices for oil, gas, electricity, road transport fuels and carbon rise. This is due to a complex interrelationship between key drivers of energy demand and supply: the growth of emerging markets, peak oil and a potential coal glut. · In effect, carbon prices will become the crucial backstop for clean energy.

4

Investing in Climate Change 2009

This page is left intentionally blank

II What is New in Climate Change Investing? • Government policy in climate change remains active. Government priorities, such as energy security and providing a ‘green collar’ economic stimulus are contributing to the climate change debate. • Carbon in Europe has been trading near or above €20s, new regions are establishing cap-and-trade regimes or discussing them, and international negotiations are cautiously moving forward towards a global agreement to succeed Kyoto. Commodity prices – particularly energy prices – have become more prominent in discussions of climate change investing. • Corporations have increased activity in climate change sectors over the past year and the investing universe has expanded. • Climate Change technologies have develped and broadened.

One year ago, we published Investing in Climate Change: An Asset Management Perspective. In that paper, we: · Recognised that there is overwhelming scientific evidence that climate change is happening; · Acknowledged that companies and investors are quickly realizing that climate change is not merely a social, political or moral issue, but an economic and business issue that is translating into a wave of investment and innovation; · Reviewed some of the broader trends within which climate change is situated, including energy security; · Provided investors with an overview of the climate change investment universe; · Explained that climate change investing is primarily driven by economic returns, but has socially responsible attributes. · Discussed the large-scale investing opportunity represented by climate change; · Examined the expanding range of climate change investment strategies available; · Set out the four pillars of climate change investment, which were: 1. Government environmental policy and regulatory drivers; 2. Carbon prices; 3. The corporate response: competitive response and risk mitigation; 4. Low-carbon technologies and services.

What has changed since last year? For investors, we have separately looked at recent financial market events in Chapter IV of Part I. More fundamentally, there have been developments in each of our four pillars of climate change since we published Investing in Climate Change: An Asset Management Perspective last year. We examine these in this chapter. There have also been important advances in: · The science of climate change, and regulation; · The growing awareness that climate change investment can exert a positive impact on economies; · More emphasis on energy security; · Carbon and commodity markets, especially energy prices; · And the scale of opportunities available to investors, in terms of expanded breadth and depth in company opportunities and underlying technologies. We have therefore adapted and expanded our views of the pillars of the climate change investment universe. See exhibit 2.1.

6

Investing in Climate Change 2009

EX 2.1: The Four Pillars of Climate Change Our updated view of the climate change investment universe

The Four Pillars of Climate Change Investment

Government environmental policy and regulatory drivers

Carbon and energy prices

- Science - Voters - Low Carbon prosperity - Energy security

Corporate response: competitive response and risk mitigation

Low carbon technologies and services

The scientific evidence base Source: DeAM analysis, 2008.

In the following sections, we review the most important developments in our pillars over the course of the past year.

Government environmental policy and regulatory drivers New Science: Carbon at 800,000 year highs We review the scientific basis for climate change in Appendix II. But one advance in our understanding of climate change that was made last year deserves special mention. Research published in Nature in May, 2008 revealed that today’s concentrations of CO2 are the highest in 800,000 years1 – longer than the history of human life on earth. The publication adds 150,000 years to the previous record. See exhibit 2.2 and box 2.1.

D. Lüthi, “High-resolution carbon dioxide concentration record 650,000-800,00 years before present,” Nature, 15 May 2008.

1

7

Investing in Climate Change 2009

II What is New in Climate Change Investing?

EX 2.2: Today’s CO2 concentrations are higher than they have been for at least 800,000 years

Atmospheric CO2 concentration, ppm

400

Concentration in 2008: 385 ppm

380 360 340 320 300 280 260 240 220 200 180 160 800,000

700,000

600,000

500,000

400,000

300,000

200,000

100,000

0

Years before present Source: D. Lüthi,“High-resolution carbon dioxide concentration record 650,000-800,000 years before present,” Nature, 15 May 2008.

The current atmospheric concentration of CO2 is around 385ppm,2 which represents an increase of nearly 40% over preindustrial levels of 280 ppm. Under business as usual projections, atmospheric greenhouse gas concentrations, measured on a CO2-equivalent basis – which take into account both CO2 and other gases, such as methane and N2O that contribute to global warming–are set to rise beyond 600ppm by 2050. There is general consensus in the scientific community that this cannot be allowed to take place, at the risk of catastrophic warming. The scientific evidence appears to be overwhelming on any credible basis. New climate models, which incorporate nonlinear feedback loops, demonstrate that at each heightened concentration of greenhouse gases, the potential warming is much higher than originally thought.

Hansen, J (2008) NASA’s Goodard Institute for Space Studies, Target Atmospheric CO2: Where Should Humanity Aim?.

2

8

Investing in Climate Change 2009

Box 2.1: The EPICA Project

Photo: By Guillaume Darguad, EPICA Glaciology Project

After similar projects in Greenland and at the Kohnen Station in Dronning Maud Land, Antarctica, the European Project for Ice Coring in Antarctica (EPICA) drilled an ice core to a depth of 3,270 meters at the Concordia Station, Dome C in Antarctica. This core provides the longest climate record that we possess today. Core segments were extracted using a cylindrical drill. A variety of tests were then conducted on the cores including analysis of the gas trapped in air bubbles, analysis of isotopes present in the ice or the air bubbles, optical analysis of the ice (polarity of thin slices, transmission properties), size of the crystals, electrical properties of the ice (electrical resistance depending on dissolved salts), temperature where it was extracted, thickness of each layer and time reconstruction. In May, 2008, EPICA published an article in Nature that documented that atmospheric CO2 concentrations are now at the highest levels they have reached over the past 800,000 years, adding another 150,000 years to the previous climatic record.

9

Investing in Climate Change 2009

II What is New in Climate Change Investing? Government: environmental policies and regulations We discuss the opportunity for governments to use climate change as an impetus for growth during the credit crisis in Chapter III of Part I. Update on the UN negotiating process The United Nations Framework Convention on Climate Change (UNFCCC) is responsible for international climate change negotiations. In December 2007, negotiators met for the 2007 United Nations Climate Change Conference in Bali. The conference included meetings of the 13th Conference of Parties (COP 13) to the UNFCCC and the 3rd Meeting of the Parties (MOP 3) to the Kyoto Protocol. The countries participating in the conference agreed to adopt the Bali Road Map. The Road Map is meant to lead to a binding commitment to succeed the Kyoto Protocol, which expires in 2012. This commitment should be negotiated at COP 15, which will take place in Copenhagen in December, 2009. The Bali Road Map, agreed by the parties to the UNFCCC at the conference: · Gained acknowledgement from the signatories to the UNFCCC, which includes the US, EU, China and India, that evidence for global warming is unequivocal and that reduced emissions were required to avoid severe climate change impacts; · Stipulated that nations would develop policy and incentives to protect forests; · Recognised that nations would enhance cooperation around adaptation; · Underscored the need for nations to facilitate transfer of clean technologies. The next 12 months – including the US Presidential election – will be crucial in determining how well these ideas can be expressed at a global policy level, particularly in the face of weaker economies. New developments in national and regional regulation Significant regulatory and legislative activity also took place at the national and regional level over the course of the past year. United States:



10

· The America’s Climate Security Act of 2007, also known as the Lieberman-Warner bill, made it through Senate committee and was debated on the Senate floor. Although the bill did not pass, it represents an important milestone in US regulation, as it included long-term emissions reductions targets that were reasonably ambitious and it proposed a cap-and-trade scheme for the power, transportation and industry sectors; · Meanwhile, a long awaited discussion draft of the Dingell-Boucher Climate Change Bill was released early in October 2008. The Bill seeks to cut US greenhouse gas emissions by around 80% over the next 40 years and calls for a cap-and-trade program to achieve these reductions, with two major provisions for carbon offset credits: a domestic offset program and an international emission allowance program. · Both John McCain and Barack Obama have announced their support for emissions cap-and-trade. Both have talked extensively about energy security, alternative energy policy and creating new ‘green’ jobs. · Significant regional leadership has emerged on climate change. Thirty-two states now have renewable portfolio standards, up from 25 in 2007, a number of regional climate initiatives are moving rapidly towards instituting cap-and-trade regimes with the Northeastern Regional Greenhouse Gas Initiative (RGGI) starting to trade, and Assembly Bill 32 (AB 32) established a comprehensive program of regulatory and market mechanisms for mitigation in California. · Congress extended incentives for wind and solar as part of the Emergency Economic Stabilization Act of 2008.

Investing in Climate Change 2009



The Production Tax Credit (PTC) has been extended for one year for large-scale wind projects and the Investment Tax Credit (ITC) has been extended for eight years for solar projects. The new legislation now also permits utilities to take advantage of the energy tax credits. $2.5bn was granted for CCS demonstration.

European Union: · In the Climate Action and Renewable Energy Package released in January, 2008, the European Commision committed to unilaterally reduce overall emissions to at least 20% below 1990 levels by 2020 (and to 30% if other developed countries make comparable efforts), and targeted increasing the share of renewable energy use to 20% by 2020; · In a revision of the EU ETS, the European Parliament’s Environment Committee voted in October, 2008, to cut EU greenhouse gas emissions from most industrial sectors by 21% from 2005 levels by 2020 and to phase out free allocation of emission permits, leading to full auctioning, with an exception for energy-intensive sectors that face international competition; · On a more cautious note, Germany’s government has backed an almost total exemption for industry from the new European rules that would force companies to pay for the carbon dioxide they emit through auctioning emission credits in the ETS rather than through the current system of free distribution of permits. Italy is also pushing for free distribution of carbon permits for specified sectors, and a coalition of eastern European countries have pressed to delay discussion of the EU climate plan beyond December 2008; · A framework has been developed to allow additional state aid for carbon capture and storage demonstration plants; · The EU has proposed capping carbon dioxide emissions from new vehicles to an average of 130g/km by 2012, compared to the current 158g/km; · While most developments have indicated increased ambition and action in the climate change space, the EU goal of increasing the share of biofuels in transport to 10% has been rolled-back to 5%, in light of food vs. fuel debates. China: · In December 2007, China issued its first white paper on energy conditions and policies that advocated for energy conservation, accelerated technological innovation, and improved coordination between energy and environmental development; · The tax rate for big cars has been doubled to 40%, while the tax on cars with small engines has been reduced from 3% to 1%; · Government buildings are now required to conform to energy efficiency standards; · Ten provinces, municipalities and regions have begun piloting a new energy regulation to stop fixed-asset projects that do not meet national energy standards. This regulation is set to be rolled-out nationwide once piloting is complete; · In 2009, a package of laws will come into force that aim to create a “recycling economy”, reduce pollution 10% below 2005 levels by 2010, and increase monitoring of capital-intensive assets. India: · The Indian National Action Plan on Climate Change was released in June, 2008. The plan established 8 national ‘missions’ running through 2017, which include major investments in solar capacity, energy efficiency, water use efficiency, and forestry; · The Indian government is also mandating the retirement of inefficient coal-fired power plants and requiring big consumers of energy to conduct energy audits.

11

Investing in Climate Change 2009

II What is New in Climate Change Investing? Carbon and energy prices Energy prices and their complex “linkage” to climate change When we last published, oil prices had hit $80 a barrel. These were record prices, and energy was justifiably high on the agenda. With energy prices having risen so much further through 2008 and then recently corrected back to 2006/07 levels, there has been an increased focus by the market on their influence. In the past year, we have seen oil prices pass $140 a barrel, with extraordinary increases in price volatility. See exhibit 2.3. EX 2.3: Oil price trends Crude oil prices saw a ten-fold increase between their low in the late 1990s and high in July 2008, but have recently fallen back to 2006/07 levels.

Source: US EIA, 2008; The National Industrial Transportation League, 2008 and DeAm Team Analysis, 2008.

Coal prices have risen significantly from about $50/ton in 2007 to a $195/ton record in July, 2008, before falling back to around $115/ton in October. Natural gas (Henry Hub benchmark) has gone from about $5.50/MMBtu a year ago to over $13/MMBtu this summer, and has come back under $7/MMBtu as of publication. Energy prices are volatile – and have gotten significantly more volatile over the course of the past year. Relying on them for the scaling of clean technologies is risky. And in the long run, coal is plentiful and prices are likely to fall. For this reason, we believe that regulation – and carbon pricing in particular – are vital backstops to energy prices, diversifying the risks facing clean energy investment and bringing an increased level of predictability to the market. We look in much more detail in Chapter VII of Part I at the long-term outlook for energy prices and how these might impact the prospects of renewable energy and carbon pricing. Energy security and America, BP CEO Tony Hayward details commitment to U.S. energy security in the new era, The Houston Forum, November 8, 2007.

3

12

Investing in Climate Change 2009

Carbon markets Since last year, carbon markets have grown significantly, the price of carbon has increased, and new regions and countries are considering establishing carbon cap-and-trade markets. Developments of particular note are: • The European Union Emission Trading Scheme (EU-ETS) entered its second phase in January, 2008. In its second phase of operation, the regime is significantly strengthened: · Trading volumes have been strong since Phase II has begun. See exhibit 2.4. EX 2.4: Trading volumes on the EU-ETS are growing Over-the-counter and exchange volumes for EUAs

OTC-Volume

Exchange -Volume

Source: DeAM Team Analysis; Press Search, 2008.



13

· EU emission allowances (EUAs) have been trading near or above the €20/ton range – putting a much more meaningful price on carbon than was the case under the price collapse at the end of Phase I. See exhibit 2.5.

Investing in Climate Change 2009

II What is New in Climate Change Investing? EX 2.5: Phase-II EU carbon prices have been trading near or above €20 Price for Forward EUAs

Source: DeAM Analysis; Press search, 2008

· The National Allocation Plans for the second phase will result in average cuts of 7% below 2005 emission levels. This cut is significantly more stringent than the 1.9% rise over 2005 levels that was allowed under the Phase I; · Phase II credits are bankable into Phase III – which should prevent a price collapse at the end of Phase II; · The scheme has expanded to include three new, non-EU, countries – Norway, Iceland and Liechtenstein; · The aviation industry is set to join the scheme around 2010, expanding the sectors covered by the EU-ETS. · In Chapter VII of Part I we look at the relationship that carbon prices have with energy prices in general. The EU ETS tends to encourage a fairly noticeable correlation between oil prices and carbon prices due to the fuel switch focus between gas and coal. See exhibit 17 in Chapter VII. The Kyoto Protocol Mechanisms are healthy, with more than 3,000 Clean Development Mechanism projects in the pipeline according to the UNFCCC. These projects are expected to result in 2.7 GT of Certified Emissions Reductions (CERs) from Clean Development Mechanism (CDM) projects through 2012. Over the last year, aside from the growth in CDM projects, two important trends have emerged: · The secondary CER market is growing quickly, registering 1,000% growth over 2007; · The Emissions Reduction Unit (ERU) market under the Joint Implementation mechanism has also emerged as a rapid center of growth. Prices for CERs and ERUs have been strong, with some forward CER contracts trading near €25/ton over the summer. · New Zealand and Australia are the first countries outside the EU-ETS to establish mandatory national emissions trading schemes. Legislation establishing an emissions trading scheme in New Zealand was passed on September 10, 2008, and legislation for an Australian trading scheme is being drafted for release in December, 2008. · The voluntary markets – although small compared to the EU-ETS and markets for Kyoto Protocol credits – are also growing quickly. Volume on the Chicago Climate Exchange from January to August, 2008, was up by over 300% compared to the same period in 2007. · US regional markets, such as the Regional Greenhouse Gas Initiative (RGGI) in the Northeast US, are ramping up. In October, 2008, RGGI held its first pre-compliance CO2 auction.

14

Investing in Climate Change 2009

Corporations are faced with meeting economic, environmental and social goals. As we discussed in Investing in Climate Change: An Asset Management Perspective, there are two key ways in which corporations will respond within the economics of climate change: 1. Competitive response and developing the opportunity set – mainly focuses on mitigation. Climate change becomes a focus of corporate attention and corporations launch new business opportunities; 2. Risk management – mainly focuses on adaptation and corporate responsibility. Increasingly, markets will start to focus on the net carbon position of companies and businesses will integrate climate change risk into their policies and procedures.

robust post-Kyoto agreement, companies are channelling funds towards increasing the supply of clean technology and investment in the sector has grown; · Businesses also have been vocal at the G8, underscoring the need for a ‘rapid and fundamental strategy to reach a low-carbon world economy’ in a paper delivered to Prime Minister Fukada of Japan at the G8 meeting in Hokkaido-Toyako; · A McKinsey survey3 reveals that 60% of global executives regard climate change as strategically important and a majority consider it important to product development, investment planning and brand management. 34% of executives in China, 37% of those in Europe and 40% of respondents in India report that their companies frequently or always consider climate change in overall strategy.

Increased corporate focus on climate change

Competitive Response - Where are the opportunities?

Over the past year, the public discourse on climate change has been active:

Markets for climate change products and climate change-related businesses are growing fast:

· In advance of the Bali conference, 150 leaders of global companies issued a communiqué underscoring the urgency of climate change action. The business leaders wrote that a legally binding UN agreement to reduce greenhouse gas emissions is necessary for businesses to make the right investments in clean technologies and infrastructure, and that an extended carbon market needs to be part of the framework because it allows for flexibility and a low-cost transition to a low-carbon economy; · As businesses have advocated for a

· In 2007, there were nearly 500 Private Equity and Venture Capital deals in climate change – representing $13.5 billion of investment. This is up 46% from 2006; · There were 1,900 Private Equity and Venture Capital investors in climate change in 2007; · In 2007, Germany, China and the United States were the leading investors in new renewable energy capacity with $14 billion, $12 billion and $10 billion respectively; · There are close to 300 mutual fund managers acting in the climate

Corporate response: Competitive response and risk management

change space, along with a growing number of hedge funds and private equity managers;4 · No less an oilman than T. Boone Pickens has announced plans to build 4 GW of wind capacity in Texas – and is running commercials promoting alternative energy; · Renewable businesses are growing to scale. Iberdrola Renovables was the second biggest IPO of 2007 by funds raised, with a deal value of $6 billion – and the funds raised by IPOs for clean tech companies across the board increased by over 300%, from $7.5 billion in 2006 to $32 billion in 2007;5 · As part of the Masdar Initiative, Abu Dhabi – an emirate that holds about 8% of the world’s oil reserves – broke ground in 2008 on a revolutionary clean city. The broader initiative, which was launched in 2006, aims to promote energy efficiency and develop alternative sources of energy and $15 billion has been announced for new green investments; · Alternative energy dominates capacity additions in some markets: wind made up 40% of newly installed electric power generation capacity in Europe in 2007; · Estimates show that the global market for emissions trading will soon be worth $150 billion;6 · Global investment in sustainable energy broke all previous records with $148.4 billion of new money raised in 2007, an increase of 60% over 2006;7 · The IEA forecasts a massive scaleup of investment to $45 trillion in order to meet the joint objectives of build-out of the energy infrastructure and mitigation of climate change.

For more details on this, we explore the

3 Mckinsey & Company, 2008: How Companies think about Climate Change: A McKinsey Global Survey. 4Hodge, N, 2008, The Big Picture on Renewable Energy, GreenChipStocks. 5Billion Dollar Deals Return to the Onshore Wind Sector, New Energy Finance Week in Review, May 2008. 6Investors tap into UK emissions trading expertise’, UK Trade & Investment. 7Global Trends in Sustainable Energy Investment 2008: Analysis of Trends and Issues in the Financing of Renewable Energy and Energy Efficiency

15

Investing in Climate Change 2009

II What is New in Climate Change Investing? growing investing opportunity in climate change in Chapter V of Part I.

Risk Management - What are the risks and how are they being managed? · The insurance industry has already begun to feel the effects of climate change and takes the issue seriously. In the US insurers have started to cancel homeowner policies in hurricane and wildfire risk areas; · In 2007, a group of global insurers, re-insurers and brokers developed a set of ‘ClimateWise’ principles in response to global warming, designed to promote greener policies. The principles will enable companies throughout the world to build climate change into their business opera-

tions; · Some insurance companies are already adjusting their products and services to suit emerging markets that have resulted from climate change such as weather risk, carbon trading and the clean technology industry; · The Carbon Disclosure Project (CDP) operates to create lasting relationships between shareholders and corporations regarding implications for shareholder value and commercial operations presented by climate change. It represents 385 institutional investors with a combined $57.5 trillion of assets under management; · A coalition in the US, led by Ceres, has encouraged improved climate change disclosure and governance

at dozens of companies and has engaged with regulators such as the Securities and Exchange Commission by calling for publicly traded companies to assess and fully disclose their financial risks from climate change. Deutsche Asset Management was a signatory; · We are seeing more attempts to measure the net carbon position of companies and then assess carbon risk or carbon beta.

Low carbon technologies and services – While no “silver bullet” technologies have been discovered since we published Investing in Climate Change: An Asset Management Perspective last year, there has been talk of planet-level solutions to climate change – although proving these proposals seems unlikely at present. See box 2.2.

Box 2.2: Geo-planetary Engineering – Looking for ‘silver bullet’ solutions to climate change? Scientists have recently discussed planetary engineering as one climate change mitigation strategy. The Royal Society in the UK has published a series of papers outlining some of the options and suggesting a few experiments to test these. Proposals include: • Fertilizing the oceans with iron, as this is the limiting nutrient in some ocean areas, to encourage blooms of planktonic algae that draw carbon dioxide out of the atmosphere; • Recycling carbon dioxide from the atmosphere into fuel, by reacting it with hydrogen; • Ejecting carbon dioxide from the atmosphere at the Earth’s poles, using the planet’s magnetic field; • Reflecting sunlight back to outer space to cool the planet. This is proposed by increasing the amount of pollution in the atmosphere so that particles reflect sunlight back in to space; • Spraying clouds with seawater, resulting in particles of salt forming through evaporation. These act as nuclei around which droplets of water can condense, creating more sunlight-reflecting clouds The Economist magazine notes that history is littered with plans that went awry because too little was known about complex natural systems. Altering the atmosphere or the oceans on the scale required to do this would be extremely risky, expensive and complex. Modifying the climate will have physical and biological consequences, some of which will be unpredictable and could be more detrimental than the problems they were designed to remedy. There is also a large moral hazard here, that people would see geo-engineering as an excuse to continue polluting the atmosphere. Although the jury is still out on geo-planetary engineering, we doubt it will be the silver bullet that solves climate change.

16

Investing in Climate Change 2009

It is impossible for us to list all of the gradual advances in technology that have occurred over the past year. In terms of a standout, a notable potential advance in technology involves storage of solar energy. Massachusetts Institute of Technology (MIT) developed a process that allows the sun’s energy to be used to split water into hydrogen and oxygen gases to store energy. Later, the oxygen and hydrogen may be recombined inside a fuel cell, creating carbon-free electricity. While it will take about a decade for the technology to reach commercial development and deployment, it represents an important step forward for alternative energy. See box 2.3.

Box 2.3: Advances in solar storage technologies at MIT

Photo: Tom White, MIT: “Major discovery’ from MIT primed to unlease solar revolution”, MIT News, July 31, 2008

Inspired by photosynthesis, Daniel Nocera’s team of researchers at MIT has discovered a low-cost process to store solar energy. The process uses the sun’s energy and catalysts to split water into oxygen and hydrogen gas. Later, the oxygen and hydrogen can be recombined in a fuel cell, allowing use of solar energy even at night. More work is needed to integrate the technology into solar systems, but the advance is an important step forward -- it may be the critical technology needed to allow solar and other renewable sources to be used as baseload power rather than as intermittent sources, enabling a significant decarbonization of the electricity generation market.

17

Investing in Climate Change 2009

III Low Carbon Prosperity

•

As the credit crisis continues, the focus is shifting to the world economy slipping into a recession.

•

Politicians recognize that the difficulties confronting financial markets today are some of the worst they have seen. But as the financial sector stabilizes, the real economy will become the key focus.

•

Low carbon prosperity, linked to energy security, is emerging as a potential way to lift the economy out of its current morass. Writers and politicians point to the potential for a low carbon Industrial Revolution to create millions of new, high-paying jobs.

•

This is leading in the short-term to a focus on more incentives and tax breaks. However, in the longer-term, a carbon price will still be required, and how the costs and benefits of the carbon price are distributed will be a key issue.

•

It is also interesting to see energy efficiency as a driver during an economic downturn. Over time, money can actually be saved through efficiency measures.

In Chapter IV of Part I, we look at the direct impact of the credit crisis on climate change investment markets in detail. Here, we discuss the great potential climate change presents at this critical point in time. Unlike the initial outbust of interest in climate change from 1990 through 1992, which faded in the face of a financial crisis and recession, we believe that climate change investing in the early 21st century, based upon solid science, is poised to make a very different impact as governments look for ways to stabilize economies and promote energy security. Over the past year, commentators and policymakers have become increasingly vocal about the potential to build a prosperous, low-carbon world. For instance, Yvo de Boer, the Executive Secretary of the UNFCCC, stated in October 2008 that the current global market situation could provide an opportunity for the world financial system to reconstruct itself to promote low carbon growth as “governments now have an opportunity to create and enforce policy which stimulates competition to fund clean industry.” And in October 2008, the Independent Climate Institute said that the current global market turmoil reinforces the need and urgency for strong leadership on climate reforms. It is our belief that after the financial system is stabilized, the urgent question will be how to stabilize the broader economy. We believe that “climate change,” “green” and “energy security” will be key aspects of government support of economies.

I. Low carbon prosperity: An answer to the credit crisis? Over the past year, climate change and its relationship to other government priorities, such as energy security and low-carbon prosperity, have moved up the global agenda. It is worth examining the recent emphasis on energy security.

18

Investing in Climate Change 2009

The quest for security of energy supply in a world of scarce resources is not new. For most of the past 100 years, sovereign states have sought to avoid political dependence on their energy suppliers by promoting diversity of supply. In more recent times, oil’s exhaustibility – or the limits to production within a given timeframe and the implications of ever-increasing-demand in a world of limited supply – have come to the fore. In the wake of the recent spike in energy prices and global uncertainty about the future price trend, the issue has gained new prominence on the political stage. While energy security is often seen as “independence” of supply, more importantly, it is easy access to a plentiful supply of a scarce and dwindling resource. See box 3.1.

Box 3.1: Energy Security In November 2007, BP CEO Tony Hayward defined energy security as “access to reliable sources of energy, at an affordable price, produced in environmentally responsible and safe manner.”1 Hayward’s definition adds a fourth pillar to the traditional definition of energy security: environmental responsibility. Politicians and businessmen have recognized the importance of clean alternatives for energy security – and are actively promoting renewable energy. In many senses, politicians are citing energy security more than climate change just now in their push for renewable energy policies. While the result may be similar in the shortterm, in the long-run, we believe that climate change is a more serious challenge and a more encompassing one for policymakers, and energy security should not be an excuse to divert from renewables to dirtier fossil fuel sources such as tar sands and oil shale. Low Carbon Prosperity – Economic Growth Opportunities In addition to increasing energy security, politicians and business people are realizing that alternative energy can be a source of growth. Over the past year, low-carbon prosperity has entered the political discourse – policymakers now cite the creation of high-paying ‘green collar’ jobs as a major reason for pursuing ambitious innovation policy in the cleantech space. 1 2

19

Much of the debate about climate change has focused on the cost to the economy of implementing the required clean-up. Indeed, Stern’s analysis (See chapter 10 of the Stern Review Report) was expressed in this way; however, as Stern points out (See page 240 of the Stern Review Report), there are many macroeconomic climate change models showing a wide range of economic outcomes. Some, which emphasize the investment dollars needed to upgrade the economy’s infrastructure, show a net gain to the economy. It is this investment need (See Market Sizing, Chapter VI of Part I), that the prosperity of the low carbon economy is based on and that provides the opportunity for investors. Research by the Potsdam Institute indicates that, in Germany, the transition to a low-carbon economy will spur a wave of innovation and job growth. A new study published by the Center for Energy, Resources and Economic Sustainability at the

University of California, Berkeley, indicates that California’s energyefficiency policies created nearly 1.5 million jobs from 1977 to 2007. Global insight has recently published a study citing the potential for green job growth in the US.2 In light of these findings, US politicians have been vocal about the job creation potential of climate change: Barack Obama has proposed spending $150 billion over 10 years in a push to create 5 million “green collar” jobs. He plans to raise this money by auctioning carbon credits. This raises the issue of the cost of a cap-and-trade system. Certainly some sectors will be affected by carbon pricing, but the scale and shape of the impact depends on how the transfer costs are dealt with, as well as how markets are designed. We discuss carbon market design in more detail in Chapter II of Part II.

Energy security and America, BP CEO Tony Hayward details commitment to U.S. energy security in the new era, The Houston Forum, November 8,2007. US Metro economies: Current and potential jobs in the US economy, Global Insight, 2008.

Investing in Climate Change 2009

III Low Carbon Prosperity

comments of politicians around the world, as collected in box 3.3.

Nevertheless, we believe that anything that resembles a tax or increase in cost will need to be well understood and phased-in to gain acceptance. Right now, the focus is more on providing a stimulus to the economy through incentives. This becomes evident in reviewing the

We discuss the short-term magnitude of the investment task in Chapter VI of Part I. However, it is worth looking at the challenge from a long-term perspective. In June, 2008, the

McKinsey Global Institute published a report outlining the challenge of raising carbon productivity, comparing the potential to the rise in labor productivity in the Industrial Revolution. See exhibit 3.1

EX 3.1: A low carbon Industrial Revolution is urgently needed

Carbon productivity needs to rise three times as fast as labor productivity did during the Industrial Revolution Index Year 0=1

10

Carbon productivity growth required 2008-2050

8 6 4 2

US labor productivity growth 1830-1955

0 0

10

20

30

40

50

60

70

80

90

100

110

120

130 Years

Source: Contours of the World Economy 1-2003 A.D., Maddison, 2007; McKinsey analysis.

Achieving the increases in carbon productivity required to meet longterm stabilization targets will require a revolution on the scale of the Industrial Revolution. But while, in the Industrial Revolution, it took over 120 years for labor productivity to rise 10fold, we have only 40 years to achieve a commensurate increase in carbon productivity. Some of the challenge in raising carbon productivity will lie in a massive decarbonization of the

20

Investing in Climate Change 2009

world’s infrastructure. Over the past 150 years, thousands of cities, airports, highways, power plants and factories have been built – many of which rely on fossil fuels and carbonintensive processes. We are entering a period of massive capital stock turnover in the next few decades. Much of the aging infrastructure in the West will need to be replaced, and the global infrastructure base will expand dramatically as China, India and the rest of the developing world continue to rapidly industrialize.

Where infrastructure investments are climate-friendly – such as many investments in water, agriculture, renewables, energy efficient buildings and public transport – they fit the broader climate change investing theme. Against the backdrop of the scale of investment that needs to be made in clean energy and infrastructure, some commentators see the potential to reinvigorate the broader economy. In his 2008 book Bad Money, Kevin

Phillips argues that the recent economic turmoil is caused by an over-reliance on debt and the financial sector in the US. The way to rebuild the economy, according to Phillips, is through activities that create real value. The one he cites as holding the most promise is alternative energy: not only would it create high-paying, domestic jobs, but it would also decrease America’s dependence on imported oil and on the willingness of oil-exporting states to buy US debt to finance America’s thirst for energy. Thomas Friedman’s thesis in his most recent book, Hot, Flat and Crowded also underscores the potential that a low carbon Industrial Revolution holds. Friedman quotes an interview with energy expert David Rothkopf as he sets up his thesis: “The hallmark of those companies and countries that continually thrive is that they continually reinvent themselves,’ noted David Rothkopf, an energy expert and visiting scholar at the Carnegie Endowment. ‘We reinvented ourselves as a continental industrial power in the nineteenth century, and we reinvented ourselves as a global industrial power in the twentieth century and then as a global information society in the twenty-first century.’ Now we have to – for our own sake and the world’s – reinvent ourselves one more time. Making America the world’s greenest country is not a selfless act of charity or naïve moral indulgence. It is now a core national security and economic interest.

3

21

Thomas Friedman, Hot, Flat and Crowded, 2008, p. 23.

Investing in Climate Change 2009

‘Green is not simply a new form of generating electric power,’ added Rothkopf. ‘It is a new form of generating national power – period.”3 The challenge is great, and so is the opportunity. The Industrial Revolution was a time of great innovation – the steam engine, the telegraph, the locomotive, the telephone, the airplane, the automobile and the sewing machine all came into being in that time of great change. The life expectancy and standard of living of most Westerners improved as a result of the Industrial Revolution. Increasingly, intellectuals and writers are recognizing that a low carbon Industrial Revolution holds much of the promise of the original Industrial Revolution. And politicians are beginning to develop policy proposals that would begin to implement these ideas.

III Low Carbon Prosperity

Energy efficiency – the low-cost, long-term payback option While we do not focus on energy efficiency in detail in this edition, it is worth noting that in the current turbulent economic times, energy efficiency – using less energy to provide the same level of services – has become even more compelling. Short-term investments in energy-efficient products and infrastructure can stimulate economic growth while reducing emissions. Because many energy efficiency opportunities are net cost negative, over the long-term, the investments made in energy efficiency more than pay themselves back. Amory Lovins, Chairman and Chief Scientist of the Rocky Mountain Institute and a member of the Deutsche Bank Climate Change Advisory Board, has long advocated for the promise of energy efficiency – a promise which, The Economist magazine noted on September 4, 2008, others are beginning to understand. Lovins argues that the US’s electricity bill could be halved through energy-efficiency measures, many of which could pay for themselves in about a year. Improvements in both supply-side and demand-side efficiency can reduce the world’s dependence on fossil fuels and mitigate greenhouse gas emissions. On the supply-side, more efficient power plants, such as Integrated Gas Combined Cycle plants, save energy by lowering the heat rate. On the demand-side, increased end-user efficiency can be achieved through use of more energy-efficient equipment and appliances such as low-energy light bulbs. The McKinsey-Vattenfall greenhouse gas mitigation policy curve shows that the abatement potential from energy efficiency could be as much as 6 GT CO2e/year by 2030 and this is achievable at negative costs varying between -€160/tonCO2e and -€10/tonCO2e.3 Because the costs are negative, some efficiency changes should happen naturally as they make economic sense. However, some individual energy savings may not be made without intervention. This is due in part to ‘bounded rationality’ – where consumers are locked into preconceived ideas and fail to make changes even when presented with information that justify those changes. We look at how the regulatory environment would enable us to unlock some of this opportunity in more detail in Chapter II of part II. Lovins believes energy efficiency and renewables can solve the whole energy problem, describing the ‘hard energy path’ as involving inefficient liquid fuel, automotive transport and centralized electricity generating facilities. The ‘soft energy path’ on the other hand involves the efficient use of energy, diversity of energy production methods and reliance on ‘soft’ technologies including wind and solar. His book, Winning the Oil Endgame, presented the US with an independent, transdisciplinary analysis of ways to reduce petroleum dependence. The book argues that half of our oil needs, half of our gas needs and three-fourths of our electricity requirements could be eliminated, if intelligent investments were made, while maintaining a stable, growing economy. Lovins also introduced the concept of ‘negawatt power’ in the book, whereby investment is made to reduce electricity demand instead of increasing generating capacity. Negawatts are the hypothetical tradable units of saved energy due to energy efficiency. The wisdom of Lovins’s arguments was recognized by The Economist magazine: “Mr Lovins should be pleased, but his satisfaction at having been proved right is tempered by lingering unease that there are echoes of the 1980s in today’s debate. The main problem with the approach to energy in the 1970s, he argues, was that the issue was defined as a supply shortage. The question they asked was how to get more energy, at any price, instead of asking: How should we use energy, why are we using it so wastefully and what do people really use energy for?”4

4

22

McKinsey-Vattenfall greenhouse gas abatement cost curve, 2007.

Investing in Climate Change 2009

Although we acknowledge the potential that energy efficiency has in stimulating economic recovery, reducing energy costs to end-users and climate change mitigation, a more detailed analysis of the benefits and factors surrounding energy efficiency are out of the scope of this paper.

II. Political support for a low carbon Industrial Revolution Politicians around the world and across the political spectrum have been vocal in recognizing the opportunity lowcarbon prosperity represents. Many of them have proposed and are implementing tax credits, subsidies, incentives and R&D programs for clean-technologies. We provide an overview of what politicians are saying about low-carbon prosperity: Politicians and low-carbon prosperity (in no particular order) “And it is absolutely critical that we understand this is not just a challenge, it’s an opportunity, because if we create a new energy economy, we can create five million new jobs, easily, here in the United States. It can be an engine that drives us into the future the same way the computer was the engine for economic growth over the last couple of decades. And we can do it, but we’re going to have to make an investment. The same way the computer was originally invented by a bunch of government scientists who were trying to figure out, for defense purposes, how to communicate, we’ve got to understand that this is a national security issue, as well.” – US Senator Barack Obama, Democratic Presidential Nominee, US Presidential Debate, Nashville, September 7th 2008. “Look, we are in tough economic times; we all know that. And let’s keep – never forget the struggle that Americans are in today. But when we can – when we have an issue that we may hand our children and our grandchildren a damaged planet, I have disagreed strongly with the Bush administration on this issue. I traveled all over the world looking at the effects of greenhouse gas emissions, Joe Lieberman and I.... We can move forward, and clean up our climate, and develop green technologies, and alternate – alternative energies for – for hybrid, for hydrogen, for battery-powered cars, so that we can clean up our environment and at the same time get our economy going by creating millions of jobs.” – US Senator John McCain, Republican Presidential Nominee, US Presidential Debate, Nashville, September 7th 2008. “With American people pinched at the pump, and seriously concerned about the state of the economy, the House has taken action today to cut taxes for millions of middle-class families, invest in renewable energy technologies to create high-paying green jobs, make America more energy independent....” – Nancy Pelosi, Speaker, US House of Representatives, Statement on Renewable Energy and Job Creation Tax Act of 2008. “The US has invested nearly $18 billion to research, develop and promote clean and efficient energy technologies. Our investments in research and technology are bringing the world closer to a remarkable breakthrough – an age of clean energy where we can power our growing economies and improve the lives of our people...it will be a moment when we choose to expand prosperity instead of accepting stagnation” – US President George Bush, Remarks at the US Department of State, Washington DC, September 2007.

5

23

The Economist, September 2008. The Frugal Cornucopian

Investing in Climate Change 2009

III Low carbon prosperity

“I think we can all agree that we need to view this not as a crisis but as an opportunity. The transition from fossil fuels of old to the renewable fuels of tomorrow can create jobs, protect our national security and cleanse our environment.” – Harry Reid, US Senate Majority Leader, Bipartisan Senate Energy Summit, September 12th, 2008. “All our needs of the country, all our goals as an economy point in exactly the same direction – to tackle climate change, to improve energy security, to create jobs and to stimulate business to grow. Every economy in the world… now share a common interest in this transition to a low carbon global economy. For the threat of climate change…is a threat to the prosperity and security of the whole world. I believe that the benefits to families and to businesses of reducing oil dependence and tackling climate change will be immense. It will mean the creation of hundreds, indeed thousands of new jobs and business opportunities to meet the new demand for environmental goods and services. And this is the biggest prize of all: the chance to seize the economic future securing our prosperity as a nation by reaping the benefits of the global transition to a low carbon economy. The fact is that, in the 21st century, the global low-carbon economy will be a key driver of our economic prosperity…. And now you should look at it this way, we are about to embark on a fourth technological transformation to low-carbon energy and energy efficiency. And in their wake – as before – will come a myriad of changes in the way we live, the way we move around, the way we will run our businesses, the things we produce and consume which will make the low carbon economy a new engine of productivity and economic growth.” – Gordon Brown, Prime Minister of the United Kingdom, Speaking at The Government’s Low Carbon Economy Summit, June 27th 2008. “Britain can’t afford not to go green…for the sake of our future prosperity and our current cost of living, we must wean ourselves off fossil fuels and go green.” – Rt. Hon David Cameron, MP, Leader of the Conservative Party in the United Kingdom. “In tough economic times, some people ask whether we should retreat from our climate change objectives. In our view it would be quite wrong to row back and those who say we should, misunderstand the relationship between the economic and environmental tasks we face.” – Rt. Hon Ed Miliband, UK Secretary of State for Energy and Climate Change, Speech in Parliament, October 16, 2008. “France isn’t late but France wants now to be in the lead…. We haven’t got to choose between saving the planet and growth, we need a growth that consumes less energy and fewer raw materials.” – Nicolas Sarkozy, President of France, Speech at the UN General Assembly, September 2007. “The climate package is so important that we cannot simply drop it, under the pretext of a financial crisis.” - Nicolas Sarkozy, President of France, EU Summit in Brussels, October 16, 2008. “We absolutely must get an agreement on the climate and energy package that aims to make Europe a lowenergy and low-carbon economy. The idea is to encourage European companies to reduce their energy needs and emissions. Admittedly, this requires heavy investment, but it means European industry has the chance to get a head start. Tomorrow’s competitiveness and jobs depend on it.” – Jean-Louis Borloo, French Minister of the Environment, Interview in the weekly Le Journal du Dimanche, June 2008. “Climate change tests our ability to open a new chapter in economic development which will, in turn, pose entirely new challenges…. We can experience a win-win situation if we decide to invest in new ways – in research and technology, in new structures to secure our opportunities and thereby securing jobs in the long term.” – Angela Merkel, Chancellor of Germany, Speech at the International Transport Forum, May, 2008. “The systematic expansion of renewable energy is not only good from the environmental and climate policy point of view but also for innovation, growth and employment in Germany.” – Sigmar Gabriel, German Environment Minister,

24

Investing in Climate Change 2009

Renewable Energy World, April, 2008. “Countermeasures to global warming will create new demand, new jobs and new income. A low-carbon society is one that offers great opportunities for economic activity that is compatible with the environment.” – Yasuo Fukada, Outgoing Prime Minister of Japan, Speech at the Japan Press Club, 9th June 2008 “I believe that the pursuit of ecologically sustainable development need not be in contradiction to achieving our growth objectives.” – Manmohan Singh, Prime Minister of India, Prime Ministers address at 63rd session of UN General Assembly, September 27th, 2008. “Environmental protection is the fundamental policy of our country and is crucial to the existence and development of the nation.” – Hua Jianmin, State Council Secretary General, China, Speaking about the restructuring of the State Council to elevate the status of the State Environmental Protection Administration to a Ministry, March 11th, 2008. “Biofuels can generate jobs in poor countries and more energy security for all.” – Luiz Inacio Lula da Silva, President of Brazil, Remarks delivered to the Americas Society/Council of the Americas, September 22nd 2008. “Government, the business community, scientific experts and community organizations must work together if we are to tackle the challenges of climate change and seize the long-term opportunities opening up for Australia in low carbon energy technologies and environmental science.” – Kevin Rudd, Prime Minister of Australia, Address to The National Business Leaders Forum, May 2008.

25

Investing in Climate Change 2009

IV The Credit Crisis and Climate Change Investing • Climate change-related public equity markets have experienced the same extreme selling pressure as have all markets in response to the credit crisis – a general liquidity squeeze • Falling commodity prices, pressure on the housing and construction industries, and some regulatory uncertainty all contributed to the climate change sell-off • Given stretched valuations late last year in solar and to some extent wind, the public-equity climate change universe has given back about 40% of its out-performance built up in 2006/2007 • In terms of valuations, the larger more diversified stocks have corrected back more in line with the larger market indices, but there is a lot of potential value showing up in the smaller cap companies embedded in the supply chain • There is no doubt that the current stand-off in lending is being felt in both public and private climate change sectors • Clean tech private markets have maintained their growth going into the fourth quarter, but are being affected by the credit squeeze now – equity financing will require more attractive valuations in the absence of debt financing • In our view, as the financial markets stabilize, many climate change sectors should recover early in both public and private markets, as they have regulatory support and strong long-term growth prospects This chapter is divided into five major sections that discuss the implications of the credit crisis on the climate change invesment universe.

1. Credit crisis and funding 2. What’s been happening in climate change public equity markets during the credit crisis 3. Climate change correlations with broader markets 4. Valuations - Bursting some sector bubbles? 5. What’s been happening in clean tech private markets

Credit crisis and funding While the credit crisis has affected public equity market pricing in a dramatic way, the key underlying issue is the availability of credit. Climate change investing includes the clean and renewable energy sectors such as solar and wind. Many companies in the solar and wind energy sectors face tough times obtaining the financing they need for projects now. Just as banks have been reluctant to lend to each other, they are also less likely to lend to renewable energy projects. There is no doubt that in speaking to equity analysts, venture capitalists, and private equity investors, that at the moment there is great concern about the financing options available to public and private companies. This is likely to continue until there is a global stabilization in the financial sector. As a result, some financially stretched projects and companies might not make it through this stage, or they will at least need repricing.

26

Investing in Climate Change 2009

The long term support of demographic-driven demand, with regulatory support for clean energy, agriculture, and water, will mean that interest will remain strong in these sectors, and we believe capital flow will become available early in any recovery. What’s been happening in climate change public equity markets during the credit crisis Over the past few months, we have seen climate change-related sectors fall in sympathy with general market conditions due to the credit crisis. September and continuing into October saw sharp corrections in many climate change sectors. In terms of public equity markets, we compare the climate change universe, as represented by the HSBC Climate Change Index, with the MSCI World Index since 2006. Following a strong 2006 to 2007 period, the index began tracking the general equity market’s performance from its peak through early 2008. The climate change universe then suffered a more rapid fall as the credit crisis took its toll on anything related to housing or construction, energy prices dropped, and regulatory support such as the Investment Tax Credit (ITC) and Production Tax Credit (PTC) in the US wavered and Spain capped its solar building capacity. EX 4.1: The climate change universe has historically outperformed the world index

200 180 160 140 120 100 80 1/2/08

3/2/08

5/2/08

7/2/08

9/2/08 10/17/08

3/2/08

5/2/08

7/2/08

9/2/08 10/17/08

11/2/07

9/2/07

1/2/08

HSCCBT Index

7/2/07

5/2/07

3/2/07

1/2/07

11/2/06

9/2/06

7/2/06

5/2/06

3/2/06

1/2/06

60

MXWO Index

Source: Bloomberg, DeAm analysis, 2008.

EX 4.2: The ratio of the climate change universe to the world index

160 150 140 130 120 110 100 90

Source: Bloomberg, DeAm analysis, 2008.

27

Investing in Climate Change 2009

11/2/07

9/2/07

7/2/07

5/2/07

3/2/07

1/2/07

11/2/06

9/2/06

7/2/06

5/2/06

3/2/06

1/2/06

80

IV The Credit Crisis and Climate Change Investing Correlations with financial markets Over the entire period of January 2006 through September 2008, the climate change universe (as measured by the HSBC Climate Change Index) showed moderate to strong correlation to the broad market, as well as energy and industrial stocks in general. If we look at constituents, it is really only agriculture that has shown noticeably lower correlation to the MSCI World. EX 4.3: The climate change universe shows variable correlation to financial markets January 2006-September 2008 Crude Oil

MSCI WORLD

SP 500

ECO Index Commodity

Water

AG

SP Energy HSBC CC

MSCI SmCap

MSCI Ind MSCI WE NEX Index

1.00

Crude Oil MSCI WORLD

0.00

1.00

SP 500

-0.21

0.97

ECO Index

0.25

0.53

0.45

1.00

Commodity

0.94

-0.17

-0.38

0.22

1.00

Water

0.34

0.91

0.81

0.62

0.14

1.00

AG

0.86

0.42

0.23

0.43

0.76

0.70

1.00

SP Energy

0.80

0.56

0.39

0.50

0.66

0.80

0.95

1.00

HSBC CC

0.58

0.79

0.64

0.56

0.40

0.94

0.88

0.93

1.00

MSCI SmCap

-0.36

0.87

0.92

0.42

-0.46

0.67

0.01

0.18

0.46

1.00

MSCI Ind

0.19

0.96

0.89

0.63

0.01

0.97

0.58

0.70

0.88

0.79

1.00

MSCI WE

0.80

0.57

0.40

0.56

0.67

0.80

0.93

0.99

0.91

0.22

0.71

1.00

NEX Index

0.61

0.75

0.59

0.65

0.43

0.93

0.88

0.92

0.98

0.43

0.86

0.92

1.00

CORRELATION LESS THAN 0.4

CORRELATION BETWEEN 0.4 AND 0.65

1.00

CORRELATION GREATER THAN 0.65

Source: Bloomberg, DeAM analysis, October, 2008

Note: OIL: USCRWTIC INDEX Bloomberg West Texas Intermediate Cushing Crude Oil Spot Price, MSCI World Index, SPX Standard and Poors 500 Index, ECO Wilderhill Clean Energy Index, Commodity CRY Reuters/Jefferies CRB Commodity Price Index, Water: PIIWI Index Palisades Global Water Index, AG: DXAG Index DAXGlbl Agribusiness Performance USD, SPENER: S5ENRS Index S&P’s 500 Energy Index HSBC CC: HSBC Climate Change Index, MSCI SC Small Cap Index, MSCI Industrial Index; MSCI WE, MSCI World Energy Index; NEX Index, The WilderHill New Energy Global Innovation Index..

As discussed, the time period from Jan 2006 to November 2007 mostly saw a bull market in commodity and equity markets and a sharp rise in the climate change universe, as measured by the HSBC Climate Change Index. The outperformance by the climate change universe indicates that markets were responding to the broader economic demand of adapting to and mitigating climate change, generating excess returns. From November 2007 through May 2008, there was a correction and then a recovery for both climate change and equity markets in general, followed by a severe correction as the credit crisis really made its impact felt. In relative terms, the climate change universe suffered a correction from May 2008 through September 2008. In terms of the drivers of these trends, it is useful to look at a correlation matrix on different time scales to determine which drivers had the most influence on stock prices in the climate change universe. EX 4.4: The correlation of the climate change universe to financial markets over different timeframes Crude Oil

MSCI WORLD

SP 500

Jan 2007 to Nov 2007

0.86

0.95

0.88

0.91

From Nov 2007 to May 2008

0.18

0.91

0.84

0.71

From May 2008 to Sept 2008

0.81

0.96

0.84

0.92

0.81

HSBC CC VS

CORRELATION LESS THAN 0.4

ECO Index Commodity

Water

AG

SP Energy

0.87

0.96

0.95

-0.15

0.90

0.17

0.96

0.96

CORRELATION BETWEEN 0.4 AND 0.65

MSCI SmCap

MSCI Ind

0.94

0.28

0.83

0.62

-0.05

0.06

0.93

0.55

0.62

CORRELATION GREATER THAN 0.65

Source: Bloomberg, DeAM analysis, October, 2008; Abbreviations as above.

During the November 2007 to May 2008 period, the correlation with oil and commodities broke down, as the latter exploded in price and the influence of the credit crisis expanded and dragged on equity markets. From May onwards, the

28

Investing in Climate Change 2009

effect of the credit crisis was to reestablish the correlation of most of these factors. This response has the elements of a “liquidity squeeze” and a number of hedge funds that held renewable stocks liquidated early in September 2008. However, during the sell-off of the broader market, companies concentrated in sectors that are most affected by credit facilities and housing, such as industrials, constructoin, materials, and energy, have been hit the hardest. The sector that is most likely to be influenced by energy and oil prices is the renewable energy sector. We would expect that prices for renewable energy stocks are positively correlated with oil as the oil price increases due to the corresponding improvement in the economic breakeven for renewable energies as traditional energy prices rise. However, as oil prices begin to drop, that correlation should breakdown as prices for renewables are buffered by the subsidies that support these companies. Any changes in the view on subsidies would of course affect this correlation. EX 4.5: The correlation between energy and the solar sector Correlation of energy prices and the solar sector (Sept 06 - Oct 08) $180

$160 Relationship breaks down on subsidy concerns

$120

$160 $140 $120

$100

$100

$80

$80

$60

$60

$40

$40

Good correlation between oil and solar

$20

Solar Market Cap($bn)

Oil Price (USD/bbl)

$140

$20 $0

Oil Prices

8 /0 30 9/

8 /0 30 6/

8 /0 31 3/

/3

1/

07

7 12

/0 30 9/

7 /0 30 6/

7 /0 31 3/

12

/3

1/

06

6 /0 30 9/

6 /0 30 6/

6 /0 31 3/

05 1/ /3 12

9/

30

/0

5

$0

Solar Market Cap

Source: DeAM analysis, Bloomberg, Merrill Lynch, September, 2008.

Exhibit 4.5 shows the correlation between oil prices and the market capitalization of the solar sector. Through the beginning of summer, 2008, the two are closely correlated. During this time period, the correlation is driven by the fact that as energy prices increase, the economic break even for renewables draws nearer. This drives the performance of renewable stocks upward. However, around the beginning of June 2008, concerns began to emerge in the solar sector that the Investment Tax Credit in the US might not be renewed and that there would be a step-down of feed-in-tariffs across Europe. The solar sector is heavily driven by subsidies, and the fear that subsidies could be eliminated meant the stocks did not have downside protection. Overall, the credit crisis affected climate change equities through a number of parallel forces. First, the market experienced a general “liquidity squeeze,” which increased the correlations between most asset classes and hurt industrial and construction related industries. Second, there were sector-specific uncertainties over some regulations. Third, there was the added headwind of a market focus on oil and energy price correlations as these commodities declined in value. Fourth, there was fear of the potential for credit markets to dry up and hinder project development in areas like wind and solar. These forces led in turn to a sharp correction in the climate change universe, particularly in September and going into October raising questions over valuations. In the long-term, climate change sectors should find support from government policies and the general economic impetus required to tackle climate change.

29

Investing in Climate Change 2009

IV The Credit Crisis and Climate Change Investing Valuations – Bursting some sector bubbles? Prior to the credit crisis, there had been talk of whether “bubbles” existed in the climate change investment world. In the public equity markets, valuations as measured by the price to earnings ratio, P/E, are the obvious key measure of a bubble. At an overall level, P/E’s, when aggregated across the universe, were not stretched dramatically and at no point approached the NASDAQ technology sector levels of 1999/2000. We now use the DWS Climate Change Alpha Pool, which is the global pool of investable stocks used by the DWS Climate Change mutual funds. EX 4.6: Historical P/E of the DWS Climate Change Alpha Pool vs. the MSCI World Index

Monthly P/E, with 12 month trailing earnings 30 28 26 24 22 20 18 16 14 12 10 Sep-05 Dec-05

Mar-06

Jun-06 Sep-06

Dec-06

Mar-07 Jun-07

Sep-07 Dec-07

DWS Climate Change Alpha Pool

Source: Bloomberg, DeAM analysis, 2008.

Mar-08 Jun-08

Sep-08

MSCI World

Exhibit 4.6 shows the market cap weighted historical price / earnings ratio of the DWS Climate Change Alpha Pool and the MSCI World. While the DWS Climate Change Alpha Pool has historically been higher than the MSCI World, it has recently moved in line with it. EX 4.7: Distribution of historical P/E of the DWS Climate Change Alpha Pool

Year end P/E, with 12 month trailing earnings Distribution of Current P/E

Distribution of P/E 2006

160

80 56 40

108

106

35

25

27

19

Companies (P/E>0)

Companies (P/E>0)

120

125

120

80

74

57 40 25

6 0 <5

5-10

10-15

15-20

20-25

25-30

30-35

31 22

19

0

>35

<5

5-10

10-15

Range of P/E

20-25

25-30

30-35

>35

Distribution of P/E 2005 120

96

91 80

74 56

40 15

28

20

Companies (P/E>0)

120 Companies (P/E>0)

15-20

Range of P/E

Distribution of P/E 2007

96 86 80 58 40

41

44

35

27

17

12 0

0 <5

5-10

10-15

15-20

Source: DeAM analysis, 2008.

30

70

Investing in Climate Change 2009

20-25

Range of P/E

25-30

30-35

>35

<5

5-10

10-15

15-20

20-25

Range of P/E

25-30

30-35

>35

As shown in exhibit 4.7, across the DWS Climate Change Alpha Pool, we see that P/E ratios are clustered in the 5 to 15x range. This has shifted further to the left since the end of 2007, with the highest frequency now at 10-15x instead of 1520x. The pool of outliers at the 35x+ range also decreased substantially year-to-date in 2008. On a price / earnings basis, the climate change sector as measured by the DWS Climate Change Alpha Pool does not appear to be overvalued. Relative to the MSCI World, the earnings multiples are not significantly higher across the sector. Interestingly, there are many stocks grouped in the 5-10x earnings range, representing potentially strong value in the small to mid cap range along the supply chain of the key sectors. Wind and solar – Valuations were stretched However, certain sectors of the climate change / renewable energy space did exhibit elevated valuations prior to the credit crisis correction. Exhibit 4.8 shows leading wind companies’ multiples. The companies reached 25-35x forward earnings at the peak late last year. In the context of wind’s historical performance, this is hardly a bubble, but they were certainly at the high end when confidence in the market was challenged. The recent correction has seen a drop to the 15-28x range.

Wind Sector Price Earnings with 1 year forward earnings

EX 4.8: Leading wind companies’ P/E with one year forward earnings 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 Aug07

Sep07

Oct07

Nov07

Dec07

GAMESA Source: HSBC, September, 2008.

31

Investing in Climate Change 2009

Jan08

Feb08

NORDEX

Mar08

Apr08

SUZLON

May08

Jun08

VESTAS

Jul08

Aug08

Sep08

IV The Credit Crisis and Climate Change Investing

Exhibit 4.9 below shows leading solar companies’ multiples, which demonstrate much higher valuations in the 20-80x range at the end of 2007. First Solar, a thin film solar PV company (NasdaqGS: FSLR), reached highs of 248x monthly P/E during the time period and is not included on the chart. In this sense, there was more of a bubble mentality in the solar sector and the correction has been severe, with forward earnings multiples heading to the 10-20x range. The solar correction started in Q407, earlier than wind. Now, P/E’s have begun to retreat to levels more in line with the larger market.

EX 4.9: Leading solar companies’ with one year forward earnings Solar Sector PriceP/EEarnings with 1 year forward earnings

120.0 10/07: FSLR reached 248x 100.0

80.0

60.0

40.0

20.0

K\YOCERA

SHARP

Q-CELLS

9/

26 /2 00 8

08

20 08 12 /

9/

00 8 /2

29 /2 0

8/

8/ 15

8

20 08 8/ 1/

8

20 0 18 /

4/ 20 0

SOLARWORLD

7/

7/

8

20 08

20 0

20 / 6/

08

SUNTECH

6/ 6/

23 /2 0

5/

08

00 8 /2 5/ 9

25 /2 0

08

MEMC

4/

00 8

11 /2 0

4/

00 8

8/ 2 3/ 2

20 08

4/ 2

3/ 1

9/

00 8

WACKER CHEMIE

2/ 2

00 8 /2

20 08

5/ 2 2/ 1

2/ 1

20 08

18 /

4/

REC

1/

20 07

1/

12 /2 1/

00 7

20 07

3/ 2

/7 / 12

11 /2

20 07

/2 00 7

11 /9

2/ 20 07

/2 6/

/1

10

10

00 7 28 /2 00 7 9/

14 /2

9/

8/

31 /

20 07

0.0

SUNPOWER

Source: HSBC, September, 2008.

As of yet, there has not been a good test of falling oil prices when subsidies have indeed protected the renewable stocks on the downside. However, the US congress has passed the renewal of incentives (ITC/PTC), so any downside may be met by some resilience from renewables over the longer term. Eventually stock prices will respond to their underlying earnings. At this moment, analysts and companies are reassessing the short-term outlook given the financing constraints. Assuming that more highly regulated markets have more secure earnings potential, the market-led downturn potentially creates a significant value opportunity across the wind and solar sectors for the medium and long term.

32

Investing in Climate Change 2009

What’s been happening in cleantech private markets As already discussed, the credit crisis will certainly affect the funds available to companies and projects in the venture capital private equity space. Some will be stressed through this current phase; some may need repricing. However, the good news is that the sector went into this crunch with strong capital flows and, if anything, more of a fear of bubbles, with market participants reporting strongly competitive demand for deals. As we will discuss in Chapter VI on Market Sizing, venture capital and private equity investment in cleantech has soared over the past several years. Investor demand for access to emerging early-stage companies has been at an all time high, and press releases indicate that new funds have been entering the market across all stages of the capital investment spectrum. Indeed, given recent memories of similar circumstances in the tech boom, investors had been nervous about the possibility of a speculative bubble developing in the private markets. However, a major difference between the recent influx of capital to cleantech sectors and previous investment booms is the asset heavy nature of the new cleantech companies. Clean energy companies require significant capital to finance the construction and operation of utility scale power plant installations or biofuel plants.

EX 4.10: VC investment: Information Technology vs. clean tech ($ billion)

50 45 40 35 30 25 20 15 10 5 0 2000

2001

2002

2003 IT VC

Source: New Energy Finance, McKinsey, September, 2008.

33

Investing in Climate Change 2009

2004 Cleantech VC

2005

2006

2007

IV The Credit Crisis and Climate Change Investing

In Exhibit 4.10, we look at a comparison of clean tech and Information Technology (IT) venture capital in terms of the total investment flows of both streams of venture capital. Even in the trough after the IT bubble, IT venture capital remains many times larger than clean tech venture capital is now. The relative size of the clean tech market to IT venture capital indicates that discussions of overwhelming amounts of capital flowing to this sector are heavily exaggerated. In light of the long term economic demand for the sector, the increasing flows of capital are warranted at the climate change investment level. Additionally, many VC / PE market participants report that the sector is still too young to adequately assess the impact of new capital flows and caution that the possibility of speculative bubbles is more appropriately assessed at the level of individual sectors within the larger theme of climate change investing. New Energy Finance reported that in 2006 venture capital funds deployed only 73% of available capital. We expect the soon to be released totals for 2007 to show a similar level of deployed capital. That means that following the credit crisis, equity capital now has an opportunity to look for the very best investments as debt investors fund less over the coming months. However, as equity in effect replaces debt more during the crisis, projects will require higher returns. This means that only the highest quality projects are going to be able afford increased equity financing and move ahead. Sector specifics: Wind, solar, and biofuels showing increased late-stage confidence from investors While the overall clean tech private investment market has not shown signs of a consistent and wide spread bubble, the sub-sectors of the theme have from time to time seen large capital inflows chasing projects. All areas have shown increases in capital deployed over the past several years, however three sub-sectors stand out as having shown particularly differentiated levels of investment: wind, solar, and biofuels. Indeed, as discussed earlier, wind and solar have seen stretched valuations in the public markets over the past year. In exhibit 4.11, we show the breakdown of solar, wind, and biofuels venture capital and private equity investing from Q1 2007 through Q2 2008. All of the sectors show the beginnings of a shift from high early stage investing to an increased dominance by later stage investment and expansion capital, often coming largely from private equity investors. This shift towards investment in later stage rounds is encouraging for the stability of the longer term trend. Later stage investing, while still risky, represents a greater faith on the part of investors that an underlying technology is ready to begin the transition from early-stage development to commercialization. While there has been plenty of capital looking for a home, there has also been plenty of projects available, though not always at a moderate valuation. EX 4.11: Sub-sector VC / PE investment by stage Sector by Financing Type ($ millions) Sector/Financing Type Wind VC Early Stage VC Late Stage PE Expansion Capital PE Buy-out PIPE/OTC

Solar VC Early Stage VC Late Stage PE Expansion Capital PE Buy-out PIPE/OTC

Biofuels VC Early Stage VC Late Stage PE Expansion Capital PE Buy-out PIPE/OTC Source: NEF, September, 2008.

34

Investing in Climate Change 2009

Q1 2007

Q2 2007

Q3 2007

Q4 2007

Q1 2008

Q2 2008

Total

$381

$610

$440

$384

$154

$1,947

$3,924

$5 $5 $140 $110 $120

$21 $22 $52 $414 $100

$32 $53 $24 $300 $39

$5 $0 $212 $137 $26

$2 $39 $13 $97 $5

$14 $0 $653 $1,024 $256

$82 $118 $1,095 $2,083 $545

$798

$961

$1,183

$841

$919

$1,526

$6,221

$161 $5 $562 $0 $70

$195 $80 $197 $422 $56

$205 $264 $180 $267 $267

$156 $135 $187 $255 $105

$215 $69 $323 $40 $272

$139 $63 $571 $838 $110

$1,072 $617 $2,019 $1,822 $891

$865

$276

$347

$538

$467

$1,018

$3,511

$69 $0 $505 $221 $79

$57 $33 $5 $171 $10

$29 $1 $205 $74 $118

$47 $84 $288 $0 $118

$24 $36 $292 $107 $8

$110 $123 $744 $0 $24

$325 $278 $2,039 $573 $296

Wind and solar specifically show large increases in the amount of private equity buy-out activity that has been taking place. Even more than expansion rounds, this type of investment is a sign that investors have been confident in the readiness of technology to be expanded, listed publicly, or shopped to strategic buyers. However, within late stage wind investing, some market participants state that the sector was getting stretched. Obviously the credit crisis supply implications mean that project success will now be more focused, and investors will be looking for higher returns to compensate for capital availability.

35

Investing in Climate Change 2009

V Investment Attributes of the Climate Change Universe • We have addressed the short term background for climate change investing in Chapter IV • At a fundamental, longer-term level, climate change sectors show low correlation to the economy. Short term, they have shown higher correlation with public equity markets • Renewable energy has been correlated with oil prices but should decouple on the downside due to regulatory support • The climate change universe is well suited to publicly listed equities, private markets and infrastructure as investment strategies. • Historically, inclusion of climate change sectors in a portfolio improves expected returns Investing in climate change Investing in climate change strategies gives the investor a concentrated exposure to a major economic force. Government regulations, economic and market trends, and the development of new technologies are acting in concert as drivers of adaptation to, and mitigation of, the impacts of climate change. The confluence of these factors has resulted in a broad and deep investment universe that not only takes advantage of these trends, but reflects a necessary shift in the organization of the global economy. In this chapter, we will describe the economic and financial attributes of the climate change universe and discuss why it lends itself to certain asset classes. The investable universe to mitigate and adapt to climate change is enormous. Within certain asset classes, the spectrum of investment is also a consideration when deciding how to deploy capital. By investing across many asset classes, including alternatives, a diversified portfolio may reduce overall portfolio volatility and correlation to the broad public markets. Ultimately, climate change analysis can be applied to all investment portfolios. In some cases, the risk of having a large carbon exposure can be assessed across the portfolio holdings, such as the carbon beta of a public equity portfolio. Including climate change sectors in an investment portfolio through proper asset allocation can improve the risk return profile for investors while giving them exposure to a transformation of the economy on the level of the Industrial Revolution. This chapter is divided into five major sections that discuss the considerations an investor should utilize when approaching an investment in climate change sectors.

1. 2. 3. 4. 5.

The climate change universe Persistence of climate change as an identifiable alpha source Fundamental attributes of climate change Applying climate change to different asset classes Benefits of including climate change in asset allocation

The climate change investment universe Human responses to climate change fall into two major categories: mitigation and adaptation. Mitigation is the more widely considered response, although adaptation is a key component to an integrated and balanced response (IPCC 2001, Working Group II).

36

Investing in Climate Change 2009

EX 5.1: Climate change: An integrated framework of mitigation and adaptation Climate change Food and water resources Ecosystem and biodiversity Human settlements Human health

Adaptation

Climate change Temperature rise Sea-level rise Precipitation change Droughts and floods

Orange arrows: cycle of cause and effect Blue arrows: societal response to climate change impacts

Greenhouse gases Aerosols

Socio-economic development paths

Mitigation

Climate change

Adaptation

Economic growth Technology Population Governance

Source: IPCC Climate Change 2001: Synthesis Report - Summary for Policymakers.

Mitigation (also called abatement) is intervention by humans to reduce the sources of greenhouse gases or decrease their environmental impact on the world. Adaptation is adjustments in practices, processes, or structures to take account of changing climate conditions. We then define the climate change investment universe to include all companies that provide any of a diverse range of goods and services that further mitigation or adaptation to climate change. We have identified four broad sectors (i) Clean energy, (ii) Environmental resources management including agriculture and water, (iii) Energy and material efficiency and (iv) Environmental services. Combined, these sectors represent a fast-growing multi-hundred billion dollar marketplace, which offers numerous and compelling investment opportunities. EX 5.2: The climate change investment universe

Environmental Resource Management

Clean Energy Power Generation

Water

Solar Wind Clean coal (sequestration, infrastructure) Other clean power generation (Geothermal, hydro, biomass, wave / tidal, methane capture, nuclear)

Power Storage Technology Battery technology and fuel cells

Land conservation

Wastewater treatment Distribution and management

Lightweight substitues Solvents and biodegradables

Environmental restoration Timberland

Seeds Timberland

Recycling Toxin management Energy from waste Low carbon transportation Bio-diesel, ethanol

Source: DeAM analysis, October, 2008.

37

Building Efficiency

Investing in Climate Change 2009

Land remediation

Forestry Sea defenses Carbon

Building management including green data center management Heating & cooling systems Lighting systems Insulation Micro generation / micro CHP

Waste Management

Transport & Sustainable Biofuels

Environmental Protection

Advanced coatings

Irrigation innovation Clean pesticides Consumer food purity

Infrastructure management Supply chain management

Advanced Materials

Environmental Services

Desalination / purification

Agriculture

Cleantech Infrastructure

Energy & Material Efficiency

Power Grid Efficiency Transmission (including smart grids) Smart metering Storage Infrastructure

Business Services Insurance Logistics Green focused banking Microfinance Consultancy/advisory Intellectual property Weather

V Investment Attributes of the Climate Change Universe

Clean energy Clean energy solutions include products that promote and enhance the diversity of energy supply sources and reduce negative environmental effects such as greenhouse gas (“GHG”) emissions. Clean energy includes, but is not limited to, renewable or alternative energy sources in power genration, such as solar, wind, geothermal, hydro, and nuclear. There are also enabling technologies such as batteries and key storage systems. In the transport sector, it includes the use of biofuels in place of fossil fuels. Environmental resource management: Agriculture and water Climate change is affecting both agriculture and water supply and distribution. The production and processing efficiency of agricultural goods, management of forests and indirect land, development of irrigation equipment/technologies, and application of fertilizers are key to agricultural advancement. There is also a growing market for agricultural raw materials for the growth of biofuel and biodiesel production, as well as demographics-driven increases in the demand for food. Moreover, as global populations increase and environmental influences, such as climate change, impact fresh water sources, the uncertain availability of clean water is of pressing concern. New water treatment technologies and processes are emerging to purify and treat water, which can include drinking, industrial or medical uses, and to allow treated water to be released into the natural ecosystem without any negative environmental impacts. Transportation, infrastructure, and other areas will be crucial in delivering water to global communities in the future. This area of investment includes but is not limited to global water utilities, water treatment technologies, such as desalination and purification, as well as wastewater treatment, distribution, and management. Energy and material efficiency A key area of mitigation technology revolves around energy efficiency and new materials. These sectors span existing and well-known technologies in buildings such as insulation and efficient air conditioning, all the way through to the new nanotechnologies which would evolve efficiency in broad new ways. The use of advanced materials will offer a competitive advantage for new technologies. Such materials include innovative coatings, lightweight substitutes, solvents/biodegradables, nano-materials, and many others. The construction industry is also using new materials for energy efficiency. Supply-side technologies include efficient transmission (including smart grids), smart metering, storage, and infrastructure. Environmental services Investment vehicles for environmental goods and services are developing rapidly, such as carbon credit trading, weather derivatives, and general business services. Trading carbon credits is one method of reducing carbon emissions (cap-andtrade), while weather derivatives allow companies to hedge the impacts of weather activities on their financials. Companies are also now offering business services to address the effects of climate change, such as insurance, consultancy, and microfinance services.

Persistence of climate change as an identifiable source of excess returns As we view climate change as a distinct economic and global theme, we expect the excess return profile of the climate change factor to resemble that of other global themes i.e., to outperform the market over a long period of time and then move generally back in-line with the market as it matures and becomes fully priced in. This is shown in exhibit 5.3.

38

Investing in Climate Change 2009

EX 5.3: The illustrative lifetime of an identifiable investment theme

1 Theme idenitified as a return driver

Source: DeAM analysis, 2008.

We define persistence to mean a factor identifiable at a quantitative level that leads to distinct excess returns over the long term. In our paper, Investing in Climate Change: An Asset Management Perspective, published last year, we identified climate change as such a theme. The question is how long it will remain a distinct theme. In 2006 and 2007, climate change acted as a separate and identifiable theme as evidenced by its excess returns relative to the broader market (See Exhibit 4.1). During 2008, this has corrected, but we view this as a short term phenomenon of the credit crisis. The question of when the theme begins to become the new “normal” and is submerged within the overall market will have different implications for different asset classes. Listed equity and hedge funds may find it more difficult at the far end of our time horizon to successfully pick stocks that can be appropriately classified within the climate change sector. This could happen if large, diversified companies become dominant and the notion of “renewable” fades into “energy.” As discussed later in this chapter, climate change could ultimately become simply a factor in an overall diversified portfolio, measured by carbon risk and carbon beta. Having said that, smaller, emerging pure plays representing innovative business models

39

Investing in Climate Change 2009

2 Theme becomes widely known

3 Theme matures, becoming part of the market

Time and technologies, are likely to remain for many years. Indeed, for strategies focused on identifying, developing, and commercializing innovative new technologies, the potential for sustainable returns will remain. As the sector matures, technologies will become more complex, requiring ever more specialized expertise. Climate change venture capital and private equity investors should expect a long term persistence of the theme as it relates to their focus. The acceptance of the theme by the broader market only offers a more diverse end-market into which they can sell technologies and companies. Infrastructure investment strategies are designed to provide stable returns to investors, and the scope of climate change will require enormous new infrastructure. The installation of new infrastructure projects will extend far into the future. It is possible that “climate change” aspects of infrastructure investment will merge into nearly every “normal” project. As such, they would no longer be identifiable in a separate sense. Overall, as a global economic megatrend, we believe that climate change will persist as an investment theme that requires specialized knowledge. The capital needed to confront the

challenge of mitigation, as pointed out in earlier chapters, is very significant. Government regulations are creating market conditions that are conducive to a global “mega trend” for decades to come. Nonetheless, as an investment theme, it should be regularly evaluated using quantitative factor analysis to verify its continued persistence in terms of excess returns. Fundamental attributes of the climate change universe Climate change sectors: Economic attributes Looking at the climate change universe, sectors of the economy that give rise to significant investment opportunities often have low correlation to the broader economy. For example, annual growth in agriculture exhibits low correlation to GDP. Secondly, the correlation of the annual growth in energy consumption with annual GDP is moderate and has declined over time. The correlation of renewable energy with GDP has been much lower. Water utilities also exhibit low correlation to real GDP growth. The economic attributes of key climate change sectors exhibit low correlation to the general economy. Obviously, housing and construction would be more correlated, particularly at the moment.

V Investment Attributes of the Climate Change Universe

EX 5.4: Economic correlations of climate change sectors Correlations of sector real growth with real GDP growth 1978-2006 0.99

Private industries

0.20

Agriculture, forestry, fishing, and hunting Farms

0.20

Forestry, fishing, and related activities

0.07

Correlations of sector real growth with real GDP growth

Utilities

0.32 1978-2006 0.60 0.99

Waste management and remediation services Private industries Correlations of energy consumption growth (by type) with real GDP growth Agriculture, forestry, fishing, and hunting Source: DeAM analysis, 2008. Hydro and Coal

Solar and Wind

0.57

n/a

1965-2007 0.73 0.69 0.36 0.59 Utilities 1990-2007 0.51 0.75 0.02 0.47 Waste management and remediation services EX 5.5: Climate change sector correlations with real GDP growth

n/a -0.19

-0.07

Total energy

Farms

Petroleum

Nat gas

0.78 0.69 0.48 1950-2007 Forestry, fishing, and related activities

0.20

Nuclear

Wood and Waste

Total renewables 0.20

-0.11

n/a

0.16

-0.13

0.08

0.20

-0.14

0.25

-0.05 0.07 -0.07 0.32 0.04

Geothermal

0.60

Correlations with real GDP growth Correlations of energyTotal consumption growth real GDP growth Ag Farms(by type) with Other Total energy

1948-2007 Petroleum 1978-2007

Nat gas 0.04 0.20

1950-2007

0.78

0.69

0.48

1965-2007

0.73

0.69 1985-2006

0.36

0.34

0.51

1990-2006 0.75

0.02

0.40

1990-2007

1978-2006

0.20

Coal

0.57

Solar- and Wind -

-0.11

Nuclear

Wood and Waste

Total renewables

n/a

0.16

-0.05

0.59

0.33 n/a

-0.13 0.14

0.08

0.20

-0.07

0.47

0.39 -0.19

0.18 -0.07

-0.14

0.25

0.04

0.20

n/a

Hydro and Geothermal 0.07

Correlations with real GDP growth Total Ag

Farms

Other

1948-2007

0.04

-

1978-2007

0.20

-

-

1978-2006

0.20

0.20

0.07

1985-2006

0.34

0.33

0.14

1990-2006

0.40

0.39

0.18

Source: DeAM analysis, 2008.

Correlations with financial markets: 2006 to 2008 While this sets a strong fundamental basis in an economic sense, financial markets are more correlated with the climate change sectors. Our discussion in Chapter IV of the impact of the credit crisis shows that: · From 2006-2007, the HSBC Climate Change Index was highly correlated with the MSCI World Index, industrials, energy, and oil · The correlation tightened in the credit crisis correction this year, with the housing and construction sectors weak · At a more disaggregated level, agriculture was more moderately correlated before the credit crisis Longer term, we would expect financial market correlation of the climate change sub-sectors to become more moderate given the less correlated economic trends versus the overall economy.

40

Investing in Climate Change 2009

Renewable energy and energy prices: Case study Again, as discussed in Chapter IV, the sector that is most likely to be influenced by oil prices in particular is the renewable energy sector. This relationship should be more complex than the actual market trends seem to indicate. We would expect that prices for renewable energy stocks are positively correlated with oil as the oil price increases due to the economic breakeven improving for renewable energies as traditional energy prices rise. However, as oil prices begin to drop, that correlation should breakdown as prices for renewables are buffered by the subsidies that support these companies. Any change in the sustainability of subsidies would of course effect this correlation. Applying climate change to different asset classes The climate change universe has different attributes that lend themselves to certain asset classes. The risk / return profile as well as investment time horizon varies for each asset class. In our paper, Investing in Climate Change: An Asset Management Perspective, published a year ago, we represented the opportunities in terms of risk and return and environmental focus, as shown in exhibit 5.6.

EX 5.6: Specific investment strategies for climate change

Infrastructure • Biofuels • Renewables • Water

Long/Short Cimate Equity

+ FoF Carbon

Carbon Trading

Physical Commodities Including carbon

CDM Carbon Fund Project Origination

Diversified Infrastructure Equities Commodities Including renewables

Forestry

DIVERSIFIED CLIMATE

Risk

• Retail Mutual Funds • Institutional Funds • Structured Products

Venture Capital Clean Tech

Clean Tech small company

Agribusiness ESG Climate Screeen

• New Resources • Climate Mitigation • Climate Adaption

Looking for business opportunities in companies working on climate related products / services

Environmental Focus

0

Source: DeAM analysis, 2008.

41

Investing in Climate Change 2009

++

V Investment Attributes of the Climate Change Universe

EX 5.7: The climate change universe asset class fit

Asset Class Relevant asset class attributes

Relevant Climate Change sectors • Clean energy • Environmental resource management • Energy and material efficiency • Environmental services • Policy and regulatory support for many sectors

Listed Equity • Broad opportunity set for diversification across universe

VC/PE • Emerging technology cycles • Capital requirements

• Diversified large companies where climate change is making an impact • Pure play established companies

•Invest along the value chain e.g. • Solar • Biofuels • Smart grid • Batteries • Etc.

Infrastucture • Established sectors with: • Solid cash flows • Low volatility • Large capital requirements • Government supported

• Public transport • Pipelines, e.g. water and CO2 • Electricity grids

• Emerging microcap from VC/PE cycle

Hedge Funds • Access to all asset classes including progressive (i.e. carbon, weather) • Wide dispersion of returns • Utilize high volatility for upside and downside profit • Derivatives and other instruments • Hedging index/commodities where applicable

Source: DeAM analysis, October, 2008.

In exhibit 5.7, key asset classes are associated with a set of climate change attributes to match their suitability. Investment attributes provide background for different asset classes and climate change sectors offer investment opportunities across all stages of the investment spectrum from venture capital through to listed equities. It is deep knowledge of investment attributes that provides investors with an information advantage. Listed equities Listed equities offer investment opportunities in established and new companies, a broad range of sectors and market capitalizations, and are for the most part highly liquid. In the DWS Climate Change Alpha Pool, we have identified and tracked over 1,000 companies that fall within the scope of climate change related themes. Investing in listed equities and the DWS Climate Change Alpha pool was

42

Investing in Climate Change 2009

covered a year ago in Investing In Climate Change. In terms of alpha generation, we have already looked at the 2006 – 2007 bull run where climate change generated out-performance. The out-performance by the climate change universe indicates that markets were responding to the broader economic demand of adapting to and mitigating against climate change, and this was a source of excess return. In 2008, about 40% of the excess returns generated by climate change in 2006/2007 have been lost on the downside so far. However, the regulatory support, along with the longerterm need for the products and services in climate change, indicates to us that as the dust settles, even with a period of weaker energy prices, climate change can outperform. Measuring carbon’s role in portfolios In addition to investing in mitigation and adaptation companies, integrat-

ing climate change parameters such as carbon risk into the overall investment process in listed equities has emerged as a new opportunity. Investors in listed equities can assess the degree to which portfolios are subject to climate change risk by addressing carbon intensity of different industry sector exposures, individual company risk positioning and carbon financials (e.g., the costs of compliance). Going further and explaining the “risk” scale of the equation, investors could enhance climate change investments by including carbon leaders in the portfolio and avoiding or shorting carbon laggards. Innovest Strategic Value Advisors, for example, has conducted studies on this effect and has shown significant out-performance by carbon leaders (Exhibit 5.8).

EX 5.8: Carbon beta leaders versus laggards Return for 14 quarters

Annualized return

Annulaized difference

Carbon beta Rating Leaders monthly average return

60.18%

17.19%

1.92%

Carbon beta Rating Laggards monthly return

53.45%

15.27%

All sectors

Exhibit 5.8 shows a 1.92% premium for companies with lower carbon beta ratings. Carbon beta incorporates factors such as whether a company has effectively anticipated the future cost of carbon compliance, or already begun to take advantage of low-carbon business opportunities. Source: Innovest Strategic Value Advisors, September, 2008.

Opportunities for hedge funds Within the universe of listed equities described previously, there has been a wide dispersion of returns which is a measure of volatility. A wider dispersion indicates both a riskier investment but also one that offers the potential for absolute higher returns (exhibit 5.9). In the case of climate change listed equities, the dispersion of returns as well as volatility (exhibit 5.10), offers the opportunity for certain asset classes, such as hedge funds, to utilize multiple strategies beyond a longonly framework in order to capture outsized returns using short-selling, derivatives and other techniques. Without a wide enough dispersion, for example, shorting of stocks is not possible, and the potential for effective hedging strategies is limited. This of course is now subject to any long term changes to financial regulation in the wake of the credit crisis. EX 5.9: The spread of market cap weighted returns of the climate change universe 35%

EX 5.10: The volatility of the climate change universe 30.0% 25.0%

30%

20.0%

25%

15.0% 10.0%

20%

5.0%

15%

Source: DeAM analysis, 2008.

Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08

Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08

0.0%

Source: DeAM analysis, 2008.

Private capital (Private equity / venture capital) Private equity (PE) and venture capital (VC) have other attributes that are attractive for climate change investors. First, this asset class is the first sector to pick up emerging technology cycles. VC’s typically invest in innovations around specific technologies, and they ultimately seek to be invested in a disruptive technologies that can change whole industries. For example, many VC’s have been investing in cellulosic biofuel technologies (See Chapter VI on Market Sizing). As the technology emerges, private equity investors step in and provide expansion capital in order for the start-up companies to take their technologies to market.

43

Investing in Climate Change 2009

V Investment Attributes of the Climate Change Universe

The Financial / Investment spectrum Company stage, investment style, and investment attributes are also associated with the amount of capital deployed. Moving across the capital spectrum from infrastructure project finance to venture capital, the risk profile increases, thereby increasing the required return profile. Each investment style requires different amounts of capital and will be influenced by regulations and market dynamics. EX 5.11: The investment spectrum for the private market climate change universe

Capital Deployed $5 million– $20 million

Company Stage

Technology development

Pilot plant

$20 million– $100 million

Demo plant

Venture Capital Investment Style

Investment Attributes

Angel/ A Round

B&C Round

Technology expertise, sector kowledge, Management building

Business strategy

First commercial plant

$100 million

Project portfolio finance

Company expansion

Private equity D Round/Exit-IPO

Sector knowledge, Company building, Financial engineering Material knowledge

Infrastructure Equity

Buyout/PIPES

Project finance

Market knowledge

Source: Hudson Capital Partners.

It is interesting to note that in the clean technology PE/VC/infrastructure space, there is much debate about potential blurring around the “D” round. VC investors still see plenty of risk at the first commercial plant stage and believe that high returns should reflect this level of risk. Private equity investors see this as a more mature phase with some risk. Increasingly infrastructure / project finance investors are looking to de-risk this phase as much as possible. However, the recent credit crisis is likely to put equity, where it is available, in the driver’s seat. PE/VC investments in the climate change universe are attractive for institutional and private investors. A study by the Cleantech Venture Network suggests that a hypothetical portfolio of North-American clean tech companies in the period of 1987-2003 would have returned an estimated 6.2x invested capital, and European markets have reported similar expansion in clean tech investing. Adding PE/VC to a portfolio can have diversification benefits due to reported low correlation to equity markets and lower overall portfolio volatility. However, due to the staleness of pricing, the difficulty of marking to market of illiquid assests, and market volatility, the effect will vary and in some cases not be as great. In addition, private equity can have a much longer time horizon of investment and therefore have lower volatility than the broad equity markets. Since the private markets have difficulty effectively pricing the sales of companies, this style of investing can offer very attractive upside potential. This is particularly true in the climate change universe, where the complexities surrounding clean energy regulation, market access, technology, finance, commodity risk management, and taxation require a sophisticated understanding in order to properly manage investment risk.

44

Investing in Climate Change 2009

Private equity can offer a number of advantages, including a potential for high risk-adjusted returns and diversification relative to other asset classes. Climate change private equity adds diversification to an investment portfolio due to potential improvements to the risk/return characteristics of a portfolio. It also offers access to a rapidly growing segment within the economy.

EX 5.12: U.S. Private Equity Index® Compared to Other Market Indices for the One Year Ended December 31, 2007

U.S. Private Equity Index®

20.39

Nasdaq Composite

9.81

Dow Jones Industrial Average

8.88

Lehman Brothers Govt/Corp Bond Index

7.23

Dow Jones Top Cap

6.26

Russell 1000®

5.77

Down Jones Wilshire 5000

5.62

S&P 500

5.49

Dow Jones Small Cap Russell 2000

®

-5

2.32 -1.57 0

5

10

Source: Bloomberg, Cambridge Associates LLC U.S Private Equity Index®, Lehman Brothers, Inc., Standard & Poor’s, Frank Russell Company, Thomson Datastream, The Wall Street Journal, and Wilshire Associates, Inc. From: Cambridge Associates, LLC., Powered by: Dow Jones Private Equity Analyst Plus, October, 2008.

45

Investing in Climate Change 2009

15

20

25

V Investment Attributes of the Climate Change Universe

Infrastructure investing At a global level, changing demographics and economic development are driving demand for improved infrastructure worldwide. Climate change only enhances this growing demand and therefore the risk / return profile of any investment. Demand for energy will be increasing, even without the added pressure of a carbon limit, and will therefore require value-added strategies not only for developers but their investors as well. Due to historical under-spending on public infrastructure in energy, water, and transportation, climate change regulations will make the supply / demand imbalance more acute. Governments are finding that they cannot fund infrastructure demand through traditional sources and must use private capital in a responsible way. Climate change portends new constraints and opportunities for infrastructure developers and therefore investors. For example, electric utilities are now faced with Renewable Portfolio Standards, and new efficiency standards are leading to smart grid installations. Parking garages and storage facilities are now being outfitted with solar cells in order to send energy back into the grid. Constraints on water resources as a result of climate change will challenge water infrastructure developers. Successful infrastructure fund managers will have a unique understanding of potential regulatory arbitrage across jurisdictions, as well as a keen understanding of the global interplay between traditional energy generating sources, renewable energy sources, and the impact of a future price for carbon. Most infrastructure funds raising capital today are focusing primarily on “mature” infrastructure investment opportunities, broadly defined as all developed infrastructure and not “greenfield” development opportunities. Mature infrastructure funds generally have somewhat different strategies and targeted returns, but most share certain unique features including: (1) a focus on investments generating stable cash yield, (2) moderate but steady asset appreciation, (3) portfolio diversification and risk mitigation, and (4) returns hedged against inflation. In general, infrastructure investors will seek to acquire investments that are not exposed to a large degree of technology risk. Clean energy in particular offers investment opportunities that will fit well with infrastructure funds’ risk / reward investment profiles. Clean energy developments can offer investors a fixed income stream, as they typically sell their generated energy through attractive power purchase agreements with established creditable counterparties. Another area in which climate change investors are interested is transmission and distribution (T&D). T&D assets provide many of the investment characteristics desired by infrastructure investors. The opportunities for climate change investors are widespread all-encompassing electricity grids and power generation, energy storage, and water infrastructure. EX 5.13: What is infrastructure investing? Transport

Utilities

Other

• Bridges

• Gas networks

• Parking garages

• Education facilities

• Toll roads

• Electricity networks

• Storage facilities

• Healthcare facilities

• Tunnels

• Power generation

• Airports

• Water & sewerage

• Sea ports

• Renewable energy

• Freight rail

• Communications

• Public transportation

• Correctional facilities

infrastructure

Focus on: “User-pays” assests that provide essential services capable of generating a strong and stable cash return Source: RREEF analysis, October 2008.

46

Social infrastructure

Investing in Climate Change 2009

Not a focus at this time

EX 5.14: The low volatility of infrastructure investing

Stocks: Wilshire REIT Russell 2000 Stock Index NAREIT-Equity REITs Standard & Poor’s 500

Core Real Estate: NCREIF Property Index Bonds: U.S. Long-Term Govt. Bonds U.S. Int-Term Govt. Bonds U.S. 30-Day Treasury Bills U.S. Inflation (CPI)

Return rank

Mean return

Volatility (Std. Dev.)

1 2 3 4

13.9 10.6 10.0 9.8

17.4 17.9 6.4 14.6

5

10.3

6.4

6 7 8 9

7.8 7.7 5.3 4.1

2.5 2.7 3.2 3.0

Source: RREEF analysis, October 2008.

For instance, as climate change continues to impact meterological patterns, additional water infrastructure investments will be required, especially in drought ridden areas. A large portion of infrastructure funds that target industrialized countries focus on impoving existing assets. By contrast, infrasturcture funds targeting emerging companies may have a greater focus on “greenfield” assets. In many of the emerging economies, before government authorities give concessions to private operators / developers to build new infrastructure, they are increasingly requiring “sustainable” or “green” types of developments to be used. The credit crisis may well create headwinds for debt heavy infrastructure for a while. However, a fiscal stimulus could well come to the rescue here, as many sectors in infrastructure, including those related to climate change, would likely receive funds. EX 5.15: Infrastructure investing: Relative placement along risk return spectrum Development infrastructure

“Opportunistic” investment strategies

Opportunistic real estate

Potential reward

Growth infrastructure

Value-added real estate

Mature infrastructure

Real estate securities Listed infrastructures

“Core” investment strategies

securities Core plus real estate Core real estate

Source: RREEF analysis, October 2008.

47

“Value added” investment strategies

Investing in Climate Change 2009

Risk

V Investment Attributes of the Climate Change Universe

Sustainable timberland and forestry investing - Reforestation Forests offer the climate change investor the opportunity to sequester carbon and even potentially derive valuable and tradable carbon credits. The key to this is using a sustainable approach to managing the forest and ensuring that the end use of the timber reduces carbon emissions (e.g. second generation biofuels, housing, furniture). Reforestation of degraded lands would be particularly positive for carbon sequestration. Therefore, from a climate change perspective, forestry and timberlands offer a tremendous opportunity for investing. Timberland investing offers uncorrelated returns with financial assets historically, and also has served as an inflation hedge. Timberland investment is a sub-sector of the real estate investment class. Like real estate, timberland investors are able to invest in both timberland focused funds, pure play timber companies, and in the actual timberland itself. Timberland is generally differentiated from basic real estate investments, insofar as it is focused on the production of timber, a saleable asset. Unlike farmland, owners of timberland can choose to delay harvesting the wood on their land. Depending on the price of lumber and the state of the larger timber markets, this characteristic offers investors a possible mechanism to hedge against downturns in current timber prices. The long-term nature of timberland investing often matches the investment goals of the long-term pension liabilities they serve. Moreover, the biological growth of the forest of 5-15% per year and the harvest decision as a valuable option are also advantages of this investment. Studies have shown that the major components of timber returns include land prices of 5%, timber prices of 33%, and biological growth of 61%. Over the long run both inflation and timberland returns have been positively correlated, and the class is often cited as an inflation hedge, especially against unexpected levels of inflation. Timberland can also be a better risk adjusted investment than equities.

EX 5.16: Timberland investing: Relative placement along risk return spectrum

Return (%/Year)

16% 14% Small Cap Equities

Timberland

12% 10%

S&P 500

International Equities*

Commercial Real Eastate*

8%

Long-Term Corporate Bonds

6% 4%

U.S. Treasury Bills

0%

5%

10%

15%

20%

25%

30%

Standard Deviation (%/Year)

Source: Hancock Timber Resource Group, October, 2008.

48

Investing in Climate Change 2009

Benefits of including climate change in asset allocation Investors seek investment mangers that can provide returns within a certain tolerance of risk. While we believe that many investment managers have deep knowledge of market risk, the knowledge and sophistication required of the climate change universe offers a unique information advantage. Recall that it is the understanding of governmental regulations, break even analysis of technologies, and the various market trends that are the key factors that can lead to a manager’s alpha, the value added above beta exposure that reflects a manager’s skill. In addition to the selection of managers, studies have shown that strategic asset allocation explains >90% of the variability of an investment plan’s returns over time and that there is 35-40% variability of returns across investors. The ‘unexplained’ portion of return is from a variety of sources including style within asset classes.

Box 5.1: Efficient frontier: Balancing risk and return

When alternatives are introduced to the portfolio, the potential return may increase. More importantly, however, a portfolio of alternatives can provide a potential increase in returns with a lower amount of corresponding risk. Additionally, the plot of the alternative risk/return profile is not as linear as the tradtitional portfolio. The return increases rapidly with commensurately less risk increase, until a point on the curve when the increase of return begins to slow and the increase of risk begins to speed up. Successful portfolio allocation can move the efficient frontier further and further above the line plotted by the traditional portfolio.

[ For illustrative purposes only ] Overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return Target Portfolio

Expected Return

The efficient frontier provides a method of comparing the relative risk/return profiles of different portfolios. With increasing risk, a portfolio is typically expected to return at a higher rate. A traditional portfolio consisting of a mix of cash, bonds, and public equities can be expected to generate a moderate risk-adjusted return. This return is tightly correlated to the amount of risk that the portfolio holds.

With Alternatives

Efficient Frontier Risk-Free Asset

Risk Source: DeAM analysis, October 2008.

Case study: Historical performance of introducing listed climate change companies in a portfolio (historic data) In order to understand the role that climate change strategies can play in a well diversified portfolio, we conducted research using an efficient frontier analysis and a portfolio optimizer tool, Portfolio Choice™. We have looked at the effect of adding climate change sectors into a portfolio based on the return, volatility, and correlation over the period January 2006 to September 2008. We then constructed our efficient frontier using three scenarios of 1%, 3%, and 5% allocation to each strategy, with a total of three strategies for a total climate change allocation of 3%, 9%, and 15%. Due to their unusually low returns, we used our strategic return views and historic volatilities for the MSCI World and the Citi WorldBIG indices, and the historic returns and volatilities for the climate change strategies. We used the following indices to represent our three climate change strategies: Water (PIIWI Index Palisades Global Water Index), Agriculture (DXAG Index DAXGlbl Agribusiness), and Clean energy (NEX, The WilderHill New Energy Global Innovation Index).

49

Investing in Climate Change 2009

V Investment Attributes of the Climate Change Universe

In the following table we show the historical returns and volatility of the respective indices that we used for our analysis. [ For illustrative purposes only ]

EX 5.17: Inputs for efficient frontier analysis ASSET CLASS

Number of Periods

Return View

Historical Ann Return

Historical Ann Volatility

Predicted Ann Return

Predicted Ann Volatility

MSCI WORLD

33

6.63%

0.60%

13.05%

7.06%

14.66%

CITIGROUP WORLD BIG (HEDGED)

33

3.70%

3.82%

2.57%

3.62%

2.82%

CLEAN ENERGY

33

-

12.94%

26.98%

-

-

AGRICULTURE

33

-

22.27%

26.35%

-

-

WATER

33

-

4.82%

21.55%

-

-

Source: DeAM analysis, October 2008.

EX 5.18: Efficient frontier: Adding climate change can potentially add benefits to portfolios

Efficient Frontier: Adding Climate Change

[ For illustrative purposes only ]

8.0% 7.5%

Expected Return

7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

Standard Deviation Traditional

Traditional + CC 5% each

Traditional + CC 3% each

Traditional + CC 1% each

Source: DeAM analysis, October 2008.

From a historical perspective, while all three portfolios with climate change indices did shift to the right on the volatility measure, the increase in total portfolio volatility versus the traditional portfolio is relatively small compared to the increased returns. The addition of climate change assets improved the efficient frontier. Incremental increases in return were associated with each increase in allocation with similar measures of risk. This indicates to us the positive impact of climate change sectors on portfolio performance.

50

Investing in Climate Change 2009

In order to understand this dynamic even further, we selected a portfolio with the risk measure of 8% and evaluated that portfolio’s other attributes. According to our model, the probability of outperforming target returns would increase significantly across each allocation level. For example, moving from the traditional portfolio with an 8% return target and an 8% volatility, the probability of outperforming our target returns went from 37.8% to 39.8% for the 3% change and to 40.7% for the 5% allocation (for the full table of attributes, please see exhibit 5.20). By adding climate change strategies, we improve the probability of outperforming our target returns across various target returns. Furthermore, the probability of negative returns decreased across our target returns as well as in each end point portfolio. Mean return is 70 basis points higher with climate change indices with an allocation of 5% to each strategies. From these results, we see that adding climate change can certainly add significant value to a traditional portfolio. Not only are expected returns increased, but the overall risk of the portfolio can be reduced. EX 5.19: Traditional portfolio with 5% allocation of each climate change sector Traditional + Climate Change 5% each 4.00%

6.00%

8.00%

Manager MSCI WORLD CITIGROUP WORLD BIG (HEDGED) CLEAN ENERGY AGRICULTURE WATER

Target Return:

29.19% 55.81% 5.00% 5.00% 5.00%

36.92% 48.08% 5.00% 5.00% 5.00%

36.92% 48.08% 5.00% 5.00% 5.00%

Probability of Outperforming Target Return Probability of < 0% Return Expected shortfall versus Target Return Conditional shortfall versus Target Return Mean Return Volatility

58.4% 23.84% 2.30% 5.54% 6.32% 7.98%

49.62% 23.98% 3.23% 6.41% 6.23% 7.98%

40.68% 23.98% 4.34% 7.31% 6.23% 7.98% [ For illustrative purposes only ]

Source: DeAM analysis, October 2008.

Note that all returns are pre-tax. Efficient frontiers and illustrative returns are based on proprietary model and are presented for illustrative purposes only. Actual use of the model results requires a review of assumptions and important information from the model itself. Forecasts for traditional assets based on Deutsche Bank forecasts. Past and/or forecast performance is no guarantee of future results.

Attractive returns generally to continue in future years Obviously, the returns of both agriculture and clean energy were boosted significantly in the bull run of 2006 / 2007. These absolute levels are unlikely to continue, but we believe that the climate change sector trends mean that the key sectors will continue to out perform and so improve the risk return trade off for investors. The returns mentioned above are for the known indices and do not reflect the potential for larger returns associated with the theme that could be generated by a successful manager. As we have discussed, climate change investing can be suitable for all asset classes. Different asset classes provide distinctly different risk / return profiles, and investors should pay close attention to their individual portfolio asset allocation needs and goals. Our case study has shown the potential effect of adding only climate change listed equities to a portfolio. The inclusion of alternative asset classes such as hedge funds, private equity, infrastructure, and timberland would continue to influence the risk / return profiles of a portfolio.

51

Investing in Climate Change 2009

V Investment Attributes of the Climate Change Universe EX 5.20: Comparison of traditional portfolios with climate change strategies Traditional 4.00%

6.00%

8.00%

Manager MSCI WORLD CITIGROUP WORLD BIG (HEDGED) CLEAN ENERGY AGRICULTURE WATER

Target Return:

62.34% 37.66% -

62.34% 37.66% -

62.34% 37.66% -

Probability of Outperforming Target Return Probability of < 0% Return Expected shortfall versus Target Return Conditional shortfall versus Target Return Mean Return Volatility

55.67% 26.64% 2.60% 5.85% 5.53% 8.01%

46.42% 26.64% 3.58% 6.68% 5.53% 8.01%

37.85% 26.64% 4.75% 6.68% 5.53% 8.01%

Traditional + Climate Change 1% each 4.00%

6.00%

8.00%

Manager MSCI WORLD CITIGROUP WORLD BIG (HEDGED) CLEAN ENERGY AGRICULTURE WATER

Target Return:

57.72% 39.28% 1.00% 1.00% 1.00%

57.72% 39.28% 1.00% 1.00% 1.00%

57.72% 39.28% 1.00% 1.00% 1.00%

Probability of Outperforming Target Return Probability of < 0% Return Expected shortfall versus Target Return Conditional shortfall versus Target Return Mean Return Volatility

56.33% 26.16% 2.54% 5.82% 5.68% 8.04%

47.12% 26.16% 3.51% 6.65% 5.68% 8.04%

38.58% 26.16% 4.67% 7.60% 5.68% 8.04%

Traditional + Climate Change 3% each 4.00%

6.00%

8.00%

Manager MSCI WORLD CITIGROUP WORLD BIG (HEDGED) CLEAN ENERGY AGRICULTURE WATER

Target Return:

47.80% 43.20% 3.00% 3.00% 3.00%

47.80% 43.20% 3.00% 3.00% 3.00%

47.80% 43.20% 3.00% 3.00% 3.00%

Probability of Outperforming Target Return Probability of < 0% Return Expected shortfall versus Target Return Conditional shortfall versus Target Return Mean Return Volatility

57.31% 25.17% 2.43% 5.69% 5.97% 8.04%

48.54% 25.17% 3.38% 6.56% 5.97% 8.04%

39.80% 25.17% 4.51% 7.48% 5.97% 8.04%

Traditional + Climate Change 5% each 4.00%

6.00%

8.00%

Manager MSCI WORLD CITIGROUP WORLD BIG (HEDGED) CLEAN ENERGY AGRICULTURE WATER

Target Return:

29.19% 55.81% 5.00% 5.00% 5.00%

36.92% 48.08% 5.00% 5.00% 5.00%

36.92% 48.08% 5.00% 5.00% 5.00%

Probability of Outperforming Target Return Probability of < 0% Return Expected shortfall versus Target Return Conditional shortfall versus Target Return Mean Return Volatility

58.4% 23.84% 2.30% 5.54% 6.32% 7.98%

49.62% 23.98% 3.23% 6.41% 6.23% 7.98%

40.68% 23.98% 4.34% 7.31% 6.23% 7.98%

Source: DeAM analysis, October, 2008.

52

Investing in Climate Change 2009

[ For illustrative purposes only ]

This page is left intentionally blank

Market Sizing: Scarce Resources and the VI Size of the Markets • IEA calls for a potential of $45 trillion of investment in renewable energy technologies by 2050. • $148 billion of new clean technology capital market investment in 2007 • YTD 2008 investment figures depict a continuously growing and healthy climate change sector. • Potential for annual $600 billion clean technology capital market investment landscape by 2020.

In 2007 and YTD 2008, we have seen the underpinning of a long-term secular investment trend in climate change. Primarily driven by continued scientific arguments for mitigation and adaptation, technological advancements, government regulatory action and social awareness, the climate change sector has experienced an influx of investment in 2008 thus far. We will examine the past growth and projected development of this sector.

I. Underlying supply framework–market size projections Energy demand will lead to a potential of $45 trillion in renewable energy investments by 2050, says IEA. EX 6.1: Low carbon projected growth of renewable power generation

Source: © OECD/IEA, 2008, Energy Technology Perspectives.

Energy demand to increase In the absence of major regulatory changes, the International Energy Agency (IEA) forecasts a 70% increase in oil demand by 2050, and a 130% increase in CO2 emissions, compared to 2005 levels. However, with ambitious new policies, emissions can be reduced significantly and oil demand can be reduced by 27% compared to the 2005 level. Renewable energy sources have the potential to comprise 46% of total electricity supply by 2050, See exhibit 6.1.

54

Investing in Climate Change 2009

$45 trillion needed by 2050 To meet increasing renewable energy demand, along with a greenhouse gas emissions reduction target of 50% from 2005 levels by 2050, the IEA finds that $45 trillion of investment will be needed from present day through 2050. Capital would need to be heavily deployed into the development of next-generation technologies to create energy efficiency and low carbon options.

Demand for water and food supplies will reach record levels. The world population is expected to grow to over 9 billion in 2050, causing significant effects on food and energy resources. Driven by higher inevitable demand, water, agriculture and other resource depletion will lead to carbon emissions and climate change as key consequences. EX 6.2: Water Consumption and population 6000

9

Annual Water Consumption

8

World Population

5000

7 6 5 3000 4 3

2000

2 1000 1 0

Source: UN, World population prospects, the 2006 Revision: FAO of the United Nations

EX 6.3: Demand and production of cereal food balances by 2030

Source: Food and Agriculture Organization of the United Nations, 2008.

55

Investing in Climate Change 2009

30 20

20 20

10 20

00 20

90 19

80 19

70 19

60 19

50 19

40 19

20 19

19

00

0

billions

km3

4000

Market Sizing: Scarce Resources and the VI Size of the Markets II. Underlying technology market size projections

EX 6.4: Wind, solar, biofuels and fuel cells expected to see $254.5bn of global revenue by 2017

Climate change will continue to initiate substantial new, emerging markets, ranging from solar and wind to nanotechnology, energy storage, nuclear and Carbon Capture and Storage (CCS) technologies. We examine the astonishing potential size of these cleantech markets below.

Source: Clean Edge, Inc., 2008 -- www.cleanedge.com.

The solar industry is expected to remain robust and profitable over the next few years as the technology approaches grid parity or commercial breakeven with traditional fossil fuels. With government tax subsidies and incentives for solar in over 40 countries, innovative technologies will emerge and drive efficiency and wide-scale use. The global solar market will grow from $33.3bn in 2008 to $100.4bn in 2013 Source: Lux Research, “Solar State of the Market Q3 2008”.

EX 6.5: Total solar PV installations by 2013, Global (MW)

EX 6.6: Total solar PV installations by technology by 2013, Global (MW)

Source: Lux Research, “Solar State of the Market Q3 2008”.

Source: Lux Research, “Solar State of the Market Q3 2008”.

EX 6.7: Crystalline silicon continues to lead by global market share through 2013 - $64.1bn

Source: Lux Research, “Solar State of the Market Q3 2008”.

56

Investing in Climate Change 2009

Wind power generation can respond profitably to growing energy demand, and has the ability to compete advantageously with traditional fossil fuels. Capable of wide-scale use, the wind power sector experienced the most new capital market investments in 2007, compared to any other renewable energy source.

EX 6.8: Wind power installations, Global (MW)

EX 6.9: Wind penetration by 2030, % of total generating capacity (MW)

Source: Clean Edge, Inc., 2008 -- www.cleanedge.com.

Source: New Energy Finance, 2008.

EX 6.10: Offshore wind projects

Source: New Energy Finance, as of 2007.

57

Investing in Climate Change 2009

Market Sizing: Scarce Resources and the VI Size of the Markets Storing energy from various sources has become critical for the purpose of saving and then using the otherwise wasted energy at a different time, place, or form. Energy storage is typically defined as encompassing the following technologies: 1) batteries, 2) capacitors, 3) fuel cells, 4) non-electrochemical energy storage, and 5) energy harvesting. The $41.2bn energy storage market will grow to $63.9bn globally in 2012 Source: Lux Research, “Alternative Power and Energy Storage State of the Market Q2 2008”.

EX 6.11: Energy storage market size by sector, Global $bn

EX 6.12: Transportation energy storage market size, Global 2004 - 2012

Source: Lux Research, “Alternative Power and Energy Storage State of the Market Q2 2008”.

Source: Lux Research, “Alternative Power and Energy Storage State of the Market Q2 2008”.

The nanotechnology industry saw approximately $13.5 billion of corporate, government and venture capital funding in 2007. According to Lux Research, Nanotechnology was used in $147 billion worth of products last year. Nanotechnology is defined as a field of applied science related to the engineering of matter and the fabrication of devices on an atomic scale, generally 100 nanometers or smaller. Revenue from products incorporating nanotechnology will grow to $3.1tn in 2015 globally from $238bn in 2008 Source: Lux Research, “Nanomaterials State of the Market Q3 2008”.

EX 6.13: Global sales of products incorporating nanotechnology by sector ($M)

Source: Lux Research, “Nanomaterials State of the Market Q3 2008”.

58

Investing in Climate Change 2009

Brazil and the United States account for most of the world’s ethanol production, while a number of other countries are creating initiatives to increase ethanol production. Renewable fuel standards and government incentives are just a few of the drivers contributing to this growth. The European Union is the largest biodiesel producer, with rapeseed oil as its main feedstock. EX 6.14: Biofuels produced, Global (Gallons)

EX 6.15: Ethanol production mostly from grain feedstocks except for Brazil, Global

Source: Clean Edge, Inc., 2008 -- www.cleanedge.com.

Source: USDA, May 2008.

EX 6.16: Biodiesel production, Global

Source: USDA, May 2008.

EX 6.17: Global new nuclear capacity planned (GW)

There is much discussion of nuclear energy as a low carbon option for energy markets and a number of forecasts show it growing quite rapidly in the coming years. Much of this depends on nuclear waste storage.

Source: New Energy Finance.

59

Investing in Climate Change 2009

Market Sizing: Scarce Resources and the VI Size of the Markets

In the long-term, CCS is expected to be developed and plays a key role in mitigation. Proving that will require demonstration plants to be successful. See Appendix III for more detail.

EX 6.18: Planned carbon capture & storage (CCS) projects

Source: New Energy Finance, 2008.

60

Investing in Climate Change 2009

III. Capital market investment projection & activity EX 6.19: Annual worldwide clean technology investment is expected to reach $450bn by 2012 and $600bn by 2020

Source: New Energy Finance, 2008.

3Q 2008 Investment update

EX 6.20: Global venture capital investment, 3Q08

Despite the impact of the global credit crisis on market conditions in 3Q 2008 (see Chapter IV in Part I), venture capital invest-

$1,125

ment continued to increase in the clean technology sector over this period. According to early reports released by the Cleantech Group, clean technoloby VC investments increased from $2.2 billion in the second quarter to $2.6 billion in the third quarter, an 18% increase QoQ. These investments were made in a broad array of sectors, including solar, wind, biofuels, energy storage,

$270 $167

$123

cling, among others. All together, the Cleantech Group found

In 3Q08, the solar industry dominated once again, primarily driv-

Water & wastewater

Transportation

Biofuels

Wind

to 106 in the last quarter.

Solar

that there were 127 disclosed VC financing deals, in comparison

$98

$80 Agriculture

water & wastewater, agriculture, advanced materials and recy-

Source: Cleantech Group (cleantech.com), October 2008. Select sectors listed above.

en by strong VC investment in thin-film technologies. The solar market saw approximately 40% of all cleantech VC investments,

EX 6.21: Global venture capital investment by region, 3Q08

while wind made up approximately 10% of all investments.

6%

The third quarter was also a breakthrough period for Algal-based biofuels and the water sector, which experienced significant growth from the second to third quarter. See exhibit 6.20. 30%

64%

North America

Europe/Israel

Europe/Israel

Source: Cleantech Group (cleantech.com), October 2008. Select sectors included in above.

61

Investing in Climate Change 2009

Market Sizing: Scarce Resources and the VI Size of the Markets 2007 & 1H 2008 Investment update

EX 6.22: Total global new investment in clean energy 2007 & 1H 2008

In 2007, the clean technology sector saw approximately $148 billion of new worldwide investment, a 60% increase from 2006 investment levels, according to New Energy Finance. See exhibit 6.22. Investment capital was allocated across a number of markets: research & development, venture capital / private equity, project / asset financing and public markets. The rise in clean technology investment over the past year depicts a greater interest in the advancement of next-generation technologies, as well as an increase in renewable energy capacity in areas outside developed nations. Importantly, in the first half of 2008, many markets continued to show growth in the face of the credit crisis. In 2007, wind, solar and biofuels saw the most new global investment. See exhibit 6.23.

Source: New Energy Finance, Adjusted for reinvestment. Geared re-investment assumes a 1 year lag between VC/PE/Public Markets funds raised and re-investment in projects. *Figures are based on industry estimates/indicative values only. VC/PE estimate excludes buyouts; Asset Finance excludes refinancing & acquisitions; Public Markets excludes investor exits. M&A estimate includes buyouts, asset acquisitions and PM investor exits.

EX 6.23: Global new investment by technology 2007 & 1H 2008, $M

Source: New Energy Finance Note: Grossed-up values based on disclosed deals. The figure represents total new investment in clean energy only, and so excludes investor exits made through public market offerings. PE buy-outs and acquisitions of projects and companies.

62

Investing in Climate Change 2009

Regional analysis Europe saw the majority of investment in the last five years,followed by the US. See exhibit 6.24. EX 6.24: New investment by region (VC/PE, Public Markets, Asset Finance), 2004 vs. 2007

Source: New Energy Finance. The figure represents total new investment in clean energy only, and so excludes investor exits made through public market offerings. PE buy-outs and acquisitions of projects and companies.

Private equity / Venture capital investment reaches record high in 2008 YTD

In 2007, there were a total of 486 disclosed clean technology

In 2007, there was $13.5 billion of clean technology private equity

PE/VC deals, of which 200 were VC early stage deals alone.

and venture capital investment, of which approximately $9.9 billion

In 1H 2008, there were a total of 184 disclosed deals.

was new investment (excludes PE buy-outs). The total amount invested in 2007 represents a 46% increase from 2006 levels.

In 2007 and 1H 2008, solar saw the most PE/VC investment, See exhibit 6.26.

In 1H 2008, a total of $8.3 billion clean technology PE/VC investments was made, of which $6.1 billion was new investment. Given the historical rate of growth, we expect the clean technology PE/VC sector to reach another record year of investments by the end of 2008. See exhibit 6.25. EX 6.25: Global PE/VC transactions in clean energy companies, $M

Source: New Energy Finance.

63

Investing in Climate Change 2009

EX 6.26: VC/PE investment by technology, $M

Market Sizing: Scarce Resources and the VI Size of the Markets

Project / Asset financing cleantech investments

EX 6.27: Global asset financing, $M

Asset financing represents all capital invested in renewable energy projects, from internal company balance sheets, debt finance or equity finance. In 2007, there was approximately $108.3 billion invested in clean technology through asset financing, a 61% increase YoY, primarily driven by the construction of new power generation projects. Of this total, $83.7 billion was new investments (new-build, excludes refinancing and acquisitions). In 1H 2008, there was $50.4 billion of asset financing, of which $35.3 billion was new investments. See exhibit 6.27. All together, there were 672 disclosed asset financing deals in 2007, compared with 414 in 2006. In 1H 2008, there were 241 of disclosed asset financing deals. In 2007 and 1H 2008, wind saw the most asset financing investment, See exhibit 6.28.

EX 6.28: Asset financing investment by technology, $M

Source: New Energy Finance, 2008.

64

Investing in Climate Change 2009

Source: New Energy Finance, 2008.

Public markets

EX 6.29: Global transactions on public markets, $M

In 2007, there was $23.4 billion of new equity raised on public markets for initial public offerings, in comparison to $10.9 billion raised in 2006. In 1H 2008, the amount of capital raised for IPOs was minimal compared to previous years due to an economic downturn. Nonetheless, there was a total of $5.9 billion raised, primarily in 2Q 2008. The increase of equity raised in the second quarter represents the sector’s gradual recovery from market volatility, scarce liquidity and investor concern. See exhibit 6.29. In 2007, there were a total number of 154 public market offerings. In 1H 2008, there were 55. In 2007, wind saw the most activity in public markets. In 1H 2008, solar saw the most activity in public markets. See exhibit 6.30.

Source: New Energy Finance, 2008. Excludes investor exits.

EX 6.30: Public market investment by technology, $M

Source: New Energy Finance, 2008. Excludes investor exits.

65

Investing in Climate Change 2009

Market Sizing: Scarce Resources and the VI Size of the Markets Carbon markets

EX 6.31: Growth of carbon markets: reported transaction volumes from 2003-2008, Gt CO2e

Since the inception of the Kyoto Protocol, the European Union’s Emissions Trading Scheme (ETS) and the UN’s Clean Development Mechanism (CDM) systems have come to represent the main implemented carbon markets. In 2007, the overall volume of global carbon emissions traded was 2.7 billion tons (Gts). Of this total, approximately 1.6 billion tons of CO2 was traded through the EU’s ETS system, while growth in trading volume and frequency within the EU ETS is expected to further increase in 2008. All member states of the European Union can auction up to 10% of their carbon allowance credits for the second phase of the EU ETS “cap-and-trade” scheme, from 2008 to 2012. The United States currently has three emerging markets: Regional Greenhouse Gas Initiative 2003 (covers 10 North-East/Mid-Atlantic states), Western Climate Initiative 2007 (covers 11 US and Ca-

Source: Point Carbon, 2008.

EX 6.32: Potential total size of carbon markets in 2020

nadian states), and the Midwestern Governors Association 2007 (covers 12 US states). More importantly, there is still the possibility of Congress passing a revised version of a cap-and-trade bill. If adapted, this would provide a massive boost for carbon markets and would lead to explosive growth. As of January 2008, more than half of the 907 CDM projects registered with the UNFCCC were located in China and India. India accounts for the largest share of these projects, but China leads in its total value of CDM projects.

Source: Point Carbon, 2008.

66

Investing in Climate Change 2009

IV. Climate change-related fund market There has been continued growth in the number and size of climate change-related funds across different asset classes.

EX 6.33: Sustainable energy funds by type and asset class, March 2008

EX 6.34: Carbon funds, 2004 – 2007, $M

29,968 26,396

Source: New Energy Finance, 2008. Clean energy funds: those that invest more than 50% in renewable energy or energy efficiency companies. Environmental funds / climate change: those with less than 50% of their investments in renewable energy or energy efficiency and climate change funds.

Source: New Energy Finance, 2008.

EX 6.35: Estimated number of climate change-related mutual funds/ETFs, March 2008

EX 6.36: Estimated number of green hedge fund managers

Source: Lipper FERI, Strategic Insight, Simfund. Notes: Data also include clean technology and energy funds, 2008.

Source: DeAM analysis, 2008.

EX 6.37: Estimated number of private equity funds, September 2007

Source: New Energy Finance, 2008.

67

Investing in Climate Change 2009

VII Carbon and Energy Prices

• Three fossil fuels – coal, oil and gas – supply 88% of the world’s primary energy. Consumption is set to rise as the world’s population grows and wealth increases. • These three fossil fuels are responsible for about 60% of global greenhouse gas emissions. • Fossil fuel prices have been rising but volatile in the last few years, recently spiking significantly and then declining. In the long-run (beyond 2015), oil prices are expected to return to above $90 a barrel (in real terms), gas prices are expected to return to at least $9/MMBtu (in real terms), and coal prices are expected to fall back to a $50-$75/ton range (in real terms). Low coal prices will have serious implications for greenhouse gas mitigation and carbon pricing. • Carbon price, the supply/demand balance of each of the three fossil fuels, and the scaling capacity of renewables are intricately linked in a dynamic relationship. • Currently, the market has tended to correlate carbon prices in Europe with oil prices. In the long-run, we do not expect that to hold, especially as coal becomes more plentiful. This is a key input into our view that the carbon price has a long-term central role to play in policy by acting as a backstop to ensure reduced emissions. The combustion of fossil fuels accounts for about 60% of anthropogenic greenhouse gas emissions and 88% of the world’s primary energy. As fossil fuel prices spiked recently, some have argued that high energy prices alone are enough to prompt a massive decarbonization of the global economy because renewables will reach breakeven faster against their fossil fuel competitors. The reality of the supply and demand of coal, oil and gas – and their relationship to greenhouse gas mitigation – is far more complex, as illustrated by the recent drop in fossil fuel prices. We therefore devote a chapter to understanding the dynamics of fossil fuel markets and their relationship to carbon, renewables and greenhouse gas mitigation. This chapter is divided into four major sections: 1. Global coal, oil and gas use – and their contributions to anthropogenic greenhouse gas emissions 2. Developments in coal, oil and gas prices 3. The dynamic interrelationship of coal, oil, gas and carbon prices 4. The impact of the scaling capacity of renewables

We would like to acknowledge the contribution of Dr. Bruce Chadwick from Chadwick Consulting.

68

Investing in Climate Change 2009

I. Global coal, oil and gas use – and their contributions to anthropogenic greenhouse gas emissions Climate change and energy are directly linked via the emission of greenhouse gases in fossil fuel combustion and other energy activities. In 2005, more than half of global anthropogenic greenhouse gas emissions came from CO2 produced in the burning of fossil fuels. Fossil fuel combustion also emits methane (CH4) and Nitrous Oxide (N2O), bringing the total emissions from these energy sources to about 60%. See exhibit 7.1.

EX 7.1: More than half of greenhouse gas emissions came from fossil fuel combustion in 2005

100%=50 GT

N20 other HFCs PFCs 1% 6% CH4 other 11% CH2 other 3%

CO2 deforestation decay 3%

CO2 fossil fuel use 55%

N2O energy 2% CH4 energy 4%

Source: UN IPCC; IEA; DB Global Markets Research, 2008.

Although coal, oil, gas and other fossil fuels have been used since antiquity, the intensification of their use that accompanied the Industrial Revolution led to a significant increase in greenhouse gas emissions. See exhibit 7.2.

69

Investing in Climate Change 2009

VII Carbon and Energy Prices

EX 7.2: CO2 emissions from fossil fuel combustion have increased dramatically since the beginning of the Industrial Revolution Carbon emissions from gas flaring

30,000

Carbon emissions from solid fuel consumption 25,000

Carbon emissions from liquid fuel consumption Carbon emissions from gas fuel consumption

Mtons / Year

20,000

15,000

10,000

5,000

17 51 17 58 17 65 17 72 17 79 17 86 17 93 18 00 18 07 18 14 18 21 18 28 18 35 18 42 18 49 18 56 18 63 18 70 18 77 18 84 18 91 18 98 19 05 19 12 19 19 19 26 19 33 19 40 19 47 19 54 19 61 19 68 19 75 19 82 19 89 19 9 20 6 03

0

Year Source: Carbon Dioxide Information Analysis, Oak Ridge National Laboratory.

Over time, the fuel mix has changed, which has changed the emissions intensity of energy as well as other elements of energy quality. See exhibit 7.3. EX 7.3: Over time, the US has transitioned from dirty, inefficient fuels to cleaner, more efficient fuels 100

wood

80

coal

Percent

60 oil

40 gas animal feed 20 nuclear and renewables 0 1800

1820

1840

Source: Energy Bulletin; US EIA; DeAM analysis, 2008.

70

Investing in Climate Change 2009

1860

1880

1900

1920

1940

1960

1980

2000

In the US, this progression has been from a primarily agrarian society, that used animal feed to power draft animals and cut down first-growth forests for fuel wood (non-renewable biomass), to a steam-powered society dependant on coal, and from there to a petro-economy based on oil and natural gas. This transition has changed the quality of the energy mix in the US in the following ways: Improved energy quality1

Worsened energy quality

Volumetric density: the concentration of energy in a given volume has significantly increased.

Spatial distribution: supply is increasingly concentrated in difficult-to-access regions (e.g. the North Slope, Siberia, deepwater Gulf of Mexico).

Gravimetric density: the energy-to-weight ratio has improved.

Financial risk: financial risk of developing energy sources has increased, due to high exploration costs, the uncertainty associated with exploration, and long lead times.

Energy surplus: the energy return on investment (EROI) has increased.

Risk to human health: Oil and natural gas pose greater risks to human health than wood.

Ease of transport: Increased volumetric and gravimetric density makes transportation of fuels easier and less costly.

Amenability of energy source to storage: more specialized storage containers are needed for oil and natural gas.

Emissions intensity of energy: The emissions per Joule of energy associated with natural gas is lower than that of oil, which is lower than that of coal, which is lower than that of non-renewable biomass. Intermittency: the intermittency (i.e.: on-demand availability) has improved through increased reliance on machinery and decreased use of draft animals.

The most notable improvements that have been made during this 200-year transition are those of volumetric density. A given volume of oil contains much more energy than a similar volume of wood or animal feed. And meaningful advances have also been made in terms of emissions intensity of energy. As coal supplanted wood, and oil and natural gas took the place of coal as the most important sources of US energy, the quantity of greenhouse gasses emitted per Joule of energy generated has been reduced:

· Emissions for non-renewable biomass are approximately 109.6 tCO2 per TJ; · Emissions for coal are approximately 98.3 tCO2 per TJ; · Emissions for oil are approximately 73.3 tCO2 per TJ; · Emissions for natural gas are approximately 56.1 tCO2 per TJ.2

The advances made in volumetric density and emissions intensity of energy over the past 200 years more than compensate for the increased financial risk, heightened storage difficulties, more problematic spatial distribution of energy, and the risks to human health associated with the petro-economy. But it is clear that there is much left to play for in terms of improved energy quality. The challenge of the 21st Century will be unleashing a revolution that dramatically reduces the carbon intensity of energy by scaling up renewables and sequestering emissions from fossil fuel sources. However, a low-carbon revolution will not improve energy quality on all dimensions, just as the transition we have witnessed over the past 200 years has not improved all aspects of energy quality. In a world where renewables have grown to scale, the likely changes in energy quality include:

1

The energy quality framework has been adapted from Cutler J. Cleveland, Energy transitions past and future, http://www.eoearth.org/article/Energy_transitions_past_and_future.

Information for non-renewable biomass sourced from: Switch from Non-Renewable Biomass to Lower Emission Fossil Fuels for Thermal Applications by the User, UNFCCC, http://cdm.unfccc.int/UserManagement/File Storage/8NI830VTBWI3399LCYYYW1P4ZVTQ7F; Other figures are sourced from Energy and Fuels, World Resource Institute, http://pdf.wri.org/navigating_numbers_chapter8.pdf, and converted from tons of carbon to tons of CO2 by multiplying by 44/12.

2

71

Investing in Climate Change 2009

VII Carbon and Energy Prices

Improved energy quality

Worsened energy quality

Emissions intensity of energy: The emissions per Joule of energy associated with renewables are substantially lower than those associated with fossil fuels.

Volumetric density: The concentration of energy in a given volume of biofuels is lower than that in conventional fuels.

Spatial distribution: Renewable power generation can be distributed to load centers (e.g. rooftop solar) and does not typically require transport of feedstocks over long distances.

Gravimetric density: The energy-to-weight ratio of biofuels is lower than that of conventional fuels.

Risk to human health: The risk to human health of most renewables is substantially lower than those associated with flammable and toxic fossil fuels such as oil or natural gas.

Energy surplus: The energy return on investment (EROI) for most renewables is lower than that associated with fossil fuels, at present.

Financial risk: Financial risk associated with wind turbines, solar farms, and biofuels plantations is substantially lower than that associated with oil exploration and production in increasingly remote regions (e.g. the Arctic seabed).

Amenability of energy source to storage: Storing solar and wind energy will require a sophisticated network of specialized batteries and smart-grids, while oil could be stored in comparitively simple tanks or underground. Ease of transport: Decreased volumetric and gravimetric density makes transportation of renewables harder and more costly. Intermittency: Wind and solar are both intermittent energy sources, whereas fossil fuels can generally be combusted on demand.

While energy quality will decline against important metrics as the world trasitions to increased use of renewables, such as volumetric density, EROI, intermittency, and ease of transport, the potential economic loss of business as usual climate change is so large that the improved emissions intensity of energy associated with renewables justifies the shift. Over the past century, the energy quality problems associated with oil and natural gas have created enormous economic opportunities: · An $80 billion a year business (oil shipping) has grown up to address spatial distribution problems. 1.2 million people are employed in this industry; · A $36 billion a year business (oil pipeline construction) has developed to address spatial distribution problems; · A $96 billion a year industry (gas pipeline and terminal construction) has developed to address spatial distribution problems; · A multi-trillion dollar futures and derivatives market has grown up to manage risk of bringing oil to market. Other risks around exploration, production and shipping are managed through large contracts with reinsurers – creating meaningful business lines for giants like Swiss Re, Munich Re and Lloyds; · A $4.4 billion a year business (independent oil storage) has emerged to address oil and petrochemical energy storage issues. Just as enormous industries have emerged to address some of the energy quality issues of oil and natural gas, we expect significant economic growth and technological development in addressing the specific energy quality issues associated with renewables over the next half century, specifically:

72

· Batteries and smart electric power grids to address intermittency and amenability of energy to storage; · More energy-intense biofuels (e.g. biobutanol) to address ease of transport; · More efficient solar cell development processes to address EROI; · Development of hydrogen fuels to address gravimetric density; · Development of biodiesel hydrogenation to improve volumetric density.

Investing in Climate Change 2009

II. Developments in coal, oil and gas prices Global energy demand The three major input assumptions behind energy demand projections are

· Population · Economic growth · And energy intensity

The formula that captures the essence of the relationship is: Global Energy Demand = (Population) X (Per Capita Income) X (Energy Demand Per Dollar of Output) Each of these three factors is set to change over the next two decades. The UN estimates that by 2030, the world’s population will grow to 8.3 billion people, or about 1% per year. Population growth in the developed world is forecast by the UN to be small, rising from 1.2 billion people in 2005 to 1.3 billion in 2030. Most of the world’s growth is in developing countries, where population is expected to rise from 4.9 billion in 2005 to 7.0 billion in 2030. As global GDP increases, so will the demand for energy. Many academic studies put the long-term growth in global per capita income at about 2% per year. The IEA estimates that global per capita income will rise by circa 2.5% per year over their 2007-2030 forecast period. Energy intensity measures the amount of energy used to generate a unit of economic output. Energy intensity tends to decline over time as a function of underlying efficiency gains and the transition to a more service-based economy. Government policies can play a crucial role in how energy intensity changes. Over the period 1980-2005, energy intensity fell by about 1% per year, from circa 2.5 barrel of oil equivalent (boe) per $1,000 of GDP to about 2.1 boe. ExxonMobil estimates that energy intensity will fall by about 1.6% per year from 2005-2030 as new technologies are developed and deployed, reducing energy intensity from about 2.1 boe to about 1.3 boe per $1,000 of GDP. Taking each of these three drivers into account, the IEA has developed a projection for energy demand growth through 2030. See exhibit 7.4.

73

Investing in Climate Change 2009

VII Carbon and Energy Prices

EX 7.4: Energy demand is expected to increase significantly by 2030

World Energy Demand - Reference Scenario 18 CAGR = 1.8%

14 12 10 8 6 © OECD/IEA 2007

billion tonnes of oil equivalent

16

4 2 0 1980

1990 Coal

Oil

2000 Gas

Nuclear

2010 Hydro

2020 Biomass

2030

Other renewables

Source: IEA; US DOE/EIA; DB Global Markets Research.

Exhibit 7.4 sets out energy demand that can be separated into two distinct – but related – markets: · The road transport fuel market, which consists of oil and biofuels (included under “other renewables” in exhibit 7.4); · And the electricity and industrial processes fuel market, which includes coal, natural gas, nuclear, hydro, biomass and most other renewables. While there are some exceptions to this general division, we will use this organization for our discussion of pricing dynamics.

The road transport fuel market Over the past two years, oil has gone from $60-$70 per barrel – a high price by historical standards – to the astronomical heights of $120-$150 and has come back to about $70 per barrel again. See exhibit 7.5.

74

Investing in Climate Change 2009

EX 7.5: The West Texas Intermediate Crude Oil price has been volatile

150 140 130 120 110 Price (USD/bbl)

100 90 80 70 60 50 40 30 20 10 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

NYMEX WTI Monthly Swap (M01) - Close Price Source: DB Global Markets Research, 2008.

As prices spiked, volatility also increased in fossil fuel energy markets. This has been most recently and meaningfully illustrated by a number of one-day price variations. On September 22, 2008, oil, which had closed at $104.55 on the previous business day, spiked by $25.45 to hit $130 a barrel. By the end of the day, oil was back to $120.92 – but the rise of $16.37 over the previous day’s close still broke the previous record one-day jump of $10.75, which had been set on June 6, 2008. One week to the day after the new record for a one-day price increase for oil was set, we witnessed a one-day price drop of $10.52. This drop fell just $0.04 short of the record for a one-day price drop, which was set when Iraqi forces were expelled from Kuwait during the First Gulf War, on January 17, 1991. The extraordinary volatility of energy markets over the past year has forced energy economists to revisit their longterm price projections for oil, and to revert to the fundamentals that drive pricing in the market. For road transport fuels, much of the demand-side growth expected in both the short-term and long-term comes in the Asia-Pacific and Middle East regions. In addition to rising GDP, the role of oil subsidies at the consumer level - instituted to help the less affluent afford basic fuel, but often benefiting middle and upper income earners - remains an important factor in driving oil demand growth in these regions. The cost of these subsidies has skyrocketed as oil prices have spiked, but eliminating them is very difficult politically, meaning that they

75

Investing in Climate Change 2009

VII Carbon and Energy Prices

are unlikely to disappear in the short-term. High price cases for oil tend to be built on the view that most of the world’s remaining oil reserves are held in OPEC countries. These petroleum exporters may seek high prices for their valuable goods. Under high price scenarios, demand outpaces supply and pushes oil prices toward nominal values in the $150-200 per barrel range. See exhibit 7.6.

EX 7.6: The majority of world oil reserves are concentrated in OPEC countries Estimated world oil reserves 1,238 billion barrel at end of 2007

10% 2% 2% 2%

Saudi Arabia

23%

Iran Iraq

3%

Kuwait United Arab Emirates

3%

Venezuela 3%

Russian Federation Libya 12%

7%

Kazakhstan Nigeria US Canada

7%

Qatar 10% 8%

Other

8%

Source: BP Statistical Review; DB Global Markets Research; DeAM analysis, 2008.

Lower price cases tend to be driven by replacement cost calculations. Finding costs have been rising rapidly since 2000. The significant rise in per barrel costs reflects a combination of higher total finding and development (F&D) costs (bonuses, royalties, labor, materials, etc.) and poor reserve replacement. Continuing cost increases being reported by companies for 2007 and 2008 along with spotty reserve additions, suggest that F&D costs could quickly be headed toward $25-35/bbl. See exhibit 7.7.

76

Investing in Climate Change 2009

EX 7.7: The finding costs for oil are increasing USD per boe (constant 2006 dollars) 50 45 40 35 More difficult access

30 25 20

Technological improvement and opening of new production regions

15 10 5 0 1980-82

1987-89

1994-96

2001-03

2008-10E

Source: US DOE/EIA, DB Global Markets Research, 2008.

A long-term relationship of about 3:1 exists between finding costs of oil and oil price. See exhibit 7.8. EX 7.8: The finding costs of oil and oil price are related 125

Real Oil Price (USD/bbl)

100 1980-2006 y = 2.62x + 7.53 R ² = 0.95

75

2007E - 2015E

50

25

0 0

5

10

15

20

25

30

Real F&D Costs (USD/bbl) Source: US DOE/EIA, DB Global Markets Research, 2008.

77

Investing in Climate Change 2009

35

40

45

50

VII Carbon and Energy Prices

Based on this relationship and projections of finding costs going forward, lower-bound long-term price for oil is in the $75-$90/bbl range in real terms, but this will go higher most likely in the out years as costs continue to rise. In the short-term, due to the potential for a recession in 2009, the oil price may dip below this figure – Deutsche Bank projections estimate $50-$60 per barrel as an arresting point on the downside – but the long-term lower-bound for oil price is likely to be higher. In exhibit 7.9, we collate the views of analysts on future oil prices.

EX 7.9: Market views on long-term oil prices as of Spetember 2008 (real $)

Dec Figures

2008 (Starting Point)

2015

2030

2040

110.2

100

100

100

100

125

90-110

75-150

83.59

59.85

70.45

-

Citigroup3 Oil $/bbl Deutsche Bank4 Oil $/bbl EIA5 Oil $/bbl Source: DeAM market scan, September 2008.

The electricity and industrial processes fuel market The two most important feedstocks for electricity and industrial processes are natural gas and coal. Each of these feedstocks has different price drivers and has a different relationship with the climate change opportunity set. We therefore will treat them separately, in turn. Natural gas Gas prices have spiked over the past two years, from $4-$6/MMBtu to prices around $13/MMBtu, and have then come down below $7.00/MMBtu. See exhibit 7.10.

Figures for Citigroup provided by Alan Heap, Citigroup Commodity Research, September 2008. Figures for Deutche Bank provided by Adam Sieminski, Deutsche Bank Global markets, September 2008. Figures from US EIA online, 2008.

3 4 5

78

Investing in Climate Change 2009

EX 7.10: The Henry Hub natural gas price

A

15 14 13

Price (USD/mmBtu)

12 11 10 9 8 7 6 5 4 2004

2005

2006

2007

2008

2010

Date NYMEX Natural Gas (USD/mmBtu, M01) Close Price

Source: DB Global Markets Research.

The recent dip in natural gas prices is the result of two factors: · Gas prices, like oil prices, have seen a recent correction due to worsening economic conditions and anticipation of a potential recession in 2009; · Some of the recent decline is also seasonal. Recently traded M01 contracts are for gas delivery in October and November – months that, in Europe and the US, are not so warm that they require significant use of gas peakers to satisfy high energy demand (and decreased power plant efficiency), but also are not so cold that they require significant domestic heating. In most markets outside the US, natural gas prices tend to be closely aligned with crude oil and oil product prices due to contractual ties. US natural gas prices tend to move on their own set of supply and demand dynamics in the short run, but for many years have generally mean-reverted toward oil prices at an *:1 or 10:1 ratio. The recent natural gas price increases, which have been correlated to the oil price spike, have underscored this relationship. Many models make the assumption over the long-term that growth in global Liquified Naural Gas (LNG) markets will ultimately result in a single world-wide natural gas market in the same way that the markets have established global oil prices. Based on forecasts from Wood MacKenzie, shown in exhibit 7.11, demand for LNG in the period form 2012-2015 may be strong enough to establish such a market.

79

Investing in Climate Change 2009

VII Carbon and Energy Prices

EX 7.11: The global supply/demand balance for LNG mmt/y 350

Greenfield Supply Base Supply Total Demand

300

250

200

150

100

50

0 1995

2000

2005

2010E

2015E

Source: Wood MacKenzie DB Global Marketing Research

In exhibit 7.12, demand outstrips supply in a meaningful way in 2010, driving up rents and encouraging further investment and development of LNG. The continued divergence of centers of supply and demand for natural gas is a second critical factor that will contribute to the globalization of the LNG market. See exhibit 7.12. EX 7.12: The natural gas trade is increasingly global Exporters

bcf/d*

% of World

Importers

bcf/d

% of World

Qatar

3.7

17%

Japan

8.6

39%

Malaysia

2.9

13%

South Korea

3.3

15%

Indonesia

2.7

12%

Spain

2.3

11%

Algeria

2.4

11%

US

2.1

10%

Nigeria

2.0

9%

France

1.3

6%

Australia

2.0

9%

Taiwan

1.1

5%

Trinidad

1.8

8%

India

1.0

4%

Egypt

1.3

6%

Turkey

0.6

3%

Oman

1.2

5%

China

0.4

2%

Brunei

0.9

4%

Belgium

0.3

1%

Other

1.1

5%

Other

1.0

5%

World

21.9

100%

World

21.9

100%

Source: BP Statistical Review, DB Global Markets Research (2007 data). *Billion cubic feet/day

80

Investing in Climate Change 2009

While forward gas swaps are currently trading in the $8-$9/MMBtu range through 2020, a consensus is emerging that gas prices will ultimately be higher than this. This is due in part to the market fundamentals discussed before. But this is also because, like crude oil, gas markets are normally in backwardation – that is, the forward gas curve is normally downward sloping, pricing in a premium a buyer would pay for immediate delivery of the commodity. The forward curve currently shows a gentle upward slope. When the effect of backwardation is taken into account, the slope of real prices through 2020 is likely to be much steeper. The market’s current view of long-term gas prices is set out in exhibit 7.13 EX 7.13: Market views on long-term natural gas prices as of September 2008 (real $) Dec Figures

2008 (Starting point)

2015

2020

2030

9.40

12.50

14.50

16.00

Gas $/MMBtu *Forecasts as of September 2008. Source: DeAM market scan, September 2008.

Coal Coal’s share of world energy use has increased sharply since 2000, with consumption in China doubling over the period 2000-2007. Over that same period, the US and India are responsible for 9% each of the increase in world coal use. The rapid expansion in coal use has coincided with a dramatic increase in coal prices. See exhibit 7.14. EX 7.14: The Newcastle coal price has recently spiked 200 190 180 170 160 150

Price (USD/tonne)

140 130 120 110 100 90 80 70 60 50 40 30 20 2003

2004

2005

2006

2007

Date Source: DB Global Markets Research, 2008

81

Investing in Climate Change 2009

Newcastle Coal Monthly Swap (M01) - Close Price

2008

2009

VII Carbon and Energy Prices The EIA forecasts that this rapid expansion of coal use will continue. See exhibit 7.15. EX 7.15: The rapid expansion of coal use is likely to continue billion kilowatt hours 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 2005

2010

Coal

Liquids

2015

2020

Natural Gas

2025 Renewables

2030 Nuclear

Source: US DOE/EIA, DB Global Markets Research

This rapid expansion is driven by some of coal’s natural advantages: · It is plentiful, with hundreds of years of proven reserves in place; · Energy-hungry countries, such as China and the United States, possess vast supplies of domestic coal, potentially enhancing energy security. Analysts predict that the price of coal will spike in the short-term, but will decline in the longer-term. As coal prices recede, this energy feedstock is set to become advantaged against competitors, such as natural gas and renewables with all the associated implications for increased carbon emissions. See exhibit 7.16. EX 7.16: Market views on long-term coal prices as of September 2008 (real $) Dec Figures

2008 (starting point)

2015

2030

2040

123.47

74.72

50

50

Citigroup3 Coal $/t Deutsche Bank

4

Coal $/t EIA

160

75-85

5

Coal $/t

35.23

34.24

*Forecasts as of September 2008.

Figures for Citigroup provided by Alan Heap, Citigroup Commodity Research, September 2008. Figures for Deutche Bank provided by Adam Sieminski, Deutsche Bank Global markets, September 2008. Figures from US EIA online, 2008.

3 4 5

82

Investing in Climate Change 2009

35.03

-

III. The dynamic interrelationship of coal, oil, gas and carbon. As carbon pricing spreads to new geographies, the interrelationship between coal, oil, gas and carbon becomes more complex. At the simplest level, carbon prices:

· diminish demand for fossil fuels at the margin and; · help cleaner energy sources become competitive with fossil fuels.

The correlation between fossil fuel prices and carbon prices will depend on a number of factors – including which fossil fuel is under consideration. We have created several scenarios that outline the possible correlation between carbon prices and the prices of coal, oil and gas. In reality, multiple scenarios will exist simultaneously, and therefore overlap and interact. The scenario that dominates will determine the direction of correlation. The key scenarios are: Supply shocks – these come in two types, both of which imply negatively correlated carbon and fossil fuel prices: · Constraints (peak oil scenario, see exhibit 7.22): Fossil fuels are exhaustible resources. Once half of ultimately recoverable crude oil reserves have been depleted, production inevitably will fall, according to traditional peak oil theory6. Crude oil production may be near its peak, and natural gas may follow soon after. · Surplus (coal glut scenario, see exhibit 7.23): Although other fossil fuels may be more constrained, coal is still plentiful, and the technologies for extracting it are improving. High prices for oil and natural gas may stimulate the availability of coal, and new technologies may in fact make it extremely cheap. Demand boom (Emerging market growth scenario, see exhibit 7.24): Conservation and efficiency notwithstanding, world energy demand is likely to grow substantially over the next 20-50 years, and much of it likely supplied by fossil fuels, unless clean energy sources can scale up production rapidly. Demand-led scenarios imply positively correlated carbon and fuel prices. The peak oil scenario (negative correlation for carbon and oil prices) addresses the “other environmental issue” in fossil fuels: their exhaustibility. If it is true that we are facing an energy crisis – increasingly limiting our ability to produce large quantities of fossil fuel on short notice – supply scarcity will drive fossil fuel prices higher. Fossil fuel scarcity and higher prices will create an environment where renewable energy is more competitive as a substitutable energy source and decarbonization may be self-sustaining. If energy demand stays constant as supplies dwindle:

· Higher oil and gas prices will promote switching to alternatives in transport and electricity markets, · Switching can occur without extremely high carbon prices, · Total oil and gas use will decline, along with emissions from oil and gas.

To the extent that oil and and gas use drives the total demand for carbon, the peak oil scenario implies that oil and gas prices and carbon prices will tend to move in opposite directions. The coal glut scenario (negative correlation for carbon and coal prices) addresses the possibility that coal may become extremely inexpensive and plentiful as global reserves remain substantial and the technologies for extracting and utilizing it improve in the medium term, bringing more of this resource to market. In this case, better technologies and substantial reserves allow for more coal to be supplied at cheaper prices. Other things equal, the quantity used will increase, driving up demand – and prices – for carbon offsets in a cap-and-trade carbon market. As coal prices collapse, carbon prices move higher to stop a massive shift towards coal use under a cap-and-trade system with a carbon target. Without a cap-andtrade carbon market in this scenario, there would be catastrophic emission consequences. Cf King Hubbert, Geolosist for Shell and the USGS who used this theory to predict to predict 1970 peak oil in US production.

6

83

Investing in Climate Change 2009

VII Carbon and Energy Prices

The emerging market growth scenario (positive correlation possible for carbon and fossil fuel prices) focuses on the recent growth of emerging market energy demand, which, together with industrialized energy use, increases demand for all energy sources. This scenario sees fossil fuel prices rising as well, but, in this case, because of increased global demand. The result is greater fossil fuel use, even at higher prices. With more fossil fuels being used, there is more demand for carbon offsets, and so fossil fuel and carbon prices rise in tandem. The correlation between carbon and fossil fuel prices depends on which of these scenarios prevails.

The current situation These scenarios can and probably will happen simultaneously, but the correlation of fuel and carbon prices will depend on which one dominates. Until recently, it looked like the emerging market growth scenario with tight energy markets would be most likely to dominate in the near-term. However, in the context of market events, as the world moves into a likely recession, energy supplies will come under less pressure in the near-term, and prices are likely to remain lower. In terms of the carbon price in Europe, the relationship between carbon and energy prices has been a function of the fuel switch between coal and gas leading to a reasonably high correlation between oil prices and carbon prices. See exhibit 7.17. EX 7.17: Oil and gas prices have been correlated with European Union Allowance (EUA) prices

60-Day Rolling Correlation of Oil and Natural Gas with Daily EUA Returns: 22 Apr 2005 - 30 Sep 2008 Oil vs EUA

Gas vs EUA

0.7 0.6 0.5

Correlation Coef.

0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 17-Feb-05

5-Sep-05

Source: Bloomberg, 2008.

84

Investing in Climate Change 2009

24-Mar-06

10-Oct-06

28-Apr-07

14-Nov-07

1-Jun-08

18-Dec-08

Exhibit 7.17 shows the 60-day rolling correlation between daily 2008 EUA spot returns and both crude oil and natural gas returns. Except for a few short periods in 2006 and the start of 2007, daily correlations have been consistently positive with a long-term upward trend. Over the total period, EUA daily returns are correlated 0.194 with Crude returns and 0.124 with Natural Gas returns. Correlations have varied considerably over the time period, from –0.3 to just over +0.5.

Long-term outlook In the long-run, the emerging market growth scenario looks most likely to dominate, with peak oil and coal gluts both likely. Assuming global carbon is priced via cap-and-trade, the long-term price implications are laid out in exhibit 7.18.

EX 7.18: In the long-term, carbon and energy prices are likely to increase

Demand-side scenario

Emerging market growth: • Coal, oil, gas demand and price • Electricity price • Road transport fuel price • Carbon price to offset increased emissions Most likely scenario: Peek oil scenario: • Oil and gas price (reduces demand) • Electricity price

Supply-side scenario

• Road transport fuel price • Carbon price due to lower fossil fuel demand Coal glut scenario: • Coal price due to supply • Carbon price to offset increased emissions • Electricity price • Road transport fuel price

Source: DeAM analysis, 2008.

85

Investing in Climate Change 2009

• Coal price • Oil, gas price • Electricity price • Road transport fuel price • Carbon price

VII Carbon and Energy Prices

IV. The impact of the scaling capacity of renewables. The IEA World Energy Outlook projects global energy consumption will grow 38-52% by 2030,7 from 7.6 billion tons of oil equivalent today to somewhere between 10.5 and 11.6 billion tons of oil equivalent. About 68% of the 2004 figure consists of fossil fuels (coal, oil, natural gas), and both their standard and alternative scenarios anticipate fossil fuel use at over 60% of total energy in 2030. If renewables can meet the entirety of new energy needs, demand for fossil fuels will stay constant and carbon prices will be inversely correlated to fuel prices. However, it may be too soon for renewables to meet the scale requirements of a 40-50% increase in energy needs. Therefore, fossil fuel and carbon prices are likely to rise and fall in tandem. We explore the relationship between fossil fuel prices, carbon prices, the scaling capacity of renewables, the sizing of markets and mitigation potential in detail in this section.

The scaling capacity of renewables is critical to stabilize energy and carbon prices The points of commercial breakeven discussed in Chapter III of Part II are critical to fuel switching decisions and the path to a society with a low-carbon energy mix. When a clean fuel source reaches commercial breakeven with a fossil fuel equivalent, it does not mean society suddenly stops using fossil fuels – many of the cost inputs associated with commercial breakeven are capital costs, invested long ago in the case of operational power plants. Utilities are unlikely to decommission viable power plants unless the variable costs of continued operation exceed revenues. Commercial breakeven without carbon pricing or incentives Commercial breakeven without carbon pricing or incentives represents an inflection point in energy use patterns; it is not the fossil fuel switch-off point. Exhibit 7.19 helps explain why: EX 7.19: Supply and Demand Equilibrium for Substitutable Fuels Energy price

DAll Energy SAlt SFossil Equilibrium price with both fuels available

eAlt only eFossil only

Peq

qAlt

Source: DeAM Analysis, 2008,

qAlt

qFossil Energy quantity

IEA, World Energy Outlook, 2006.

7

86

Investing in Climate Change 2009

QDemand qAlt + qFossil = QDemand

Exhibit 7.19 shows the supply and demand relationships for energy coming from fossil fuels or clean alternative sources. Consumers typically do not care what source their energy comes from as long as it is there, and they would prefer as much as possible at as low a price as possible. The demand line (DAll Energy) shows total energy demand from all available sources. The supply curves show the total cost of delivering both fossil fuels and alternative (clean) energy; on this chart, fossil fuels are cheaper to deliver, but the cost difference diminishes as the quantities go up. If society were restricted only to fossil fuels or only to alternatives, the market would deliver the quantities and prices shown by eFossil and eAlt only, respectively. The availability of both energy sources allows society to have more energy at a cheaper price than it could with either energy source alone, and society also uses less of each source. The market settles at a price (Peq) where the quantity of alternatives (qAlt) plus the quantity of fossil fuels (qFossil) exactly matches the total energy demanded (QDemand) at that price. Exhibit 7.19 shows that even if the cost per kWh of delivering alternatives is higher, it is still economic to use some alternative energy sources in the total mix.8 This means that even “expensive” clean energy can help to reduce fossil fuel use through substitution. More importantly, if alternatives can get to the commercial breakeven point or beyond, the adoption of clean energy sources will accelerate dramatically. Without carbon pricing included, the dynamic works as follows: • If the marginal cost of adding alternative energy is higher than the marginal cost of adding fossil fuels, most additional energy needs will be met with fossil fuels; • If the marginal cost of adding alternative energy is lower than for fossil fuels, most additional energy needs will be met with alternatives; • If the marginal cost of adding alternative energy is the same as fossil fuels (i.e. at the breakeven point), additional energy use will be 50% alternatives and 50% fossil fuels. Commercial breakeven with carbon pricing without incentives Carbon prices can be added to fossil fuel use to raise the price of delivering energy from fossil fuel feedstocks – this is equivalent to looking at the point of commercial breakeven with carbon pricing without incentives. Carbon pricing is a critical element in driving the scaling of renewables. Exhibit 7.20 shows the addition of carbon prices shifting SFossil 1 upwards to SFossil 2 and creating a new market equilibrium at price Peq 2. The carbon price reduces fossil fuel use and increases the substitution of clean energy to make up some of the difference. Lower fossil fuel use also reduces both demand for and the price of carbon credits, until both energy sources and carbon prices settle into a new equilibrium in an iterative process of adjustments.

Mathematically, the proportion of additional energy needs from each source will adjust until the weighted average of the marginal costs of each energy source equals the marginal benefit of meeting additional demand.

8

87

Investing in Climate Change 2009

VII Carbon and Energy Prices

EX 7.20: The effect of carbon prices on equilibrium for substitutable fuels Energy price

SFossil 2

DAll Energy

SAlt

SFossil 1

Equilibrium price with both fuels available

Peq 2 Peq 1

qAlt Source: DeAM analysis, 2008.

qFossil Energy quantity

QDemand qAlt + qFossil = QDemand

The scaling capacity of renewables is critical Increased clean energy supply capacity is critical to achieving commercial breakeven with carbon pricing without subsidies and crossing the inflection point to a low-carbon energy supply. Exhibit 7.21 shows how the relative slopes of supply curves – their elasticities – determine how an increase in the market price contributes to the uptake of clean energy. The flatter curve means that society can produce more clean energy inexpensively, whereas the steep curve means that more clean energy can be produced only at great expense. The scaling capacity of clean energy is central because exhibit 7.21 shows how a small change in the market price will increase clean energy use dramatically if the scaling capacity is there, and will only increase use a little without it. Even if clean energy is more expensive to produce at low quantities, keeping the clean energy supply curve as flat as possible to allow scaling will ensure that both supply and demand shocks increase the use of clean energy alternatives. If carbon policies and peak oil dynamics steepen the supply curve for fossil fuels, the transition to low-carbon energy sources will happen even faster.

88

Investing in Climate Change 2009

EX 7.21: Scaling Capacity Leads to Greater Uptake of Clean Energy Energy Price

Low Capacity Clean Energy Supply Curve

Policy Goal: Build clean energy scaling capacity, even if the energy is more expensive in low quantities.

High Capacity Clean Energy Supply Curve 2

P2 P1

1

2

1

Energy Quantity Source: DeAM analysis, 2008.

Finally, if clean energy sources have significant scaling capacity, this can act as a “damper” to supply and demand shocks, reducing overall volatility in both carbon and fossil fuel prices. The ideal end-state is that, as Saudi Arabia loses its ability to be the swing producer of oil, renewables begin to fill the gap. In this role, renewables would occupy a central space in energy production year-in, year-out, but could quickly scale to respond to supply and demand shocks, keeping energy prices and carbon prices in check. A transition to a world where renewables play the role of swing supplier would set us firmly on the road to a future of low-carbon prosperity.

89

Investing in Climate Change 2009

VII Carbon and Energy Prices

Relationship between fossil fuel prices and carbon prices. Supply Shock: Constraints (peak oil scenario) Increasing oil and natural gas scarcity drives road transport fuel and electricity feedstock prices up. Carbon prices are inversely correlated to oil/gas prices.

Supply Shock: Surplus (coal glut scenario). Large reserves and better extraction/use of coal mining technologies bring electricity feedstock prices down. Carbon prices are inversely correlated to coal prices.

EX 7.22: Supply shock: Constraints (peak oil scenario)

EX 7.23: Supply shock: Surplus (coal glut scenario)

S2

S1

D Oil/Gas Price

D S1

e2 e1

Oil/Gas Quantity Used Source: DeAM analysis, 2008.

Sequence of Events 1. Increasingly scarce oil and gas become more expensive to bring to market. 2. The supply curve shifts upwards because the same quantity of oil and gas is more expensive to supply. 3. Market equilibrium moves from e1 to e2. 4. Oil and gas prices rise. 5. Oil and gas use quantities drop. 6. There is a lower demand for carbon to offset oil and natural gas emissions. 7. Other things equal, carbon prices drop.

Coal Price

S2

e1 e2

Coal Quantity Used Source: DeAM analysis, 2008.

Sequence of Events 1. Improved extraction technologies, combined with large reserves, make coal cheaper to bring to market. 2. The supply curve shifts downward because large quantities of coal are less expensive to supply. 3. Market equilibrium moves from e1 to e2. 4. Coal prices drop. 5. Coal use quantities rise. 6. There is a higher demand for carbon to offset coal emissions. 7. Other things equal, carbon prices rise.

Carbon prices are inversely correlated to oil/gas prices. Carbon prices are inversely correlated to coal prices.

90

Investing in Climate Change 2009

Demand expansion (Emerging market growth scenario) Increasing global energy demand drives fossil fuel prices up. Carbon prices are correlated to fuel prices. EX 7.24: Demand expansion (emerging market growth scenario)

D2 Fossil Fuel Price

S

D1 e2 e1

Fossil Fuel Quantity Source: DeAM analysis, 2008.

Sequence of Events 1. An increase in global energy demand means more fuel will be consumed unless prices rise. 2. The demand curve shifts upwards because more bidders for a given fuel quantity raises prices. 3. Market equilibrium moves from e1 to e2. 4. Fossil fuel prices rise. 5. Fossil fuel use quantities rise. 6. There is higher demand for carbon to offset fossil fuel emissions. 7. Other things equal, carbon prices rise. Carbon prices are correlated to fossil fuel prices.

91

Investing in Climate Change 2009

Part II. An Analytical Perspective • Government regulation, including carbon pricing, traditional regulation (mandates and subsidies) and innovation policy (incentives and subsidies) are major drivers of investment opportunities in climate change. • We believe that carbon pricing, which prices the externality associated with greenhouse gas emissions, is the key long-term, market-related climate change policy. • When it comes to assessing a specific project for investors, a set of complex variables comes into play at a granular level in a specific region and market context. Aggregate level analysis, while useful, needs to be articulated to a project-level. • Clean technologies are becoming broader and deeper over time. It is important to understand their stage of development for investment purposes. For venture capitalists, driving costs down the learning curve is a key focus for any technology investment. • In the long run, the most sustainable breakeven point for renewables is when they are commercially viable without subsidies, but with a carbon price regime as a de-risking backstop. In this paper, we develop an analytical framework for understanding the climate change opportunity. The components we examine in detail are: · Government policy and regulation: an analytical framework; · The investor perspective: risk and return around commercial breakeven; · Clean technologies: deepening, broadening and developing.

II. Government policy and regulation: An analytic framework Setting targets from the science · The science is conclusive in our view. Atmospheric CO2 concentrations are at an 800,000 year high and global temperatures are rising; (Appendix 2) · The scientific evidence base – and the risks of not addressing climate change – have led to the establishment of mitigation targets. In order to avoid heightened probability of dangerous levels of warming, the IPCC estimates that long-run atmospheric concentrations of greenhouse gases should not exceed 450 ppm CO2e, and annual emissions should be reduced by at least 50% from 1990 levels by 2050; · Immediate action is important: the longer the world waits, the more difficult it will be to stabilize around 450 ppm CO2e. The next few years are critical in establishing the stabilization path. A map of climate change regulation – carbon pricing is the key in the long-term. · As a starting point for analysis, the McKinsey-Vattenfall mitigation policy curve sets out the mitigation options for policymakers, along with their economic costs; (See Ex. 2.2) · Currently, governments use three broad sets of regulatory tools to address climate change: (See Ex. 2.3) · Carbon pricing; · Traditional regulation (mandates and standards); · And innovation policy (incentives and subsidies). · These three tools are used for different reasons. Carbon pricing is used to internalize the external costs of climate change, traditional regulation is used to correct for market failures and consumer behavior, and innovation policy is used to incentivize the development of expensive, but promising new technologies.

92

Investing in Climate Change 2009

Optimal carbon pricing and policy of regulation · Using carbon prices alone to incentivize the early development of emerging technologies – some of which could require carbon prices of nearly €100/ton to incentivize commercial development – may be inefficient, as such a high carbon price could put a disproportionate drag on the overall economy. (See Ex. 2.4) · Other regulatory instruments, such as R&D subsidies, can be used to drive innovation of what are currently more expensive opportunities such as CCS, allowing government to buy promising technologies down the learning curve without subjecting the entire economy to very high carbon prices. Trends in climate change regulation and implications for investors · Traditional regulation and innovation policy are currently the predominant policy tools in use, but we expect carbon pricing to become more dominant as time goes on; (See Ex. 2.10) · Understanding the existing regulatory framework on a geographical level, and how it interacts with local development priorities is essential to strategic asset allocation; · The primary opportunities to generate tactical returns will happen when regulatory policies change due to scientific, political, or economic factors. An ability to predict these trends is obviously an alpha source. From the policy curve to the commercial breakeven and investor opportunity · While the greenhouse gas mitigation policy curve is a useful framework to consider from a policy perspective, it is not an investor opportunity curve; · To get to an investor curve, taxes, specific project costs, regulatory support for clean technologies including incentives and subsidies would need to be included. Dynamic energy cost assumptions, specific regional costs and specific discount rates would also need to be considered to arrive at the investor curve. (See Ex. 2a.1)

III. The investor perspective: risk and return around commercial breakeven Understanding commercial breakeven · For a particular climate change technology to be adopted at scale, it must be commercially viable – breakeven or better against competitive, less environmentally-friendly options. We call this commercial breakeven. · Over time, four factors have converged to drive the commercial breakeven of renewables: · Traditional and innovation-based incentives have been established. · Fossil fuel prices have increased; · Carbon prices are being introduced; · And the cost of renewables has declined as they have moved down the learning curve. · There are different ways of calculating commercial breakeven, which can include or exclude subsidies,incentives and carbon prices. It is important for an investor to be aware of what is and is not included when assessing the economics of renewables; (See Ex. 3.1) · In the longrun, the most sustainable breakeven point for renewables is when they are commercially viable without subsidies, but with a carbon price regime as a de-risking backstop. Using Levelized Cost of Energy (LCOE) as a tool for measuring investor opportunities · LCOE is a framework that can be used to assess the economic viability of opportunities in the electricity markets; · While the idea of LCOE is attractive at an industry level, adapting the framework to work as a project-level investor model is ultimately more useful. The investor opportunity model should take a number of factors into account: · Most importantly, the discount rate should match the individual project risk profile and cost of capital, and local energy market dynamics need to be modeled;

93

Investing in Climate Change 2009



· Scenario analysis on fuel prices, incentives and subsidies, and carbon pricing needs to be performed; · The learning rate and other inputs need to be project-specific.

Using the investor’s model to understand project risk and return · As the investor model is developed for individual projects, a set of complex variables come into play at a granular level in a specific region and market context; · There is a set of critical risk/return trade-offs investors need to take into account, specifically: operational, financial, regulatory, energy feedstock, learning rate, underlying electricity price and carbon. These risk-return trade-offs will be sources of alpha generation. (See Ex. 3.4)

IV. Clean technologies: deepening, broadening and developing Pacala and Socolow’s wedges · Pacala and Socolow developed a method for understanding climate change mitigation opportunities. In their research, they determined that there is no single technological solution to climate change; (See Ex. 4.1) · Instead, a variety of technologies will need to be deployed at scale to address the challenges of a warming planet. (See Ex. 4.2) The technology development process · Each broad technological umbrella (e.g. solar) covers a broad array of subtechnologies. Each of these subtechnologies is at a different stage of commercialization, presenting differen opportunities to investors; · The technology development process takes a long time. As technologies move through the pipeline, the nature of the investment opportunity, as well as the risk/return profile, changes; (See Ex. 4.3) · In clean energy, there is significant room for improvements in existing technologies, as well as meaningful op portunities to develop and commercially deploy new, early-stage technologies such as CCS. Investor implications · New clean technologies have emerged over the past decade and technological advances in the clean technology space open up opportunities for investment in a range of new products and ideas; · Understanding the characteristics of the subtechnologies moving through the pipeline is essential for investors; · Deep knowledge of the technology development process, as well as a detailed overview of the technological landscape within each sector, is necessary to generate alpha in the space.

94

Investing in Climate Change 2009

This page is left intentionally blank

Government Policy and Regulation: II An Analytical Framework • Regulation is a major driver of investment opportunities in climate change. Government climate change regulatory activity is increasing. • The climate provides valuable services, which can be harmed by rising temperatures. Greenhouse gas emissions cause global warming. • Economic theory dictates that carbon pricing is necessary to shift the costs of greenhouse gas emissions onto those who are responsible for them. Carbon pricing provides a critical “backstop” to other incentives for development and deployment of renewable technologies. • While this works in theory, a number of constraints stand in the way of the complete efficacy of carbon pricing. Lord Nicholas Stern recognizes that other regulatory levers will be necessary to unlock highly desirable mitigation opportunities. However, the use of these levers should decline over time as carbon pricing takes over as the dominant policy tool. • Investors need to understand where regulation is headed and what the profit potential is under different regulatory scenarios. The rationale for climate change regulation: Economic theory and the science The climate is an important public good. Once it is accepted that the climate is being harmed by carbon emissions, these emissions become an externality that need to be addressed. No one pays for many of the climate’s most valuable services, and all too often, no one pays when the environment is degraded, thereby decreasing its ability to provide critical ecosystem services and ultimately constraining economic growth. Climate change is, in the words of Lord Nicholas Stern, “the result of the greatest market failure the world has ever seen.”1 In Wealth and Welfare,2 the economist Arthur Cecil Pigou argues for government intervention to correct market failures. The tools Pigou proposes include taxes and subsidies. Government policy and regulation has therefore become a major driver of the climate change investment market. Policy creates opportunities and has a major influence on returns in many areas. Successful investors in climate change opportunities therefore need to understand

· The climate change regulatory framework; · The current state of play in the regulatory framework; · And likely future developments in the trends of climate change regulation.

This chapter addresses all three of these aspects of regulation, and then leads these into an investor risk and return framework in Chapter III of Part II.

We would like to acknowledge the contribution of Dr. Bruce Chadwick from Chadwick Consulting. Lord Nicholas Stern, Stern Review Report, 2007, i. Pigou, A.C (1912), Wealth and Welfare, London (Macmillan).

1 2

96

Investing in Climate Change 2009

This chapter is divided into six major sections that discuss the background, shape of and rationale for the set of regulatory instruments associated with climate change: 1. Setting targets from the science – Scientists can estimate greenhouse gas emission levels that are considered sustainable, and these can be articulated to develop long-term targets. 2. A framework for mapping climate change regulation – The greenhouse gas mitigation curve for policymakers is a useful tool for understanding regulation. 3. Carbon pricing – the central plank of good policy – While still in an emerging phase globally, placing a price on greenhouse gas emissions is central to achieving reductions that are economically efficient in most parts of the economy. As other factors such as energy prices vary, a carbon price becomes a backstop that derisks low- carbon investments. 4. Traditional regulation – Some mitigation efforts appear to lag in spite of their current cost-effectiveness; these challenges may require command-and-control mandates, public education, or the creation of attractive financing mechanisms. 5. Innovation policy – Some mitigation technologies have high R&D costs, long lead times, and would require extraordinarily high carbon prices before they are profitable, potentially leading to politically unacceptable transfer costs and overall drag on the economy. If it is reasonable to expect research and learning to bring down the implementation costs, the prospects for carbon mitigation are substantial, and there are spillover benefits of innovation (‘learning externalities’), there may be a case for publicly subsidized research and development, as well as concessionary financing or subsidies for implementation costs. 6. Trends in climate change regulation and implications for investors – We expect that carbon pricing will emerge as the major policy tool in the long-term.

97

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework

I. Setting targets from the science. There is now overwhelming evidence that our climate is changing and that humans have contributed to this change. Certainly, the climate is highly complex and ocean cycles, for instance, will contribute to warmer and cooler cycles. But human-based emissions have fundamentally shifted the global climate balance. A more detailed review of the scientific evidence base can be found in Appendix II.

Mitigation targets To avoid exceeding 2oC of warming, as discussed in Appendix II, leading scientists have developed a set of targets: · Long-run atmospheric CO2e concentrations should not exceed 450 ppm; · To be consistent with that long-term target, a 50% cut in greenhouse gas emissions must be made by 2050 from 1990 levels Leaders of G8 countries – including US President George W. Bush – signed up to the 50% target at the G8 summit in Hokkaido-Toyako. But while the Bali Climate Change Declaration by Scientists3 was quite clear that the 50% cuts should be measured from a 1990 baseline, the G8 agreement did not define the baseline year for the cuts. This will make measuring and monitoring difficult: A 50% cut from 1990 levels is much different from a 50% cut from 2008 levels, which in turn is much different from a 50% cut from business-as-usual emissions. Clearly, there is more work left to do at a policy level. As leaders craft the emissions mitigation path, a series of interim targets will need to be developed to ensure that adequate early progress is made towards this goal. If the world sticks to a long-term stabilization goal of 450 ppm CO2e,4 the time when reductions begin to be made – and the time at which emissions peak – will have a central role in shaping the rate of future cuts, the cost of mitigation and the price of carbon. See exhibit 2.1. EX 2.1: The longer the world waits before beginning significant mitigation, the more radical the curve needs to be

Pathways for global emissions consistent with long-term stabilization at 450 ppm

??

60 Annual global emissions (GTCO2e)

Delaying the starting date increases the required annual rate of reductions

Business as usual

70

5

2005

6

3 1

40

2015

? 2020 2030 2040

1.3% 1.8% 2.4% 3.3%

4

50

2010

5.7% Equal to entire US electric power sector

2

Unlikely

30

?

6.1%

Uncertain

16.6% Probable

20 10 0 1990

2000

2010

2020

2030

2040

2050

2060

2070

2080

2090

2100

Source: EDF calculations using the MAGICC climate model and IPCC assumptions, published in Keohane & Goldmark (2008) “What Will it Cost to Protect Ourselves from Global Warming? The Impact on the U.S. Economy of a Cap-and-Trade Policy for Greenhouse Gas Emissions”, Environmental Defense Fund report. 3 More than 200 international climate scientists issued a declaration in December 2007 urging politicions at the United Nations Climate Change Conference in Bali to agree on strong targets for tackling climate change. 4 Based on CO2-equivalent volumes (CO2, methane, N2O, HFCs, PFCs and SF6 )

98

Investing in Climate Change 2009

We have already missed path #1, in exhibit 2.1, and are set to miss path #2 as it looks unlikely that emissions will peak sometime in the early 2010s. If the world wants to hit 450 ppm as a long-term stabilization target, concerted action will need to be taken in the next few years to set us on a trajectory to follow path #3 or path #4. The costs of waiting to follow path #5 or path #6 are likely to be very high – and sticking to those paths will be very difficult. Stern notes that it is likely to be very difficult to reduce emissions by more than a few percent a year while sustaining economic growth.5 If the world follows path #5, greenhouse gas emissions would need to decline at a faster rate than they did in the former Soviet Republics in the decade after the collapse of the Soviet Union – a period of significant economic contraction for the region. Avoiding the high costs and painful cuts of such a path is what makes interim targets so important.

II. A map of climate change regulation The greenhouse gas mitigation curve for policymakers is a useful tool for understanding regulation.

Understanding the mitigation curve In 2007, McKinsey and Vattenfall developed a cost curve for greenhouse gas mitigation for policymakers. The policy curve that was published in February of that year presented a view of the economic cost of approximately 27 GT of mitigation in 2030. The policy curve is an effective tool to measure the cost of mitigation for policymakers, as it takes into account the economic cost of pursuing greenhouse gas mitigation opportunities, but may not measure the true threshold carbon prices necessary to incentivize corporations to invest. The figure of 27 GT was arrived at by developing a view of the total global greenhouse gas mitigation opportunities available at under €40/ton around 2030, assuming action starts in 2008. Near the top of the cost curve, around 27 GT in 2030, the total mitigation potential is consistent with a long-term stabilization of greenhouse gas concentrations at 450 ppm CO2e. This pathway near the top of the curve falls somewhere between path #1 and path #2 in exhibit 2.1, and implies that significant action would be undertaken almost immediately. The curve presents policymakers with a translation of those targets into a set of individual mitigation policy options. See exhibit 2.2. Box 2.1: Climate change: mitigation, abatement and cost “Mitigation” and “abatement” are often used interchangeably in climate change. The goal of mitigation and abatement is to limit anthropogenic emissions of greenhouse gases” and to protect and enhance “greenhouse gas sinks and reservoirs” in such a way as anthropogenic climate change will be limited.6 When we published Investing in Climate Change: An Asset Management Perspective, we defined both terms, but preferred “mitigation” to abatement. This is because mitigation is the term that is used in the United Nations Framework Convention on Climate Change, appears more frequently in the Kyoto Protocol, and is more commonly employed by the Inter-Governmental Panel on Climate Change. “Cost,” which can be used in different ways, is also an important notion in the discussion of climate change mitigation. We define “economic” cost to be the cost at a policy level which then needs improvement to arrive at a “commercial” cost.

Lord Nicholas Stern, Stern Review Report, 2007, p. 203-205. United Nations Framework Convention on Climate Chnage, 1992, Article, 4, 2a

5 6

99

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework Ex 2.2: Different regulatory policies impact different parts of the greenhouse gas mitigation policy curve Industrial feedstock substitution Forestation

40 30

Smart transit

20

Idustrial nonCO2 Airplane effeciency

Small hydro

10

CCS EOR new coal

Livestock/ soils

Wind, low pen.

Forestation

Nuclear

CCS coal retrofit

Soil

Coal-togas shift

Avoided deforestation Asia Waste

Solar

Stand-by losses

0 -10

1

2

3

4

5

6

7

-20

9

Cellulose ethanol

-30 -40

Fuel-efficient vehicles

-60

Water heating

-80 -90 -100 -110 -120

Air Conditioning Lighting systems

Fuel-efficient commercial vehciles

-130 -140 -150

10

11

Inudstrial non-CO2

12

13

14

15

16

Co-firing biomass

17

18

19

20

Insulation Improvements

21

22

Avoided deforestation Amercia

CCS new coal

Industrial motor systems

Surgarcane biofuel

-50

-70

8

23

24

25

26

27

Industrial CCS

Abatement GT CO2e/year

About the curve: • The curve shows mitigation opportunities by 2030, but requires action starting in 2008. • The curve measures economic cost in € /ton, and includes capital operating and maintenance costs, as well as a real discount rate of 7%. Transaction costs, communication/information costs, taxes, tariffs and subsidies are excluded. • The curve presents a set of opportunites consistent with a long-term stabilisation potential of around 450 ppm as you approach 27 GT of abatement. • Assumptions include: Energy prices, cost of technology and learning rate, abatement potential, 7% discount rate, starting date of abatment.

-160

Overlap between traditional regulation and innovation policy

Current regulatory regime Traditional regulation: mandates, standards and education

Innovation policy (e.g. subsidies, incentives and R&D) Carbon price: regional, not all sectors are covered Source: McKinsey-Vattenfall greenhouse gas abatment cost curve; DeAM analysis.

Each bar on the chart in exhibit 2.2 represents a greenhouse gas mitigation opportunity (i.e. how much a particular technology/sector can contribute to reaching the mitigation target). The horizontal width of a bar represents the total quantity of annual emissions that can be eliminated by that method, and bar heights show the economic cost of the method that makes it cost-effective in 2030, measured in cost of CO2e per ton. The height of each bar also takes into account the learning rate of the technology – which is vital for projecting the future cost of emerging technologies on the mitigation curve, as many of them are coming down the learning curve at 5-10% a year. This means that within a decade, the cost of many of the technologies on the curve halve. Finally, the area of each bar represents the approximate total cost of mitigation with the method if it is fully utilized, assuming a static energy cost.

100

Investing in Climate Change 2009

By ranking mitigation methods left-to-right from the lowest break-even price to highest, the chart traces out the economic cost for emissions mitigation. If a given technology is cost-effective, all technologies to the left of it should also be costeffective and fully utilized. The horizontal position of the rightmost bar that is still cost-effective at a given carbon price will then indicate the total quantity of emissions that can be economically eliminated at a particular carbon price, from an economic perspective. It should be noted that the curve is derived using a number of assumptions. These include energy price, cost of technologies, learning rates, mitigation potential from each technology and a uniform discount rate of 7%. This discount rate was chosen on the basis of utilities – with low costs of capital – which will be the businesses responsible for unlocking many of the mitigation opportunities along the curve. The curve does not include subsidies or taxes. Incorporating these factors, and varying some of the assumptions used to develop the policy curve, can be highly useful exercises for investors, however. We look at this in more detail at the end of this chapter and in Chapter III of Part II.

The importance of acting early Linking this back to climate change targets, the curve assumes that mitigation efforts begin soon. Delaying mitigation efforts will change the curve: · The shape of the curve will change: some mitigation opportunities have slower learning rates, and require more time to get to scale. If action is delayed, the mitigation opportunities may be reordered along the curve, and some opportunities may be lost; · The scale of mitigation potential for each option (the horizontal width of each bar) will shrink. This will mean that for economic costs of €40/ton, less mitigation will be possible; · The cost of mitigation will increase for the options that are sensitive to economies from learning, meaning that for economic costs of €40/ton, less mitigation will be possible. One example opportunity that is extremely sensitive to delays is Carbon Capture and Storage (CCS). It is very expensive today, and is expected to derive significant economies through learning. If CCS demonstration projects are not seriously pursued until 2020, it is unlikely to be a major contributor to greenhouse gas mitigation in 2030 – and mitigation from CCS will cost more in that timeframe than if demonstration projects were well underway by 2010. Delaying action on CCS will therefore shrink the bar horizontally, and extend the bar vertically. For that reason, early action is therefore required so that the full spectrum of needed mitigation options are available down the road. We will discuss the spectrum of technology options further in Chapter IV of Part II.

Regulation and the mitigation curve The lower part of exhibit 2.3 illustrates the current regulatory environment and policy options. Today, most climate change policy around the world is concentrated either in traditional regulation (renewable portfolio standards, biofuels mandates, efficiency standards, building codes and emissions standards) or in innovation policy (feedin tariffs, tax credits, direct subsidies and funding for research and development). These two policy options, while theoretically best-suited to the extreme ends of the greenhouse gas mitigation policy curve, actually extend throughout the curve, as indicated in exhibit 2.2: many mitigation opportunities, such as biofuels in the US or wind in Europe, are influenced both by traditional regulation and innovation policy. Carbon pricing is, as of yet, an emerging regulatory tool, given its still modest price, superimposed on the European regulatory system through the European Emissions Trading Scheme and the Kyoto Protocol Mechanisms. As regulation is the focus of this chapter, we have broken down the policy options available into a more detailed set. We examine these regulatory policy options in detail in the next three sections of the chapter, but provide an overview in exhibit 2.3.

101

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework

Ex 2.3: There are three broad sets of policy options available

Regulatory policy

Traditional regulation

Mandated standards

AND

Public education

NOTE: This will vary by geography.

Source: DeAM analysis, 2008.

Carbon pricing

Carbon taxes

OR

Innovation policy

Cap-andtrade

Knowledge management • • •

AND

Technology transfer Publicly funded research, development, demonstration and deployment Inudstry research consortia

Adjustment assistance • Direct subsidies • Feed-in tariffs • Tax credits • Concessionary financing

III. Carbon Pricing – The Central Plank of Good Policy While still in an emerging phase globally, placing a price on greenhouse gas emissions is central to achieving reductions that are economically efficient in most parts of the economy. As other factors such as energy prices vary, a carbon price can become the constant or backstop that keeps the market moving towards a solution.

The importance of putting a price on the greenhouse gas externality Economic theory classifies climate change as a ‘commons’ or ‘public goods’ problem. These problems arise because – without regulation – neither the producers nor the consumers of greenhouse gas-producing goods pay for the full cost of the climate-change consequences of their transaction.7 The economic actors who benefit from the valuable services provided by the climate without paying for it are ‘free riders’ – and when their activities harm the environmental quality enjoyed by others, they are behaving like ‘disruptive free riders’ who transfer the costs of their own disruptive activities onto the rest of society. Because these ‘disruptive free riders’ do not pay for the true, external costs of the goods they produce or consume, the price of greenhouse gas-emitting goods is too low compared to their true costs to society. As a result, society collectively consumes too much, exacerbating global warming. An economist’s ideal solution to market externalities is to “internalize” these costs by requiring at least one party in a transaction to pay8 for the contribution to global warming. For climate change mitigation, this means establishing a carbon price9 to compensate society for emissions. Which party in a transaction is actually charged for carbon is irrelevant in theory, because costs will ultimately be shared by both the producer and consumer. The norm is to keep charges as close to the emissions source as possible: the “Polluter Pays” principle. Coase, Ronald H, Journal of Law and Economics, 3, 1960. “The Problem of Social Cost.” Ronald Coase points out that the difficulty of transacting or organizing to recover damages is the key issue. If there were no transaction costs, society could pay a producer not to emit CO2 or demand that the producer reimburse them for doing so. 8 Whether the producer or consumer pays turns out to be irrelevant: the relative elasticities of supply and demand determine how that cost is divided between the producer and consumer, although differences in tax rates may influence this as well. Emissions are accounted for in terms of “CO2 equivalents,” hence the shorthand “carbon.” 9 Technically speaking, all greenhouse gases must be paid for; in practice, emissions are accounted for in terms of “carbon dioxide equivalents,” hence the shorthand “carbon.” 7

102

Investing in Climate Change 2009

In practice, a carbon price can be established either by a: a) Carbon Tax Approach: places a tax on greenhouse gas emissions equal to the marginal costs of the emissions on society, or b) Cap-and-Trade Approach: places a cap on total emissions, issuing emissions credits, and allowing entities to buy credits they need and sell excess credits to others as long as all total emissions are accounted for by credits. Joseph Kruger notes that carbon pricing, especially through an emissions cap-and-trade regime, is starkly different from other forms of regulation. Under carbon pricing, the regulated companies are in charge of making decisions on technologies and compliance strategy, while the regulator monitors emissions, tracks transfer of emissions credits and ensures companies comply with regulatory requirements.10 This allows markets to select winning technologies – while establishing a regulatory framework to incentivize appropriate technological development and deployment. We believe that establishing a carbon price is central to climate change regulation. It is an essential “backstop” on more risk exposed approaches to develop alternative energies, such as relying on high fossil fuel prices, and will be a critical enabler that provides predictability to investors in the space. It also allows the market more flexibility to fund the cheapest mitigation options, rather than government choosing certain industries as winners through incentives.

Why cap-and-trade instead of a carbon tax? Some local governments (e.g. Boulder, Colorado, USA; British Columbia, Canada) and early-action countries (Sweden, Finland, the Netherlands in the 1990s) have implemented carbon taxes. Over time, however, a cap-and-trade orientation has begun to dominate policy approaches. More detail on example carbon pricing regimes is included in exhibit 2.4. Ex 2.4: Examples of carbon pricing in practice European Union Emissions Trading Scheme covering 50% of EU emissions and monitoring large fixed sources of emissions. Links exist between the EU-ETS and the Kyoto Protocol mechanisms.

Cap-and-Trade

Carbon Taxes

103

European Union

The Clean Development Mechanism allows countries without emissions requirements under the Kyoto Protocol to sell Certified Brazil, China Emission Reductions to countries/companies in compliance systems Voluntary emissions markets allow companies to make verified reductions to meet public commitments. This is enforceable under US contract law.

USA (not implemented by public authorities, but enforceable by legal system)

Other emerging regional and national trading schemes

New Zealand, Australia, Western US (WCI), Northeastern US (RGGI)

Municipal Carbon Tax; $1.33 per month per resident.

Boulder, CO, USA

Provincial Carbon Tax, made tax neutral by allowing carbon payments to be credited toward other tax bills.

British Columbia, Canada

Sweden taxed carbon at approx $100 per ton, starting 1990; raised to $150 per ton in 1997. Industrial users pay a lower rate.

Sweden. Similar policies adopted in The Netherlands, Finland, Norway, Italy

The UK implemented a Fuel Price Escalator in 1993, a pollution tax on retail petroleum fuels.

United Kingdom

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework In simple terms, a cap-and-trade sets a target for emissions in a geographic region consistent with a carbon stabilization level (i.e. 450 ppm). The cap is then pushed down to individual industries and companies that are given permits to emit that can be traded. These permits can be auctioned or provided for free. In either case, for markets to function properly, clear rules of private ownership must be established for what was, initially, a public good.11 Once emissions permits have been allocated, companies can then trade excess or deficits in their permits. The trading system can also include credits from other geographies. There are other important issues, such as sectoral coverage and banking and borrowing of credits that are important parts of the architecture of cap-and-trade regimes. While either a tax or a cap-and-trade system can address greenhouse gas reductions, cap-and-trade has a number of advantages. Cap-and-trade drives efficient mitigation by encouraging businesses with inexpensive mitigation opportunities to reduce emissions as much as possible and sell excess credits to businesses with higher marginal mitigation costs.12 It allows Ricardo’s theory of comparative advantage to work with emissions mitigation. We recognize that markets with public goods are less efficient than standard markets,13 but believe that the advantages of a market approach outweigh the disadvantages. The result of a carbon market – even one with suboptimal efficiency – is that those who can reduce emissions most efficiently are able to free up resources for those who cannot, and emissions reductions are therefore achieved at the lowest total cost to the economy.

A cap-and-trade system also allows the market to set the appropriate price of carbon, whereas in a tax regime, regulators would need to try to derive that price. The principal disadvantage of cap-and-trade is that price is less certain, and there is potential volatility. Inclusion of flexible mechanisms in a cap-and-trade regime, such as offsets, banking and borrowing, bring measures of stability to the market and mitigate the biggest disadvantage of cap-and-trade. Clear signals from regulators – which are at the origin of demand for carbon credits – can also help to bring long-term stability to the markets.14 While faith in market mechanisms has been shaken by the credit crisis, and there has been talk that could potentially lead to more focus on a carbon tax rather than a cap-and-trade regime, we believe that the benefits of cap-and-trade outweigh the disadvantages. While the UNFCCC and Kyoto Protocol do not specify that carbon must be priced, the Kyoto Protocol includes explicit mechanisms to permit emissions trading. Policy options such as the Clean Development Mechanism and Joint Implementation enable international cap-and-trade mitigation at least cost. Through these mechanisms – and the growing European Union Emissions Trading Scheme (EU-ETS) – cap-and-trade is growing in prominence year by year. The International Carbon Action Partnership (ICAP), which shares best practice in carbon trading schemes across borders, and other initiatives are promoting global linkages between and scaling of capand-trade regimes. The US is looking at its options for creating a cap-andtrade system through the LiebermannWarner and the Dingell-Boucher bills,

and as well as other proposals before the House and Senate. The importance of a robust global solution continues to grow. Why carbon pricing isn’t enough at the initial stage. While in theory, an adequate carbon price should be all that is required to achieve efficient mitigation. In the real economy, this is not always the case. The carbon mitigation cost curve demonstrates why. Along the carbon mitigation cost curve, there are a number of mitigation policy options that are viable at a negative carbon price in 2030 (i.e. they save costs). Many of these opportunities – such as improved insulation – are economic today. In a perfectly efficient market, these mitigation policy options should already be ideally fully utilized and profitable even without a carbon price. While the recent rise in energy prices has led to an increase in uptake of these measures, as reported in The Observer on August 3, 2008,15 we are far from capturing the total potential savings represented by energy efficiency. The fact that these methods are still not fully employed demonstrates that, for a variety of reasons (lack of information, short-term up-front costs and other behavioral factors), carbon prices may not be sufficient initially to promote adequate greenhouse gas mitigation in the real world. This leaves a role for energy efficiency standards and some incentives. At the other end of the curve, some technology solutions are currently very expensive and innovation theory suggests they should be incentivized directly.

Graciela Chichilnisky and Geoffrey Heal, Environmental Markets: Equity and Efficiency, 2000, p. 25-27 The tax method encourages firms to reduce emissions up to the point that marginal cost equals marginal benefits, but firms are locked in to marginal mitigation costs that depend on their own production process – they cannot take advantage of other firms’ lower mitigation costs nor offer their own mitigations to other firms. 13 Graciela Chichilnisky and Geoffrey Heal, Environmental Markets: Equity and Efficiency, 2000, p. 3. 14 State and Trends of the Carbon Market 2008, Washington D.C: World Bank Institute. 15 Tesco said it had seen customers stocking up on home insulation, while sales of its energy-saving lightbulbs have quadrupled. Homebase also said that sales of energy-saving lightbulbs were up 60% YoY, while B&Q has seen sales increase by 30% in the past 3 months. Bye Bye Standby, “Record numbers switch gas suppliers,” The Observer, August 3, 2008. 11 12

104

Investing in Climate Change 2009

Stern notes that carbon pricing is only one part of the solution, and that the regulatory policies used in traditional regulation and innovation policy are both vital tools in the climate change toolkit: “Carbon pricing is only one part of a strategy to tackle climate change. It must be complemented by measures to support the development of technologies, and to remove the barriers to behavioural change, particularly around take-up of energy efficiency.”16 Long-term optimal carbon price Using carbon prices alone to incentivize the early development of emerging technologies – some of which could require carbon prices of nearly €100/ ton to prompt inefficient, as such a high carbon price may put a disproportionate drag on the overall economy. This would also entail enormous transfer payments – potentially larger

in scale than those that flow from the OECD to petroleum exporting countries today. The recipients of these payments would benefit from enormous windfall profits at very high carbon prices. And the poor may be hit harder than the rich, as carbon pricing is without compensating transfer, a regressive tax. This is unlikely to be politically or socially acceptable, unless it comes about gradually. “Optimum” or even “acceptable” long-term carbon prices are therefore likely to be well below €100ton, although during the process of establishing the trend, they may spike to high levels if the market does not move fast enough towards mitigation. (See Appendix I for a discussion by Kevin Parker.) Other regulatory instruments, such as R&D subsidies, can be used to drive innovation of what are currently more expensive opportunities such

as CCS; this will allow government to buy promising technologies down the learning curve without subjecting the entire economy to very high carbon prices. The economy-wide costs of the subsidies and incentives associated with such a policy are likely to be much lower than the economic drag associated with a very high carbon price. See exhibit 2.5. Therefore, climate change mitigation policy will need to include two distinct sets of regulation to compliment carbon pricing: Traditional regulation and innovation policy. These policy options will overcome market failures and prevent imposition of an initial carbon price so high that it could have negative consequences for the entire economy.

EX 2.5: Looking for a global carbon price

A very high carbon price may be untenable, due to economic drag and the significant transfer payments it would imply Economic cost of mitigation, €/ton CO2e, 2030

Potential carbon price

40 30 20 10 0 -10

1

2

3

4

5

6

7

-20

-40

-60 -70 -80 -90 -100 -110 -120 -130 -140 -150 -160

Lord Nicholas Stern, Stern Review Report, 2007, 324.

105

Investing in Climate Change 2009

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

About the curve: • Total economic cost of maximizing all opportunities on the curve in 2030 is approximately €22 billion a year. This is the integral of the green area that lies under the curve. This includes: 8 GT of abatement, representing €380 billion of savings from measures that lie under the curve – these measures are NPV-positive with a 7% discount rate 19 GT of abatement, representing €403 billion of economic costs from measures that lie between €0 and €40 on the cost curve • At a carbon price of €40/ton, transfer payments would be equivalent to approximately €1.3 trillion in 2030. This assumes: All 27 GT of abatement potential on the curve is unlocked, reducing 2030 emissions from the BAU projections of 62 GT to 35 GT That all 35 GT of emissions that remain face a carbon price of €40/ton • Windfall profits from a carbon price would be approximately €700 billion in 2030. This area is represented by the area that between the carbon price and the cost curve. For negative-cost options, only that area between €0/ton and €40/ton has been added to this total, as the rest of the potential profits are not directly attributable to a carbon price. • Regulators may wish to avoid a very high carbon price: carbon pricing is, in effect, a tax. Imposing a very high carbon price to incentivize a few costly technologies may depress overall economic activity.

Source: McKinsey-Vattenfall greenhouse gas abatment cost curve.

16

9

26

27

Abatement Gt CO2e/year

-30

-50

8

Government Policy and Regulation: II An Analytical Framework

IV. Traditional regulation Some mitigation efforts appear to lag in spite of their current cost effectiveness; these challenges may require commandand-control mandates, public education, or the creation of attractive financing mechanisms. Enhanced public education and financing provide one way of support that can be used to shift behaviors to more climatefriendly technologies. These tools are not new. Governments often lead by example in terms of energy efficiency requirements in buildings and transport fleets, and providing incentivized loan packages for energy security. Mandatory standards, such as the US’s increasingly demanding performance standards for light bulbs, EU vehicle emissions standards and the frequent use of Renewable Portfolio Standards (RPS) in the US are other policies that regulators use to correct for market failures and consumer behavior. While economists typically see these policies as suboptimal to using a price mechanism, when they are pursued in situations where pure price signals have failed, the negative consequences are reduced. A summary of some traditional regulations mentioned in use today for climate change are included in exhibit 2.6. Box 2.2 illustrates the RPS in the US in more detail. Ex 2.6: Examples of traditional regulation in practice

Mandates & Standards

Public Education

Fuel emissions standards requiring new automobiles to reduce carbon emissions by 10% or more over 1990 levels.

California, USA; European Union

Phase-out of incandescent bulbs. New bulbs must use 25% less energy, rising to 70% more efficient by 2020.17

USA (starts 2012) Australia (starts 2010)

Renewable Portfolio Standards (RPS) requiring energy companies to supply a minimum percentage of energy from clean / renewable sources.

Various US States (California, Nevada, Texas)

Mandatory forest conservation: newly-settled land in forested areas can clear a maximum of 50% of the initially forested area.

Brazil

Energy standards for buildings: requires regular inspection and minimum energy standards for ordinary residences and office buildings (historic buildings may be exempted).

European Union

Energy Star Program certifies energy efficiency standards and promotes inter-industry knowledge sharing.18

USA

Energy conservation awareness campaigns.

Municipalities around the world

Global warming and environment incorporated into school curriculum.

Major industrial and developing countries

Higher efficiency cookstoves to reduce deforestation.

Parts of Africa

Al Gore’s public climate change awareness campaign.

Mainly in the US

Lord Nicholas Stern’s review on climate change and economics.

Global Reference

The Carbon Trust.

UK scheme

Intergovernmental Panel on Climate Change (IPCC).

Global reference

News and Documentary Channels.

Global

Comes as part of the Energy Independence and Security Act of 2007 signed by President Bush, December, 2007. Energy Star is a joint program of the U.S Environmental Protection Agency and the U.S Department of Energy helping consumers save money and protect the environment through efficiency products and practices.

17 18

106

Investing in Climate Change 2009

Box 2.2: Renewable Portfolio Standards (RPS) in the US

RPS are flexible, market-driven, regulatory policies that place an obligation on electricity suppliers to produce a specified proportion of their electricity from renewable energy sources. The goal of RPS is to stimulate the market and encourage the development of key technologies so that, ultimately, renewable energy will become commercially competitive with conventional forms of electric power. RPS are frequently used in the US, with 32 states (plus the District of Columbia) mandating that between 4-30% of electricity is generated from renewable sources by a specified date. See exhibit 2.7. Certified renewable energy generators earn certificates (RECs in the US) for every unit of electricity they produce. They can sell these, along with their electricity, to supply companies who then pass the certificate to a regulatory body to demonstrate compliance with regulatory obligations. Ex 2.7: 32 US states have renewable portfolio standards

Mandatory RPS RPS via Voluntary Utility Commitments

Source: Pew Center on Global Climate Change; updated 20 June 2008.

Coordination with other energy policies at the federal and state level is of particular importance for the growth of the renewable energy sector. RPS have generally been most successful when they have been used in conjunction with other policies such as Investment Tax Credits (ITCs) and Production Tax Credits (PTCs). Notably, in periods where PTCs have been withdrawn, RPS alone have sometimes been insufficient to incentivize significant new capacity installation. The structure of individual RPS can influence investor confidence, the ability for markets to develop, and opportunities for project developers and investors to recover capital investments. Regional market considerations will also impact the economics of individual projects.

107

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework V. Innovation policy Some mitigation technologies have high R&D costs, long lead times, and currently would require very high carbon prices before they are profitable, leading potentially to politically unacceptable transfer costs and overall drag on the economy. If it is reasonable to expect research and learning to bring down the implementation costs, the prospects for carbon mitigation are substantial, and there are spillover benefits of innovation ‘learning externalities’, there is a case for publicly subsidized research and development, as well as concessionary financing or subsidies for implementation costs.

Why innovation policy is important It is difficult for private investors to fully capture the benefits of innovation. Therefore, there is chronic underinvestment unless government support is present. This is true across all sectors of the economy, but especially true in the energy sector. CCS, lignocellulosic ethanol and biobutanol are not presently developed and deployed at commercial scale. This is because up-front R&D and capital costs are high, and therefore, only start to become feasible at high carbon prices. Public research and development, capital subsidies, and concessionary financing terms are justifiable when:

· A technology promises to achieve a large reduction of emissions; · It has high startup costs and lower marginal mitigation costs thereafter; · The potential for reducing startup costs through learning, scale, or network effects is high; · And there are promising potential spillover effects (“learning externalities”) of innovation.

Under these circumstances the government may need to assume some of the investment risk in research and development, and reduce business exposure to the risk that carbon prices might not rise fast enough to justify short-term implementation. The advantage is that expensive technologies will achieve large-scale feasibility at a lower carbon prices and become operational faster. The criticism is that government is picking winners.

The importance of increasing R&D budgets Stern notes that global energy R&D needs to be dramatically scaled up to confront the challenge of climate change: “Global public energy R&D support has declined significantly since the 1980s and this trend should reverse to encourage cost reductions in existing low-carbon technologies and the development of new low-carbon technological options. The IEA R&D database shows a decline of 50% in low-emission R&D between 1980 and 2004. This decline has occurred while overall government R&D has increased significantly. A recent IEA publication on RD&D priorities strongly recommends that governments consider restoring their energy RD&D budgets at least to the levels seen in the early 1980s. This would involve doubling the budget from the current level of around $10 billion. This is an appropriate first step that would equate to global levels of public energy R&D around $20 billion each year.”19 While increasing energy R&D and promoting the development of clean technologies are worthy goals, regulators will need to confront one core difficulty associated with innovation policy: picking winners. In some cases, government support for technologies has led to the creation of successful, low-carbon industries, such as nuclear power generation in France. The government played a critical role in supporting the sector, providing seed capital, scientific expertise, and central coordination that ensured efficient roll-out of modular nuclear plants across the country. While the story of nuclear in France is generally considered a success, there are other examples of “clean” industries that have grown off the back of regulation that require more careful consideration. The combination of a $0.52/gal subsidy on ethanol and a corresponding $0.54 import tariff has resulted in a US ethanol market that uses corn as the predominant Lord Nicholas Stern, Stern Review Report, 2007, 371-372.

19

108

Investing in Climate Change 2009

feedstock for fuel. The greenhouse gas emissions from corn ethanol are not significantly lower than those from gasoline; it’s relatively expensive to produce corn ethanol, compared to sugarcane ethanol; and the energy that is consumed in the production process for corn ethanol is relatively high. It is usually energy security that is cited as the key rationale these days for the US biofuels policies. Politicians and regulators are now insisting on sustainability criteria for biofuels to correct the problems that have emerged in the US ethanol industry. As innovation policy is used to promote other clean technologies, regulators will need to be careful to ensure that they are not setting up incentive systems that will promote the wrong kind of behavior. A summary of some cases of innovation policy in practice in the climate chnage space is included in exhibit 2.8. Ex 2.8: Examples of innovation policy in practice Knowledge Management

Public Education

Sustainable Forestry Research and Development Initiatives (e.g. nontimber forest product development and marketing).

Brazil, India

Public Research for Carbon Capture and Storage (CCS).

European Union

The Production Tax Credit (PTC) reduces renewable energy producers’ tax burden by 1.5 to 2 cents per kWh, depending on the type of energy. The PTC has been renewed for 1 year for large-scale wind projects as part of the Emergency Economic Stabilization Act of 2008.

USA

Feed-in Tariffs provide energy producers a guaranteed premium for clean energy.

Spain, Germany, Italy, France, India

The investment Tax Credit (ITC) reduces capital expenses for solar electric and solar water heating equipment by 30%. The ITC has been renewed USA for 8 years for solar. Renewable Energy Credits (RECs) allow renewable energy suppliers to sell credits to large utilities facing renewable portfolio standards.

USA

Microfinance for purchase of improved cookstoves in poor communities to reduce local deforestation in the search for firewood.

Several African countries

R&D funding for major CCS demonstration projects.

EU

Box 2.3: Feed In Tariffs

A feed-in-tariff is a renewable incentive structure that obliges regional or national electricity utilities to buy electricity produced from renewable resources at above market rates over a set period. The tariff is set by the government and aims to overcome the cost disadvantage of renewable energy sources and ensure investment security. The cost of this is then spread across all consumers of electricity. Developments of wind power in Germany and Spain have been catalyzed by feed-in-tariffs; new regions, including Switzerland, Bulgaria and the Czech Republic, are establishing feed-in tariffs to encourage scale-up of renewable energy. The clearest benefit of feed-in tariffs is the certainty they provide to developers of renewable energy, effectively derisking investments in the space. However, if feed-in tariffs are too generous, they may encourage inefficient development and deployment of renewable technologies, where renewables that are not best suited to a particular region are installed because of the generous support they receive in the form of feed-in tariffs. There are important variations on the basic concept of the feed-in tariff, that are important for project developers and investors. In some geographies, the feed-in-tariff subsidy is received in addition to the basic power price, allowing owners to share in the upside and downside risk of electricity markets. In other geographies, such as Spain, a price floor is established by the feed-in tariff, where a minimum total price per MWh is guaranteed for renewables in the event that the power price falls below profitable levels.

109

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework Case study: Carbon Capture and Storage (CCS) & Forestry CCS is a crucial example where innovation policies can unlock substantial opportunity, because it is a highly important technology that could reduce emissions from fossil fuel power plants and other major sources by 80-90% – while enabling continued use of the fuels that provide the world with 88% of its primary energy supply. A variety of cost estimates exist for CCS plants, depending on the type of plant CCS is used for, and whether the plant is built with CCS already integrated, or has to be retrofitted with CCS. In a report published in September, 2008, McKinsey estimates the marginal mitigation costs for early commercial CCS plants at between €35 and €50/ton CO2e by 2030. Early demonstration projects are expected to be more costly, with marginal costs of mitigation between €60 and €90/ton CO2e. CCS has very high up-front high capital costs, lengthy construction times, requires more fuel to deliver the same energy, and in most cases would demand a network of pipelines for carbon dioxide transport. From a business perspective, carbon prices might have to be higher than the economic marginal cost of abatement to justify deployment of CCS at scale. This is because carbon revenues are somewhat uncertain and take place far out in the future, while the costs are more certain and immediate. Society clearly has a need to develop a way to continue using fossil fuels, while limiting the harmful emissions they cause in a relatively cost-effective manner (at around €35 to €50 per ton). Waiting for carbon to be priced over €90 per ton before the private sector starts to implement CCS may result in energy (and other carbon-intensive) costs that act as an overall drag on the economy, constraining economic growth and potentially calling into question the political sustainability of cap-and-trade rules. In this situation, it makes sense for the public sector to take on some of the business risk of unknown carbon prices, shoulder a portion of the up-front research and construction costs with direct subsidies, tax incentives, and perhaps even guaranteed carbon prices. The government’s role in establishing the knowledge and physical infrastructure required for CCS can lower the costs of entry for firms that then scale up. The network effects of constructing pipelines means that the cost of transporting carbon will drop substantially as the number of CCS plants rises. As technologies become more standardized and learning eliminates unnecessary expenditures, up-front costs of deploying CCS will drop and more activity will become feasible at a lower carbon price. Additional benefits (“learning externalities”) of R&D into CCS may spill over into other sectors of the economy. Is forestry an alternative to CCS? Potentially making a large impact on deforestation and encouraging reforestation could boost the available mitigation from this source so much that it reduces the short-term (i.e.: out to 2030) need for CCS, giving more time for technological learning to take place. In Appendix III, we discuss the promise of CCS and the challenges facing it in more detail. We also bring forestry – the other major carbon sink that humans can meaningfully influence – into the discussion to gain a more complete understanding of the portfolio of carbon storage options available.

VI. Trends in climate change regulation and implications for investors. Uptake of policy around the world Regulatory activity is high in climate change, and ranges across the full spectrum of regulatory options. exhibit 2.9 documents uptake of these policy levers in 60 countries and indicates currently:

110

Investing in Climate Change 2009

· Renewable incentives such as Feed-in tariffs and tax credits are popular across the board; · Compared to industrialized and transitional countries, developing countries have comparatively fewer direct capital subsidies and public investment loans, possibly because of the development climate over the last two decades which discouraged direct subsidy methods and infrastructure spending; Developing countries also appear to lag in tradable renewable certificates (RECs), renewable obligation certificates (ROCs) and renewable portfolio standards, perhaps because energy is a strategic development input to be scaled up as quickly as possible. Ex 2.9: Uptake of regulatory policy in 60 countries.

Renewable Energy Policy Choices in 60 countries 2007 (37 Developed/23 Developing) Total

Developed

Developing

Feed-in tariff Capital subsidies, grants, rebates Investment or other tax credits Sales, energy, excise, or VAT tax concession

Policy

Public investment loans or financing Tradable renewable certificates Public competitive bidding Renewable portfolio standard Net Metering Energy production payments or tax credits 0%

Source: REN21 policy network, 2007; Renewables 2007 Global Status Report; DeAM analysis, 2008.

10%

20%

30%

40%

50%

60%

70%

80%

Percent of sample using policy

How will things change? We expect carbon prices should become more dominant over time. In the long term, carbon pricing is likely to become more dominant in climate change regulation, because the price mechanism should generate the most cost-effective greenhouse gas reductions possible, and we expect governments to act rationally in the face of this. The next year will be critical, however, for developing the future regulatory framework. Negotiations are now going on in the lead-up to the UN Climate Change Conference in Copenhagen, which will take place in December, 2009. A robust global deal in Copenhagen could significantly accelerate the development and deployment of a global carbon regime – and help set the stage for the long-term regulatory transition from a system based primarily on traditional regulation and innovation policy to one that is centered on internalizing the climate change externality. If a robust global climate regime is established – or if enough countries establish linked carbon markets to create a de-facto global regime – improved learning rates leading to commercial breakeven with carbon pricing will enable governments to scale-back incentives and subsidies and the lowest cost options for mitigation will be realized. See exhibit 2.10.

111

Investing in Climate Change 2009

Government Policy and Regulation: II An Analytical Framework Transitions incentives are required to drive learning curves Ex 2.10: As mitigation options reach commercial breakeven, carbon price can replace most other incentives in new technologies until they breakeven Cost of abated Carbon, €/t

Innovation policy (e.g. subsidies, incentives and R&D) Carbon Price Profit

2010

2030

Learning curve for given technology, e.g., wind

Source: McKinsey & Company; DeAM analysis, 2008.

As corporates and individuals realize the economic benefits of many clean technologies – when the blue line crosses the red line in exhibit 2.10 – they will adopt them.

The way forward: in the long-run, confidence in the system, regulatory transparency and predictability are key In the long-run, investors look for certainty, predictability and transparency in the regulatory space. While that is a few years off, our understanding of the regulatory framework points to a few developments down the road: · Mandates are likely to be rolled back as technologies reach commercial breakeven; · Carbon pricing will likely emerge as the dominant regulatory force – first in individual, regional pockets (e.g. in the EU), and progressively linking globally to allow efficient mitigation; · Relying on learning rates and high energy prices to eliminate all government regulation may appear to be a great idea, but ultimately, the carbon price remains the essential backstop to reach a climate stabilization goal. In the medium- to long-term, carbon pricing should come to be the regulatory instrument that is used to motivate action along most of the policy mitigation greenhouse gas mitigation policy curve, with some amount of traditional regulation left where irrational behaviors still exist at the left-hand side of the curve, and some continued innovation policy for promising technologies, some of which we may not foresee today. See exhibit 2.11.

112

Investing in Climate Change 2009

Ex 2.11: Different regulatory policy sets impact different parts of the greenhouse gas mitigation policy curve 40 30 20 10 0 -10

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

-20 -30 -40 -50 -60 -70 -80 -90 -100 -110 -120 -130 -140 -150 -160

Likely 2030 regulatory regime assuming continued global progress on cap-and-trade

Carbon price: global, most sectors of economy covered Source: McKinsey-Vattenfall greenhouse gas abatement cost curve; DeAM analysis. 2008.

Climate change regulation presents both strategic and tactical opportunities. For investors, deep understanding of the regulatory landscape is necessary to maximize returns. Understanding the existing regulatory framework on a geographical level, and how it interacts with local development priorities is essential to strategic asset allocation – and will allow the investor to anticipate future regulatory developments. Regulatory systems that overuse traditional regulation and apply innovation policies indiscriminately will end up diverting investment from optimal opportunities to alternatives selected by regulators. This will tend to reduce return on investment for the overall economy. Therefore, we expect rationality to prevail and these types of regulatory settings to disappear. Taking a view on these trends is crucial for investors. The primary opportunities to generate tactical returns will happen when regulatory policies change due to scientific, political, or economic factors. An ability to predict these trends is a potential an alpha source. When regulations are updated or change, three considerations guide tactical investment opportunities: · The degree to which a company can optimize its regulatory burden by relocating operations to other regulatory zones: this tends to favor large-cap global firms; · Elasticities of supply and demand: industries that can pass regulatory costs on to either customers or suppliers (or both) will tend to outperform; · Technological flexibility: companies that can redesign production processes rapidly will tend to outperform: this typically favors less capital intensive companies. Allocation with respect to both these strategic and tactical considerations will allow investors to maximize returns from the attractive opportunities present in the climate change space.

113

Investing in Climate Change 2009

From the Policy Curve to the Commercial IIa Breakeven Opportunity

• The insights of the greenhouse gas mitigation policy curve can be used to build up an investor curve, taking into account additional factors such as carbon pricing, incentives and subsidies, taxes and specific project costs. • Other factors already included in the policy curve, such as energy prices and the discount rate, can be varied to provide realistic parameters for an investor. • Other strategic considerations, such as competitive advantage and barriers to entry, should be considered alongside these factors. Developing a dynamic carbon mitigation curve for investors The greenhouse gas mitigation policy curve allows policymakers to understand the marginal economic cost of mitigating greenhouse gas emissions, but it is not an ‘investor’s’ curve. To get to a set of investor’s opportunities, a number of calculations would need to be performed: · The economic impact of regulatory support for clean technologies, such as incentives and subsidies, would need to be built into the curve by geography, and would need to be projected forward to 2030; · Taxes and specific project costs would need to be included; · Other assumptions, each of which would generate a specific curve in a specific situation, would need to be varied. These include the discount rate and energy price assumptions. These additions to the curve – considered alongside strategic issues like sources of competitive advantage – would provide investors with a tool to help them strategically allocate capital across climate change mitigation opportunities. In exhibit 2a.1, we lay out how these dynamic factors would be used to build up the investor curve. In the initial work carried out on the curve, technologies were aggregated, and regional differences were accounted for only at a very broad level (e.g. OECD Europe, US, China). To develop the investor curve further, it would need to be expressed at a regional and specific level, with increased breakdown of technology portfolios and additional dynamics such as local energy prices and regulation included. Some regional curves, such as the German curve, do include information on taxes and subsidies, but investors will need to factor in taxes, regulatory instruments, and drill down deeper into individual technologies to maximize alpha generation from climate change opportunities. This includes choosing appropriate discount rates.

114

Investing in Climate Change 2009

Ex 2a.1: Building the commercially viable investor curve

A number of additional factors need to be included in the policy curve to arrive at the commercially viable investor curve A Mitigation policy curve

Economic cost of mitigation, €/ton CO2e, 2030 Energy cost assumptions: oil, coal, natural gas

40 20 0 -20 -40 -60 -80 -100 -120 -140 -160

1

2

3

Assumptions on the cost of technologies, including learning rate

4

5

6

7

8

9

Assumptions on mitigation potential for specific technologies

10 11 12 13 14 15 16 17 18 19 20 21 22 23

B

24

25 26 27

C Regulatory support for clean technologies, including incentives and subsidies

D

E

Investor curve

Factors that need to be varied: Dynamic energy cost assumptions, specific regional costs, different discount rates based on technological risk

Other investor considerations, including sources of competitive advantage, such as barriers to entry (e.g. capital intensity, intellectual property rights, scarcity of resources)

Source: DeAM analysis, 2008

115

Uniform discount rate

Investing in Climate Change 2009

Taxes and specific project costs

The investor perspective: Risk & Return III Around Commercial Breakeven

• There are different ways of calculating commercial breakeven, which can include or exclude subsidies, incentives and carbon prices. It is important for an investor to be aware of what is and is not included when assessing the economics of renewables. • In the long run, the most sustainable breakeven point for renewables is when they are commercially viable without subsidies, but with a carbon price regime in place as a de-risking backstop. • When it comes to assessing a specific project for investors, a set of complex variables comes into play at a granular level in a specific region and market context. Aggregate level analysis, while useful, needs to be articulated to a project-level. • There is a set of critical risk/return trade-offs investors need to take into account, specifically: operational, financial, regulatory, energy feedstock, learning rate, underlying electricity price and carbon.

In the previous chapter, we introduced the carbon mitigation policy curve, and discussed how it would need to be modified to arrive at an investor curve. Incorporating considerations such as tax, different hurdle rates based on risk, regulatory tools such as incentives and subsidies, and dynamic energy price inputs are essential for investors to understand the value of clean technology projects. In this chapter, we will look in detail at how these opportunities work, what they mean for the commercial breakeven of clean technology projects and how the value of these projects shifts over time. To do this, we first look at a particular mitigation opportunity on the curve and see how it is analyzed – in effect, we discuss how the height and width of a bar is determined. We then delve deeper into the bar, developing a methodology investors can use to analyze individual projects. The chapter is organized into three major sections: 1. Understanding commercial breakeven: Commercial breakeven is the point at which alternatives are economically viable compared to other, less environmentally-friendly options. This is critical for the ultimate scaling of the market. 2. Using Levelized Cost of Energy as a tool: Levelized Cost of Energy (LCOE) is the methodology used to understand the commercial breakeven of alternative energy technologies in the electricity market. There are two ways to use the tool: (1) at an industry level, and (2) at an individual project level, varying assumptions to assess project economics. While the idea of LCOE is attractive at an industry level, adapting the framework to work as a projectlevel investor spreadsheet is ultimately more useful. 3. The investor equation: An investor needs to understand the risk and return associated with different parts of the commercial breakeven equation and the impact of changing assumptions on project economics.

116

Investing in Climate Change 2009

I. Understanding commercial breakeven: Commercial breakeven is the point at which alternatives are economically viable compared to other, less environmentallyfriendly options. This is critical for the ultimate scaling of the market. As the costs of fossil fuels have increased, renewables have come down the learning curve, and incentives and carbon prices have been developed, a variety of clean technologies are rapidly moving towards commercial breakeven. We have developed a chart that can help understand the relationship between: • Fossil fuel prices – gas, coal, oil • The cost of alternative technologies • Learning rates • The benefits of incentives and subsidies for driving technologies down the learning curve • And the points of commercial breakeven (1) with incentives without carbon pricing (2) with carbon pricing and incentives (3) with carbon pricing without incentives (4) without carbon pricing or incentives (5) beyond breakeven We use the chart to illustrate the principle of commercial breakeven. See exhibit 3.1. EX 3.1: Dynamics of commercial breakeven Cost of alternatives

Learning rate drives down costs over time

1

Commercial breakeven with incentives without carbon pricing e.g. some US states

2

Commercial breakeven with carbon pricing and incentives e.g. EU

3

Commercial breakeven with carbon pricing without incentives

4

Commercial breakeven without carbon pricing or incentives

5

Beyond Breakeven

Carbon price

Cost

Incentives to make technologies economically viable diminsh over time

2

3 4 Cost of fossil fuel-based energy (oil, gas, coal prices)

5

1

Time Source: DeAM analysis, 2008

Exhibit 3.1 lays out how commercial breakeven works for a specific opportunity along the mitigation curve. The purple line shows the trend of increasing fossil fuel prices that we have witnessed since the late 1990s. As we will discuss in more detail in Chapter VII, the days of $15-$20 oil are over: the consensus is that relatively high fossil fuel prices are here to stay, with long-term oil prices above $90 a barrel. Declines in the short-term due to a potential recession in 2009 will be temporary, and in the long-run, prices will return above $90 a barrel, as discussed in Chapter VII of Part I. However, the long-term dynamics of oil are not shared by all fossil fuels: coal prices are expected to decline in the long-run, a trend which we discuss in more detail in Chapter VII of Part I.

117

Investing in Climate Change 2009

The investor perspective: Risk & Return III Around Commercial Breakeven

The carbon price, depicted by the green line, drives up the cost of conventional energy. Substantial evidence points to the growth of carbon pricing going forward: Markets have grown rapidly over the past year, the price of carbon is strengthening, and new regions are considering adopting cap and trade schemes. The cost of clean alternatives, brought down over time by the learning rate, is shown by the blue line, this has steadily decreased due to investment, economies of scale and technical improvements. The trend of declining costs is motivated in part by an array of renewable incentive schemes that encourage development and deployment of new technologies and pull down the cost of renewable technologies. Incentive schemes are depicted by the dashed grey lines. As the blue line approaches the green and purple lines, the dashed grey lines become shorter. This is because the incentives required to steer the development of the technology decrease as it approaches commercial breakeven without subsidies. There are five “breakeven points” indicated on exhibit 3.1, depicted by aquamarine circles: • Breakeven point 1 indicates where a technology achieves commercial breakeven excluding carbon pricing, but including other incentives. In countries where there is no carbon price in place, this is the point at which it first makes economic sense for corporations to deploy the technology. For states in the US that have tax credits or other incentives for renewables, this is the point of breakeven; • Breakeven point 2 indicates where a technology achieves commercial breakeven including all incentives and carbon pricing. This is the point of break-even for EU countries with carbon pricing and other incentives for renewables; • Breakeven point 3 indicates where a technology achieves commercial breakeven including carbon pricing, but excluding other incentives. In countries where a carbon price is in place, this is the point at which the technology hits electric grid parity; • Breakeven point 4 indicates where a technology achieves commercial breakeven excluding carbon pricing and incentives. At this point, the technology makes economic sense for corporations to roll-out without any regulatory support. • Breakeven point 5 indicates where a technology is beyond breakeven. At this point, the technology has moved down the learning curve, and costs less than its conventional counterpart. It is likely to scale up within the bounds of supply-side constraints, and may start to bring down the price of its conventional power peer. Technologies will move progressively from breakeven point 1 through to breakeven point 5 depending on the market structure and incentives in place for different countries. The US is currently at breakeven point 1 (although some states are introducing carbon prices) for some renewable technologies, while some renewable technologies have reached breakeven point 2 in the EU. A factor that shifts commercial break-even in the EU is feed-in tariffs. Governments establish feed-in tariffs to encourage development of renewable capacity by providing long-term premium payment for renewable energy generated and fed into the grid. An effective feed-in tariff is set at such a price that the renewable it targets is at commercial breakeven today, prompting significant capacity build-out. Over time, feed-in tariffs can be rolled back, as renewables come down the learning curve and become less expensive. Once renewables reach breakeven points 3, 4 and 5, feed-in tariffs can be eliminated and the technology will continue to be deployed, assuming there is a system in place for the renewable to feed its electricity onto the grid.

118

Investing in Climate Change 2009

II. Using Levelized Cost of Energy as a tool: Levelized Cost of Energy (LCOE) is the methodology used to understand the commercial breakeven of alternative energy technologies in the electricity market. There are two ways to use the tool: (1) at an industry level, and (2) at an individual project level, varying assumptions to assess project economics. While the idea of LCOE is attractive at an industry level, adapting the framework to work as a project-level investor spreadsheet is ultimately more useful. In box 1, we discuss how LCOE is calculated. Box 1: Calculating LCOE Economic Inputs Not all variables are taken into account when developing an LCOE model; often, varying boundaries, assumptions or scenarios are established to compare the LCOEs of different technologies under different scenarios. Different fuel prices, tax incentives and carbon prices may be key shifting factors. The standard, industry-level LCOE uses a common discount rate, but for this methodology to be used in project evaluation, the discount rate would need to be varied. See exhibit 3.2.

LCOE considers the total electrical output generated by a technology over its lifetime, divided between the total cost of investment, the interest rate, cash flow during construction, and any additional operational and maintenance costs, all in present value terms. Typically, the LCOE result is given in a currency per kilowatt (or megawatt)-hour unit, such as $/kWh or €/MWh. Depending on which of the breakeven points is under consideration, carbon pricing and incentives and subsidies can be switched on or off in an LCOE model. EX 3.2: Key drivers of LCOE for a specific technology.

Costs incurred on the purchase of land, buildings, equipment and construction

CO2 emissions rate Output degradation

Repairs, maintenance, SOx and NOX emission costs

Availability Amount of time a plant is available to produce power.

4 Carbon price

3

Subsidies and incentives

LCOE with carbon price

2

+

119

Investing in Climate Change 2009

LCOE with subsidies and incentives

LCOE with carbon price, incentives and subsidies

Electricity price Source: DeAM analysis, 2008.

1

The investor perspective: Risk & Return III Around Commercial Breakeven LCOE at an industry level Each energy-generating technology has different underlying economic characteristics. It can be difficult to make a direct comparison between different technologies by only considering one or a few of those characteristics. This is a critical issue when performing a cross-industry comparison of conventional and alternative sources of energy, as their economic drivers are quite different. For example, capital costs for renewable installations tend to be higher than those for fossil fuel power plants, while renewables do not have any fuel expenditures, meaning that their operating costs are often lower than those of their fossil fuel counterparts. The only fair way to compare power generation methods at an industry-level, then, is through a methodology that takes both capital and operating costs into account, and translates the two into a common currency. The Levelized Cost of Energy (LCOE) model is an effective way to determine a consistent comparison that accounts for fixed and variable drivers behind each technology.

LCOE? The discount rate question and project-level analysis Normally, the LCOE model uses a common discount rate when comparing different technologies and energy sources. This has some merit, as it permits analysts to understand the breakeven point at an industry level. However, this does not fully satisfy the needs of the investor. The discount rate chosen, and other project-level inputs, such as specific regional factors in the electricity markets, will have an important influence on project economics. Before discussing each of the factors that need to be varied in developing a project-level analysis, we introduce the most important characteristics of electricity markets. See box 2.

120

Investing in Climate Change 2009

Box 2: Understanding electricity markets

The structure of electricity markets Electricity is a vital good with a number of characteristics that set it apart from other commodities: • • •

It is difficult to store and has to be available on demand; It is not normally possible to ration electricity or have customers queue for it; Demand and supply vary continuously, within a very short timeframe.

There are five main participants in electricity markets: • • • • •

Power generators, who operate power plants; Transmission system operators, who manage the electric power grid and ensure its reliable operations; Electric power distribution companies, who serve as power retailers for businesses and residences; Power traders, who act as financial intermediaries in the relationship between power generators and electric power distribution companies; Customers, who demand a reliable supply of electric power.

Contracts are the principal instruments used to govern the relationships between the actors in the power markets. Normally, these are concluded between power generators and electric power distribution companies or power traders. These contracts can be established on a long-term basis. For example, in the US, there is a 7-day, 24-hour market (a contract to provide a constant supply of baseload power) and a 5-day,16-hour market (a contract to supply power during peak demand periods). They can also be established on a short-term basis, either in the day-ahead market, or in the hour-ahead market (the spot market)

What does this mean for renewables? Conventional LCOE analyses have compared renewables to “electric grid parity”, stating that parity is the point at which power generation from an energy source becomes competitive with the electric power grid. When the electric grid parity of alternatives is assessed, day-ahead and hour-ahead peak power prices have normally been used. These are significantly higher than prices in the 7-24 market, because more expensive gas peakers that can be brought on-line within half an hour when demand peaks set the marginal cost of power in this market. These peakers are more costly than baseload coal or nuclear, because they consume relatively expensive fuel, and depending on the demand, older, less-efficient plants may need to be brought on-line. It may be fair to compare solar power to peak power, as solar panels produce the most power during the early afternoon on hot, sunny days – when the electric power system is at the height of peak production. The arguments for wind being compared to peak power are less compelling. However, the fact that solar and wind are both intermittent sources of power prevents them from securing the conventional, longerterm 5-16 and 7-24 contracts. Renewables are instead forced to secure contracts in other ways: 1. 2.

In the wholesale market at the “generator” end of electricity markets (e.g. wind parks), feed-in tariffs are used in geographies like the EU, while purchasing price agreements (PPAs) are normally used in geographies without a feed-in tariff. Some renewable producers are also taking on merchant generator risk, by deciding to sell some of their production on the spot electricity markets; In the retail market at the “customer” end of electricity markets (e.g. rooftop solar), net metering and feed-in tariffs in geographies like the EU have established a purchase price for renewables. Where there is no feed-in tariff, renewable power generation is sold onto the grid at spot electricity prices.

While in the build-out phase, the intermittency of renewable generation will not be an insurmountable challenge for the electric power grid. However, some studies have suggested that as penetration of intermittent sources of power increases to around 20% of generation capacity, the grid may need to be upgraded to handle the increased capacity. These factors will all be dependent on the specific characteristics of regional electricity markets. Investors will need to evaluate the condition of local electricity markets, and how individual projects are likely to play into these markets, as they make investment decisions – underscoring the importance of adapting the industry-level LCOE model to an investor’s spreadsheet, and taking into account broader factors from the competitive landscape.

121

Investing in Climate Change 2009

The investor perspective: Risk & Return III Around Commercial Breakeven Developing an “investor’s spreadsheet” for individual projects from the LCOE model requires a number of modifications. Revisiting the LCOE model, the principal factors that would be varied in the investor’s spreadsheet are laid out in exhibit 3.3.

EX 3.3: Developing the investor’s spreadsheet: each input can be varied, but some are more important than others

Discount rate needs to be adapted to match individual project risk profile and cost of capital

Least Important

Most Important

Fuel price scenario analysis needs to be conducted

Costs incurred on the purchase of land, buildings, equipment and construction

Learning rate should not be assumedindividual project costs replace it

CO2 emissions rate

Carbon price scenario analysis needs to be conducted

Output degradation Availability

Repairs, maintenance, SOx and NOX emission costs

Amount of time a plant is available to produce power.

4 Carbon price

3 All inputs need to be project-specific

LCOE with carbon price

2

Source: DeAM analysis, 2008.

Subsidies and incentives

+

1

LCOE with subsidies and incentives

LCOE with carbon price, incentives and subsidies

Scenario analysis on subsidies and incentives should be performed

Electricity price

Local energy market dynamics need to be modeled

While all of the inputs into the investor’s spreadsheet will need to be project-specific, some of the inputs will be more important than others: • The most important factors for project evaluation will be tailoring the discount rate to the individual project under consideration, as well as modeling how the project fits into the local energy market. This is because these factors will have the greatest impact on the economic viability of projects across the board; • Other factors that will be important to investors include performing scenario analysis on fuel price, carbon price and incentives and subsidies in order to determine the exposure of the investment target to these factors, and develop a view of the risk/return profile of the target. By adapting the LCOE model to take these factors into account, investment decisions and project evaluation become considerably more sophisticated. In the next section of this chapter, we look at how the investor’s spreadsheet can be used to develop a more comprehensive view of risk/return.

122

Investing in Climate Change 2009

III. The investor equation: An investor needs to understand the risk and return associated with different parts of the commercial breakeven equation and the impact of changing assumptions on project economics.

Using the investor’s spreadsheet to understand project risk and return The investor’s spreadsheet can be used to understand the trade-off between risk and return. In this discussion risk is defined as (1) volatility and (2) the likelihood that a given technology will make it onto the mitigation curve at a reasonable cost; whereas return is defined as alpha generation. Adapting the investor’s spreadsheet into a risk map can be a useful approach to understanding the space. See exhibit 3.4. EX 3.4: Using the investor’s spreadsheet to illustrate the risk/return drivers of alpha. Other Critical Factors

Financial risk/return

Costs incurred on the purchase of land, buildings, equipment and construction

CO2 emissions rate Output degradation Availability

Critical discount rate choice

Repairs, maintenance, SOx and NOX emission costs

Amount of time a plant is available to produce power.

4 Carbon price

3

LCOE with carbon price

2

Subsidies and incentives

+

1

LCOE with subsidies and incentives

LCOE with carbon price, incentives and subsidies

Electricity price

Source: DeAM analysis, 2008.

Each of the risk-return trade-offs is a potential source of alpha for investors: • Core competence in the energy markets and knowledge of the volatility associated with coal (likely to be relatively low), and gas and oil (likely to be high) will allow investors to create alpha from energy price risk/return and electricity price risk/return; • Insight into technology development and deployment will allow investors to generate alpha from learning risk/return. Venture capitalists frequently focus on this aspect; • Possessing a deep understanding of the regulatory framework – and predictive ability of the future direction

123

Investing in Climate Change 2009

The investor perspective: Risk & Return III Around Commercial Breakeven

of travel of regulation – will allow investors to derive alpha from the zone of regulatory risk/return; • Privileged technological and operational knowledge will allow investors to generate alpha from the zone of operational risk/return; • Deep understanding and careful management of project finance – as well as clear views on project risk and the appropriate discount rate associated with individual projects – will allow investors to derive alpha from the zone of financial risk/return; • Expertise in carbon markets will enable investors to extract alpha from the zone of carbon risk/return. The degree of risk associated with each of the risk/return trade-offs is different, as illustrated by the colors used for each risk/return trade-off in exhibit 3.4. These risk-return trade-offs are interrelated, and form part of the dynamics of the investment equation. A few of the most important dynamic interactions are: • The relationship between learning risk/return and regulatory risk/return. This may be particularly applicable for VC investors: Selecting a particularly privileged technology, that moves down the learning curve faster than its peers, while benefiting from regulatory support can be particularly attractive. An example of one of one such technology is solar PV in Spain in late 2007, when it benefited from a feed-in tariff of €0.44/kWh, allowing large windfall profits and rapid scale-up for solar manufacturers in Spain. • The relationship between energy price risk/return and learning risk/return. This is important over time, especially for PE investors who would like to see economies from reduced costs. At higher oil prices, it is possible that additional investment and capacity additions across the market could drive higher learning rates than are assumed in the greenhouse gas mitigation policy curve, thereby shifting the costs of clean technologies down at an accelerated rate. Investors may be able to generate alpha from learning risk/return through understanding the ability to accelerate the learning rate of individual clean technologies under certain favorable energy price scenarios. • The relationship between carbon risk/return and regulatory risk/return. This is important over time, as in the long-term, the policy framework used to encourage development and deployment of clean technologies is expected to shift from being based primarily on innovation policy and traditional regulation to one based on carbon pricing. This will reduce potential regulatory risk/return, and increase potential carbon risk/return. In Chapter VII of Part I, we discuss in detail the relationship between carbon prices and energy prices. Ultimately, the most complex and important interrelationship is that between energy and electricity price risk/return, carbon risk/return and regulatory risk/return. In the climate change space, these three factors each can de-risk each other. See exhibit 3.5.

124

Investing in Climate Change 2009

EX 3.5: Energy price, carbon and regulatory risk/return are engaged in a dynamic interaction Each factor can derisk the others through diversification

Carbon risk/return

Source: DeAM analysis, 2008.

By adopting a collective understanding of volatility and risk in clean tech markets alpha can be generated by maximizing return and understanding how the interlinked risks mitigate and offset each other. One example of this in action is the backstop effect that carbon pricing has against energy and electricity price risk/return. In a robust cap-and-trade regime, if over the long term, the price of coal falls relative to the price of oil, natural gas and clean alternatives, carbon price will rise, offsetting some of the energy and electricity price risk. By diversifying the risk associated with the breakeven of a clean technology across carbon risk/return, energy price risk/return and regulatory risk/ return, risk is mitigated and hedged, and investors stand to see potentially large returns. This will incentivize investment in clean technology, as risk is mitigated and returns are preserved. Ultimately, a general economic equilibrium model would be the only way

125

Investing in Climate Change 2009

to solve the equation, but investors will need to work on these factors to generate alpha. Changing energy price assumptions: some implications using mitigation curve analysis. As discussed at the end of the last chapter, the McKinsey-Vattenfall greenhouse gas mitigation policy curve is a useful tool for understanding the economic cost of carbon mitigation. It is also closely linked to the concept of LCOE, and in turn, the investor’s spreadsheet: Each of the renewable energy bars along the cost curve is derived by comparing the LCOE of a renewable and its fossil fuel counterpart. Just as the investor’s spreadsheet yields different results under different energy price scenarios, so too does the curve. The original curve was developed with an oil price assumption of $40 a barrel. This long-term assumption is now clearly too low.

Changing the energy price assumption shifts the curve down If oil prices of $100 a barrel are assumed, the curve shifts down. This is because: • Energy efficiency measures such as improved insulation and fuelefficient vehicles, which are already NPV-positive with oil at $40 a barrel, make even more economic sense at $100 oil; • And renewables such as biofuels, solar, and wind shift down, with lower economic costs for a given quantity of mitigation at higher oil prices. The effect of higher fossil fuel prices on the shape of the curve is set out in exhibit 3.6.

The investor perspective: Risk & Return III Around Commercial Breakeven EX 3.6: The curve shifts down if oil and energy prices increase

n

prices

Source: DeAM analysis, 2008.

We recognize that not all mitigation options will become comparatively less expensive with higher energy prices: Carbon Capture and Storage (CCS) becomes more expensive with high coal prices as it actually uses more fuel to capture the carbon. Some highly capital-intensive energy efficiency opportunities may also become more expensive. Investors will need to be attuned to these sensitivities when they use the investor’s spreadsheet. However, on the whole, the curve will move down as the marginal cost of clean technologies decreases when compared to their conventional counterparts. Changing the energy price assumption extends the curve to the right at a given economic cost of carbon and alters the sensitivity of mitigation opportunities The extent of mitigation possible for a given economic cost of carbon is also extended if the energy price

126

Investing in Climate Change 2009

assumptions change. This is because opportunities that sat beyond the threshold cost become more economic at higher energy price assumptions. Some of these opportunities include: • Motor systems, which came in at €40-80/ton under oil price assumptions of $40 a barrel: 0.38 GT CO2e mitigation potential • Energy production adjustment, which came in at €50/ton under oil price assumptions of $40 a barrel: 0.35 GT CO2e mitigation potential • Energy efficiency in existing basic materials production processes, which came in at €40-80/ton under oil price assumptions of $40 a barrel: 0.11 GT CO2e mitigation potential • Biodiesel, which came in at €60/ ton under oil price assumptions of $40 a barrel: 0.09 GT CO2e mitigation potential • Power train and non-engine diesel, which came in at €60/ton under oil price assumptions of $40 a barrel: 0.09 GT CO2e mitigation potential While the curve as a whole will shift

down and more mitigation will be possible at a given carbon price if energy prices increase, some mitigation opportunities, such as forestry, will feel limited effects from the changes in oil prices, while others, such as CCS, may become more expensive. In the case of CCS, this is because the process increases the amount of energy needed to produce a single kilowatt hour sold onto the electric grid – so a rise in fossil fuel prices will drive costs higher. CCS, which is an expensive mitigation opportunity in a €40 oil world, may move up and to the right of the curve in a $100 oil world, potentially coming in at over €40 a ton in 2030. This would require a higher carbon price to finance it, increased innovation incentives, or increased reliance on other mitigation opportunities that would become less expensive under $100 oil and similarily high coal prices. In exhibit 3.7, we color-code each of the mitigation opportunities based on its sensitivity to oil prices.

EX 3.7: Different mitigation opportunities have different sensitivities to changes in oil price

dark blue light blue

dark blue light blue

Source: McKinsey-Vattenfall, The McKinsey Quarterly, February 2007: A cost-curve for greenhouse gas reduction.

A number of insights come from a review of the impact of high energy prices on the policy curve: • Energy efficiency and renewables become more attractive under high energy prices: The economics of these green-shaded projects generally improve, risk decreases and is diversified – making these opportunities more attractive for investors. There are a number of caveats to observe: · Some capital-intensive projects that would ostensibly shift down in cost under high fossil fuel prices, such as some efficiency projects, have energyintensive inputs and may become less attractive under very high fossil fuel prices. · The sensitivities of different mitigation options, such as biofuels and

127

Investing in Climate Change 2009

wind, are responsive to different fossil fuels. If oil prices increased, and coal prices decreased, biofuels would probably become more attractive compared to gasoline, while wind would probably become less attractive as a means of generating baseload power. The attractiveness of wind as a means of generating peak power would depend on natural gas prices. • The attractiveness of forestry and land-use projects remain relatively unchanged: The economics and risk of these dark blue-shaded projects remain largely unchanged; • And CCS becomes less attractive: The economics of these light blueshaded projects worsens as costs go up, risk increases and becomes more concentrated in the regulatory domain. If fossil fuel prices increase signifi-

cantly, some major CCS opportunities that are on the curve in exhibit 3.7 will move off the curve (that is, they will cost more than €40/ton, and sit above and to the right of where the curve terminates). If a combination fossil-fuel scenario took place, where oil prices increased, while coal prices decreased, the economics of CCS would probably improve. These insights shift the risk/return profile, and can be a source of alpha generation for investors. Taking this to the next level of understanding would require similar work be conducted at the level of the investor’s curve. Ultimately, a general equilibrium model would need to be developed before any conclusive results could be drawn.

Clean Technologies: Deepening, Broadening IV and Developing • There is no single technological solution to climate change. A variety of technologies will need to be deployed at scale to address the challenges of a warming planet. • The technology development process takes a long time. As technologies move through the pipeline, the nature of the investment opportunity, as well as the risk/return profile, changes. • Clean technologies have emerged over the past decade as a major asset class, and technological advances in the clean technology space are opening up opportunities to investment in a range of new products and ideas. • Within each major clean technology sector, a vast number of sub-technologies are moving through the pipeline. Understanding the characteristics of these sub-technologies is essential for investors. In order to understand the technological landscape at a high level, we introduced the work on “climate change wedges” last year in Investing in Climate Change: An Asset Management Perspective. It is worth revisiting that analysis as an overview. “Humanity already possesses the fundamental scientific, technical, and industrial know-how to solve the carbon and climate problem for the next half-century. A portfolio of technologies now exists to meet the world’s energy needs over the next 50 years and limit atmospheric CO2 to a trajectory that avoids a doubling of the preindustrial concentration. Every element in this portfolio has passed beyond the laboratory bench and demonstration project; many are already implemented somewhere at full industrial scale. Although no element is a credible candidate for doing the entire job (or even half the job) by itself, the portfolio as a whole is large enough that not every element has to be used,”2 argue Stephen Pacala and Robert Socolow, who is a member of the Deutsche Bank Climate Change Advisory Board. Two key points emerge from Pacala and Socolow’s work: · A portfolio of technologies will be required to confront the challenge of climate change – there is no silver bullet; · A set of technologies is in development today that, if scaled up, would allow us to confront the challenges of stabilization around 450 ppm. Pacala and Socolow argue that a set of technologies sufficient to confront the challenge of climate change is in development today. Many of the mitigation opportunities such as biofuels, solar, and nuclear fission, already have examples at the commercial scale, while others such as Carbon Capture and Storage (CCS) are still to be commercialized. But in many senses, the categories they cite are sectors or groupings, and within each sector, there are many opportunities for innovation at the sub-technology level. In our view, some of these sub-technologies will require serious development to ensure that they are implemented effectively. There also remains the opportunity for disruptive technologies as yet unknown. The potential for innovation and improvements across the technology spectrum – and the opportunity this presents to investors – justify a closer look at the technology development process. This Chapter is divided into six sections:

1. Pacala and Socolow’s wedges 2. The technology development process 3. Growth of clean technology 4. Case study I: Opportunities in nanotechnology 5. Case study II: Opportunities in solar technology 6. Investor implications

Stephen Pacala and Robert Socolow, Stabilization Wedges: Solving the Climate Problem for the Next 50 Years with Current Technologies, Science, August 13, 2004, 968.

2

128

Investing in Climate Change 2009

I. Pacala and Socolow’s wedges Pacala and Socolow mapped business-as-usual emissions through 2054, and then applied a mitigation target to those emissions that was consistent with stabilization between 450 and 550 ppm. This target, which is 7 GT carbon, is roughly equivalent to the potential of 27 GT CO2e in the McKinsey Vattenfall Carbon Mitigation policy curve. The difference between the current emissions pathway and the emissions cap necessary for long-term stabilization between 450 and 550 ppm forms a triangle. See exhibit 4.1.

EX 4.1: Understanding mitigation through the stabilization triangle, and Pacala and Socolow’s “wedges”

*

Avoided Emissions

Source: Princeton, CMI resources; Based on Socolow et al, June, 2004, Science. Stabilization wedges: Solving the climate problem for the next 50 years. DeAm Team Analysis. *Emissions have grown since the Mihol Socolow research was conducted in 2004 and the current scale on the vertical axis may be closer to 8 and 16

Pacala and Socolow took triangle A, which represents the emissions that need to be avoided through 2054, and divided it up into “wedges” (triangle B), each of which could reduce emissions by 1 billion GT per year in 2054. Pacala and Socolow then presented a portfolio of 15 technological options that could be combined to achieve mitigation of 7 GT carbon in 2054. The 15 technological options Pacala and Socolow cite are:

129

· · · · · · ·

Improved fuel economy Reduced reliance on cars More efficient buildings Improved power plant efficiency Substituting natural gas for coal Storage of carbon captured in power plants (CCS) Storage of carbon captured in hydrogen plants (CCS)

Investing in Climate Change 2009

Clean Technologies: Deepening, Broadening IV and Developing

·

· · · · · · ·

Storage of carbon captured in synfuels plants (CCS) Nuclear fission Wind electricity Photovoltaic energy Renewable hydrogen Biofuels Forest management Agricultural soils management

Each technology can contribute a “wedge” of mitigation to the total goal (triangle C). These wedges can be combined to achieve the total mitigation target. Not all of the 15 wedges will be necessary to achieve the goal, but some combination of them will be required to arrive at 7 GT of mitigation by 2054. One likely combination is grouped and shown in exhibit 4.2. EX 4.2: Combining wedges to achieve mitigation targets Filling the stabilization triangle with “wedges”

Source: Robert Socolow, Stephen Pacala, Jeffery Greenblatt, Princeton University, June 29 2004, “Wedges”: Early mitigation with Familiar Technology.

II. Mapping the technology development process Pacala and Socolow argue that we possess an adequate portfolio of technologies to confront the challenge of climate change over the next 50 years. But the fact that we have existing biofuels, wind and nuclear technologies is no more a signal that the process of technological innovation is complete in clean energy than the notion that Westinghouse’s introduction of the rotary dial telephone in 1919 was the end of innovation in telecommunications. As in telecommunications, in clean energy there is significant and meaningful room for improvements in existing technologies, as well as opportunities to develop and commercially deploy new, early-stage technologies such as CCS. Each of Pacala and Socolow’s wedges group a variety of technologies together. When investing, it is necessary to look at technologies in a much more granular way. Under each broad technological category sits a vast array of sub-technologies that are technologically distinct, at different stages of development, and present different risk-return characteristics. As an example, exhibit 4.3 lays out the technology development process, from early lab research to commercial deployment of clean coal. The time it takes to move through the pipeline varies by sub-technology, but it can take 10-20 years – or more – for successful sub-technologies to move from early research/proof of concept to commercial deployment.

130

Investing in Climate Change 2009

EX 4.3: The technology development pipeline.

Source: McKinsey, DeAm Team Analysis, 2008.

In exhibit 4.3, some of the most important clean coal sub-technologies in the pipeline for clean coal are mapped onto the technology development pipeline. The technologies range from those that have existed for many years, and are now being deployed at commercial scale, like Subcritical CFB, to very early-stage opportunities, such as chemical looping. The risk-return profiles of such diverse technologies are very different, as are the challenges of bringing them to market. While a commercialized technology such as Subcritical CFB could be attractive to investors in public equities/PE, chemical looping is still some time off even from the angel stage of VC funding. As the sub-technologies move through the pipeline, the type of investments they will seek will shift as their risk/return profile changes. Investors need to be conscious of movement through the pipeline in order to optimise their exposure to the most attractive sub-technologies at different stages of development.

III. Growth of clean technology – broader and deeper The past year has seen explosive growth in clean technology, with no sign of a slowdown in 2008, see Chapter VI of Part I. There has been significant activity in next generation technologies such as cellulosic ethanol, thin-film solar technologies and energy efficiency. Since we last published a year ago, the technological universe has become both broader and deeper. See exhibit 4.4.

131

Investing in Climate Change 2009

Clean Technologies: Deepening, Broadening IV and Developing

EX 4.4: Examples of technological developments

Solar

· According to renewable energy world, researchers at the US Department of Energy’s National Renewable Laboratory have moved closer to creating a thin-film solar cell that can compete with the efficiency of the more common silicon-based solar cell; · Suniva Inc. announced that its R&D team has developed several silicon solar cells in its lab with more than 20% conversion efficiencies, using its patented combination of cell design and screen printing technologies; · Solar in buildings – MIT announced a new approach to harnessing the sun’s energy using windows with special transparent dyes that concentrate and disperse sunlight to solar PV cells at the edges of windows;

Algae

· Algae has emerged in the past year as one of the lowest cost feed-stocks for the biofuel industry and looks to be a promising source of renewable oil. Venture capital invested $280 million in advanced biofuels in the second quarter of 2008 alone, and in California, Sapphire Energy debuted its ‘green crude’, a gasoline equivalent refined from algae; · Shell started a project at the beginning of the year in Hawaii to grow algae that can be converted into biodiesel fuel; · International Energy Inc. announced that researchers have devised and instituted a patent-pending technology capable of rapidly determining the accumulation of bio-oil and other high-value compounds in microalgae, an important advance in the development of tools for the commercial production of biofuels from algae;

Energy efficiency

CCS

Advanced materials

Wind

· Fuel cells – Ceramic Fuel Cells Limited announced a 50% increase in cell power density and an increase in fuel cell stack lifetime; · Hybrid Vehicles – Toyota announced a breakthrough with their advanced fuel cell hybrid vehicle in June, with a newly designed high performance fuel cell stack that yielded significant fuel efficiency gains; · The world’s first complete carbon capture and storage technology pilot began in Germany. The plant uses an oxyfuel boiler that involves burning coal in an atmosphere of pure oxygen; · Materials – Researchers at the University of Queensland discovered that miniature crystals could revolutionize the way solar energy is harvested. These nanocrystals form part of a growing group of clean nanotechnologies which are discussed further in section IV; · Materials – University of Texas scientists achieved a breakthrough in September in the use of a one-atom thick structure, ‘graphene’, as a new carbon based material for storing electrical charge in ultracapacitor devices for uses in wind and solar power; · Membranes – ITM, a British company, claimed a breakthrough in electrolysers and fuel cell technology in August through development of a new polymer membrane that cuts costs of a square meter of polymer from $500 to $5; · Batteries – Researchers at MIT have developed lithium nickel manganese oxide electrodes for a new type of battery that offers a charge discharge rate considerably better than the current battery electrode material of choice. The new material is also more stable; · UK researchers claimed in August that new acoustic radar technology can provide wind farm developers with data on wind flow patterns and turbulence.

In the next two sections of this chapter, we look at two case studies, where we examine nanotechnology and solar in detail to provide a more concrete view of how climate change-related technology is developing. In both of these case studies, we draw upon recent work by Lux Research.

132

Investing in Climate Change 2009

IV. Case study I: Opportunities in nanotechnology Nanotechnology is defined as the purposeful engineering of matter at a scale of less than 100 nanometers to achieve sizedependent properties and functions. The field is multidisciplinary and covers a diverse array of products used in the fields of engineering, biology, physics and chemistry. It is inaccurate to say that there is a single nanotechnology industry or sector emerging – rather, multiple distinct nanotechnology sectors are growing. The overall market for nano-products is likely to be measured in trillions of dollars within the next 10-15 years. Although their use spans many sectors, in terms of likely impacts on climate change, it is the role of nanotechnology in electronics, manufacturing and materials that is of most significance. Nanomaterials offer the ability to enhance many key properties of energy technologies to achieve sustainability and secure the future energy supplies. Examples include:

· Solar cells and batteries – with the help of nanotechnology, the commercialization of new batteries for electric cars, chargeable in 10 minutes with a range of 190 miles, is on its way; · Wind power – there are potentially enormous improvements in the strength-to-weight ratio of composite materials used by windmill blades; · Automobiles – nanomaterials can be employed to develop paints, light metals and catalysts to make vehicles lighter and improve fuel efficiency; · Insulation materials – there is potential to improve insulation materials using nanotechnology, such as nanotubes and nanofibers; · Lithium ion cells – these represent the basic building blocks of batteries proposed for the next generation of advanced hybrid electric vehicles. A new family of electrode materials is now being developed that performs much better when synthesized as nanoparticles; · Gasification - The production of biofuels from gasification is an active area of research. It is hoped that by combining gasification with high-tech nanoscale porous catalysts, ethanol can be created from a wide range of biomass, including distiller’s grain, grass, wood pulp, animal waste and domestic waste.

Scan of nanotechnologies at different stages of commercialization Across the sector, there are many compelling examples of nanotechnology opportunities at different stages of commercialization, as shown in exhibit 4.4 and detailed below:

133

Investing in Climate Change 2009

Clean Technologies: Deepening, Broadening IV and Developing EX 4.5: Mapping the nanotechnology development pipeline

Nanoporous filters

Carbon nanotubes

Nanometals

Source: McKinsey, Lux Research, DeAm Team Analysis, 2008.

1. Early research/proof of concept: The estimated near-term market size for graphene, the two-dimensional cousin of carbon nanotubes, is $13.5 million in 2012.2 Graphene has applications in fuel cells, batteries and automobiles. There are few startups in the technology, and the performance to cost ratio of Graphene developments have yet to be defined. Major chemical companies are expected to take interest in this low-risk nanomaterial. 2. Early research/proof of concept: The estimated market size for nanowires is $38 million in 2012.2 This nanotechnology has applications in solar cells and electronics, but it will need to move beyond lab testing before it can grow to full scale. 3. Commercial with refinements needed: The estimated market size for metal nanoparticles is $500 million in 2012.2 These are projected to impact new electronics and energy markets, including catalysts in fuel cells. Challenges that need to be confronted ahead of full commercial deployment include developing supportive infrastructure for fuel cells and improving performance of nanoparticles. 4. Commercial with refinements needed: The estimated market size for nanoporous materials is $690 million in 20122. These are materials full of nanoscale holes with high absorption ability and reactivity with other compounds. Applications include usage for battery, capacitor, solar cell or fuel cell electrodes. 5. Approaching full commercial deployment: The market for nanotech energy storage as a whole is estimated to grow from $350 million in 2007 to $7.7 billion in 20122 as a wide range of nanotechnologies impact the sector including nanomaterials, nanoparticles and nanotubes. Improvements to energy storage technologies will come on-line in different timeframes.

Lux Research, July 2008, Nanomaterials State of the Market Q3 2008: Stealth Success, Broad Impact.

2

134

Investing in Climate Change 2009

V. Case study II: Opportunities in solar technology. Solar technology harnesses solar energy to create electricity and heat. Although we count on the sun for all of our energy, solar energy conventionally refers to two core technology groups: 1. Solar Photovoltaic (PV): Where a solar cell is used to convert light into electric current using the photoelectric effect. Photons from sunlight hit the solar panel, knocking electrons loose, which flow through the multi-layered cell creating electricity. 2. Solar thermal Solar thermal breaks down into two broad sub-categories: · Solar thermal power, where sunlight is used to heat water to low or medium temperatures. This technology is used to heat pools, for cooking, or to desalinate or disinfect water; · Concentrated solar power (CSP), where sunlight is used to boil water, producing steam that drives turbines. The solar sector is growing rapidly. Lux Research, predicts that the market will grow to $100 billion by 2013. Scan of solar technologies at different stages of commercialization Across the sector, there are a number of interesting examples of solar technology opportunities at different stages of commercialization, as shown in exhibit 4.6 and detailed below:

EX 4.6: Mapping the solar technology development pipeline

Solar pipeline

Fresnel

inverters

Source: McKinsey, Lux Research, DeAm TeamAnalysis, 2008

135

Investing in Climate Change 2009

Clean Technologies: Deepening, Broadening IV and Developing 1. Early research/proof of concept: The estimated 2013 market size for organic and Grätzel PV is $18.4 million, up from $2.42 million in 2008. Grätzel PV is a technology where light is absorbed by organic dye molecules, which transfer electrons to titanium dioxide nanoparticles. Research is currently being conducted on the ideal dyes to use, but ruthenium polypyridine is emerging as the leading dye. In the lab, efficiencies of 11% have been achieved, but significant improvements over the early pilot efficiencies of 2.5% are needed before this can move into later stages of development3. 2. Lab testing: The estimated 2013 market size for thin-film solar is $25.8 billion, up from $7.13 billion in 2008. While thin-film technologies have been in development since the 1970s, most are still nascent, with significant room for efficiency improvements. Amorphous silicon has made advances in repeatability, but cell efficiency is still low, around 5-6%, compared to nearly 20% for polysilicon. Next-generation (“micromorph”) amorphous silicon holds much promise, improving efficiency to 8-8.5%, but significant room for improvement remains3. 3. Lab testing: The estimated 2013 market size for multi-junction PV is $1.20 billion, up from $341 million in 2008. Multi-junction PV cells are generally constructed with a layer of gallium arsenide and gallium indium phosphide on top of a germanium substrate. Multi-junction PV cells have achieved very high efficiencies (43% in lab testing and 37% in commercial applications), but they remain expensive, and will require significant cost reduction before they can be deployed commercially at scale3. 4. Commercial with refinements needed: The most mature thin-film technologies have been developed by First Solar. Using cadmium telluride semi-conductors, First Solar has brought costs down to $1.12/Watt. While First Solar’s cell efficiency of 10.6% is respectable for thin-film technology, there is still significant room for improvement in the next few years3. 5. Commercial: The estimated 2013 market size for crystalline silicon PV is $64.1 billion, up from $33.4 billion in 2008. There are a number of sub-technologies within crystalline silicon PV, including monocrystalline modules and polycrystalline modules. While manufacturers continue to improve efficiency and bring down costs, this opportunity is at commercial scale today3. 6. Commercial: The estimated 2013 market size for solar thermal is $9.26 billion, up from $1.10 billion in 2008. There are a variety of sub-technologies within solar thermal, which are distinguished by how the solar heat is concentrated. Parabolic mirrors, Fresnel mirrors and heliostat mirrors are all used to concentrate solar energy onto a receiver, warming a working fluid that, in turn, boils water and drives turbines. The technology is commercial and scalable today3.

VI. Investor implications Each climate change sector offers investment opportunities at all stages of the technology development process, appropriate for investors with different risk/return appetites and time horizons. A deep knowledge of the technology development process, as well as a detailed overview of the technological landscape within each sector, is necessary to generate alpha in the space.

Lux Research, September 2008. Solar State of the Market Q3 2008: The Rocky Road to $100Billion.

3

136

Investing in Climate Change 2009

Appendix I: Kevin Parker, Perspective on Carbon Prices

Kevin Parker Member of the Group Executive Committee

The Financial Times printed an article by Kevin Parker, Global Head of Deutsche Asset Management, on July 16th, 2008. In the article, titled “Carbon emitters’ free ride is about to end”1, Parker argued that most companies in the EU were short carbon, and that the price of carbon is set to rise dramatically going forward.

Gloabal Head of Deutsche Asset Management

“The astonishing truth about the carbon market is that nearly everyone is short carbon: companies will breach their emissions limits and do not own allowances to make up the difference. When I ask market participants: “who has surplus allowances to sell? I get back blank stares. It cannot be long before the market recognizes this fundamental supply/demand imbalance. The carbon market, in addition to allowing offsets, should also encourage the switching away from pollutionintensive fossil fuels such as coal to less carbon-intensive gas and renewables. Carbon pricing should be correlated with oil and natural gas prices, which are soaring. A recent report by my colleague Mark Lewis at Deutsche Bank (“It takes CO2 to contango”, May 30, 2008) argues that carbon’s market clearing price with oil at $85 (€55) a barrel and coal at $90 (€58) a tonne is about €40 a tonne. However, with the actual oil price at about $135 (€87) and coal at $200 (€127), the market clearing price for carbon is €75 to €80 a tonne – nearly three times its current level. The markets have an uncanny ability to find the weak hand. Those emitters with too few allowances to cover their carbon output are going to get squeezed by the lack of supply, and a rise to at least €100 looks inevitable….

1

Carbon emitters’ free ride is about to end, Financial Times, July 16, 2008

137

Investing in Climate Change 2009

The effects of a repricing of carbon will be profound. Carbon will take its place alongside oil, coal and gas as one of the most closely followed commodities in the world. This will mark the beginning of externalities at last being priced into the cost of production. It will signal that carbon emitters have had a free ride for long enough. Governments – the US’s in particular – will have to join Europe to create a global market for pricing carbon and businesses around the world will have to accept the price the market sets. A higher carbon price will force companies to make radical changes to their business models (this has already begun in the European utility sector). Early movers are likely to be winners. It will be an economic imperative for corporate boards and managements to take into account carbon pricing in their business and strategic planning…. The rising cost of carbon will also drive the need for, and the viability of, alternative technologies. Capital will start to flow to new areas of investment: existing technologies to conserve power and mitigate carbon emissions, developing technologies for carbon capture and alternative energy. Like many turning points, the carbon price rise will be fraught with risk. However, that is worth the enormous opportunities and benefits it will create….”

Appendix II: The Science of Climate Change

The fundamental science behind climate change is not new: the greenhouse effect was initially explored in the 1820s by Jean-Baptiste Joseph Fourier in his Théorie analytique de la chaleur. The ‘greenhouse effect’ is a naturally occurring process resulting in a mean warming of Earth caused by the retention of heat energy from sunlight by the atmosphere. Without this retention, the Earth’s temperature would be on average -18oC. Of the surface heat captured by the atmosphere, more than 75% can be attributed to the action of greenhouse gases that absorb thermal radiation emitted by the Earth’s surface. The major greenhouse gases on Earth are carbon dioxide, methane, water vapor and ozone. The climate changes in response to external forcing, including that of atmospheric greenhouse gas concentrations. Human activity, which has increased the atmospheric concentration of some of these gases, has enhanced the natural greenhouse effect and caused warming of the Earth above natural levels. Warming of the climate system is now ‘unequivocal’ according to the Inter-Governmental Panel on Climate Change (IPCC): • Over the 20th century, global-average surface temperature increased by 0.6 degrees;1 • Global average sea level increased by 10-20cm; • 11 of the 12 years between 1995 and 2006 rank among the highest on instrumental record of global surface temperatures. The scientific consensus is that the increase in atmospheric greenhouse gases due to anthropogenic activity has caused most of the warming observed since the start of the industrial era. Since this time, energy production, transport, industry, deforestation and land use changes have substantially added to the amount of heat-trapping greenhouse gases in the atmosphere. Greenhouse gas concentrations in the atmosphere will increase during the next century unless emissions are substantially reduced from present levels. The amount and speed of future climate change will depend on:

• Whether greenhouse gas concentrations increase, stay the same, or decrease; • How much climate varies as a result of natural influences.

The major greenhouse gases emitted by human activities remain in the atmosphere for decades, and even centuries. The thermal inertia of the Earth’s oceans and slow responses of other indirect effects mean that the Earth’s current climate is not in equilibrium with the forcing imposed, therefore even if greenhouse gas emissions returned to pre-industrial levels, a further warming of about 0.5 °C would still occur. In the US, the Old Farmer’s Almanac recently claimed that the planet would cool over the next half century. The claims were based on the work of Dough Hathaway at Nasa and Khabibullo Abdusamatov at the Russian Academy of Sciences, who noted that the current solar cycle is likely to be one of the least active on record, reducing the ultimate amount of solar heat the Earth is exposed to. Although the Almanac argues that the planet will be cooler over the next half-century, it does not deny the anthropogenic contributions to greenhouse gas concentrations, or argue that greenhouse gases do not warm the planet. If the Almanac’s predictions prove true, global warming has not been averted: it has just been delayed – and humans are likely to have less time to adapt to it when solar activity picks up later this century, potentially leading to more catastrophic impacts.

1

138

United Nations Intergovernmental Panel on Climate Change (IPCC) Fourth Assessmenth Report (AR4): Climate Change 2007

Investing in Climate Change 2009

Concentrations of greenhouse gases in the atmosphere: The enhanced atmospheric greenhouse effect results from multiple substances. CO2 contributes most to the greenhouse effect, followed by a variety of other gases. Combined, the six gases included in the Kyoto protocol exert radiative forcing equivalent to a CO2-equivalent concentration of 432ppm in the atmosphere as of 2005, however the total atmospheric radiative forcing equivalent is 375ppm CO2e as of 2005, owing to the balancing effect of aerosols and natural albedo feedbacks. This cooling effect is often discounted, as it is presumed to weaken in the future as aerosols are phased out and ice cover lessens. See exhibit A2.1.

EX A2.1: Anthropogenic greenhouse effect results from multiple sources.

Anthropodenic raditative forcing expressed in CO2 equivalents, 2005

HUMAN FORCING PPM CO2 Equivalents

300

350

400

450

500

CO2 Methane (CH4)

Kyoto

Strat. water vapour from CH4 Nitrous Oxide (N2O) Kyoto Halocarbons Montreal Gases

Montreal

Trop/strat ozone Persistent contrails Total direct aerosols Cloud albedo effect Surface albedo

Total atmospheric radiative forcing equivalent: 375 ppm

Aerosols partly balance the effect of greenhouse gases, but are short-lived

Source: McKinsey & Company (2008); IPCC 4th Assessment, Working Group 1; DeAM analysis, 2008.

Atmospheric concentrations of CO2 have increased dramatically from 280ppm at pre-industrial times to 379ppm in 2005, and methane concentrations have more than doubled over the period. CO2 and methane concentrations are now considerably higher than at any time during the last 800,000 years. We profiled the EPICA team, who performed the research that proved this, in Chapter II of Part I.

139

Investing in Climate Change 2009

Appendix |I: The Science of Climate Change

The rate of future rises in greenhouse gas concentrations will depend on economic, technological and social factors. Projections are that if we remained on a ‘business as usual’ track, concentrations of CO2 would increase to as much as 630ppm by 2050 and 1,200ppm by the end of the century. See exhibit A2.2.

EX A2.2: Atmospheric greenhouse gas concentrations are on the rise

Greenhouse gas concentrations in the atmosphere are expected to rise to more than 600 ppm CO2e by 2050 GHG CONCENTRATION* ppm CO2e

800

Business as usual: 630 ppm

700

Constant emissions at 2005 levels: 560 ppm**

600

500

Comfort zone

432 ppm in 2005

400

Without intervention GHGs could reach 1,200 ppm CO2e by 2100

300

200

1850

1900

1950

2000

2050

* Kyoto gases ** Assuming current natural carbon absorption levels

Source: Stern Review (Part I); IPCC report; McKinsey & Company team analysis

Warming Scenarios Projections of future climate change suggest a global temperature increase of between 1 to 6 degrees by 2100. The magnitude of potential warming varies according to different forecasts. See exhibit A2.3

140

Investing in Climate Change 2009

EX A2.3: Range of warming scenarios

There is a range of possible temperature increases, but most models show significant global warming ahead Under Business-as-Usual much bigger disruption is coming

Last time temperatures were 3°C above 1900 level was ~30 million years ago, with sea level 20-30m higher than today.

Note: Shaded bands denote 1 standard deviation from mean in ensembles of model runs

6.0

Global surface warming (°C)

Last time temperatures were 2°C above 1900 level was 130,00 years ago, with sea level 4-6m higher than today.

5.0

A2 A1B B1 Constant composition commitment 20th century

4.0 IPCC (2007) scenarios

3.0 2.0

EU target ∆T ≤ 2°C

1.0 0.0 -1.0

1000

2000

3000

Source: IPCC, 2007.

What are the climate implications of rising greenhouse gas concentrations? There are some potential economic benefits of climate change. In northern latitudes, deaths from cold in winter will be reduced more than deaths from heat in summer increase; agricultural productivity may increase with CO2 fertilization effects; and some areas, such as Scandinavia and Canada, will see increases in tourism. However, on the balance, ecosystems, water supply, sea-levels, agriculture and health are all likely to suffer from continued climate change. Stern notes that Business-as-Usual warming will lead to temperature increases of 2-6oC by the end of this century.2 The impact of a temperature rise on this scale would, in all likelihood, be catastrophic:

• Wide swaths of land in sensitive ecosystems, such as the Mediterranean and the Sahel, are likely to desertify; • Miami, London, New York, Shanghai and other coastal cities would be threatened by rising sea levels; • Tropical diseases such as yellow fever, dengue fever and malaria would spread to formerly unafflicted areas.

Most importantly, Stern argues that climate change of 5-6oC could reduce global utility by an equivalent of 20% forever by the end of the century. He builds this number up by beginning with direct market impacts of Business-as-Usual warming. These impacts are likely to decrease global utility by 5% on average. Stern then includes non-market impacts on health and the environment, which increases the average cost of Business-as-Usual warming to an 11% decline in global utility. Stern then looks at the possibilities that the climate system may be more responsive to greenhouse gas emissions than previously thought, due to feedback loops, which increase the potential cost of climate change to 14%. Finally, Stern looks 2

141

Discussion based on Stern, N (2006) The Economics of Climate Change: The Stern Review, Cambridge.

Investing in Climate Change 2009

Appendix I|: The Science of Climate Change

at the proportion of climate change costs that fall on the poor of the world – who are likely to be most impacted – and adjusts the weighting of his predictions to take this into account. He uses the standard assumptions of welfare economics, which are generally supported by empirical evidence on behavior and preferences, that hold that marginal utility falls as income increases. Thus, a dollar of utility lost in the developing world is worth more than a dollar lost in the developed world. The additional weighting given to impacts on the poor brings the total potential cost of Business-as-Usual climate change to 20% of global consumption. Stern applies a discount rate of 0.1% to his projections, which increases the future cost predictions of climate change. He argues that it is difficult to justify a higher discount rate based on ethical grounds, purely because some consumption is in the future. He therefore applies a discount rate that is meant simply to take into account the annual prospect of catastrophe eliminating society.3 Given Stern’s projections, the consensus currently is that warming of over 2oC should be avoided, as it presents many dangerous potential impacts, including feedback loops that may lead to much higher warming. More detailed examples of the potential harm caused by climate change at different warming levels are included in exhibit A2.4. EX A2.4 : Examples of possible impacts of climate change

Temperature increase will have significant negative impact Temperature change (relative to pre-industrial) 0°C

1°C

1

Weather

2

Water

3

Food

2°C

3°C

4°C

Rising intensity of storms, forest fires, droughts and heat waves Threat to local water supply due to loss of glaciers

Major world cities threatened by sea level rise

Significant changes in water availability threatening up to 1 billion people

Falling crop yields in many developing regions Entire regions experience major declines in crop yields

Rising number of people at risk of hunger

Yields in many developed regions decline even with strong carbon fertilization

Rising crop yields in high-latitude developed countries given strong carbon fertilization

4

5°C

Ecosystems

Coral reef ecosystems extensively damaged

Possible collapse of part of all of Amazonian rainforest

Large fraction of ecosystems unable to maintain current form 20%-50% of species face extinction

Increasing number of deaths from 150,000 to 300,000 p.a. under BAU

5

Health

6

Social

7

GDP

Loss of GDP in developing countries

8

Systems

Increased risk of weakend carbon sinks, melting of pole ice and reduction of THC

More than 1 billion people at risk of having to migrate–increased risk of conflicts

Source: Stern Review 3

142

Lord Nicholas Stern, Stern Review Report, 2007, pp. 143-157.

Investing in Climate Change 2009

Loss of up to 20% of Global GDP

Appendix III: Carbon Capture and Storage (CCS) & Forestry: Using the Major Carbon Sinks

Forestry and carbon capture and storage (CCS) are the two carbon sinks over which humans have the most influence. Although the system approaches of forest management and CCS are very different, they both have important roles to play in greenhouse gas and climate change mitigation. The potential for forestry as a carbon sink is so large that some believe it could supplant the need for CCS at least in the short-term, as it is potentially much cheaper. However, risk mitigation suggests that we should pursue both of these carbon sinks.

Forestry and how it fits as a CO2 Mitigation Option Forests cover 30% of the world’s land mass and store around 1.2 trillion tons of CO2 in their trees, vegetation and soil. They are important for the global climate balance because: 1. Land use changes, deforestation and degradation can cause net emissions from forests 2. but forests also have enormous potential to remove CO2 from the atmosphere through re-forestation. So, forestry projects broadly fall into two categories: • Reduced Emissions from Degradation and Deforestation (REDD), where land that would have been deforested or degraded is instead used sustainably; • Afforestation/Reforestation (A/R), where tree cover is restored to deforested land (reforestation) or new forests are planted on land that was not initially under tree cover (afforestation). Approximately 18% of world emissions come from deforestation – and there is significant potential to safe-guard the carbon capacity of forests through A/R projects. According to the work done by McKinsey and Vattenfall1 in their 2007 greenhouse gas mitigation policy curve, REDD and A/R have the potential to mitigate greenhouse gas emissions by 3.1 GT per year by 2030. Many of these opportunities are low-cost. The work conducted in 2007 revealed that the actual potential mitigation from forestry is much higher than the final estimate of 3.1 GT. The initial figures McKinsey developed were adjusted down to 3.1 GT to present a more conservative view of the potential. For the initial mitigation potential from forestry. See exhibit A3.1.

McKinsey-Vattenfall, The McKinsey Quarterly, February 2007: A cost-curve for greenhouse gas reduction.

1

143

Investing in Climate Change 2009

Appendix III: Carbon Capture and Storage (CCS) & Forestry: Using the Major Carbon Sinks Avoided deforestation Forestation

EX A3.1: Mitigation measures below €40/ton in forestry could save 7.9GT CO2e by 2030

Additional potential at €40-80 CO2 € CO2e 2030

OECD Asia America Africa

65

Africa America Asia

60 55 50 Asia

45 Americas

40 35 25

Africa

OECD

Americas

OECD Africa OECD America

America Africa Africa

15 10 5 0 0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

Source: McKinsey analysis, 2007.

CCS and how it fits as a CO2 Mitigation Option CCS is a three-stage process. It involves: 1. separating CO2 from industrial and energy-related sources; 2. transporting it; 3. and storing it in secure geological formations, including in mature oil and gas fields, in saline aquifers, or under high pressure in the deep ocean. The development and deployment of CCS is critical to allow continued use of fossil fuels: along with intensive forestry, it is the only climate change mitigation opportunity that allows significant, continued use of conventional energy resources. In the 2007 policy curve developed by McKinsey and Vattenfall, CCS opportunities allowed mitigation of 3.5 GT CO2e by 2030. Assuming economies of scale and learning over time: • Some CCS opportunities would be at a modest cost of about €20/ton, when combined with Enhanced Oil Recovery projects (where CO2 is stored in depleted oil wells, ultimately permitting additional oil recovery and improving project economics); • CCS with new coal plants would cost about €30/ton; • And CCS retrofitted to old coal plants, or CCS in industry, would be relatively high-cost, around €40/ton. Recent work carried out by McKinsey has been more pessimistic about the project economics of CCS. In a report issued in September, 2008, McKinsey estimates the costs of CCS with new coal plants at between €35 and €50/ton – noting that early pilot plants will be much more expensive, between €60 and €90 a ton. Most of the project costs are tied to the capture stage of the process, but the greatest uncertainty in costs is tied to storage.2 See exhibit A3.2. McKinsey & Company, Carbon Capture and Storage: Assessing the Economics, p 6-7, 16.

2

144

Investing in Climate Change 2009

EX A3.2: Economics of early commercial CCS projects

Total cost of early commercial CCS projects €/tonne CO2 abated; ranges include on- and offshore

Assumption 1

Capture

25-32 • • •

2

Transport

4-6

•

•

3

Storage

4-12 •

•

Total

35-50*

• •

CO2 capture rate of 90-92% CCS efficiency penalty of 7-12% points Same utilization as non-CCS plant(86%) CO2 compression at capture site Transport through onshore/offshore pipeline network of 200/300 km in supercritical state with no intermediate booster station Use of carbon steel (assumed sufficiently dry CO2) Injection depth of 1,500m in supercritical state Use of carbon steel (assumed sufficiently dry CO2) Vertical well for onshre/ directional for offshore

Source: McKinsey analysis, 2007. *Ranges are nearest 5 on total

EX A3.3: BCG estimates that the costs of CCS will be significantly lower than those developed by McKinsey The Carbon dioxide market price could cover CCS cost by 2030 in Europe and North America But subsidies will be needed until 2030 € per ton of carbon dioxide

Not everyone agrees with McKinsey’s high cost estimates. BCG estimates that CCS can be developed and deployed at more modest costs. See exhibit A3.3.

50 45 40 35 30

CCS subsidy

25 20 15 10 5 0 2008

2030 Price of carbon dioxide

Source: BCG, Carbon Capture and Storage: A Solution to the Problem of Carbon Emissions, 2008.

145

Investing in Climate Change 2009

Cost of CCS

Appendix III: Carbon Capture and Storage (CCS) & Forestry: Using the Major Carbon Sinks

One of the key assumptions BCG uses to develop its optimistic cost scenario is the belief that the carbon transport market will develop much like the natural gas transport market: Initially, there will be individual, isolated projects, with capture, transport and storage systems integrated; when CCS is deployed at true scale, however, BCG believes that “trunk” carbon dioxide lines will be built, allowing economies to be achieved and potentially ushering in regulated, utilitylike returns in the market. Regardless of whether McKinsey or BCG’s cost estimates are closer to reality, CCS remains a high-cost near-term play. While we recognize the importance of CCS, given its high-cost and project risks, we anticipate modest scaling of the procedure in the medium-term, and more ambitious scaling of forestry, in the short- to medium-term.

Challenges Both forestry and CCS permit continued use of fossil fuels through sequestration of emissions in carbon sinks. While forestry projects are generally much cheaper than CCS, there are limitations to the potential of forests. As world food demand doubles over the next two decades, the demand for land will become more intense. Degraded and deforested land can be reforested – and the ecosystem services of forests, such as clean water and climate regulation can form part of the justification for these projects – but large-scale conversion of agricultural land to forests will not be possible. Avoided deforestation is key here as deforestation and degradation account for 18% of global emissions. Improving the economics of these projects will be vital to unlocking their mitigation potential. Importantly, 1.2 billion people live in the world’s major rainforests so there must be an equitable solution at a community level for them. It will therefore be necessary to develop and deploy both forestry and CCS if we are to achieve sufficient long-term mitigation targets. This becomes more important further out in time, as larger cuts in emissions are required. In the near-term, for us to maximize use of carbon sinks, critical action will need to be taken to drive down the costs of CCS and to overcome the practical and ethical challenges facing forestry.

3 4

146

Variable

CCS

Mitigation Potential

• CCS is predicted to become commercialized for gas, biomass and coal-fired electricity generating facilities between 2020 and 2030.3 • CCS has the potential to reduce CO2 emissions from fossil fuel power stations by as much as 90% and could contribute up to 28% of global CO2 mitigation by 2050 (IEA, 2008). • The McKinsey-Vattenfall carbon mitigation cost curve shows a 3.5 GT mitigation potential in 2030.

Costs & Social implications

• Costs are generally very high because the technology is in its infancy. • Costs are highly dependant on coal price, because the process is very energy intensive. • In the short-term, the technology is only likely to be deployed with a supporting high carbon price between $60-$100/tonne CO2. • There is significant cost reduction potential as the technology develops.

Forestry

• Tropical forest deforestation accounts for about 20% human-generated CO2 emissions. • The McKinsey-Vattenfall carbon mitigation cost curve shows a 3.1 GT mitigation potential in 2030, but recent work carried out by McKinsey indicates that much more may be possible.4

• Operating costs are low. Most costs are associated with land purchase. • As commodity prices rise, relative cost rises. • As land becomes more scarce, forestry projects may compete with farming projects. • The welfare of people living in forested regions will need to be taken into account in any future decision about forestry projects.

IPPCC 4th Assessment, 2007; Lewis, M (2008) Deutsche Bank Global markets Research: Carbon Emissions. Emissions in remissions? Looking at-and through-an EU recession McKinsey-Vatenfall.

Investing in Climate Change 2009

Variable

CCS

Forestry

What is needed?

• The individual technical components of CCS are not novel, but have not yet been demonstrated in an integrated system or at sufficient scale. • CCS would require an integrated carbon transport infrastructure to separate, transport and store carbon in a permanent CO2 sequestration site. • Challenges include making sites ‘captureready’. • Advances in demonstration projects are needed if all new coal-fired power plants are to be built with CCS by 2020, a vision articulated by the EU.5 • Increased human and manufacturing capacity will be required to capture the opportunity. • Funding for demonstration is needed and it is unclear where this money will come from – a number of demonstration projects worldwide have been announced and then later cancelled, reducing investor confidence. • Potentially, government support could allow the industry to scale, as it did in the case of nuclear in France.

Risks and Drawbacks

• The EU Commission notes that the main risk for CCS is geological storage. Slow leakage of CO2 will require careful design and monitoring. However, the IPCC estimates that for well selected and managed sites the risks are comparable with current hydrocarbon activity. • Long project lead times may deter investors. • Opposition from local communities is a barrier to implementation. • Shortage of craft skills and professional engineers will constrain overall capacity to deploy CCS. • CCS significantly reduces plant efficiency and incurs an additional energy penalty – the technology is expected to use between 10-40% of the energy produced by a power station, thus CCS could lead to a doubling of power plant costs and an electricity price increase to the consumer (Rochon, 2008).

Additional Revenue Streams

• Enhanced Oil and Gas Recovery can improve the economics, as injecting CO2 in oil and gas reservoirs can increase overall recovery. Estimates indicate that injecting one ton of carbon into a depleted oil well can allow additional recovery of 5-10 barrels of oil.

• Forestry products can be used for pellets, biofuels, or biomass for electricity generation, as long as trees are continually replanted. • Community-based precision logging. • Degraded land can be restored and recovered through forestation. • Non-timber products (e.g. soap, perfume).

Operating and Maintenance

• MRV challenge - Continued monitoring, risk reporting and verification of storage retention. • Standards governing design and operation of geologic repositories need to be developed.

• MRV challenge - Continued risk assessments, monitoring and verification of carbon pools and fluxes.

• A robust policy framework will need to be developed to include forestry projects in a meaningful way in the successor to the Kyoto Protocol. • The understanding of forestry carbon sequestration is still developing as are the technologies to manage carbon data of forests. • Improvements in data verification of rates of carbon sequestration in forests are needed in order to allow origination and trading of forestry carbon credits. • Improved remote sensing technologies for vegetation analysis and mapping land-use changes need to be developed and deployed. • Tree species improvement can be used to increase biomass productivity. • Improved understanding of the feedback loops and potential of forests to mitigate climate change is required (Bonan, 2008). • Further work on carbon accounting is needed.

• There are concerns about the permanency of forest carbon stocks, difficulties in quantifying stock changes and socioeconomic impacts of large scale reforestation (Canadell & Raupach, 2008). • Old growth forests may be net emitters of CO2 owing to decomposition outweighing growth. • Fires may result in releases of carbon dioxide. • Sustainable forest plantations are more costly at first in comparison to slash and burn techniques, implying increased capital needs • Sustainable development and indigenous peoples’ issues must be taken into account in forestry projects.

The Zero Emissions Fossil Fuel Technology Platform (ZEP) produced a research agenda for CCS and a prpgramme in 2007 in 2007 for strategic deployment and recommends a network of 10-12 integrated, large scale CCS demonstration projects across Europe.

5

147

Investing in Climate Change 2009

Appendix III: Carbon Capture and Storage (CCS) & Forestry: Using the Major Carbon Sinks

Variable

CCS

Location effects

• Storage depths greater than 800m and wellsealed cap rocks are required so that the carbon is physically trapped. • Storage capacity is not always available at the source of CO2 emissions (Schrag, 2007).

Regulation

Example Projects

• Ensuring the timely and widespread deployment of CCS requires a new policy framework encompassing a greenhouse gas cap-and-trade programme, subsidies for R&D, and financial support to plant developers to offset the cost differential between conventional plants and those with CCS. • CCS is not eligible under the Clean Development Mechanism (CDM). Funding from the CDM or its successor regime needs to be unlocked to incentivize deployment in developing countries.

• Saskatchewan Power Clean Coal Project, Canada, will become the world’s first ‘near zero emission’ coal plant. It is due to be operational by 2013.6 • The 100 MW power station will capture 90% of CO2 emissions that will be pumped to a nearby oilfield for enhanced recovery. • The plant has been backed by a regional $2 billion fund for CCS projects.

Forestry • Tropical forests are able to take in and store carbon at greater rates than temperate forests and as a result McKinsey estimates that 85% of the opportunity is located in the tropics. • Young, growing forests are the best sinks of carbon. • Most funding for forestry has been through voluntary markets and resultantly, the scale of investment in forest-carbon project start up is small. • Forestry has not been popular under CDM owing to high transaction costs. A solution to this problem will need to be found to allow broader development of forestry opportunities. • Increased funding flows will be necessary to incentivize developing countries to engage in forestry projects. • Stern notes that links between forestry and the broader carbon markets will need to be carefully architected to avoid destabilization. • Australia is engaged in a set of trial approaches for improved monitoring of forestry projects in Indonesia. • Smaller, community-based forestry projects are being launched in tropical regions.

www.saskpower.com, 2008. The proposed SaskPower demonstration project would produce 100MW of clean, base-load power and the carbon dioxide captured by the project would be used in enhanced oil recorvery. SaskPower’s demonstration project is a seven year, $1.4 billion government-industry partnership.

6

148

Investing in Climate Change 2009

Appendix IV: Recent Regulatory Developments

Regulators have been active in the climate change space over the past year. Before delving into the theory of regulation, we summarize recent developments in key markets: • United States: In the US, the America’s Climate Security Act of 2007, also known as the Lieberman-Warner bill, made it through Senate committee and was debated on the Senate floor. On June 6th, 2008, the bill fell short of the 60 votes it needed to block a filibuster. Although the bill did not pass, it represents an important milestone in US regulation:

· · · ·

It proposed emissions limits on the power, transportation and industry sectors; It stipulated that these limits would be enforced through a cap-and-trade scheme; Its long-term target of reducing US emissions by 70% by 2050 demonstrated a reasonable level of ambition; It got closer to a floor vote in the Senate than any comparable bill.

Both John McCain and Barack Obama have also announced their support for emissions a cap-and-trade regime. This is a significant departure from the Bush administration – which threatened to veto the Lieberman-Warner bill1 – and indicates that more progress may be forthcoming from the US in the coming year. Recent discussion of climate change by both candidates indicates that the US may assume a leadership position in the global debate on climate change after the elections – pointing to the potential to accelerate progress going forward. The discussion draft of the Dingell-Boucher Climate Change Bill was released in October, 2008: · Rep. John Dingell and Rep. Rick Boucher have announced a new cap-and-trade bill they intend to take up in 2009. · The bill amends the Clean Air Act to regulate greenhouse gases and would force the US to reduce greenhouse gas emissions by around 80% over the next four decades through establishment of an economy-wide cap-and-trade program. · The discussion draft covers approximately 88% of US greenhouse gas emissions and would reduce covered emissions to 6% below 2005 levels by 2020, 44% below 2005 levels by 2030 and 80% below 2005 levels by 2050. · Power plants, petroleum producers and importers, large industrial facilities, importers and producers of bulk gases, natural gas local distribution companies and geologic sequestration sites are covered by the cap-and-trade. · Sources that emit less than 25,000 tons per year are not included in the draft and instead the Environmental Protection Agency will have the authority to establish industry specific emission standards. · Performance standards are established for new coal-fired power plants. The extension of the production tax credits (PTC) and investment tax credits (ITC) were approved by Congress as part of the Emergency Economic Stabilization Act of 2008. The package includes:

· · · · · · ·

A one year extension of the PTC for wind projects. A two year extension of the PTC for geothermal facilities. An eight year residential and business ITC extension for solar power, small-scale wind and geothermal systems. Removal of the $2,000 cap on the residential ITC. Elimination of the prohibition on utilities from obtaining the ITC. Authorization of $800 million for clean energy bonds for renewable energy generating facilities. Creation of a two year ITC for marine energy technologies.

While climate change leadership at the national level will have to wait until after the elections in November, 2008, individual states have made significant regulatory moves:

Reuters, 2 June, 2008. “Bush would veto U.S. climate change bill.”

1

149

Investing in Climate Change 2009

Appendix IV: Recent Regulatory Developments

· The US Environment Protection Agency notes that 32 states now have renewable portfolio standards, up from 27 states, in 2007; · 19 states now have greenhouse gas mitigation targets; · 38 states have developed, or are developing, climate action plans, the most recent being Maryland, which released its action plan in August 2008;2 · A number of regional climate initiatives, such as the Western Climate Initiative and the Regional Greenhouse Gas Initiative have emerged and expanded,3 some of which will institute cap-and-trade for greenhouse gas emissions. · Assembly bill 32 (AR32) in California has established the first-in-the-world comprehensive program of regulatory and market mechanisms to achieve real, quantifiable, cost-effective reductions of greenhouse gases.

• European Union: In January, 2008, the European Commission released the Climate Action and Renewable Energy Package, which set out European climate change policy. The package stipulates: · A commitment to unilaterally reduce overall emissions to at least 20% below 1990 levels by 2020, and to 30% if other developed countries make comparable efforts; · A target of increasing the share of renewable energy use to 20% by 2020; · A goal of increasing the share of biofuels in transport to 10% – since then, the target has been halved, to 5%, in light of food vs. fuel debates; · A framework to allow additional state aid for carbon capture and storage (a technology that can capture carbon dioxide emitted in power-generation and industrial processes and store it underground where it cannot contribute to global warming) demonstration plants; · The EU has also proposed capping carbon dioxide emissions from new vehicles to an average of 130g/kilometer by 2012, compared to the current 158g/kilometer. In October, 2008, the European Parliament’s Environment Committee voted to cut the EU greenhouse gas emissions from most industrial sectors by 21% from 2005 levels by 2020 and to phase out the free allocation of emission permits, leading to full auctioning, with the exception of energy-intensive sectors. The Parliament voted to replace the current free distribution of carbon-dioxide permits with a mandatory auction system between the 2013-2020 timeframe in a bid to help cut European greenhouse gas emissions. MEPs stated that 85% of all emission allowances for the manufacturing sector should be allocated free of charge in 20134 and that after 2013 the free allocation should decrease each year resulting in full auctioning of all allowances in 2020 – excluding sectors with a risk of carbon leakage. The next stage is a full vote in Parliament in December 2008. Germany has been more cautious has opposed the EU Parliament plans and backed an almost total exemption for industry from the new European rules that would force companies to pay for the carbon dioxide they emit through auctioning emission credits in the ETS rather than through the current system of free distribution of permits. It wants to limit the industry’s required purchase of carbon emissions permits to a maximum of 20% a year between 2013 and 2020, well below the 100% target by 2020 proposed by the European Commission. Germany is not alone in seeking ‘opt-outs’ and Italy is also pushing for free distribution of carbon permits for specified sectors. Poland is also anxious that auctioning could affect its power companies.

• China: In 2006, China committed to lower energy consumption per unit of GDP by 20% and cut emissions of major pollutants by 10%. In the past year, China has implemented a suite of policy measures aimed at achieving the goals laid Pew Center on Global Climate Change: learning from State Action on Climate Change, May 2008. Pew Center on Global Climate Change: Regional Initiatives, 2008. European Parliament: EU Emission Trading Scheme: use permit revenues to fund climate change protection, October 7th, 2008

2 3 4

150

Investing in Climate Change 2009

out in the 2006 Five-Year Plan, and subsequently reinforced in its 2007 National Action Plan on Climate Change: · The tax rate for big cars has been doubled to 40%, while the tax on cars with small engines has been reduced from 3% to 1%; · Government buildings are now required to conform to energy efficiency standards; · 10 provinces, municipalities and regions have begun piloting a new energy regulation to stop fixed-asset projects that do not meet national energy standards. This regulation is set to be rolled-out nationwide once piloting is complete. In December 2007, China also issued its first white paper on energy conditions and policies. The white paper: · · ·

Advocated promotion of energy conservation; Stipulated improved coordination between energy and environmental development; Suggested strengthening international cooperation in the field of energy and accelerating the progress of energy technologies.

In 2009 a package of laws will come in to force containing targets to underpin the government’s climate strategy. They include:

· Goals to create a ‘recycling economy’ by reducing energy consumption and doubling renewable energy capacity; · Cutting pollution by 10% on 2005 levels by 2010; · Environmental monitoring of carbon intensive industries; · The National People’s Congress (NPC) has also approved the new legislation and is promoting clean technology in support including tax beaks on energy efficient and renewable technologies.

• India: The Indian National Action Plan on Climate Change was released in June, 2008. The plan established 8 national “missions” running through 2017, which include major investments in solar capacity, energy efficiency, water use efficiency, and forestry. The Indian government is also mandating the retirement of inefficient coal-fired power plants and requiring big consumers of energy to conduct energy audits.

151

Investing in Climate Change 2009

Appendix V: Critical Factors for Achieving Commercial Breakeven

There are a number of key sensitivities that affect the point at which renewable technologies hit the commercial breakeven points. In their research, analysts have pointed out how four sensitivities are particularly important: 1. The regulatory framework Regulation is important for low carbon technologies. These technologies can be expensive and costs need to be brought down the learning curve. There are a variety of policy levers that can be employed to do this – with the rate of learning tied to how effective policy is in encouraging the development and deployment of the technology. The policy levers available to regulators are discussed in detail in Chapter III pf Part II. 2. Local electricity price There is significant geographic variation in electricity price due to differences in fuel prices and in conventional power production methods. There are also variations between peak power and off-peak power prices, which is important to consider when evaluating the competitiveness of renewable technologies. Solar: If capital costs of solar PV could be lowered to the region of $2,500/KW and natural gas stays above the $8/ MMBtu mark, solar PV could be competitive with traditional peak power. The US has variable electricity prices that will result in different regions exhibiting different electric grid parity bands as peak retail rates in some regions have already gone above $150/MWh. Citigroup notes that, as a whole, rising electricity prices in the US are likely to drive demand for solar PV installations. High electricity prices in markets such as Spain and Italy in Europe have supported growth in solar in these countries. Wind: At current gas prices, wind is cost competitive with conventional gas in regions such as the UK and California. Despite supply chain issues, which we discuss below, onshore wind is an established form of power generation that can respond profitably, and is ready to be scaled up within favorably high gas price economies. 3. Natural resources The theoretical resources available for the exploitation of solar PV power and wind power are far larger than any practical means for development. Nevertheless some regions exhibit particularly favorable conditions, which help to explain why geographic growth pockets have emerged. Solar: Electric grid parity without carbon pricing or subsidies is dependent on location as a result of variation in insulation (solar intensity). Areas such as Southern Europe and California benefit from above average hours of sunlight and some island economies such as Hawaii have already achieved electric grid parity without carbon pricing or subsidies for solar PV, in part because of high sun resources and in part due to high fossil fuel costs. The potential for developing countries, such as India, to utilize the natural resource of the sun is high, but barriers of connectivity to electric power grids will need to be overcome. Wind: Wind power is driven by the nature of the resource. A doubling of wind speed means about an eight-fold gain in electricity production. The UK is the best region in Europe for wind power owing to high wind speeds. Similarly, the Midwest US is rich in wind energy resources. Research and development in technology may enable wind power at higher elevations, offering more wind extraction.

152

Investing in Climate Change 2009

4. Supply chain bottlenecks Material supply chain bottlenecks may potentially delay the competitiveness of both solar and wind. Solar: Severe shortages of silicon have plagued the solar PV market for the past two years and thus, the cost of supplying the modules required for solar PV has remained high. The market is currently in tight supply, a state that is expected to ease up in 2009/2010. When the silicon bottleneck does eventually clear, costs will decline as a result and the overall cost of solar PV is likely to come down the curve, moving the technology closer to commercial breakeven without carbon pricing or incentives. Goldman Sachs notes that going forward, there will be cheaper silicon prices due to significant production capacity coming online, which will move solar PV towards electric grid parity without carbon pricing or subsidies. Lehman believes that the availability of polysilicon will remain a bottleneck until 2010 as a result of greater capacity expansion plans from cell manufacturers than poly suppliers. Wind: Strong regulatory incentives, pockets of high wind resources, the push from high conventional fossil fuel prices and continued improvements in wind technology and performance have enabled wind to reach electric grid parity without carbon pricing or subsidies in some geographies. However, there are a few potential bumps in the market that could delay broad electric grid parity without carbon pricing or subsidies. The turbine market is currently in tight supply, and steel prices that are integral to turbine manufacture have increased significantly. Major capacity investments in manufacturing are needed to ease this lag in supply. In addition there are challenges of skills shortages in the sector. Both drawbacks are inherently the result of strong demand in the sector and consequently, as long as they can be overcome, the wind industry should be positioned to grow rapidly.

Beyond breakeven: The special case of biofuels: A renewable that is actually reducing the costs of conventional energy While biofuels have suffered a lot of criticism for being unsustainable, causing deforestation, harming indigenous people and being net carbon emitters, we believe that there are good biofuels out there. We consider 2nd and 3rd generation biofuels, along with a limited number of 1st generation biofuels (sugarcane ethanol and jatropha-based biodiesel) to be worthy parts of the climate change investment universe. Biofuels compete in the road transport fuel market rather than the electric power market. However, their special story deserves attention as a sign of what may be coming down the road. More so than any other renewable, the economic influence of ethanol has been felt in the conventional energy markets. Research from Iowa State University indicates that blending ethanol with gasoline has kept fuel prices $0.29-$0.40 lower than they otherwise would have been in the US;1 McKinsey analysis indicates additional upside for blending up to E10,2 with the potential to decrease retail gasoline prices by $0.43-$0.65.3 Biofuels in the US are now “beyond breakeven.” We recognise that the sustainability of much of the ethanol for sale in the US is debatable. This is problematic, and will need to be addressed. However, economically, US ethanol has reached the final goal of renewables – becoming lower-cost alternatives to fossil fuels, unlocking cheaper energy costs and a wave of low-carbon prosperity. The reason that ethanol is having this material impact on the price of retail gasoline in the US is that blending permits the replacement of expensive gasoline imports with a lower-cost substitute. 1 2 3

153

Autoblog green, June 13, 2008. Are high gas prices “forcing” Amercans towards ethanol? 10% ethanol by volume. McKinsey & Co, July 7, 2008. Impact of ethanol blending on US gasoline prices.

Investing in Climate Change 2009

Appendix V: Critical Factors for Achieving Commercial Breakeven

Biofuels have demonstrated their potential to reduce the cost of energy – and we see a promising future for them, as long as they are produced with respect to the highest standards of sustainability. This may mean that tariff regimes need to be eased to allow increased imports from tropical climates that are naturally disposed to produce biofuels, such as Africa and Brazil. In any case, the story of ethanol’s impact on US gasoline prices may become more familiar in other energy markets going forward – ethanol may be the very first of a number of renewable technologies that unlock a low-carbon revolution, where consumers pay less to consume clean, renewable fuels.

154

Investing in Climate Change 2009

Disclaimer DB Advisors is the brand name for the institutional asset management division of Deutsche Asset Management, the asset management arm of Deutsche Bank AG. In the US, Deutsche Asset Management relates to the asset management activities of Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company; in Canada, Deutsche Asset Management Canada Limited (Deutsche Asset Management Canada Limited is a wholly owned subsidiary of Deutsche Investment Management Americas Inc); in Germany and Luxembourg: DWS Investment GmbH, DWS Investment S.A., DWS Finanz-Service GmbH, Deutsche Asset Management Investmentgesellschaft mbH, and Deutsche Asset Management International GmbH; in Australia, Deutsche Asset Management (Australia) Limited (ABN 63 116 232 154); in Hong Kong, Deutsche Asset Management (Hong Kong) Limited; in Japan, Deutsche Asset Management Limited (Japan); in Singapore, Deutsche Asset Management (Asia) Limited (Company Reg. No. 198701485N) and in the United Kingdom, RREEF Limited, RREEF Global Advisers Limited, and Deutsche Asset Management (UK) Limited; in addition to other regional entities in the Deutsche Bank Group. This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute Deutsche Bank AG or its affiliates’ judgment at the time of issue and are subject to change. This document is only for professional investors. This document was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. No further distribution is allowed without prior written consent of the Issuer. The forecasts provided are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. For Investors in the United Kingdom: Issued in the United Kingdom by Deutsche Asset Management (UK) Limited of One Appold Street, London, EC2A 2UU. Authorised and regulated by the Financial Services Authority. This document is a “non-retail communication” within the meaning of the FSA’s Rules and is directed only at persons satisfying the FSA’s client categorisation criteria for an eligible counterparty or a professional client. This document is not intended for and should not be relied upon by a retail client. When making an investment decision, potential investors should rely solely on the final documentation relating to the investment or service and not the information contained herein. The investments or services mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives and circumstances, including the possible risks and benefits of entering into such transaction. You should also consider seeking advice from your own advisers in making this assessment. If you decide to enter into a transaction with us you do so in reliance on your own judgment. For Investors in Australia: In Australia, Issued by Deutsche Asset Management (Australia) Limited (ABN 63 116 232 154), holder of an Australian Financial Services License. An investment with Deutsche Asset Management is not a deposit with or any other type of liability of Deutsche Bank AG ARBN 064 165 162, Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank AG Group. The capital value of and performance of an investment with Deutsche Asset Management is not guaranteed by Deutsche Bank AG, Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank Group. Investments are subject to investment risk, including possible delays in repayment and loss of income and principal invested. For Investors in Hong Kong: Interests in the funds may not be offered or sold in Hong Kong or other jurisdictions, by means of an advertisement, invitation or any other document, other than to Professional Investors or in circumstances that do not constitute an offering to the public. This document is therefore for the use of Professional Investors only and as such, is not approved under the Securities and Futures Ordinance (SFO) or the Companies Ordinance and shall not be distributed to non-Professional Investors in Hong Kong or to anyone in any other jurisdiction in which such distribution is not authorised. For the purposes of this statement, a Professional investor is defined under the SFO.

I-007607-1.2

155

Investing in Climate Change 2009