Q&A: CE2 Capital Bullish On Carbon, Cap-and-Trade

May 20 2009 | 12:04pm ET

With the White House and a Democratic Congress on board, the U.S. is likely to adopt a carbon emissions reduction policy this year. That probability is creating enormous interest in the future of carbon trading, and investing in it.

CleanTech Brief’s Jonathan Shazar recently spoke with Gregory Arnold, managing partner of San Diego-based CE2 Capital Partners, about carbon cap-and-trade programs, the current legislative and regulatory environment, and the future of carbon investing.

Arnold, who covered energy and power during his days at Goldman Sachs, co-founded CE2 Capital Partners four years ago, and last year joined forces with private equity firm Energy Capital Partners to create CE2 Carbon Capital, which invests in the growing carbon market here in the U.S.

What was the genesis of CE2 Capital Partners?

Arnold: About five years ago, I met Harold Buchanan, the other managing partner of CE2. He had been in business development at Sempra Energy, but earlier in his career had worked at one of the large energy-trading firms. Electricity and natural gas were the growth industries in the 1990s, and emissions was this tiny little market, but he touched in it.

Back then, it wasn’t as obvious that alternative energy was going to be as big as it is right now. We saw the paradigm shift when the Europeans were beginning to trade carbon credits…Domestically in the U.S., we found the intellectual underpinnings and the earliest markets for trading carbon emissions were already in place and were actually evolving quite rapidly, despite the U.S. not having ratified the Kyoto Protocol. From that, we began trading emissions credits and renewable energy credits and now we’re up to three investment vehicles. They all have slightly different characteristics. The first one we launched was relatively liquid trading in somewhat illiquid markets.

How did you accomplish that?

Arnold: The fund has a two-year lockup, which is still relatively long. The idea was that we would attempt to match the liquidity of the instruments to the fund life.

We subsequently launched a vehicle that had a five-year time horizon, and now we’ve launched a perpetual vehicle with Energy Capital Partners, which is a large private equity firm, and that one is called CE2 Carbon Capital.

Given the state of the economy, do you think that it’s likely that the carbon credit allocation model that you favor will succeed?

Arnold: They are literally negotiating this right now in the House Energy and Commerce Committee. [Two weeks ago], they released a report on where things stand, and we expected a hybrid approach. Certain sensitive industries, such as coal-intensive industries, local distribution companies, etc., are going to be allocated credits, and over time those allocations will phase out. As I understand it, oil refining was not covered by the initial proposal. That’s the next fistfight, and I’d bet on the oil guys. The other group that’s yet to be heard from are the farmers, and how they might fit into all this.

We invest in both credits that come from projects, or we invest in the projects themselves. And we’re also looking, on a small-scale right now, at buying companies that fit into the carbon value chain, whether they be development entities or services, potentially even technology companies.

Under cap-and-trade, the government creates permits called allowances. But the offsets come from sectors that will not be regulated directly under the program: certain types of forestry products, almost any kind of methane capture and destruction or use, etc. Each ton of methane is equivalent to 20 tons of CO2. There’s going to be demand for these credits, and there is going to be capital investment required to create them. On the one hand, they will create good jobs, but they also create new technological approaches and hard capital assets that take methane out of the environment and in some cases actually increase the supply of clean energy.

Are there any challenges facing the implementation of cap-and-trade?

Arnold: The toughest part is designing the program. There is a bureaucracy associated with it and a large infrastructure. By comparison, the SO2 [Sulfur Dioxide] program is about 10 million tons. We’re talking about 4.5 to 5 billion tons. The systems and the rules are just much more dramatic. It’s a whole different order of magnitude, and it will pervade much more deeply into the economy.

The good news is, at the end of the day, it’s complex and there are different kind of instruments, but it’s just another kind of commodities market. It’s particular and peculiar and you have to understand some of the idiosyncrasies, but it’s a market with tangible permits and it’s a market that will require regulation. The EPA has already shown that it can do this type of regulation. The FERC or the CFTC will end up regulating the derivative and physical markets themselves, and they already do that kind of thing.

Let’s talk a little bit more about CE2 Carbon Capital.

Arnold: We’ve partnered with Energy Capital Partners and together put in a $125 million initial equity investment. CE2 Carbon will invest exclusively in carbon assets: credits, projects and potentially even companies along the value chain, and any derivatives that may be associated with them. It’s not a trading vehicle, but it does hold substantial commodities.

We also look at renewable energy markets, and so we’ll buy the commodities from wind farms, and then hold them, slice them up, sell them, hedge them, etc. Everything we do at CE2 Carbon starts off with a physical commodity, which is either the carbon or the renewable energy credit, projects we own, or companies that fill in the value chain.

How long has CE2 Carbon been up and running?

Arnold: It’s an investment company that has been up since last June. The other two vehicles are almost three years old.

What sort of capacity does CE2 Carbon have?

Arnold: This vehicle is a discrete vehicle, but the space could handle, right now, $500 million to $1 billion. It’s a company, so there may be more investment in it, but there may also be additional vehicles.

How risky is investing in this space, given the uncertainty?

Arnold: That's hard to define. There’s a fair amount of risk measured against a substantial amount of upside. Part of mitigating the risk is taking a portfolio view on what’s in the company, what we invest in, but also trying to understand as much as we can about what kind of carbon offsets are likely to count, and how the regulation is likely to be structured. We also spent a great amount of time—and legal fees—structuring it as much as we could to manage commodity and project risk.

Other than carbon, what are the hottest opportunities and sectors in clean energy right now?

Arnold: We’re narrowly focused, so for us it really is carbon. There are other markets that will continue to be interesting, such as markets for NOX, which is smog, in effect, markets for particulates, which are federal, regional and local in nature.

What is the future of the global carbon market, with Kyoto scheduled to expire in 2012?

Arnold: Where we are headed is toward multiple global carbon markets, with linkages between them. It’s reasonable to expect that something will come out of December’s meetings in Copenhagen. The Europeans will continue their market for a period of time. How the clean development mechanism that creates credits will continue, there’s a lot of debate about that.

Overall, I’m pretty bullish. For the markets to really thrive long-term, the U.S. needs to have a program, the Europeans need to continue theirs, and more and more the emerging economies need to be brought into the system.

We’re likely to have a program, especially under an Obama administration and a Democratically-controlled Congress. And if we have a program, that’s going to make it easier for other countries in the world to do it.

So the U.S. will be involved in Kyoto’s successor, and that involvement will help prod countries like China and India to do the same?

Arnold: It’s going to be complex, but generally yes. I don’t know that we will be a party. We will be active in negotiating this treaty, but I don’t know that we will be part of an integrated global market. But I believe that we will have our own market.

Why would the U.S. not be part of a global market?

Arnold: That would be just another layer of complexity, trying to sort it all out with the rest of the world. If we make meaningful steps and changes in good faith, my sense is that that will be enough. We will link with those markets, I just don’t know that there will be one international carbon trading umbrella that we’re part of.

Think about where we are coming from. If we really make a lot of progress and put some skin in the game, that should be enough to get the rest of the world to participate. The State Department is running the negotiations this time, which wasn’t the case in the last administration, which just had a different viewpoint.

The good faith and goodwill to proceed, to be fully engaged and to be constructive, and to negotiate in earnest, is a real linchpin for the overall Obama foreign policy. The Europeans were told, “If you’re not going to lead, get the hell out of the way.” The world is happy to have U.S. leadership on this issue. We negotiated a big chunk of the Kyoto Protocol, and it wasn’t until the end that we backed out.

How much interest have vehicles such as yours garnered from investors, particularly large, institutional investors?

Arnold: There are endowments and foundations, as well as pensions, that are very interested in this space. A number of them have made allocations. Increasingly, it’s an area of interest.

The endowments and foundations seem to be a little more advanced in thinking about these things. Some of them have some green mandates, and have actually deployed capital. The same is true of some of the pension funds.

How has the economic crisis affected this space, as well as your own fundraising efforts?

Arnold: It’s affected a number of our investors, and it certainly has had an impact. It hasn’t been a devastating impact, but it’s had an impact. That said, we do see a pretty dramatic uptick in interest in this.

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