Greenhouse Gas Spurs Non-Traditional Roles

Mr. Walker said that Swiss Re has decided to develop credit guaranties to support emissions trades between companies as a result of a comprehensive evaluation it has made of the potential greenhouse gases market. While no such guaranties have been written yet, Mr. Walker provided a glimpse into how a global reinsurer approaches the task of developing products that could support what experts believe is potentially a $36 billion trading market.

It all started about a year ago, when Mr. Walker and a colleague launched a unit of Swiss Re New Markets called Environmental Solutions. "The idea was to try to look at the environment as an opportunity, as opposed to how most insurance companies look at itas a risk," he said.

Turning their attention to greenhouse gases, they approached the chief risk officer of Swiss Re with the idea of comprehensively studying the emerging market. A six-month feasibility study into nine different areas where Swiss Re could play a role was completed in January, with a recommendation to implement four areascredit guaranties, insurance, project finance and investment.

While derivatives are a "potentially huge piece of the market," Swiss Re decided not to participate directly in derivatives trading at this point in time. "We think it's not ripe yet. It's one of the things we will hold in reserve until the market starts to develop," Mr. Walker said.

Citing figures from a University of St. Gallen feasibility study, which the Switzerland-based university put together for Swiss Re, the trading market is estimated to be between $18 and $36 billion a year, he said. "If you factor in derivatives, that would be $75 to $154 billion per year."

He explained that the figure is potentially larger for derivatives, which are commonly traded as many as four times.

Explaining the basics of the underlying $18-$36 billion market for trading emissions reductions credits, he said it allows companies to look for "the most efficient and effective means possible" to lower emissions. "If someone else can do it cheaper than me, then he can trade his emission reduction units to me."

It is cheaper for companies to start thinking about trading now, he said, noting that while negotiations to ratify the Kyoto Protocol have hit "some bumps in the road," some companies are acting already.

"Now, you can buy CO₂ credits potentially at $3 per ton," he said, noting that the price could be $50 per ton in 2008, the first year of the Kyoto compliance period. But while there are cost and reputational advantages to acting now, such actions create a long-term credit risk, he said.

Thats where the guaranties come in, he said, suggesting that credit insurance is "attractive, particularly in the early stages of the market."

"If I buy [credits from you] now, how do I know [youll] be there eight years from now? Its basically a pure counterparty risk," he said, adding that "a triple-A-rated company like Swiss Re would be an ideal risk mitigator."

He listed utilities, energy companies, oil and gas companies, transportation companies and airlines as potential traders of carbon credits.

Some early actors in Canada have bought futures options, he said. The buyers in such deals, seeing that potential sellers will potentially have more emission reduction units below than they need, buy the right to purchase the reduction units at a later datethereby creating a futures contract, he added. The buyer has a call option, in 2008, to call upon these credits, he said.

One 210,000-metric-ton trade that was announced publicly last year, involved TransAlta, an electric generation and marketing company in Alberta, Canada, as the seller in such a transaction. In November, TransAlta, which had emission reductions to sell as a result of upgrades to some of its U.S. operations, announced that it sold credits to Murphy Oil Corp., a worldwide oil and gas exploration and production company in El Dorado, Ark., for a undisclosed amount.

"Its a cheap way to comply at this point," but those who participate now in such trades "are putting money at risk many years in advance," Mr. Walker said. An insurance company, then, could step in to facilitate activity, he said.

The University of St. Gallen study projected $600 million of annual credit guaranty premiums for the entire insurance industry, he said, noting, however, that "the actual product or insurance solution" is still under development at Swiss Re.

One problem, he said, is trying to figure out "what is the best approach for the market."

"If I bought 10 credits from [a company] and I had an insurance policy for those 10 credits, what if [the seller] isnt there to deliver them? What do I want in the end? Do I want 10 like-kind credits from the insurance company? Or would I settle for some type of cash payment?"

And "obviously for us, one of the things we have to factor in is where would we obtain credits in the first placesince Swiss Re is not an emitting company," he said.

Underscoring some of the difficulties of product development, Mr. Walker said he would welcome input on various approaches from the insurance and reinsurance industry, although he noted that no other companies have publicly announced theyre in the market.

One of the items Swiss Re decided not to pursue was "certification/verification activity," he said, explaining that this is too "engineering-oriented" to make the best use of Swiss Res resources.

However, the reinsurer is in discussions with an insurance broker to develop professional liability insurance for experts performing such services.

Explaining the certification activity, Mr. Walker said that a Big Five consultant might go into a company to determine what its baseline emissions are. Going on to look at the projects it has planned, the expert would estimate the number of credits that would arise out of each project.

Beyond insurance, Swiss Re is involved in other initiatives including the Emissions Market Development Groupa joint effort between Arthur Andersen; Credit Lyonnais; Natsource, a New York trading broker of energy products; and Swiss Re. The EMDG is currently in the feasibility phase and has been joined by 15 large industrial carbon-emitting companies, he said, noting that the EMDG is trying to create a common currency for emissions credits.

"If you have two credits from the United Kingdom and I have four from Botswana, how do we match these up?" he said, explaining the underlying currency question. "EMDG, in essence, is going to be a repository," taking credits and creating a credit rating for them, such as triple-A, he said.

As a buyer, "you would likely prefer triple-A rated credits, as opposed to credits that you dont know are going to be freely exchangeable," he said, noting that rating assignments will "rely heavily" on the work of Credit Lyonnais and Swiss Re.

While that is the only role thats contemplated in the EMDG alliance for Swiss Re at this point, Mr. Walker sees potential synergies with other Swiss Re initiatives. He noted, for example, that credits could be generated through alternative energy development projects, suggesting that Swiss Re might have a role to play in supplying contingent capital to such projects.

For example, a company that embarked on a projectsay building a solar power plant or a wind farmwould be able to rely on the fact that Swiss Re, for a premium, could insure the value of the carbon reduction credits generated by the project as an additional source to generate cash flow, he said.

The insurance, he added, would be triggered if the market price of the emissions reductions fell below a certain predefined floor.

The availability of a contingent capital facility, he said, could potentially lower the cost of financing and increase liquidity, he said.

Turning to investments, the final initiative in Swiss Res four-pronged approach to the fledgling carbon-credit market, Mr. Walker said that Swiss Re has an ecology portfolio of 100 million Swiss francs ($56 million) and that the Greenhouse Group has permission to look at greenhouse gas investment funds.

A number of institutions have created investment funds that provide money for projects that will reduce emissions, "the idea being that its safer for a company to invest in a fund, because you can diversify," he said. "If one project goes belly-up, you still have others out there," he said.

"We want to encourage good environmental behavior," he said, giving one reason for Swiss Res investments in these funds. In addition, the investments can help the insurer understand how projects will work, giving some input to the project finance initiative.

Swiss Re might also be able to use these investments as a vehicle to generate a carbon credits reserve of "like-kind" credits for the guaranties it will offer, Mr. Walker said.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, June 29, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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