Smoke stream: insurers and brokers find new business opportunities in emissions trading and managing emissions risk.

Greenhouse gas emissions can force climate change and present potential liabilities to the corporations that produce them. But they also offer attractive opportunities for financial services, and the insurance industry in particular, to open up new business opportunities, including treating carbon, or C[O.sub.2] emissions, as a tradable commodity.

That's the theme sounded by Christopher T. Walker, managing director of Swiss Re's Greenhouse Gas Risk Solutions, Financial Services Business Group, in two appearances on Capitol Hill in recent months. His unit, formed in April 2001, consists of three specialists who examine business opportunities across a wide spectrum of financial service products including insurance, structured finance, third-party asset management and investments, as well as the identification of risks to Swiss Re's insurance, reinsurance and investment activities.

"We've been saying that climate change has a great potential to impact our business, so you could say this is almost an ultimate risk management for Swiss Re, if we can help companies deal with emission reduction issues," he said.

Underpinning this focus on emissions reduction is the Kyoto Protocol, in which developed nations have agreed to limit their greenhouse gas emissions relative to the levels emitted in 1990. The cap on emissions goes into effect by 2012, but many companies and governments are already preparing for the change with the notable exception of the United States. Originally, Clinton administration agreed to reduce emissions from 1990 levels by 7% during the period 2008 to 2012, but the Bush administration later pulled out of the agreement

Europe is definitely in the plan, however, and businesses in 25 European countries are already embarking on market mechanisms similar to those used effectively in the United States to curb the acid rain problem in the Northeast, Walker said.

"As countries recognized that there was a global-climate-change problem partly caused by man-made emissions, they agreed to reduce these emissions through a mechanism known as the Kyoto Protocol," Walker said. Those signatories set a global target of 5.2% in emissions reduction "and they decided to do it using these market mechanisms," he said.

The trading works something like this: A company in the United Kingdom may have a very old factory that would make it difficult for them to achieve the 5% reduction on their own. But they could work with a plant in Poland, for example, with Cold-War era, highly inefficient environmental controls. Retrofitting a plant in that location might cost 10 cents on the dollar, or much less than improving the U.K. facility. "If you could get that plant to reduce emissions by 10% in Poland, the U.K. plant can take the 5% reduction that it needs, purchasing it through a trade," Walker said. "And that's the idea of what they call market mechanisms in the Kyoto sense."

Insurers Play a Role

In this kind of transaction, insurers and reinsurers could play a role to clear the transaction, just as a clearinghouse does to match money with shares in stock purchases on the New York Stock Exchange, he said. "That's similar to what we could do," Walker said.

For Europe alone, the projected trading market in emissions is estimated to be 15 billion euro per year as of 2005, when it starts, he said. "So that could contain a pretty large insurance market, even if it's only a small percentage of that," Walker said.

Within the whole of Europe, there will be one single trading scheme "so anyone who overachieves against their emission cap in one country or one sector can basically sell that overachievement to anyone who has underachieved in any sector or any country," said Charles Eyre, climate change practice leader with Aon Risk Consulting Group in London. "A European Allowance, traded as a ton of C[O.sub.2], will be the traded unit. The first phase of the regime starts in January 2005, three years ahead of the Kyoto Protocol. In due course, subject to bilateral allowances, it could be exported to Canada or Japan and vice versa."

But while the carbon commodities market promises to be vibrant in the United Kingdom and Canada, it will be fueled by Japan, Walker said. "For the Japanese, the estimate would be about $500 a ton to retrofit their plants," he said. "So they are going to be buyers of other people's emission reductions, because if they could buy them at 10 euros, it's still much better than $500. And so they're going to be the ones who are going to be what you call the buyers in this market, the major Japanese utilities and manufacturers."

Aon Risk also has gotten involved in this activity. Eyre said his group reviews any new regulatory risk which would affect a corporate risk profile designed to sort out issues relating to emissions. "We look at climate-change type legislation--basically anything driven by national commitments on Kyoto--and we're very heavily involved in helping companies in the U.K. and Europe look at how the European emissions trading scheme will affect their overall competitive position or could change their fundamental risk exposure," he said. His unit also works on the renewable energy side, because incentive-based legislation, designed to promote this type of generation, is the other half of the Kyoto equation, he said. And Eyre keeps close tabs on other legislation that does not deal directly with climate change but directly impacts atmospheric pollution.

Corporate awareness of the emissions reduction challenge is growing in time United Kingdom. Eyre pointed to meetings between government and business leaders that six months ago drew perhaps 20 companies. Now the same topic is attracting 100 to 200 firms. "There will be about 2,000 compliant installations in the U.K.--that will represent about 300 companies--so we're getting a very high turnout now of those that will be involved," he said. "Certainly the big ones are involved, but I don't think they've necessarily all worked out exactly what the financial and competitive implications are."

Companies that sell products that have a high C[O.sub.2] content--such as utilities and cement manufacturers--seem to understand their levels of exposure, he noted. Others, however, may not. For instance, Aon Risk recently completed an assessment for one of the large international

gas companies that asked Aon to look at the overall risks associated with Kyoto across their entire operation, Eyre said. "They've done a lot of work and they're pretty well prepared, but even they were quite interested by the sort of things we helped them dig up on the business ramifications," he said.

Another problem is the lack of understanding of the impact of emissions reductions on electricity prices, Eyre said. Depending on how tough the allocation process is and the distributional effects across sectors, Aon Risk Consulting says there could be significant impacts on electricity generation costs, ultimately leading to changes in the comparative advantages and the selection of fuels for generation. "As marginal CO2 emissions become part of the opportunity cost calculation and prices go up, there will come a point when it pays to switch from coal to gas," he said. "Of course, this could result in an increase in gas demand which could push up the gas price."

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All in all, there will be more uncertainty and more volatility for those businesses directly and indirectly involved, Eyre said. "It's added a dimension, which may seem insignificant on its own, but has such wide ramifications because it "affects all energy consumption across all industries," he said. "I think that you could say that's where people haven't really sized up what's going on."

That, said Walker, applies to many insurers and reinsurers as well. "Today, climate change as a financial issue is very much underestimated from the point of view of the insurance and reinsurance industry's potentially rising costs and risks," he told a Congressional briefing in June. "The insurance industry can be the prime mover of emissions reduction activities. The reality here is simple: insurance and reinsurance companies have the potential to become prime catalysts for the development of renewables, emission reduction and energy-efficient technologies."

Affected Lines of Business

From a risk standpoint, Swiss Re has looked at various types of insurance policies that it offers to see where there is potential exposure due to emission constraints, Walker said. One example: directors and officers liability. The company also has looked at the emissions reductions issue in light of business opportunities, from the potential for risk transfer and clearing type solutions, to delivery guarantees, as well as time insuring of renewables, with wind farms a prime example, he said.

Insurers need to look at what the implications for this new asset base and revenue stream will be for their conventional insurance processes and programs, Eyre said. "They need to look at the extent to which they can come up with risk transfer solutions which include or specifically cover issues to do with emissions trading and emissions liabilities," he said. "And clearly, in the risk consulting practice, we need to start looking at whether this particular issue merits and warrants development of some capabilities on its own. But definitely it does fundamentally change some people's exposures." For example, companies doing compliance and verification work will need to consider if this materially changes their level of risk in terms of professional negligence, Eyre said. And insurers need to develop specific solutions for climate change issues, particularly project risk, where projects might be financed based on future revenue streams which would include these environmental instruments, he said.

Walker believes it is inevitable that even the United States eventually will impose emission constraints, and companies need to proactively start managing these emissions now because early action will be more cost efficient. To Eyre, the Americans' voluntary efforts to cut emissions won't deliver what is generally accepted to be required. "You have to put a level of compulsion on this," he said. "Some states in the United States have an incentivized program on the renewable energies, which is very similar to Europe, but there isn't a national compulsory program on emission reductions and you basically need the carrot and stick on both sides. If we are right in our assumptions on global warming, I would say that America is putting off the inevitable."