Memorandum from Cheyne Capital Management

 

1) Description of Cheyne Capital Management (UK) LLP and relevance to the Inquiry Cheyne Capital Management (UK) LLP is one of Europe's largest fund management groups. Cheyne Capital today manages net assets of over $10 billion in products such as its Special Situations, Long/Short Structured Credit, Pan-Asia Long/Short, Global Opportunities, Multi-Strategy, Specialty Finance and various convertible bond funds. In addition, Cheyne Capital manages gross assets of approximately $26 billion in its corporate CDO and ABS programs. Cheyne Capital Management (UK) LLP is authorized and regulated by the FSA in the United Kingdom.

 

Cheyne launched the world's first voluntary carbon offset investment fund, the Cheyne Carbon Fund ("The Fund"), focusing on sourcing, purchasing, warehousing and selling of verified and certified Emission Reductions ("ER"), in August 2005.

 

Cheyne's voluntary offset program includes only projects that generate high quality verified emission reductions ("VERs") with permanent reductions that create environmental benefits and facilitate additional investment towards sustainable development.

 

The Fund creates scalable voluntary greenhouse gas ("GHG") offset solutions enabling large industrial companies and corporate end-users to: mitigate their carbon liabilities, provide carbon-free goods and services while managing all forward price volatility and delivery risk.

 

The Fund provides liquidity in the growing voluntary carbon offset market by providing only certified and verified high quality, voluntary emission reduction offsets in large scale to industrial companies and other institutional buyers and retail offset providers. The Fund will not sell any "business as usual" ERs or ER credits generated from sectors where long-term performance and permanence may be questionable such as: forestry, certain agricultural gasses and forward reductions that have not yet occurred.

 

Credible and rigorous internationally accepted standards, such as Voluntary Carbon Standard Version 1("VCS"), should govern the otherwise unregulated voluntary offsetting industry to insure that buyers and sellers have financial and legal recourse and accountability. Voluntary markets have traditionally been fragmented, illiquid, inefficient and lacking market mechanisms that ensure quality and promote standardization. We are proponents of internationally accepted transparently created, high integrity standards, such as the VCS, that have been developed through an extensive consultation process involving multiple stakeholders and an independent steering committee with expertise in the voluntary carbon offset markets and the appropriate climate science background that ensure credibility and global buy-in.

 

The Voluntary Carbon Standard Version 1 ("VCS") was launched by The World Business Council for Sustainable Development, the World Economic Forum, The Climate Group and The International Emissions Trading Association in March 2006.

 

Creation of the VCS and a standardised emission reduction unit, named a Voluntary Carbon Unit ("VCU"), as a fungible, uniform, tradable and standardised emission reduction offset unit has removed the barriers to entry in the voluntary emission reduction space allowing financial institutions and large industrial companies to manage their reputational risk and participate in the mitigation of their long-term carbon liabilities with real, quantifiable, permanent and additional VCUs.

 

The VCS concept has created a new commoditised asset class accepted by the financial community. The VCU helps create a benchmark pricing mechanism for certified voluntary carbon units. The voluntary carbon standard and voluntary carbon units have established the first voluntary high quality commoditized assets certified in accordance with a credible performance standard.

 

All verification and certification protocols for every VCU as specified in the VCS. For example, baseline settings and monitoring must be evaluated and interpreted only by officially United Nations Framework Convention on Climate Change ("UNFCC") accredited Designated Operation Entities ("DOEs"). The Fund uses the top 3 of the 9 internationally accredited DOEs, which adds significant costs but creates certainty, reduces risk and adds an additional layer of performance insurance.

 

The Cheyne Carbon Fund stores its VCUs in a secure global custody service at The Bank of New York's VCU Registry where VCUs are assigned serial numbers to avoid double counting and ensure transparent reporting of retired VCUs. The Department of Environment, Food and Rural Affairs ("Defra") should adopt the VCS and VCUs as its code of best practice for carbon offsetting and endorse The Bank of New York ("BNY") VCU Registry.

 

Defra's January 2007 launch of "Developing a Code of Best Practice for carbon offsetting" is a positive step in the right direction towards creation of a government scheme that accredits providers and promotes international standardisation. However, many concepts, references and definitions in the 56-page Defra document are scientifically incorrect, requiring revision and causes the initiative to lack all credibility.

 

Much confusion exists regarding Defra's understanding of exactly what VERs and CERs are, the existing voluntary market mechanisms and the purposes and differences of each market. Defra has concluded, before their "consultation" to publicly endorse only certified emission reductions ("CERs") generated for the EU ETS regulatory mechanism in their "Developing a Code of Best Practice for carbon offsetting", which some assumed was a genuine consultation.

 

EU ETS CER emission reductions generated from destruction of HFC-23 in China, now represent more than 60% of all pipeline emission reductions in the EU ETS CER pipeline. These are produced for pence on the pound and sold for €15.00 on a forward basis. Purchase of these HFC-23 reductions does not promote capital market investment. It does not promote creativity or drive innovation critical to the development of new technologies. It makes no contribution towards sustainable development in the local economy where the destruction occurred. While HFC-23 is a potent greenhouse gas, it is a minor part of the global warming problem. Emissions from carbon dioxide ("CO2"), methane ("CH4") and nitrous oxide ("N2O") constitute more than 95 percent of all greenhouse gas emissions. Based on the magnitude of the problem and given the high quality and scale of some existing VER projects and standards it seems illogical to arbitrarily exclude VERs before the Defra "consultation" "Developing a Code of Best Practice for carbon offsetting. Purchase of VERs such as VCUs, certified in accordance with the VCS, can contribute substantially more towards the creation of permanent solutions that mitigate the majority of GHGs impacting global warming and climate change than the purchase of the abundant HFC-23 destruction CERs generated from projects in China, as suggested in the Defra Code of Best Practice for carbon

offsetting. Contained in the tables within Defra's "Developing a Code of Best Practice for carbon offsetting" Defra uses an overly crude model to forecast the emissions benefits resulting from 5 different "options" associated with a voluntary vs. mandatory, VER vs CER offset standard. The central factor that Defra uses in determining the estimated emissions avoided as a result of the voluntary offset market is the "consumer uptake" assumption. It concludes that issuing its proposed voluntary-CER code will increase the net emissions reduced by the voluntary offset market in the UK from 5.4 Million Tonnes per Year ("MT/yr") to 32.1 MT/yr, and uses this as quantifiable justification for its proposal to reject high-quality VERs as an eligible source of supply. The numbers chosen by Defra are completely arbitrary and are not supported by any market research or rigorous analysis.

 

In particular, Defra assumes that under the status quo or voluntary code accepting VERs (options 1 and 2a), consumer uptake will be 5%, whereas under its proposed voluntary CER code (option 3a), consumer uptake increases six-fold to 30%. No real argument or justification or market research is given to back up these random assumptions. Defra simply assumes that the introduction of its voluntary CER standard "might have a positive impact on consumer confidence in the offsetting market, and could therefore increase the take-up of offsetting products".

 

How this is quantifiably translated to a 30% consumer uptake is not explained, undermining any confidence or credibility in the conclusions drawn from the Defra Regulatory Impact Assessment ("RIA") exercise. As a result, without any documented justification or quantified market research, Defra should retain a 5% consumer uptake figure for its voluntary CER-only code scenario. In that case, the total emissions benefit to the environment will be the same as the status quo, at 5.4 MT/yr. While having a Government-endorsed code may increase consumer confidence and uptake in the market, it is not clear why a CER-only code as opposed to a VER-included code would not have a similar effect. And furthermore, differences in VER and CER prices are not incorporated into the consumer uptake analysis, a critical omission in any market impact assessment. A doubling in the cost of procuring carbon will undoubtedly have a downward effect on consumer uptake.

 

Below are summary answers to the questions raised by the Committee's Voluntary Carbon Offset Market Inquiry.

 

2) Should there be a compulsory UK or European accreditation scheme for carbon offset projects or companies? If so, how should this operate?

 

Yes, a UK government accreditation program should be implemented ensuring that the companies involved in the purchase and sale of VERs are creditworthy companies who may be held legally and financially accountable for the offsets they sell. This program should compliment the existing regulatory cap and trade scheme. This presents an enormous opportunity for the UK government to shape broad based international policy consensus regarding the creation and acceptance of internationally accepted high integrity performance standard, the VCS and fungible high quality certified VCUs stored in a industrial strength registry at The Bank of New York's VCU Registry. All verification and certification protocols for VCUs, including all baseline settings and monitoring reports, must be evaluated and interpreted only by United Nations Convention on Climate Change ("UNFCCC") accredited Designated Operation Entities ("DOEs") before the DOE can certify the VERs as VCUs under the VCS. This process adds significant costs but creates certainty, reduces risks and adds an additional layer of performance insurance regarding the robustness and permanence of each certified VCU. The BNY VCU Registry was created to suit the most stringent requirements of institutional clientele in the financial services community and should be adopted as the registry for the UK's voluntary program. The BNY is the world's largest provider of custodial services to the financial markets and is the first bank to provide a robust and credible registry for the voluntary carbon markets. BNY requires proof of title and evidence of ownership chain back to the point of origination, as well as a warranty by the depositor that the emission reductions have not been previously sold or double-counted elsewhere; each VCU has a unique serial number similar to a financial instrument. BNY holds physical custody of the title certificates and the

project documentation.

 

The international voluntary markets may soon evolve as the largest and most effective internationally accepted solution in the mitigation of CO2 and CO2e (CO2 equivalent).

 

3) Should offsetting become mandatory for some of the more carbon-intensive activities?

 

Yes, offsetting should be mandatory as this will create an internationally recognised market mechanism that can quantify the "cost of carbon" while discouraging additional investment in high carbon infrastructures and making a strong business case for increased capital market investments that will drive innovation in new technologies which can foster the transformation towards a less carbon intense global economy.

 

Participation in a robust voluntary scheme such as the VCS should reward early action and investment in new technologies. This same mechanism should severely penalise any additional or new investment in carbon-intense activities and infrastructures. Voluntary offsets may supplement the regulatory caps set by a comprehensive government scheme. A combination of both offset classes should be mandatory in offsetting carbon-intense activities.

 

4) Is there enough clarity within the offset market to allow customers to make informed choices based upon robust information about different schemes at different prices?

 

No, transparency and capital adequacy should be requirements for accreditation of all emission reduction offsets providers to clarify their financial and legal accountability and ensure that what the offset solutions they provide are exactly what they is represent them to be. This makes credible initiatives such as the Voluntary Carbon Standard a significant step forward in the international standardisation and advancement of the voluntary carbon markets. Offset providers are currently using proprietary protocols lacking the necessary components found in the VCS. These include: verification and certification of all reductions by DOEs, registration of all VCUs at The Bank of New York VCU Registry, transparent reporting of retired VCUs and more stringent accountability of the companies participating in the VCU markets. As this is an emerging market commodity asset class it is essential to create additional, robust, fungible internationally accepted VCUs that are generated from projects certified by DOEs and stored at The Bank of New York's VCU Registry. The Cheyne Carbon Fund contains globally diversified VCUs generated from many different

project types and categories.

5) Many offset projects involve afforestation or reforestation. Is the science sufficiently coherent in this area accurately to assess overall long-term carbon (or other GHG) gains and losses from such projects?

 

The VCS does not include GHG emission reductions generated from sectors where long term performance and permanence may be questionable such as: forestry, certain agricultural gasses, forward GHG reductions that have not yet occurred and therefore cannot be verified/certified, and emission reductions generated from project categories that have no existing certification protocol. Emission reduction projects receiving official development assistance/subsidies and or grants are also excluded from the portfolio.

 

6) Is there sufficient data available to guarantee accurate amounts of carbon or other GHG mitigation in the sorts of schemes that offset projects finance?

 

Verification and certification data of VCUs is extremely comprehensive and based on the CDM

methodology including baseline settings, monitoring reports and any other relevant data the UNFCC accredited Designated Operation Entities ("DOEs") may require to evaluate, interpret, guarantee and certify the exact quantity of GHG mitigated in accordance with the VCS protocol. This process may add significant cost but shall create the necessary certainty needed, adding an additional layer of performance insurance regarding the robustness and permanence of the exact amount of GHG mitigated by the VCUs certified by the DOE.

 

7) What impact will the voluntary carbon offset market have on the compliance market if the former

continues to grow as steadily as it has done over the last few years?

 

The voluntary and regulatory markets have completely different dynamics and characteristics and each market was created for a different purpose. The Kyoto protocol provided a tradable cap and trade framework on which the EU ETS was designed in conjunction with the UNFCCC. The EU ETS was the first large-scale internationally coordinated cap and trade system that allowed for GHG emission reductions to become freely traded as commodities. The extreme price volatility has illustrated the nature of this emerging market asset class. Random and arbitrary factors greatly influence and determine the arbitrary price action of emission reductions traded in the EU ETS. Governmental rules, artificially created allocations and timelines governing Phase I, II and III are major price determinants in the EU ETS. Any additional credits at the end of a crediting phase mean that the price falls to zero and all additional reductions are meaningless.

 

In the voluntary markets the corporations or individuals can determine what type of projects to purchase emission reductions from. Investment in verified and certified VCUs can promote investment in high quality sustainable development and drive investment in new technologies.

Regulatory uncertainty is a powerful driver in early recognition, evaluation, disclosure and mitigation of climate change risk. Failing to address climate change issues opens corporations up to regulatory scrutiny, investor scrutiny, as well as several other competitive and reputational risks.

 

8) What evidence is there to show that offsetting helps to change the carbon behaviour of the customer?

 

Recent opinion polls conducted indicate rapid public awareness and concern about climate change and global warming. The surveys indicate that 85% of the respondents believe action should be taken to mitigate the impacts of climate change and global warming and a further 61% said they would be willing to purchase offsets to mitigate the impact of their actions. The evolution of a voluntary universally credible, fungible, robust, commoditized and verified emission reduction unit or VCU will empower and motivate individuals and corporations to take responsibility for their actions. The substantial increase in volumes of voluntary carbon offsets purchased during the past twelve months provides evidence that global awareness and responsibility is rapidly increasing. As the science improves and receives more press, individuals and corporations take climate change, global warming and their responsibility to contribute to a solution more seriously.

 

9) To what extent are the schemes and projects funded by offset companies more broadly sustainable, in an environmental, social or economic sense?

 

The Carbon Fund maintains a well-balanced and globally diversified portfolio of emission reductions that are generated from projects with genuine environmental benefits and facilitates additional investment towards sustainable development.

 

It is important to differentiate between making a strong business case for capital market investment in new technologies that can significantly impact mitigation of CO2 and CO2 e and charitable contributions period. Many of the offset providers blur the line between these two.

 

As a participant and interested stakeholder in the voluntary carbon markets Cheyne will be available to provide further detailed evidence as requested by the Committee regarding either current or future questions pertaining to this inquiry. Thank you in advance for your consideration.

 

 

January 2007