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
mark.fulton@db.com
+1(212) 454-7881
Bruce M. Kahn, PhD

Director
Senior Investment Analyst: New York
bruce.kahn@db.com
+1(212) 454-3017
Mark Dominik
Vice President
Senior Research Analyst: London
mark.dominik@db.com
+44(20) 754-78943
Emily Soong
Research Analyst
New York
emily-a.soong@db.com
+1(212) 454-9227
Lucy Cotter
Research Analyst
London
lucy.cotter@db.com
+44(20) 754-75822
Jake Baker
Research Analyst
New York
jake.baker@db.com
+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
400
Concentration in 2008: 385 ppm
Atmospheric CO2 concentration, 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. Continued on next page.
i Investing in Climate Change 2009

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-and-
trade. 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 cli-
mate 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-friend-
ly 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 regu-
lated 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
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
iv Investing in Climate Change 2009

List of Exhibits & Boxes: Investing in Climate Change 2009
We draw from multiple sources to illustrate our thesis.
What is new in climate change investing?
Exhibit 2.1: The Four Pillars of Climate Change

Exhibit 2.2: Today’s CO2 concentrations are higher than they have been for at least 800,000 years
Box 2.1: The EPICA Project
Exhibit 2.3: Oil price trends
Exhibit 2.4: Trading Volumes on the EU-ETS are growing
Exhibit 2.5: Phase-II EU Carbon Prices have been trading near or above €20
Box 2.2: 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: Energy security

Exhibit 3.1: A low carbon Industrial Revolution is urgently needed

The credit crisis and climate change investing
Exhibit 4.1: The climate change universe has historically outperformed the world index
Exhibit 4.2: The ratio of the climate change universe to the world index
Exhibit 4.3: The climate change universe shows variable correlation to financial markets
Exhibit 4.4: The correlation of the climate change universe to financial markets over different timeframes
Exhibit 4.5: The correlation between energy and the solar sector
Exhibit 4.6: Historical P/E of the DWS Climate Change Alpha Pool vs. the MSCI World Index
Exhibit 4.7: Distribution of historical P/E of the DWS Climate Change Alpha Pool
Exhibit 4.8: Leading wind companies’ P/E with one year forward earnings
Exhibit 4.9: Leading solar companies’ P/E with one year forward earnings
Exhibit 4.10: VC investment: Informatiom Technology vs. cleantech ($ billion)
Exhibit 4.11: Sub-sector VC / PE investment by stage
Investment attributes of the climate change universe
Exhibit 5.1: Climate change: An integrated framework of mitigation and adaptation

Exhibit 5.2: The climate change investment universe
Exhibit 5.3: The illustrative lifetime of an identifiable investment theme
Exhibit 5.4: Economic correlations of climate change sectors
Exhibit 5.5: Climate change sector correlations with real GDP growth
Exhibit 5.6: Specific investment strategies for climate change
Exhibit 5.7: The climate change universe asset class fit
Exhibit 5.8: The performance of carbon beta leaders vs. laggards
Exhibit 5.9: The spread of market cap weighted returns of the climate change universe
Exhibit 5.10: The volatility of the climate change universe
Exhibit 5 11: The investment spectrum for the private market climate change universe
Exhibit 5.12: U.S. Private Equity Index® Compared to Other Market Indices for the One Year Ended December 31, 2007
Exhibit 5.13: What is infrastructure investing?
v Investing in Climate Change 2009

Exhibit 5.14: The low volatility of infrastructure investing
Exhibit 5.15: Infrastructure investing: Relative placement along risk return spectrum
Exhibit 5.16: Timberland investing: Relative placement along risk return spectrum
Box 5.1: Efficient frontier: Balancing risk and return
Exhibit 5.17: Inputs for efficient frontier analysis
Exhibit 5.18 Efficient frontier: Adding climate change can potentially add benefits to portfolios
Exhibit 5.19: Traditional portfolio 5% allocation of each climate change sector
Exhibit 5.20: Comparison of traditional portfolios with climate change strategies
Market sizing of the clean tech universe
Exhibit 6.1: Low carbon projected growth of renewable power generation

Exhibit 6.2: Water consumption and population growth
Exhibit 6.3: Demand and production of cereal food balances by 2030
Exhibit 6.4: Wind, solar, biofuels and fuel cells expected to see $254.5bn of global revenue by 2017
Exhibit 6.5: Total solar PV installations by 2013, Global (MW)
Exhibit 6.6: Total solar PV installations by technology by 2013, Global (MW)
Exhibit 6.7: Crystalline silicon continues to lead by global market share through 2013 - $64.1bn
Exhibit 6.8: Wind power installations, Global (MW)
Exhibit 6.9: Wind penetration by 2030, % of total generating capacity (MW)
Exhibit 6.10: Offshore wind projects
Exhibit 6.11: Energy storage market size by sector, Global $bn
Exhibit 6.12: Transportation energy storage market size, Global 2004 – 2012
Exhibit 6.13: Global sales of products incorporating nanotechnology by sector ($M)
Exhibit 6.14: Biofuels produced, Global (Gallons)
Exhibit 6.15: Ethanol production mostly from grain feedstocks except for Brazil, Global
Exhibit 6.16: Biodiesel production, Global
Exhibit 6.17: Global new nuclear capacity planned (GW)
Exhibit 6.18: Planned carbon capture & storage (CCS) projects
Exhibit 6.19: Annual worldwide cleantech investment is expected to reach $450bn by 2012 and $600bn by 2020
Exhibit 6.20: Global venture capital investments, 3Q 2008
Exhibit 6.21: Global venture capital investments by region, 3Q 2008
Exhibit 6.22: Total global new investment in clean energy 2007 & 1H 2008
Exhibit 6.23: Global new investment by technology 2007 & 1H 2008, $M
Exhibit 6.24: New investment by region (VC/PE, Public Markets, Asset Finance), 2004 vs. 2007
Exhibit 6.25: Global PE/VC transactions in clean energy companies, $M
Exhibit 6.26: VC/PE investment by technology, $M
Exhibit 6.27: Global asset financing, $M
Exhibit 6.28. Asset financing investment by technology, $M
Exhibit 6.29: Global transactions on public markets, $M
Exhibit 6.30: Public market investment by technology, $M
Exhibit 6.31: Growth of carbon markets: reported transaction volumes from 2003-2008, Gt CO2e
Exhibit 6.32: Potential total size of carbon markets in 2020
Exhibit 6.33: Sustainable energy funds by type and asset class, March 2008, $M
Exhibit 6.34: Carbon funds, 2004 – 2007, $M
Exhibit 6.35: Estimated number of climate change-related mutual funds/ETFs, March 2008
Exhibit 6.36: Estimated number of green hedge fund managers
Exhibit 6.37: Estimated number of private equity funds, September 2007
vi Investing in Climate Change 2009

Carbon and energy prices
Exhibit 7.1: More than half of greenhouse gas emissions came from fossil fuel combustion in 2005
Exhibit 7.2: CO2 emissions from fossil fuel combustion have increased dramatically since the
beginning of the Industrial Revolution
Exhibit 7.3: Over time, the US has transitioned from dirty, inefficient fossil fuels to cleaner,
more efficient fossil fuels
Exhibit 7.4: Energy demand is expected to increase significantly by 2030
Exhibit 7.5: The West Texas Intermediate crude oil price has been volatile
Exhibit 7.6: The majority of world oil reserves are concentrated in OPEC countries
Exhibit 7.7: The finding costs for oil are increasing
Exhibit 7.8: The finding costs of oil and oil price are related
Exhibit 7.9: Market views on long-term oil prices as of September 2008 (real $)
Exhibit 7.10: The Henry Hub natural gas price
Exhibit 7.11: The global supply/demand balance for LNG
Exhibit 7.12: The natural gas trade is increasingly global
Exhibit 7.13: Market views on long-term natural gas prices as of September 2008 (real $)
Exhibit 7.14: Newcastle coal price has recently spiked
Exhibit 7.15: The rapid expansion of coal use is likely to continue
Exhibit 7.16: Market views on long-term coal prices as of September 2008 (real $)
Exhibit 7.17: Oil and gas prices have been correlated with EUA prices
Exhibit 7.18: In the long-term, carbon and energy prices are likely to increase
Exhibit 7.19: Supply and demand equilibrium for substitutable fuels
Exhibit 7.20: The effect of carbon prices on equilibrium for substitutable fuels
Exhibit 7.21: Scaling capacity leads to greater uptake of clean energy
Exhibit 7.22: Supply shock: Constraints (peak oil scenario)
Exhibit 7.23: Supply shock: Surplus (coal glut scenario)
Exhibit 7.24: Demand expansion (emerging market growth scenario)
Government policy & regulation
Exhibit 2.1: The longer the world waits before beginning significant mitigation, the more radical the
cuts need to be
Box 2.1: Climate change: mitigation, abatement and cost
Exhibit 2.2: Different regulatory policies impact different parts of the greenhouse gas mitigation policy curve
Exhibit 2.3: There are three broad sets of policy options available
Exhibit 2.4: Examples of carbon pricing in practice
Exhibit 2.5: Looking for a global carbon price
Exhibit 2.6: Examples of traditional regulation in practice
Box 2.2: Renewable Portfolio Standards (RPS) in the US
Exhibit 2.7: 32 US states have Renewable Portfolio Standards
Exhibit 2.8: Examples of innovation policy in practice
Box 2.3: Feed-in tariffs
Exhibit 2.9: Uptake of regulatory policy in 60 countries
Exhibit 2.10: As mitigation options reach commercial breakeven, carbon price can replace most other incentives
Exhibit 2.11: Different regulatory policy sets impact different parts of the greenhouse gas mitigation policy curve
vii 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: Dynamics of commercial breakeven

Box 3.1: Calculating LCOE
Exhibit 3.2: Key drivers of LCOE for a specific technology
Box 3.2: Understanding electricity markets
Exhibit 3.3: Developing the investor’s spreadsheet
Exhibit 3.4: Using the investor’s spreadsheet to illustrate the risk/return drivers of alpha
Exhibit 3.5: Energy price, carbon and regulatory risk/return are engaged in a dynamic interaction
Exhibit 3.6: 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: Understanding mitigation through the stabilization triangle and Pacala and Socolow’s ‘wedges’
Exhibit 4.2: Combining wedges to achieve mitigation targets
Exhibit 4.3: The technology development pipeline
Exhibit 4.4: Examples of technological developments
Exhibit 4.5: 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
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
viii Investing in Climate Change 2009

• 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;


· 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)

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.

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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.

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 Carbon and Corporate Low carbon

environmental energy prices response: technologies
policy and
competitive and services
regulatory
drivers response and
risk mitigation
- Science
- Voters
- Low Carbon
prosperity
- Energy
security
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

EX 2.2: Today’s CO2 concentrations are higher than they have been for at least 800,000 years
400
Concentration in 2008: 385 ppm
Atmospheric CO2 concentration, 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 pre-
industrial 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 non-
linear 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

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.

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 bind-
ing 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:
· 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.

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.

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

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.
· 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.

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.

Corporate response: Competitive robust post-Kyoto agreement, com- change space, along with a growing
response and risk management panies are channelling funds towards number of hedge funds and private
increasing the supply of clean tech- equity managers;4
Corporations are faced with meeting nology and investment in the sector · No less an oilman than T. Boone
economic, environmental and social has grown; Pickens has announced plans to build
goals. As we discussed in Investing · Businesses also have been vocal 4 GW of wind capacity in Texas – and
in Climate Change: An Asset Man- at the G8, underscoring the need for is running commercials promoting
agement Perspective, there are two a ‘rapid and fundamental strategy to alternative energy;
key ways in which corporations will reach a low-carbon world economy’ · Renewable businesses are growing
respond within the economics in a paper delivered to Prime Minister to scale. Iberdrola Renovables was
of climate change: Fukada of Japan at the G8 meeting in the second biggest IPO of 2007 by
1. Competitive response and devel- Hokkaido-Toyako; funds raised, with a deal value of $6
oping the opportunity set – mainly · A McKinsey survey3 reveals that billion – and the funds raised by IPOs
focuses on mitigation. Climate 60% of global executives regard for clean tech companies across the
change becomes a focus of cor- climate change as strategically board increased by over 300%, from
porate attention and corporations important and a majority consider it $7.5 billion in 2006 to $32 billion in
launch new business opportunities; important to product development, 2007;5
2. Risk management – mainly investment planning and brand · As part of the Masdar Initiative, Abu
focuses on adaptation and corporate management. 34% of executives in Dhabi – an emirate that holds about
responsibility. Increasingly, markets China, 37% of those in Europe and 8% of the world’s oil reserves –
will start to focus on the net carbon 40% of respondents in India report broke ground in 2008 on a revolution-
position of companies and busi- that their companies frequently or ary clean city. The broader initiative,
nesses will integrate climate change always consider climate change in which was launched in 2006, aims
risk into their policies and procedures. overall strategy. to promote energy efficiency and
develop alternative sources of energy
Increased corporate focus on climate Competitive Response - Where are and $15 billion has been announced
change the opportunities? for new green investments;
· Alternative energy dominates capac-
Over the past year, the public Markets for climate change prod- ity additions in some markets: wind
discourse on climate change ucts and climate change-related made up 40% of newly installed
has been active: businesses are growing fast: electric power generation capacity in
Europe in 2007;
· In advance of the Bali conference, · In 2007, there were nearly 500 · Estimates show that the global mar-
150 leaders of global companies Private Equity and Venture Capital ket for emissions trading will soon be
issued a communiqué underscor- deals in climate change – represent- worth $150 billion;6
ing the urgency of climate change ing $13.5 billion of investment. This is · Global investment in sustainable en-
action. The business leaders wrote up 46% from 2006; ergy broke all previous records with
that a legally binding UN agreement · There were 1,900 Private Equity and $148.4 billion of new money raised in
to reduce greenhouse gas emissions Venture Capital investors in climate 2007, an increase of 60% over 2006;7
is necessary for businesses to make change in 2007; · The IEA forecasts a massive scale-
the right investments in clean tech- · In 2007, Germany, China and the up of investment to $45 trillion in
nologies and infrastructure, and that United States were the leading order to meet the joint objectives of
an extended carbon market needs investors in new renewable energy build-out of the energy infrastructure
to be part of the framework because capacity with $14 billion, $12 billion and mitigation of climate change.
it allows for flexibility and a low-cost and $10 billion respectively;
transition to a low-carbon economy; · There are close to 300 mutual
· As businesses have advocated for a fund managers acting in the climate 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

growing investing opportunity in climate tions; at dozens of companies and has

change in Chapter V of Part I. · Some insurance companies are engaged with regulators such
already adjusting their products and as the Securities and Exchange
Risk Management - What are services to suit emerging markets Commission by calling for publicly
the risks and how are they that have resulted from climate traded companies to assess and fully
being managed? change such as weather risk, carbon disclose their financial risks from
trading and the clean technology climate change. Deutsche Asset
· The insurance industry has already industry; Management was a signatory;
begun to feel the effects of climate · The Carbon Disclosure Project · We are seeing more attempts to
change and takes the issue serious- (CDP) operates to create lasting rela- measure the net carbon position of
ly. In the US insurers have started to tionships between shareholders and companies and then assess carbon
cancel homeowner policies in hur- corporations regarding implications risk or carbon beta.
ricane and wildfire risk areas; for shareholder value and commer-
· In 2007, a group of global insurers, cial operations presented by climate
re-insurers and brokers developed change. It represents 385 institution-
a set of ‘ClimateWise’ principles al investors with a combined $57.5
in response to global warming, de- trillion of assets under management;
signed to promote greener policies. · A coalition in the US, led by Ceres,
The principles will enable companies has encouraged improved climate
throughout the world to build climate change disclosure and governance
change into their business opera-
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.

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.

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.

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 Much of the debate about climate University of California, Berkeley,
energy security more than climate change has focused on the cost to indicates that California’s energy-
change just now in their push for the economy of implementing the efficiency policies created nearly
renewable energy policies. While the required clean-up. Indeed, Stern’s 1.5 million jobs from 1977 to 2007.
result may be similar in the short- analysis (See chapter 10 of the Stern Global insight has recently published
term, in the long-run, we believe that Review Report) was expressed in this a study citing the potential for green
climate change is a more serious way; however, as Stern points out job growth in the US.2 In light of these
challenge and a more encompassing (See page 240 of the Stern Review findings, US politicians have been
one for policymakers, and energy Report), there are many macro- vocal about the job creation potential
security should not be an excuse to economic climate change models of climate change: Barack Obama has
divert from renewables to dirtier fossil showing a wide range of economic proposed spending $150 billion over
fuel sources such as tar sands and oil outcomes. Some, which emphasize 10 years in a push to create 5 million
shale. the investment dollars needed to “green collar” jobs. He plans to raise
upgrade the economy’s infrastructure, this money by auctioning carbon
Low Carbon Prosperity – Economic show a net gain to the economy. It credits.
Growth Opportunities is this investment need (See Market
Sizing, Chapter VI of Part I), that the This raises the issue of the cost of a
In addition to increasing energy prosperity of the low carbon economy cap-and-trade system. Certainly some
security, politicians and business is based on and that provides the sectors will be affected by carbon
people are realizing that alternative opportunity for investors. pricing, but the scale and shape of the
energy can be a source of growth. impact depends on how the transfer
Over the past year, low-carbon Research by the Potsdam Institute costs are dealt with, as well as how
prosperity has entered the political indicates that, in Germany, the markets are designed. We discuss
discourse – policymakers now cite the transition to a low-carbon economy carbon market design in more detail in
creation of high-paying ‘green collar’ will spur a wave of innovation and Chapter II of Part II.
jobs as a major reason for pursuing job growth. A new study published
ambitious innovation policy in the by the Center for Energy, Resources
cleantech space. and Economic Sustainability at the
1
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.
2
US Metro economies: Current and potential jobs in the US economy, Global Insight, 2008.

Nevertheless, we believe that comments of politicians around the McKinsey Global Institute published
anything that resembles a tax or world, as collected in box 3.3. a report outlining the challenge
increase in cost will need to be well of raising carbon productivity,
understood and phased-in to gain We discuss the short-term magnitude comparing the potential to the rise
acceptance. Right now, the focus is of the investment task in Chapter VI in labor productivity in the Industrial
more on providing a stimulus to the of Part I. However, it is worth looking Revolution. See exhibit 3.1
economy through incentives. This at the challenge from a long-term
becomes evident in reviewing the perspective. In June, 2008, the
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
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 world’s infrastructure. Over the Where infrastructure investments
productivity required to meet long- past 150 years, thousands of cities, are climate-friendly – such as many
term stabilization targets will require airports, highways, power plants and investments in water, agriculture,
a revolution on the scale of the factories have been built – many of renewables, energy efficient buildings
Industrial Revolution. But while, in the which rely on fossil fuels and carbon- and public transport – they fit the
Industrial Revolution, it took over 120 intensive processes. We are entering broader climate change investing
years for labor productivity to rise 10- a period of massive capital stock theme.
fold, we have only 40 years to achieve turnover in the next few decades.
a commensurate increase in carbon Much of the aging infrastructure in Against the backdrop of the scale of
productivity. the West will need to be replaced, investment that needs to be made in
and the global infrastructure base clean energy and infrastructure, some
Some of the challenge in raising will expand dramatically as China, commentators see the potential to
carbon productivity will lie in a India and the rest of the developing reinvigorate the broader economy.
massive decarbonization of the world continue to rapidly industrialize. In his 2008 book Bad Money, Kevin

Phillips argues that the recent ‘Green is not simply a new form of
economic turmoil is caused by an generating electric power,’ added
over-reliance on debt and the financial Rothkopf. ‘It is a new form of
sector in the US. The way to rebuild generating national power – period.”3
the economy, according to Phillips,
is through activities that create real The challenge is great, and so is the
value. The one he cites as holding the opportunity. The Industrial Revolution
most promise is alternative energy: was a time of great innovation –
not only would it create high-paying, the steam engine, the telegraph,
domestic jobs, but it would also the locomotive, the telephone, the
decrease America’s dependence on airplane, the automobile and the
imported oil and on the willingness of sewing machine all came into being
oil-exporting states to buy US debt to in that time of great change. The life
finance America’s thirst for energy. expectancy and standard of living
of most Westerners improved as a
Thomas Friedman’s thesis in his most result of the Industrial Revolution.
recent book, Hot, Flat and Crowded Increasingly, intellectuals and writers
also underscores the potential that are recognizing that a low carbon
a low carbon Industrial Revolution Industrial Revolution holds much of
holds. Friedman quotes an interview the promise of the original Industrial
with energy expert David Rothkopf as Revolution. And politicians are
he sets up his thesis: beginning to develop policy proposals
that would begin to implement these
“The hallmark of those companies ideas.
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
Thomas Friedman, Hot, Flat and Crowded, 2008, p. 23.

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
McKinsey-Vattenfall greenhouse gas abatement cost curve, 2007.

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 low-
carbon 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
The Economist, September 2008. The Frugal Cornucopian

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 low-
energy 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,

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.

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 availabil-
ity 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.

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 regula-
tory 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
60
10/17/08
1/2/06
3/2/06
5/2/06
7/2/06
9/2/06
11/2/06
1/2/07
3/2/07
5/2/07
7/2/07
9/2/07
11/2/07
1/2/08
3/2/08
5/2/08
7/2/08
9/2/08
HSCCBT Index 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
80
11/2/06
11/2/07
1/2/06
3/2/06
5/2/06
7/2/06
9/2/06
1/2/07
3/2/07
5/2/07
7/2/07
9/2/07
1/2/08
3/2/08
5/2/08
7/2/08
9/2/08
10/17/08
Source: Bloomberg, DeAm analysis, 2008.

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
MSCI MSCI
Crude Oil SP 500 ECO Index Commodity Water AG SP Energy HSBC CC MSCI Ind MSCI WE NEX Index
WORLD SmCap
Crude Oil 1.00
MSCI WORLD 0.00 1.00
SP 500 -0.21 0.97 1.00
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 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 En-
ergy 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 out-
performance 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 correc-
tion 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
MSCI SP 500 ECO Index Commodity Water AG SP Energy MSCI MSCI Ind
HSBC CC VS Crude Oil
WORLD SmCap
Jan 2007 to Nov 2007 0.86 0.95 0.88 0.91 0.87 0.96 0.95 0.94 0.28 0.83
From Nov 2007 to May 2008 0.18 0.91 0.84 0.71 -0.15 0.90 0.17 0.62 -0.05 0.06
From May 2008 to Sept 2008 0.81 0.96 0.84 0.92 0.81 0.96 0.96 0.93 0.55 0.62
CORRELATION LESS THAN 0.4 CORRELATION BETWEEN 0.4 AND 0.65 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

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. How-
ever, 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 correspond-
ing 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 sup-
port 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)
$160 $180
Relationship breaks $160
$140
down on subsidy
Solar Market Cap($bn)

concerns $140
Oil Price (USD/bbl)
$120
$120
$100
$100
$80
$80
$60
$60
$40
$40
Good correlation between
$20 oil and solar $20
$0 $0
5
8
05
06
07
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
1/
1/
1/
30
31
30
30
31
30
30
31
30
30
/3
/3
/3
9/
3/
6/
9/
3/
6/
9/
3/
6/
9/
12
12
12
Oil Prices 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 begin-
ning 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 In-
vestment 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 experi-
enced 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 govern-
ment policies and the general economic impetus required to tackle climate change.

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 Mar-08 Jun-08 Sep-08
DWS Climate Change Alpha Pool MSCI World

Source: Bloomberg, DeAM analysis, 2008.
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
120
125 108
120
106
Companies (P/E>0)
Companies (P/E>0)
80 74
80 70
56 57
40 35 40
25 27 31
19 25 22
19
6
0
0
<5 5-10 10-15 15-20 20-25 25-30 30-35 >35
<5 5-10 10-15 15-20 20-25 25-30 30-35 >35
Range of P/E
Range of P/E
Distribution of P/E 2007 Distribution of P/E 2005
120 120
96 96
91
Companies (P/E>0)
Companies (P/E>0)
86
80 74 80
56 58
41 44
40 40 35
28
27
20 17
15
12
0 0
<5 5-10 10-15 15-20 20-25 25-30 30-35 >35 <5 5-10 10-15 15-20 20-25 25-30 30-35 >35
Range of P/E Range of P/E


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 15-
20x. 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
Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep-
07 07 07 07 07 08 08 08 08 08 08 08 08 08
GAMESA NORDEX SUZLON VESTAS
Source: HSBC, September, 2008.

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.
Solar Sector
EX 4.9: Leading PriceP/EEarnings
solar companies’ with
with one year forward 1 year forward earnings
earnings
120.0
10/07: FSLR reached 248x
100.0
80.0
60.0
40.0
20.0
0.0
08
08
08
08
08
08
8
8
08
07
07
07
07
07
08
08
08
00
00
00
00
00
00
00
00
00
00
00
20
20
20
20
20
20
0
20
20
20
20
20
20
20
20
/2
/2
/2
/2
/2
/2
/2
/2
/2
/2
/2
6/
4/
1/
/
/
2/
6/
3/
1/
4/
5/
9/
4/
8/
25
23
20
18
15
29
12
26
11
31
14
28
/9
/7
18
5/
6/
7/
8/
/1
/2
/2
/2
1/
2/
2
11
12
4/
5/
6/
7/
8/
8/
9/
9/
4/
8/
9/
9/
1/
2/
2/
3/
3/
10
10
11
12
K\YOCERA SHARP REC WACKER CHEMIE Q-CELLS MEMC SUNTECH SOLARWORLD 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.

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
0
2000 2001 2002 2003 2004 2005 2006 2007
IT VC Cleantech VC
Source: New Energy Finance, McKinsey, September, 2008.

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 particu-
larly 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 transi-
tion 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 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Total
Wind $381 $610 $440 $384 $154 $1,947 $3,924
VC Early Stage $5 $21 $32 $5 $2 $14 $82
VC Late Stage $5 $22 $53 $0 $39 $0 $118
PE Expansion Capital $140 $52 $24 $212 $13 $653 $1,095
PE Buy-out $110 $414 $300 $137 $97 $1,024 $2,083
PIPE/OTC $120 $100 $39 $26 $5 $256 $545
Solar $798 $961 $1,183 $841 $919 $1,526 $6,221
VC Early Stage $161 $195 $205 $156 $215 $139 $1,072
VC Late Stage $5 $80 $264 $135 $69 $63 $617
PE Buy-out $0 $422 $267 $255 $40 $838 $1,822
PIPE/OTC $70 $56 $267 $105 $272 $110 $891
Biofuels $865 $276 $347 $538 $467 $1,018 $3,511
VC Early Stage $69 $57 $29 $47 $24 $110 $325
VC Late Stage $0 $33 $1 $84 $36 $123 $278
PE Buy-out $221 $171 $74 $0 $107 $0 $573
PIPE/OTC $79 $10 $118 $118 $8 $24 $296
Source: NEF, September, 2008.

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.

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. The climate change universe

2. Persistence of climate change as an identifiable alpha source
3. Fundamental attributes of climate change
4. Applying climate change to different asset classes
5. 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).

EX 5.1: Climate change: An integrated framework of mitigation and adaptation
Climate change Climate change
Adaptation
Temperature rise Food and water
Sea-level rise resources Ecosys-
Precipitation change tem and biodiversity
Droughts and floods Human settlements
Human health
Orange arrows: cycle of cause and effect

Adaptation
Blue arrows: societal response to climate change impacts
Socio-economic
Climate change development paths
Mitigation
Economic growth
Greenhouse gases Technology
Aerosols 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 Energy & Material

Clean Energy Environmental Services
Management Efficiency
Power Generation Water Advanced Materials Environmental Protection

Solar Desalination / purification Advanced coatings Land conservation
Wind Wastewater treatment Lightweight substitues Environmental restoration
Clean coal (sequestration, infrastructure) Distribution and management Solvents and biodegradables Timberland
Other clean power generation (Geothermal, Forestry
hydro, biomass, wave / tidal, methane Sea defenses
capture, nuclear)
Agriculture Carbon
Building Efficiency
Irrigation innovation
Building management including
Clean pesticides
Cleantech Infrastructure Consumer food purity
green data center management Business Services
Infrastructure management Heating & cooling systems Insurance
Seeds
Supply chain management Lighting systems Logistics
Timberland
Insulation Green focused banking
Micro generation / micro CHP Microfinance
Power Storage Technology Consultancy/advisory
Battery technology and fuel cells Waste Management Intellectual property
Recycling Power Grid Efficiency Weather
Toxin management Transmission (including smart grids)
Energy from waste Smart metering
Transport & Sustainable Biofuels Land remediation Storage
Low carbon transportation Infrastructure
Bio-diesel, ethanol
Source: DeAM analysis, October, 2008.

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 materi-
als 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 process-
es are emerging to purify and treat water, which can include drinking, industrial or medical uses, and to allow treated wa-
ter 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 competi-
tive advantage for new technologies. Such materials include innovative coatings, lightweight substitutes, solvents/biode-
gradables, 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 infrastruc-
ture.
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-and-
trade), while weather derivatives allow companies to hedge the impacts of weather activities on their financials. Compa-
nies 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.

EX 5.3: The illustrative lifetime of an identifiable investment theme
1 2 3
Theme idenitified as Theme becomes Theme matures,

a return driver widely known becoming part of the
market

Time
We define persistence to mean a fac- and technologies, are likely to remain challenge of mitigation, as pointed out
tor identifiable at a quantitative level for many years. in earlier chapters, is very significant.
that leads to distinct excess returns Government regulations are creating
over the long term. In our paper, Indeed, for strategies focused on market conditions that are conducive
Investing in Climate Change: An identifying, developing, and com- to a global “mega trend” for decades
Asset Management Perspective, mercializing innovative new tech- to come. Nonetheless, as an invest-
published last year, we identified nologies, the potential for sustainable ment theme, it should be regularly
climate change as such a theme. The returns will remain. As the sector evaluated using quantitative factor
question is how long it will remain a matures, technologies will become analysis to verify its continued persis-
distinct theme. In 2006 and 2007, cli- more complex, requiring ever more tence in terms of excess returns.
mate change acted as a separate and specialized expertise. Climate change
identifiable theme as evidenced by its venture capital and private equity Fundamental attributes of the
excess returns relative to the broader investors should expect a long term climate change universe
market (See Exhibit 4.1). During persistence of the theme as it relates
2008, this has corrected, but we view to their focus. The acceptance of the Climate change sectors: Economic
this as a short term phenomenon of theme by the broader market only attributes
the credit crisis. offers a more diverse end-market into
which they can sell technologies and Looking at the climate change uni-
The question of when the theme companies. verse, sectors of the economy that
begins to become the new “normal” give rise to significant investment op-
and is submerged within the overall Infrastructure investment strategies portunities often have low correlation
market will have different implications are designed to provide stable returns to the broader economy. For example,
for different asset classes. Listed eq- to investors, and the scope of climate annual growth in agriculture exhibits
uity and hedge funds may find it more change will require enormous new low correlation to GDP. Secondly,
difficult at the far end of our time ho- infrastructure. The installation of new the correlation of the annual growth
rizon to successfully pick stocks that infrastructure projects will extend far in energy consumption with annual
can be appropriately classified within into the future. It is possible that “cli- GDP is moderate and has declined
the climate change sector. This could mate change” aspects of infrastruc- over time. The correlation of renew-
happen if large, diversified companies ture investment will merge into nearly able energy with GDP has been much
become dominant and the notion of every “normal” project. As such, they lower. Water utilities also exhibit low
“renewable” fades into “energy.” As would no longer be identifiable in correlation to real GDP growth. The
discussed later in this chapter, climate a separate sense. economic attributes of key climate
change could ultimately become change sectors exhibit low correlation
simply a factor in an overall diversified Overall, as a global economic mega- to the general economy. Obviously,
portfolio, measured by carbon risk trend, we believe that climate change housing and construction would be
and carbon beta. Having said that, will persist as an investment theme more correlated, particularly at the
smaller, emerging pure plays repre- that requires specialized knowledge. moment.
senting innovative business models The capital needed to confront the

EX 5.4: Economic correlations of climate change sectors
Correlations of sector real growth with real GDP growth
1978-2006
Private industries 0.99
Agriculture, forestry, fishing, and hunting 0.20

Farms 0.20
Forestry, fishing, and related activities 0.07
Utilities Correlations of sector real growth with real GDP growth 0.32
1978-2006
Waste management and remediation services 0.60
Private industries 0.99
Correlations of energy consumption growth (by type) with real GDP growth
Agriculture, forestry, fishing, and hunting
Source: DeAM analysis, 2008. 0.20
Hydro and
Solar and Wood and Total
Total energy Petroleum Nat gas Coal Nuclear
Farms Wind Geothermal Waste renewables
0.20
0.78
1950-2007 Forestry, 0.69
fishing, and 0.48
related activities 0.57 n/a -0.11 n/a 0.16 -0.05
0.07
1965-2007 0.73 0.69 0.36 0.59 n/a -0.13 0.08 0.20 -0.07
Utilities 0.32
1990-2007 0.51 0.75 0.02 0.47 -0.19 -0.07 -0.14 0.25 0.04
Waste
EX 5.5: Climate management
change and remediation
sector correlations withservices
real GDP growth 0.60
Correlations with real GDP growth
Correlations of energyTotal
consumption
Ag growth
Farms(by type) with real GDP growth
Other
1948-2007 Solar- and Hydro and - Wood and Total
Total energy Petroleum Nat gas 0.04 Coal Nuclear
Wind Geothermal Waste renewables
1978-2007 0.20 - -
1950-2007 0.78 0.69 0.48 0.57 n/a -0.11 n/a 0.16 -0.05
1978-2006 0.20 0.20 0.07
1965-2007 0.73 0.69
1985-2006 0.36 0.34 0.59 0.33 n/a -0.13
0.14 0.08 0.20 -0.07
1990-2007 0.51 0.75
1990-2006 0.02 0.40 0.47 -0.19
0.39 -0.07
0.18 -0.14 0.25 0.04
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
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.

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 renew-
able 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
Long/Short • Biofuels
Cimate Equity • Renewables
• Water
+
FoF CDM
Carbon Carbon Carbon Fund Venture
Trading Project Capital
Origination Clean Tech
Diversified Clean
Physical Infrastructure Tech
Forestry small
Commodities
company
Including
Equities
carbon
Commodities
Including Agribusiness
renewables DIVERSIFIED CLIMATE
ESG
• Retail Mutual Funds Climate
Risk
• Institutional Funds Screeen

• Structured Products
• New Resources
• Climate Mitigation
• Climate Adaption
Looking for business opportunities in companies

working on climate related products / services
-
Environmental Focus
0 ++

EX 5.7: The climate change universe asset class fit
Asset Class Listed Equity VC/PE Infrastucture Hedge Funds
Relevant asset
• Broad • Emerging • Established • Access to all asset
class attributes
opportunity set technology sectors with: classes including
for diversification cycles • Solid cash flows progressive (i.e.
across universe • Low volatility carbon, weather)
• Capital • Large capital
Relevant Climate
requirements requirements • Wide dispersion
Change sectors
• Government of returns
• Clean energy
•Invest along supported
• Environmental
• Diversified large the value chain e.g. • Utilize high volatility
resource
companies where • Solar for upside and
management
climate change is • Biofuels • Public transport downside profit
• Energy and
making an impact • Smart grid • Pipelines, e.g.
material efficiency
• Batteries water and CO2 • Derivatives and
• Environmental
• Pure play established • Etc. • Electricity grids other instruments
services
companies
• Hedging
• Policy and
• Emerging microcap index/commodities
regulatory
from VC/PE cycle where applicable
support for many
sectors
Source: DeAM analysis, October, 2008.
In exhibit 5.7, key asset classes are covered a year ago in Investing In Cli- ing climate change parameters
associated with a set of climate mate Change. In terms of alpha gen- such as carbon risk into the overall
change attributes to match their suit- eration, we have already looked at the investment process in listed equities
ability. Investment attributes provide 2006 – 2007 bull run where climate has emerged as a new opportunity.
background for different asset classes change generated out-performance. Investors in listed equities can assess
and climate change sectors offer the degree to which portfolios are
investment opportunities across all The out-performance by the climate subject to climate change risk by ad-
stages of the investment spectrum change universe indicates that mar- dressing carbon intensity of different
from venture capital through to listed kets were responding to the broader industry sector exposures, individual
equities. It is deep knowledge of economic demand of adapting to and company risk positioning and carbon
investment attributes that provides mitigating against climate change, and financials (e.g., the costs of compli-
investors with an information advan- this was a source of excess return. ance).
tage. In 2008, about 40% of the excess
returns generated by climate change Going further and explaining the
Listed equities in 2006/2007 have been lost on the “risk” scale of the equation, investors
Listed equities offer investment downside so far. However, the regula- could enhance climate change invest-
opportunities in established and new tory support, along with the longer- ments by including carbon leaders in
companies, a broad range of sectors term need for the products and ser- the portfolio and avoiding or shorting
and market capitalizations, and are vices in climate change, indicates to carbon laggards. Innovest Strategic
for the most part highly liquid. In the us that as the dust settles, even with Value Advisors, for example, has con-
DWS Climate Change Alpha Pool, we a period of weaker energy prices, ducted studies on this effect and has
have identified and tracked over 1,000 climate change can outperform. shown significant out-performance by
companies that fall within the scope carbon leaders (Exhibit 5.8).
of climate change related themes. Measuring carbon’s role in portfolios
Investing in listed equities and the In addition to investing in mitigation
DWS Climate Change Alpha pool was and adaptation companies, integrat-

EX 5.8: Carbon beta leaders versus laggards
Return for Annualized Annulaized
All sectors 14 quarters return difference
Carbon beta Rating Leaders 60.18% 17.19% 1.92%

monthly average return
Carbon beta Rating Laggards 53.45% 15.27%

monthly return
Exhibit 5.8 shows a 1.92% premium for compa-

nies 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 mea-
sure 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 long-
only 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 EX 5.10: The volatility of the climate change universe
of the climate change universe
35% 30.0%
25.0%
30%
20.0%
25% 15.0%
10.0%
20%
5.0%
15% 0.0%
Nov-05
Nov-06
Nov-07
Apr-06
May-06
Apr-07
May-07
Apr-08
May-08
Jan-06
Feb-06
Mar-06
Jun-06
Jul-06
Aug-06
Jan-07
Feb-07
Mar-07
Jun-07
Jul-07
Aug-07
Jan-08
Feb-08
Mar-08
Jun-08
Jul-08
Aug-08
Dec-05
Dec-06
Dec-07
Oct-05
Oct-06
Oct-07
Sep-06
Sep-07
Sep-08
Nov-05
Nov-06
Nov-07
Apr-06
May-06
Apr-07
May-07
Apr-08
May-08
Jan-06
Feb-06
Mar-06
Jun-06
Jul-06
Aug-06
Jan-07
Feb-07
Mar-07
Jun-07
Jul-07
Aug-07
Jan-08
Feb-08
Mar-08
Jun-08
Jul-08
Aug-08
Dec-05
Dec-06
Dec-07
Oct-05
Oct-06
Oct-07
Sep-06
Sep-07
Sep-08
Source: DeAM analysis, 2008. 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.

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–

$100 million
$20 million $100 million
First Project
Company Technology Business Company
Pilot plant Demo plant commercial portfolio
Stage development strategy expansion
plant finance
Venture Capital Private equity

Investment Infrastructure Buyout/PIPES
Style Angel/ Equity
A Round B&C Round D Round/Exit-IPO
Sector knowledge, Company

Investment Technology expertise, sector kowledge, building, Financial engineering Project Market
Attributes Management building Material knowledge finance 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 cor-
relation 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.

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 2.32
Russell 2000 ®
-1.57
-5 0 5 10 15 20 25
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.

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 opportuni-
ties, broadly defined as all developed infrastructure and not “greenfield” development opportunities. Mature infrastruc-
ture funds generally have somewhat different strategies and targeted returns, but most share certain unique features in-
cluding: (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 invest-
ment profiles. Clean energy developments can offer investors a fixed income stream, as they typically sell their gener-
ated 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 wide-
spread all-encompassing electricity grids and power generation, energy storage, and water infrastructure.
EX 5.13: What is infrastructure investing?
Transport Utilities Other Social infrastructure
• Bridges • Gas networks • Parking garages • Education facilities
• Toll roads • Electricity networks • Storage facilities • Healthcare facilities
• Tunnels • Power generation • Correctional facilities
• Airports • Water & sewerage
• Sea ports • Renewable energy
• Freight rail • Communications
• Public transportation infrastructure
Focus on: “User-pays” assests that provide essential services Not a focus at this time
capable of generating a strong and stable cash return
Source: RREEF analysis, October 2008.

EX 5.14: The low volatility of infrastructure investing
Return rank Mean return Volatility (Std. Dev.)
Stocks: Wilshire REIT 1 13.9 17.4

Russell 2000 Stock Index 2 10.6 17.9
NAREIT-Equity REITs 3 10.0 6.4
Standard & Poor’s 500 4 9.8 14.6
Core Real Estate: NCREIF Property Index 5 10.3 6.4
Bonds: U.S. Long-Term Govt. Bonds 6 7.8 2.5

U.S. Int-Term Govt. Bonds 7 7.7 2.7
U.S. 30-Day Treasury Bills 8 5.3 3.2
U.S. Inflation (CPI) 9 4.1 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”
Opportunistic real estate investment strategies
Growth infrastructure
“Value added”
Potential reward
Value-added real estate investment strategies
Mature infrastructure
Real estate securities
Listed infrastructures “Core”

securities investment strategies
Core plus real estate
Core real estate
Source: RREEF analysis, October 2008. Risk

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 inves-
tors 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 pos-
sible 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
Timberland Equities
12%
10% S&P 500

International
Commercial Real Eastate* Equities*
8%
Long-Term Corporate Bonds
6% U.S. Treasury Bills
4%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation (%/Year)
Source: Hancock Timber Resource Group, October, 2008.

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 variabil-
ity of an investment plan’s returns over time and that there is 35-40% variability of returns across investors. The ‘unex-
plained’ portion of return is from a variety of sources including style within asset classes.
Box 5.1: Efficient frontier: Balancing risk and return
The efficient frontier provides a method of comparing the relative

risk/return profiles of different portfolios. With increasing risk, a [ For illustrative purposes only ]
portfolio is typically expected to return at a higher rate. A traditional
portfolio consisting of a mix of cash, bonds, and public equities Overall investment strategy that seeks to construct an optimal portfolio
can be expected to generate a moderate risk-adjusted return. This by considering the relationship between risk and return
return is tightly correlated to the amount of risk that the portfolio

Target Portfolio With
holds.
Alternatives
When alternatives are introduced to the portfolio, the potential

Expected Return
return may increase. More importantly, however, a portfolio of

alternatives can provide a potential increase in returns with a lower
Efficient Frontier
amount of corresponding risk. Additionally, the plot of the alterna-
tive risk/return profile is not as linear as the tradtitional portfolio. Risk-Free Asset
The return increases rapidly with commensurately less risk
increase, until a point on the curve when the increase of return
Risk
begins to slow and the increase of risk begins to speed up.
Source: DeAM analysis, October 2008.
Successful portfolio allocation can move the efficient frontier further
and further above the line plotted by the traditional portfolio.
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).

In the following table we show the historical returns and volatility of the respective indices that we used for our analysis.
EX 5.17: Inputs for efficient frontier analysis [ For illustrative purposes only ]
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% - -
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%
7.0%
6.5%
Expected Return
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
From a historical perspective, while all three portfolios with climate change indices did shift to the right on the volatil-
ity 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.

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 signifi-
cantly 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

Target Return: 4.00% 6.00% 8.00%
Manager
MSCI WORLD 29.19% 36.92% 36.92%
CITIGROUP WORLD BIG (HEDGED) 55.81% 48.08% 48.08%
CLEAN ENERGY 5.00% 5.00% 5.00%
AGRICULTURE 5.00% 5.00% 5.00%
WATER 5.00% 5.00% 5.00%
Probability of Outperforming Target Return 58.4% 49.62% 40.68%

Probability of < 0% Return 23.84% 23.98% 23.98%
Expected shortfall versus Target Return 2.30% 3.23% 4.34%
Conditional shortfall versus Target Return 5.54% 6.41% 7.31%
Mean Return 6.32% 6.23% 6.23%
Volatility 7.98% 7.98% 7.98%
[ For illustrative purposes only ]

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 alloca-
tion 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.

EX 5.20: Comparison of traditional portfolios with climate change strategies
Traditional
Target Return: 4.00% 6.00% 8.00%
Manager
MSCI WORLD 62.34% 62.34% 62.34%
CLEAN ENERGY - - -
AGRICULTURE - - -
WATER - - -

Mean Return 5.53% 5.53% 5.53%
Volatility 8.01% 8.01% 8.01%

Target Return: 4.00% 6.00% 8.00%
Manager
MSCI WORLD 57.72% 57.72% 57.72%
CLEAN ENERGY 1.00% 1.00% 1.00%
AGRICULTURE 1.00% 1.00% 1.00%
WATER 1.00% 1.00% 1.00%

Mean Return 5.68% 5.68% 5.68%
Volatility 8.04% 8.04% 8.04%

Target Return: 4.00% 6.00% 8.00%
Manager
MSCI WORLD 47.80% 47.80% 47.80%
CLEAN ENERGY 3.00% 3.00% 3.00%
AGRICULTURE 3.00% 3.00% 3.00%
WATER 3.00% 3.00% 3.00%

Mean Return 5.97% 5.97% 5.97%
Volatility 8.04% 8.04% 8.04%

Target Return: 4.00% 6.00% 8.00%
Manager
MSCI WORLD 29.19% 36.92% 36.92%
CLEAN ENERGY 5.00% 5.00% 5.00%
AGRICULTURE 5.00% 5.00% 5.00%
WATER 5.00% 5.00% 5.00%

Mean Return 6.32% 6.23% 6.23%
Volatility 7.98% 7.98% 7.98%
Source: DeAM analysis, October, 2008. [ For illustrative purposes only ]

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 $45 trillion needed by 2050

In the absence of major regulatory changes, the Interna- To meet increasing renewable energy demand, along with
tional Energy Agency (IEA) forecasts a 70% increase in oil a greenhouse gas emissions reduction target of 50%
demand by 2050, and a 130% increase in CO2 emissions, from 2005 levels by 2050, the IEA finds that $45 trillion of
compared to 2005 levels. However, with ambitious new investment will be needed from present day through 2050.
policies, emissions can be reduced significantly and oil Capital would need to be heavily deployed into the
demand can be reduced by 27% compared to the 2005 development of next-generation technologies to
level. Renewable energy sources have the potential to create energy efficiency and low carbon options.
comprise 46% of total electricity supply by 2050,
See exhibit 6.1.

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
5000 World Population
7
4000 6
billions
5
km3
3000
4
2000 3
2
1000
1
0 0
00
20
40
50
60
70
80
90
00
10
20
30
19
19
19
19
19
19
19
19
20
20
20
20
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.

II. Underlying technology market EX 6.4: Wind, solar, biofuels and fuel
cells expected to see $254.5bn of global
size projections 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, EX 6.6: Total solar PV installations by

Global (MW) technology by 2013, Global (MW)
EX 6.7: Crystalline silicon continues to lead by global mar-

ket share through 2013 - $64.1bn

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.

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”.

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.

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.

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
3Q 2008 Investment update EX 6.20: Global venture capital investment, 3Q08
Despite the impact of the global credit crisis on market condi-

tions 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
water & wastewater, agriculture, advanced materials and recy- $167

$123
cling, among others. All together, the Cleantech Group found $98
$80
that there were 127 disclosed VC financing deals, in comparison

Solar
Wind
Biofuels
Transportation
Water &
wastewater
Agriculture
to 106 in the last quarter.
In 3Q08, the solar industry dominated once again, primarily driv- 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.

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 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/indica-
investment. See exhibit 6.23. tive 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.

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 invest-
ments was made, of which $6.1 billion was new investment.
Given the historical rate of growth, we expect the clean technol-
ogy 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 EX 6.26: VC/PE investment by technology, $M
energy companies, $M
Source: New Energy Finance.

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 invest-
ments (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. Source: New Energy Finance, 2008.
EX 6.28: Asset financing investment by technology, $M

Public markets EX 6.29: Global transactions on public markets, $M
In 2007, there was $23.4 billion of new equity raised on public mar-
kets 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 down-
turn. 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.

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 Develop-
ment 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.
Source: Point Carbon, 2008.

The United States currently has three emerging markets: Regional
Greenhouse Gas Initiative 2003 (covers 10 North-East/Mid-Atlantic
EX 6.32: Potential total size of carbon markets in 2020
states), Western Climate Initiative 2007 (covers 11 US and Ca-
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.

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, EX 6.34: Carbon funds, 2004 – 2007, $M
March 2008
29,968
26,396
Source: New Energy Finance, 2008. Clean energy funds: those that invest more than 50% in renew- Source: New Energy Finance, 2008.
able 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.
EX 6.35: Estimated number of climate change-related EX 6.36: Estimated number of green hedge fund managers
mutual funds/ETFs, March 2008
Source: Lipper FERI, Strategic Insight, Simfund. Notes: Data also include Source: DeAM analysis, 2008.
clean technology and energy funds, 2008.
EX 6.37: Estimated number of private equity funds, September 2007

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.

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

6% 1%
CH4 other
11%
CH2 other
3%
CO2 fossil fuel use

CO2 deforestation 55%
decay
3%
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.

EX 7.2: CO2 emissions from fossil fuel combustion have increased dramatically since the beginning of
the Industrial Revolution
30,000 Carbon emissions from gas flaring
Carbon emissions from solid fuel

consumption
25,000
Carbon emissions from liquid fuel
consumption
Carbon emissions from gas fuel

20,000
consumption
Mtons / Year
15,000
10,000
5,000
0
05
12
19
26
33
40
47
54
61
68
75
82
89
20 6
03
51
58
65
72
79
86
93
00
07
14
21
28
35
42
49
56
63
70
77
84
91
98
9
19
19
19
19
19
19
19
19
19
19
19
19
19
19
17
17
17
17
17
17
17
18
18
18
18
18
18
18
18
18
18
18
18
18
18
18
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
60
Percent
oil
40
gas
animal feed
20
nuclear and
renewables
0
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
Source: Energy Bulletin; US EIA; DeAM analysis, 2008.

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
Spatial distribution: supply is increasingly concentrated

Volumetric density: the concentration of energy in a given
in difficult-to-access regions (e.g. the North Slope, Siberia,
volume has significantly increased.
deepwater Gulf of Mexico).
Financial risk: financial risk of developing energy sources
Gravimetric density: the energy-to-weight ratio has improved. 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 Risk to human health: Oil and natural gas pose greater risks
increased. to human health than wood.
Ease of transport: Increased volumetric and gravimetric Amenability of energy source to storage: more specialized
density makes transportation of fuels easier and less costly. 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.
2
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.

Improved energy quality Worsened energy quality

Emissions intensity of energy: The emissions per Joule of
Volumetric density: The concentration of energy in a given
energy associated with renewables are substantially lower
volume of biofuels is lower than that in conventional fuels.
than those associated with fossil fuels.
Spatial distribution: Renewable power generation can be
Gravimetric density: The energy-to-weight ratio of biofuels is
distributed to load centers (e.g. rooftop solar) and does not
lower than that of conventional fuels.
typically require transport of feedstocks over long distances.
Risk to human health: The risk to human health of most Energy surplus: The energy return on investment (EROI) for
renewables is substantially lower than those associated with most renewables is lower than that associated with fossil fuels,
flammable and toxic fossil fuels such as oil or natural gas. at present.
Financial risk: Financial risk associated with wind turbines, Amenability of energy source to storage: Storing solar
solar farms, and biofuels plantations is substantially lower and wind energy will require a sophisticated network of
than that associated with oil exploration and production in specialized batteries and smart-grids, while oil could be stored
increasingly remote regions (e.g. the Arctic seabed). 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:
· 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.

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.

EX 7.4: Energy demand is expected to increase significantly by 2030
World Energy Demand - Reference Scenario

18
16 CAGR = 1.8%
14
billion tonnes of oil equivalent
12
10
© OECD/IEA 2007
4
0
1980 1990 2000 2010 2020 2030
Coal Oil Gas Nuclear Hydro Biomass 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.

EX 7.5: The West Texas Intermediate Crude Oil price has been volatile
150
140
130
120
110
100
Price (USD/bbl)
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 long-
term 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

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% 23% Saudi Arabia

2% Iran
2% Iraq
3% Kuwait
3% United Arab Emirates

Venezuela
3% Russian Federation
Libya
7% 12% Kazakhstan
Nigeria
US
Canada
7%
Qatar
10% Other
8%
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.

EX 7.7: The finding costs for oil are increasing
USD per boe (constant 2006 dollars)
50
45
40
35
30 More difficult access
25
20 Technological improvement and

opening of new production regions
15
10
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
100
1980-2006
Real Oil Price (USD/bbl)
y = 2.62x + 7.53 2007E - 2015E

75 R ² = 0.95
50
25
0
0 5 10 15 20 25 30 35 40 45 50
Real F&D Costs (USD/bbl)
Source: US DOE/EIA, DB Global Markets Research, 2008.

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 $)
2008
Dec Figures 2015 2030 2040
(Starting Point)
Citigroup3
Oil $/bbl 110.2 100 100 100
Deutsche Bank4
Oil $/bbl 100 125 90-110 75-150
EIA5
Oil $/bbl 83.59 59.85 70.45 -
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 feed-
stocks 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.
3
Figures for Deutche Bank provided by Adam Sieminski, Deutsche Bank Global markets, September 2008.
4
Figures from US EIA online, 2008.

5

A EX 7.10: The Henry Hub natural gas price
15
14
13
12
Price (USD/mmBtu)
11
10
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.

EX 7.11: The global supply/demand balance for LNG
mmt/y
350
Greenfield Supply
Base Supply
300 Total Demand
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

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

2015 2020 2030
(Starting point)
Gas
9.40 12.50 14.50 16.00
$/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
140
130
Price (USD/tonne)
120
110
100
90
80
70
60
50
40
30
20
2003 2004 2005 2006 2007 2008 2009

Date
Newcastle Coal Monthly Swap (M01) - Close Price

Source: DB Global Markets Research, 2008

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 2015 2020 2025 2030
Coal Liquids Natural Gas Renewables 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 $)
2008
Dec Figures 2015 2030 2040
(starting point)
Citigroup3
Coal $/t 123.47 74.72 50 50
Deutsche Bank 4
Coal $/t 160 75-85
EIA 5
Coal $/t 35.23 34.24 35.03 -
*Forecasts as of September 2008.
Figures for Citigroup provided by Alan Heap, Citigroup Commodity Research, September 2008.
3
Figures for Deutche Bank provided by Adam Sieminski, Deutsche Bank Global markets, September 2008.
4
Figures from US EIA online, 2008.

5

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-and-
trade 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

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
0.4
Correlation Coef.
0.3
0.2
0.1
-0.1
-0.2
-0.3
-0.4
17-Feb-05 5-Sep-05 24-Mar-06 10-Oct-06 28-Apr-07 14-Nov-07 1-Jun-08 18-Dec-08
Source: Bloomberg, 2008.

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
Emerging market growth:

Demand-side
• Coal, oil, gas demand and price

scenario
• Electricity price
• Road transport fuel price
• Carbon price to offset increased emissions
Most likely scenario:

Peek oil scenario:
• Coal price
• Oil and gas price (reduces demand)
• Oil, gas price
• Carbon price due to lower fossil fuel demand
Supply-side
scenario
• Carbon price
Coal glut scenario:
• Coal price due to supply

• Carbon price to offset increased emissions

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
eAlt only
Equilibrium
price with both
fuels available
eFossil only
Peq
qAlt
qAlt qFossil QDemand

Source: DeAM Analysis, 2008,
Energy quantity qAlt + qFossil = QDemand

IEA, World Energy Outlook, 2006.
7

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

EX 7.20: The effect of carbon prices on equilibrium for substitutable fuels
Energy
price DAll Energy SFossil 2
SAlt
SFossil 1
Equilibrium
price with both
fuels available
Peq 2
Peq 1
qAlt qFossil QDemand

Energy quantity 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.

EX 7.21: Scaling Capacity Leads to Greater Uptake of Clean Energy
Energy
Price
Low Capacity
Clean Energy
Policy Goal: Build clean energy
Supply Curve
scaling capacity, even if the
energy is more expensive in low
quantities.
High Capacity
Clean Energy
Supply Curve
2 2
P2
P1 1 1
Energy Quantity
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.

Relationship between fossil fuel prices and carbon prices.
Supply Shock: Constraints (peak oil scenario) Supply Shock: Surplus (coal glut scenario).
Increasing oil and natural gas scarcity drives road transport Large reserves and better extraction/use of coal mining
fuel and electricity feedstock prices up. Carbon prices are technologies bring electricity feedstock prices down.
inversely correlated to oil/gas prices. 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 D
S1 S2
Oil/Gas e2 Coal e1
Price e1 Price e2
Oil/Gas Quantity Used Coal Quantity Used
Source: DeAM analysis, 2008. Source: DeAM analysis, 2008.
Sequence of Events Sequence of Events
1. Increasingly scarce oil and gas become more 1. Improved extraction technologies, combined
expensive to bring to market. with large reserves, make coal cheaper to bring
2. The supply curve shifts upwards because the same to market.
quantity of oil and gas is more expensive to supply. 2. The supply curve shifts downward because large
3. Market equilibrium moves from e1 to e2. quantities of coal are less expensive to supply.
4. Oil and gas prices rise. 3. Market equilibrium moves from e1 to e2.
5. Oil and gas use quantities drop. 4. Coal prices drop.
6. There is a lower demand for carbon to offset oil 5. Coal use quantities rise.
and natural gas emissions. 6. There is a higher demand for carbon to offset
7. Other things equal, carbon prices drop. 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.

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
D1 S
Fossil
Fuel
e2
Price e1
Fossil Fuel Quantity
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.

• 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.

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;

· 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.

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 opportu-
nities 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 frame-
work 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.
1
Pigou, A.C (1912), Wealth and Welfare, London (Macmillan).

2

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.

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 mea-
suring 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 ad-
equate 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
Delaying the starting date increases the

70 Business as usual required annual rate of reductions
?? ?
60 2005 2010 2015 2020 2030 2040
6
5
Annual global emissions (GTCO2e)
1.3% 1.8%
4 2.4% 3.3%
50
3
5.7% 6.1%
2
Equal to entire US 16.6%
40 1 electric power sector
Unlikely ? Uncertain Probable

30
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 )

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 dif-
ficult. Stern notes that it is likely to be very difficult to reduce emissions by more than a few percent a year while sustain-
ing 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 avail-
able 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 “eco-
nomic” 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.

5
United Nations Framework Convention on Climate Chnage, 1992, Article, 4, 2a

6

Ex 2.2: Different regulatory policies impact different parts of the greenhouse gas mitigation policy curve
Coal-to-
Industrial gas shift Avoided
CCS deforestation
feedstock substitution coal Asia
Forestation Soil retrofit
40 Waste
Livestock/ CCS EOR
Smart transit soils new coal Wind,
30 low Solar
Small hydro Nuclear Forestation pen.
20 Idustrial nonCO2
Airplane effeciency
10
Stand-by losses
0
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
-10
Avoided
-20 deforestation Industrial
Cellulose Inudstrial CCS
ethanol Co-firing Amercia
non-CO2 CCS
-30 biomass
new coal
-40 Surgarcane
Industrial motor Abatement
systems
-50
biofuel GT CO2e/year
Fuel-efficient
-60 vehicles About the curve:
-70 Water heating • The curve shows mitigation opportunities by 2030, but requires action
starting in 2008.
-80
• The curve measures economic cost in € /ton, and includes capital operating
Air Conditioning
-90 and maintenance costs, as well as a real discount rate of 7%. Transaction
Lighting systems costs, communication/information costs, taxes, tariffs and subsidies are
-100
excluded.
-110 Fuel-efficient
-120
commercial • The curve presents a set of opportunites consistent with a long-term
vehciles
stabilisation potential of around 450 ppm as you approach 27 GT of abatement.
-130
• Assumptions include: Energy prices, cost of technology and learning rate,
-140
Insulation Improvements
abatement potential, 7% discount rate, starting date of abatment.
-150
-160
Overlap between traditional
Current regulatory regime regulation and innovation
policy
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 technol-
ogy/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 learn-
ing 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.

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 cost-
effective 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 technolo-
gies, 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, how-
ever. 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 ef-
forts 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 (feed-
in tariffs, tax credits, direct subsidies and funding for research and development). These two policy options, while theoreti-
cally 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 mod-
est 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.

Ex 2.3: There are three broad sets of policy options available
Regulatory policy
Traditional regulation Carbon pricing Innovation policy
Mandated AND Public Carbon OR Cap-and- Knowledge AND Adjustment

standards education taxes trade management assistance
• Technology • Direct subsidies

transfer • Feed-in tariffs
• Publicly funded • Tax credits
NOTE: This will vary by geography. research, development, • Concessionary
demonstration and financing
deployment
• Inudstry research
Source: DeAM analysis, 2008. consortia
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.
7
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.”

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 technolo-
gies 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 establish-
ing 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 European Union
exist between the EU-ETS and the Kyoto Protocol mechanisms.
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
Cap-and-Trade systems
Voluntary emissions markets allow companies to make verified USA (not implemented by public
reductions to meet public commitments. This is enforceable authorities, but enforceable by
under US contract law. legal system)
New Zealand, Australia, Western
Other emerging regional and national trading schemes 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
British Columbia, Canada
payments to be credited toward other tax bills.
Sweden. Similar policies adopted
Carbon Taxes Sweden taxed carbon at approx $100 per ton, starting 1990;
in The Netherlands, Finland,
raised to $150 per ton in 1997. Industrial users pay a lower rate.
Norway, Italy
The UK implemented a Fuel Price Escalator in 1993, a pollution
United Kingdom
tax on retail petroleum fuels.

In simple terms, a cap-and-trade sets A cap-and-trade system also allows and as well as other proposals before
a target for emissions in a geographic the market to set the appropriate price the House and Senate. The impor-
region consistent with a carbon sta- of carbon, whereas in a tax regime, tance of a robust global solution contin-
bilization level (i.e. 450 ppm). The cap regulators would need to try to derive ues to grow.
is then pushed down to individual in- that price. The principal disadvantage
dustries and companies that are given of cap-and-trade is that price is less Why carbon pricing isn’t enough at
permits to emit that can be traded. certain, and there is potential volatil- the initial stage.
These permits can be auctioned or ity. Inclusion of flexible mechanisms
provided for free. In either case, for in a cap-and-trade regime, such as While in theory, an adequate carbon
markets to function properly, clear offsets, banking and borrowing, bring price should be all that is required to
rules of private ownership must be measures of stability to the market achieve efficient mitigation. In the
established for what was, initially, a and mitigate the biggest disadvantage real economy, this is not always the
public good.11 Once emissions per- of cap-and-trade. Clear signals from case. The carbon mitigation cost curve
mits have been allocated, companies regulators – which are at the origin demonstrates why.
can then trade excess or deficits in of demand for carbon credits – can
their permits. The trading system can also help to bring long-term stability to Along the carbon mitigation cost curve,
also include credits from other geog- the markets.14 While faith in market there are a number of mitigation policy
raphies. There are other important mechanisms has been shaken by the options that are viable at a negative
issues, such as sectoral coverage and credit crisis, and there has been talk carbon price in 2030 (i.e. they save
banking and borrowing of credits that that could potentially lead to more costs). Many of these opportunities
are important parts of the architecture focus on a carbon tax rather than a – such as improved insulation – are
of cap-and-trade regimes. cap-and-trade regime, we believe that economic today. In a perfectly efficient
the benefits of cap-and-trade outweigh market, these mitigation policy options
While either a tax or a cap-and-trade the disadvantages. should already be ideally fully utilized
system can address greenhouse and profitable even without a carbon
gas reductions, cap-and-trade has a While the UNFCCC and Kyoto Protocol price. While the recent rise in energy
number of advantages. Cap-and-trade do not specify that carbon must be prices has led to an increase in uptake
drives efficient mitigation by encour- priced, the Kyoto Protocol includes of these measures, as reported in The
aging businesses with inexpensive explicit mechanisms to permit emis- Observer on August 3, 2008,15 we are
mitigation opportunities to reduce sions trading. Policy options such as far from capturing the total potential
emissions as much as possible and the Clean Development Mechanism savings represented by energy ef-
sell excess credits to businesses with and Joint Implementation enable in- ficiency.
higher marginal mitigation costs.12 It ternational cap-and-trade mitigation at
allows Ricardo’s theory of compara- least cost. Through these mechanisms The fact that these methods are still
tive advantage to work with emissions – and the growing European Union not fully employed demonstrates
mitigation. We recognize that markets Emissions Trading Scheme (EU-ETS) that, for a variety of reasons (lack of
with public goods are less efficient – cap-and-trade is growing in promi- information, short-term up-front costs
than standard markets,13 but believe nence year by year. The International and other behavioral factors), carbon
that the advantages of a market ap- Carbon Action Partnership (ICAP), prices may not be sufficient initially to
proach outweigh the disadvantages. which shares best practice in carbon promote adequate greenhouse gas
The result of a carbon market – even trading schemes across borders, and mitigation in the real world. This leaves
one with suboptimal efficiency – is that other initiatives are promoting global a role for energy efficiency standards
those who can reduce emissions most linkages between and scaling of cap- and some incentives. At the other
efficiently are able to free up resources and-trade regimes. The US is looking end of the curve, some technology
for those who cannot, and emissions at its options for creating a cap-and- solutions are currently very expensive
reductions are therefore achieved at trade system through the Liebermann- and innovation theory suggests they
the lowest total cost to the economy. Warner and the Dingell-Boucher bills, should be incentivized directly.
11
Graciela Chichilnisky and Geoffrey Heal, Environmental Markets: Equity and Efficiency, 2000, p. 25-27
12
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.

Stern notes that carbon pricing is only in scale than those that flow from as CCS; this will allow government to
one part of the solution, and that the the OECD to petroleum exporting buy promising technologies down the
regulatory policies used in traditional countries today. The recipients of learning curve without subjecting the
regulation and innovation policy are these payments would benefit from entire economy to very high carbon
both vital tools in the climate change enormous windfall profits at very high prices. The economy-wide costs of
toolkit: “Carbon pricing is only one part carbon prices. And the poor may be hit the subsidies and incentives associ-
of a strategy to tackle climate change. harder than the rich, as carbon pricing ated with such a policy are likely to be
It must be complemented by mea- is without compensating transfer, a much lower than the economic drag
sures to support the development of regressive tax. This is unlikely to be associated with a very high carbon
technologies, and to remove the barri- politically or socially acceptable, unless price. See exhibit 2.5.
ers to behavioural change, particularly it comes about gradually.
around take-up of energy efficiency.”16 Therefore, climate change mitigation
“Optimum” or even “acceptable” policy will need to include two distinct
Long-term optimal carbon price long-term carbon prices are therefore sets of regulation to compliment
likely to be well below €100ton, al- carbon pricing: Traditional regulation
Using carbon prices alone to incentiv- though during the process of establish- and innovation policy. These policy
ize the early development of emerging ing the trend, they may spike to high options will overcome market failures
technologies – some of which could levels if the market does not move and prevent imposition of an initial
require carbon prices of nearly €100/ fast enough towards mitigation. (See carbon price so high that it could have
ton to prompt inefficient, as such a Appendix I for a discussion by Kevin negative consequences for the entire
high carbon price may put a dispropor- Parker.) Other regulatory instruments, economy.
tionate drag on the overall economy. such as R&D subsidies, can be used to
This would also entail enormous drive innovation of what are currently
transfer payments – potentially larger more expensive opportunities such
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
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
-10
-20
Abatement
-30
Gt CO2e/year
-40
-50 About the curve:
• Total economic cost of maximizing all opportunities on the curve in 2030 is approximately €22 billion a year.
-60 This is the integral of the green area that lies under the curve. This includes:
-70 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
-80 19 GT of abatement, representing €403 billion of economic costs from measures that lie between €0 and €40
-90 on the cost curve
• At a carbon price of €40/ton, transfer payments would be equivalent to approximately €1.3 trillion in 2030. This
-100 assumes:
All 27 GT of abatement potential on the curve is unlocked, reducing 2030 emissions from the BAU
-110
projections of 62 GT to 35 GT
-120 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
-130
area that between the carbon price and the cost curve. For negative-cost options, only that
-140 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.
-150
• Regulators may wish to avoid a very high carbon price: carbon pricing is, in effect, a tax. Imposing a very high
-160 carbon price to incentivize a few costly technologies may depress overall economic activity.
Source: McKinsey-Vattenfall greenhouse gas abatment cost curve.
Lord Nicholas Stern, Stern Review Report, 2007, 324.

16

IV. 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.
Enhanced public education and financing provide one way of support that can be used to shift behaviors to more climate-
friendly 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
Fuel emissions standards requiring new automobiles to reduce California, USA;

carbon emissions by 10% or more over 1990 levels. European Union
Phase-out of incandescent bulbs. New bulbs must use 25% less USA (starts 2012)
energy, rising to 70% more efficient by 2020.17 Australia (starts 2010)
Renewable Portfolio Standards (RPS) requiring energy companies Various US States
to supply a minimum percentage of energy from clean / renewable (California, Nevada, Texas)
Mandates & sources.
Standards Mandatory forest conservation: newly-settled land in forested
Brazil
areas can clear a maximum of 50% of the initially forested area.
Energy standards for buildings: requires regular inspection and
minimum energy standards for ordinary residences and office European Union
buildings (historic buildings may be exempted).
Energy Star Program certifies energy efficiency standards and
USA
promotes inter-industry knowledge sharing.18
Energy conservation awareness campaigns. Municipalities around the world
Global warming and environment incorporated into school Major industrial and developing
curriculum. countries
Public Higher efficiency cookstoves to reduce deforestation. Parts of Africa

Education 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.
17
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.
18

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.

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 develop-
ment, and reduce business exposure to the risk that carbon prices might not rise fast enough to justify short-term imple-
mentation. 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 recom-
mends 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 coordina-
tion 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
19
Lord Nicholas Stern, Stern Review Report, 2007, 371-372.

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

Sustainable Forestry Research and Development Initiatives (e.g. non-
Knowledge Brazil, India
timber forest product development and marketing).
Management
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.
USA
The PTC has been renewed for 1 year for large-scale wind projects as
part of the Emergency Economic Stabilization Act of 2008.
Feed-in Tariffs provide energy producers a guaranteed premium for clean Spain, Germany, Italy, France,
energy. India
Public
The investment Tax Credit (ITC) reduces capital expenses for solar electric
Education
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
USA
sell credits to large utilities facing renewable portfolio standards.
Microfinance for purchase of improved cookstoves in poor communities
Several African countries
to reduce local deforestation in the search for firewood.
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.

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, car-
bon 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 under-
standing 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:

· 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
Public investment loans or financing

Policy
Tradable renewable certificates
Public competitive bidding
Renewable portfolio standard

Net Metering
Energy production payments or tax credits

0% 10% 20% 30% 40% 50% 60% 70% 80%
Percent of sample using policy

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

Transitions
Ex 2.10: As incentives
mitigation options are required
reach commercial to drive
breakeven, carbon learning
price can curves
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
Learning
curve for
given
technology,
e.g., wind
2010 2030
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.

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

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.

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 on the cost Assumptions on Uniform

assumptions: of technologies, mitigation potential for discount rate
oil, coal, natural gas including learning rate specific technologies
40
20
0 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
-40
-60
-80
-100
-120
-140
-160
B C
Regulatory support for clean Taxes and specific
technologies, including Investor curve project costs
incentives and subsidies
D
Factors that need to be varied: Dynamic energy cost
assumptions, specific regional costs, different discount rates
based on technological risk
E
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

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 modi-
fied 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 economi-
cally 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 under-
stand 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.
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.

I. 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.
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

Learning rate
Cost of drives down
1 Commercial breakeven
alternatives costs over time
with incentives without
carbon pricing e.g.
Carbon
some US states
price
Incentives to
make 2 Commercial breakeven with
technologies 3 carbon pricing and incentives
economically 2 e.g. EU
viable diminsh
Cost
over time 4
5 3 Commercial breakeven
Cost of fossil with carbon pricing without
fuel-based energy incentives
(oil, gas, coal
prices)
4 Commercial breakeven
without carbon pricing
or incentives
1
5 Beyond Breakeven
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.

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 strengthen-
ing, 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 breakev-
en 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 encour-
age 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.

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
LCOE considers the total electrical output generated by a Economic Inputs

technology over its lifetime, divided between the total cost Not all variables are taken into account when developing
of investment, the interest rate, cash flow during construc- an LCOE model; often, varying boundaries, assumptions or
tion, and any additional operational and maintenance costs, scenarios are established to compare the LCOEs of differ-
all in present value terms. Typically, the LCOE result is ent technologies under different scenarios. Different fuel
given in a currency per kilowatt (or megawatt)-hour unit, prices, tax incentives and carbon prices may be key shifting
such as $/kWh or €/MWh. factors. The standard, industry-level LCOE uses a common
discount rate, but for this methodology to be used in proj-
Depending on which of the breakeven points is under con- ect evaluation, the discount rate would need to be varied.
sideration, carbon pricing and incentives and subsidies can See exhibit 3.2.
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

Repairs, maintenance, SOx and
Output degradation NOX emission costs
Availability
Amount of time a plant is
available to produce power.
4
Carbon price Subsidies and incentives
3 LCOE with carbon price + 1 LCOE with subsidies and incentives
2 LCOE with carbon price, incentives and subsidies
Electricity price

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 En-
ergy (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 develop-
ing a project-level analysis, we introduce the most important characteristics of electricity markets. See box 2.

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, longer-
term 5-16 and 7-24 contracts. Renewables are instead forced to secure contracts in other ways:
1. 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;
2. 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 invest-
ment 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.

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

and construction
Learning rate
should not be
CO2 emissions rate assumed-
Carbon price Output degradation Repairs, maintenance, SOx and individual
NOX emission costs
scenario Availability project costs
analysis needs Amount of time a plant is
replace it
to be conducted
4
Scenario
analysis on
+ 1 subsidies and
3 LCOE with carbon price LCOE with subsidies and incentives
incentives
should be
2 LCOE with carbon price, incentives and subsidies performed
All inputs
need to be
project-specific Electricity price
Local energy market dynamics need

Source: DeAM analysis, 2008. 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 con-
siderably 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.

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

and construction
CO2 emissions rate

Output degradation Repairs, maintenance, SOx and Critical discount
Availability
NOX emission costs rate choice
Amount of time a plant is
4
3 LCOE with carbon price + 1 LCOE with subsidies and incentives
2 LCOE with carbon price, incentives and subsidies
Electricity price
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

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 invest-
ment 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.

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
By adopting a collective understand- to solve the equation, but investors Changing the energy price
ing of volatility and risk in clean tech will need to work on these factors to assumption shifts the curve down
markets alpha can be generated by generate alpha.
maximizing return and understanding If oil prices of $100 a barrel are
how the interlinked risks mitigate and Changing energy price assump- assumed, the curve shifts down.
offset each other. One example of this tions: some implications using This is because:
in action is the backstop effect that mitigation curve analysis.
carbon pricing has against energy and • Energy efficiency measures
electricity price risk/return. In a robust As discussed at the end of the last such as improved insulation and fuel-
cap-and-trade regime, if over the long chapter, the McKinsey-Vattenfall efficient vehicles, which are already
term, the price of coal falls relative to greenhouse gas mitigation policy NPV-positive with oil at $40 a barrel,
the price of oil, natural gas and clean curve is a useful tool for understand- make even more economic sense at
alternatives, carbon price will rise, ing the economic cost of carbon $100 oil;
offsetting some of the energy and mitigation. It is also closely linked to • And renewables such as
electricity price risk. the concept of LCOE, and in turn, the biofuels, solar, and wind shift down,
investor’s spreadsheet: Each of the with lower economic costs for a given
By diversifying the risk associated renewable energy bars along the cost quantity of mitigation at higher oil
with the breakeven of a clean technol- curve is derived by comparing the prices.
ogy across carbon risk/return, energy LCOE of a renewable and its fossil
price risk/return and regulatory risk/ fuel counterpart. The effect of higher fossil fuel prices
return, risk is mitigated and hedged, on the shape of the curve is set out in
and investors stand to see potentially Just as the investor’s spreadsheet exhibit 3.6.
large returns. This will incentivize yields different results under different
investment in clean technology, as risk energy price scenarios, so too does
is mitigated and returns are preserved. the curve. The original curve was
developed with an oil price assump-
Ultimately, a general economic equi- tion of $40 a barrel. This long-term
librium model would be the only way assumption is now clearly too low.

EX 3.6: The curve shifts down if oil and energy prices increase
n prices
We recognize that not all mitigation assumptions change. This is because down and more mitigation will be pos-
options will become comparatively opportunities that sat beyond the sible at a given carbon price if energy
less expensive with higher energy threshold cost become more econom- prices increase, some mitigation op-
prices: Carbon Capture and Storage ic at higher energy price assumptions. portunities, such as forestry, will feel
(CCS) becomes more expensive with Some of these opportunities include: limited effects from the changes in
high coal prices as it actually uses oil prices, while others, such as CCS,
more fuel to capture the carbon. • Motor systems, which came in at may become more expensive.
Some highly capital-intensive energy €40-80/ton under oil price assump-
efficiency opportunities may also tions of $40 a barrel: 0.38 GT CO2e In the case of CCS, this is because
become more expensive. Investors mitigation potential the process increases the amount of
will need to be attuned to these sen- • Energy production adjustment, energy needed to produce a single
sitivities when they use the investor’s which came in at €50/ton under oil kilowatt hour sold onto the electric
spreadsheet. price assumptions of $40 a barrel: grid – so a rise in fossil fuel prices will
0.35 GT CO2e mitigation potential drive costs higher. CCS, which is an
However, on the whole, the curve will • Energy efficiency in existing basic expensive mitigation opportunity in
move down as the marginal cost of materials production processes, which a €40 oil world, may move up and
clean technologies decreases when came in at €40-80/ton under oil price to the right of the curve in a $100 oil
compared to their conventional coun- assumptions of $40 a barrel: 0.11 GT world, potentially coming in at over
terparts. CO2e mitigation potential €40 a ton in 2030. This would require
• Biodiesel, which came in at €60/ a higher carbon price to finance it,
Changing the energy price assump- ton under oil price assumptions of increased innovation incentives, or
tion extends the curve to the right $40 a barrel: 0.09 GT CO2e mitigation increased reliance on other mitigation
at a given economic cost of carbon potential opportunities that would become less
and alters the sensitivity of mitiga- • Power train and non-engine diesel, expensive under $100 oil and similarily
tion opportunities which came in at €60/ton under oil high coal prices.
price assumptions of $40 a barrel: 0.09
The extent of mitigation possible GT CO2e mitigation potential In exhibit 3.7, we color-code each of
for a given economic cost of carbon the mitigation opportunities based on
is also extended if the energy price While the curve as a whole will shift its sensitivity to oil prices.

EX 3.7: Different mitigation opportunities have different sensitivi-
ties 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 wind, are responsive to different fossil cantly, some major CCS opportunities
review of the impact of high energy fuels. If oil prices increased, and coal that are on the curve in exhibit 3.7
prices on the policy curve: prices decreased, biofuels would prob- will move off the curve (that is, they
ably become more attractive com- will cost more than €40/ton, and sit
• Energy efficiency and renewables pared to gasoline, while wind would above and to the right of where the
become more attractive under high probably become less attractive as a curve terminates). If a combination
energy prices: The economics of means of generating baseload power. fossil-fuel scenario took place, where
these green-shaded projects generally The attractiveness of wind as a means oil prices increased, while coal prices
improve, risk decreases and is diversi- of generating peak power would decreased, the economics of CCS
fied – making these opportunities depend on natural gas prices. would probably improve.
more attractive for investors. There • The attractiveness of forestry and
are a number of caveats to observe: land-use projects remain relatively These insights shift the risk/return
· Some capital-intensive projects that unchanged: The economics and risk profile, and can be a source of alpha
would ostensibly shift down in cost of these dark blue-shaded projects generation for investors. Taking this to
under high fossil fuel prices, such as remain largely unchanged; the next level of understanding would
some efficiency projects, have energy- • And CCS becomes less attractive: require similar work be conducted at
intensive inputs and may become less The economics of these light blue- the level of the investor’s curve. Ulti-
attractive under very high fossil fuel shaded projects worsens as costs go mately, a general equilibrium model
prices. up, risk increases and becomes more would need to be developed before
· The sensitivities of different mitiga- concentrated in the regulatory domain. any conclusive results could be drawn.
tion options, such as biofuels and If fossil fuel prices increase signifi-

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 concentra-
tion. 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 develop-
ment 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 innova-
tion 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

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:
· 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)

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 technolo-
gies, 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 deploy-
ment 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.

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 be-
ing 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.

IV and Developing
EX 4.4: Examples of technological developments
· 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;
Solar · 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 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 sec-
ond quarter of 2008 alone, and in California, Sapphire Energy debuted its ‘green crude’, a gasoline equivalent
refined from algae;
Algae · Shell started a project at the beginning of the year in Hawaii to grow algae that can be converted into biodie-
sel fuel;
· International Energy Inc. announced that researchers have devised and instituted a patent-pending technol-
ogy 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;
· Fuel cells – Ceramic Fuel Cells Limited announced a 50% increase in cell power density and an increase
in fuel cell stack lifetime;
Energy efficiency · 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
CCS
oxyfuel boiler that involves burning coal in an atmosphere of pure oxygen;
· Materials – Researchers at the University of Queensland discovered that miniature crystals could revolution-
ize the way solar energy is harvested. These nanocrystals form part of a growing group of clean nanotechnolo-
gies which are discussed further in section IV;
· Materials – University of Texas scientists achieved a breakthrough in September in the use of a one-atom
Advanced thick structure, ‘graphene’, as a new carbon based material for storing electrical charge in ultracapacitor de-
materials vices 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
Wind 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.

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 size-
dependent 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 nanotech-
nology 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:

IV and Developing
EX 4.5: Mapping the nanotechnology development pipeline
Carbon
Nanoporous filters 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

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

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 ef-
ficiency 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 prom-
ise, 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

Appendix I: Kevin Parker, Perspective on Carbon Prices
The Financial Times printed an article by The effects of a repricing of carbon will
Kevin Parker, Global Head of Deutsche be profound. Carbon will take its place
Asset Management, on July 16th, 2008. alongside oil, coal and gas as one of the
In the article, titled “Carbon emitters’ most closely followed commodities in
free ride is about to end”1, Parker the world. This will mark the beginning
argued that most companies in the EU of externalities at last being priced into
were short carbon, and that the price of the cost of production. It will signal that
Kevin Parker carbon is set to rise dramatically going carbon emitters have had a free ride for
Member of the Group Executive Committee forward. long enough. Governments – the US’s
Gloabal Head of Deutsche Asset Management in particular – will have to join Europe to
“The astonishing truth about the create a global market for pricing carbon
carbon market is that nearly everyone and businesses around the world will
is short carbon: companies will breach have to accept the price the market
their emissions limits and do not own sets.
allowances to make up the difference.
When I ask market participants: “who A higher carbon price will force
has surplus allowances to sell? I get companies to make radical changes to
back blank stares. It cannot be long their business models (this has already
before the market recognizes this begun in the European utility sector).
fundamental supply/demand imbalance. Early movers are likely to be winners.
It will be an economic imperative for
The carbon market, in addition to corporate boards and managements to
allowing offsets, should also encourage take into account carbon pricing in their
the switching away from pollution- business and strategic planning….
intensive fossil fuels such as coal to less
carbon-intensive gas and renewables. The rising cost of carbon will also
Carbon pricing should be correlated with drive the need for, and the viability
oil and natural gas prices, which are of, alternative technologies. Capital
soaring. A recent report by my colleague will start to flow to new areas of
Mark Lewis at Deutsche Bank (“It investment: existing technologies to
takes CO2 to contango”, May 30, 2008) conserve power and mitigate carbon
argues that carbon’s market clearing emissions, developing technologies for
price with oil at $85 (€55) a barrel and carbon capture and alternative energy.
coal at $90 (€58) a tonne is about €40 a Like many turning points, the carbon
tonne. However, with the actual oil price price rise will be fraught with risk.
at about $135 (€87) and coal at $200 However, that is worth the enormous
(€127), the market clearing price for opportunities and benefits it will
carbon is €75 to €80 a tonne – nearly create….”
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

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

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 feed-
backs. 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)
Strat. water vapour from CH4 Kyoto
Nitrous Oxide (N2O)
Kyoto Halocarbons
Montreal Gases
Montreal
Trop/strat ozone
Persistent contrails
Total direct aerosols
Cloud albedo effect
Surface albedo
Aerosols partly balance
the effect of greenhouse
Total atmospheric radiative gases, but are short-lived
forcing equivalent: 375 ppm
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 consider-
ably 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.

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
600 Constant emissions at

2005 levels: 560 ppm**
500
Comfort zone
400
432 ppm in 2005
300 Without intervention

GHGs could reach 1,200
ppm CO2e by 2100
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 mag-
nitude of potential warming varies according to different forecasts. See exhibit A2.3

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 A2

were 2°C above 1900 6.0 A1B
level was 130,00 B1
years ago, with sea
Constant composition
Global surface warming (°C)
level 4-6m higher than 5.0

today. commitment
20th century
4.0
Last time temperatures
were 3°C above 1900 IPCC (2007)
level was ~30 million 3.0 scenarios
years ago, with sea
level 20-30m higher
than today. 2.0
EU target ∆T ≤ 2°C
Note: Shaded bands 1.0

denote 1 standard
deviation from mean
in ensembles of model
0.0
runs
-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 ef-
fects; 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 contin-
ued 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
Discussion based on Stern, N (2006) The Economics of Climate Change: The Stern Review, Cambridge.

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 econom-
ics, 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 catastro-
phe 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 2°C 3°C 4°C 5°C
1 Weather Rising intensity of storms, forest fires, droughts and heat waves
2
Threat to local water supply Significant changes in water availability Major world cities threatened
Water
due to loss of glaciers threatening up to 1 billion people by sea level rise
3 Food Falling crop yields in many developing regions
Entire regions experience

Rising number of people at risk of hunger major declines in crop yields
Rising crop yields in high-latitude developed Yields in many developed regions decline
countries given strong carbon fertilization even with strong carbon fertilization
4 Ecosystems Coral reef ecosystems Possible collapse of part of

extensively damaged all of Amazonian rainforest
Large fraction of ecosystems unable to maintain current form
20%-50% of species face extinction
5 Health Increasing number of deaths from 150,000 to 300,000 p.a. under BAU
6 Social More than 1 billion people at risk of having to migrate–increased risk of conflicts
7 GDP Loss of GDP in developing countries Loss of up to 20% of Global GDP
8 Systems Increased risk of weakend carbon sinks, melting of pole ice and reduction of THC
Source: Stern Review
3
Lord Nicholas Stern, Stern Review Report, 2007, pp. 143-157.

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

Avoided deforestation
EX A3.1: Mitigation measures below €40/ton in forestry could save 7.9GT CO2e by 2030 Forestation
Additional potential at €40-80 CO2
€ CO2e 2030 Africa

OECD Asia America Asia
65 America Africa
60
55
50
45 Asia
40 Americas
35 Africa
OECD OECD Americas
25
Africa
15 America
OECD America
Africa
10 Africa
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

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
• CO2 capture rate of 90-92%
• CCS efficiency penalty of 7-12% points
• Same utilization as non-CCS plant(86%)
2 Transport 4-6 • CO2 compression at capture site
• Transport through onshore/offshore pipeline

network of 200/300 km in supercritical state with
3 Storage 4-12 no intermediate booster station
• Use of carbon steel (assumed sufficiently dry CO2)
• Injection depth of 1,500m in supercritical state

Total 35-50* • 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

Not everyone agrees with McKinsey’s high 50
€ per ton of carbon dioxide
cost estimates. BCG estimates that CCS can

45
be developed and deployed at more modest
40
costs. See exhibit A3.3.
35
30 CCS subsidy
25
20
15
10
0
2008 2030
Price of carbon dioxide Cost of CCS
Source: BCG, Carbon Capture and Storage: A Solution to the Problem of Carbon Emissions, 2008.

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, utility-
like 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.
Variable CCS Forestry
• CCS is predicted to become commercialized

for gas, biomass and coal-fired electricity
• Tropical forest deforestation accounts for
generating facilities between 2020 and 2030.3
about 20% human-generated CO2 emissions.
• CCS has the potential to reduce CO2
• The McKinsey-Vattenfall carbon mitigation
emissions from fossil fuel power stations by
cost curve shows a 3.1 GT mitigation
Mitigation Potential as much as 90% and could contribute up to
potential in 2030, but recent work carried out
28% of global CO2 mitigation by 2050 (IEA,
by McKinsey indicates that much more may
2008).
be possible.4
• The McKinsey-Vattenfall carbon mitigation
cost curve shows a 3.5 GT mitigation
potential in 2030.
• Costs are generally very high because the • Operating costs are low. Most costs are
technology is in its infancy. associated with land purchase.
• Costs are highly dependant on coal price, • As commodity prices rise, relative cost rises.
because the process is very energy intensive. • As land becomes more scarce, forestry
Costs & Social
• In the short-term, the technology is only likely projects may compete with farming projects.
implications
to be deployed with a supporting high carbon • The welfare of people living in forested
price between $60-$100/tonne CO2. regions will need to be taken into account in
• There is significant cost reduction potential any future decision about forestry projects.
as the technology develops.
3
IPPCC 4th Assessment, 2007; Lewis, M (2008) Deutsche Bank Global markets Research: Carbon Emissions. Emissions in remissions? Looking at-and through-an EU recession
4
McKinsey-Vatenfall.

• The individual technical components of

• A robust policy framework will need to be
CCS are not novel, but have not yet been
developed to include forestry projects in a
demonstrated in an integrated system or at
meaningful way in the successor to the Kyoto
sufficient scale.
Protocol.
• CCS would require an integrated carbon
• The understanding of forestry carbon
transport infrastructure to separate, transport
sequestration is still developing as are the
and store carbon in a permanent CO2
technologies to manage carbon data of
sequestration site.
forests.
• Challenges include making sites ‘capture-
• Improvements in data verification of rates of
ready’.
carbon sequestration in forests are needed
• Advances in demonstration projects are
in order to allow origination and trading of
needed if all new coal-fired power plants
What is needed? forestry carbon credits.
are to be built with CCS by 2020, a vision
• Improved remote sensing technologies for
articulated by the EU.5
vegetation analysis and mapping land-use
• Increased human and manufacturing capacity
changes need to be developed and deployed.
will be required to capture the opportunity.
• Tree species improvement can be used to
• Funding for demonstration is needed and
increase biomass productivity.
it is unclear where this money will come
• Improved understanding of the feedback
from – a number of demonstration projects
loops and potential of forests to mitigate
worldwide have been announced and then
climate change is required (Bonan, 2008).
later cancelled, reducing investor confidence.
• Further work on carbon accounting is
• Potentially, government support could allow
needed.
the industry to scale, as it did in the case of
nuclear in France.
• The EU Commission notes that the main
risk for CCS is geological storage. Slow
leakage of CO2 will require careful design and • There are concerns about the permanency of
monitoring. However, the IPCC estimates forest carbon stocks, difficulties in quantifying
that for well selected and managed sites stock changes and socioeconomic impacts
the risks are comparable with current of large scale reforestation (Canadell &
hydrocarbon activity. Raupach, 2008).
• Long project lead times may deter investors. • Old growth forests may be net emitters of
• Opposition from local communities is a CO2 owing to decomposition outweighing
barrier to implementation. growth.
Risks and Drawbacks
• Shortage of craft skills and professional • Fires may result in releases of carbon dioxide.
engineers will constrain overall capacity to • Sustainable forest plantations are more
deploy CCS. costly at first in comparison to slash and burn
• CCS significantly reduces plant efficiency techniques, implying increased capital needs
and incurs an additional energy penalty – the • Sustainable development and indigenous
technology is expected to use between peoples’ issues must be taken into account
10-40% of the energy produced by a power in forestry projects.
station, thus CCS could lead to a doubling
of power plant costs and an electricity price
increase to the consumer (Rochon, 2008).
• Forestry products can be used for pellets,
• Enhanced Oil and Gas Recovery can improve
biofuels, or biomass for electricity generation,
the economics, as injecting CO2 in oil and
as long as trees are continually replanted.
Additional Revenue gas reservoirs can increase overall recovery.
• Community-based precision logging.
Streams Estimates indicate that injecting one ton
• Degraded land can be restored and recovered
of carbon into a depleted oil well can allow
through forestation.
additional recovery of 5-10 barrels of oil.
• Non-timber products (e.g. soap, perfume).
• MRV challenge - Continued monitoring, risk
• MRV challenge - Continued risk assessments,
Operating and reporting and verification of storage retention.
monitoring and verification of carbon pools
Maintenance • Standards governing design and operation of
and fluxes.
geologic repositories need to be developed.
5
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.

• Tropical forests are able to take in and store

• Storage depths greater than 800m and well- carbon at greater rates than temperate
sealed cap rocks are required so that the forests and as a result McKinsey estimates
Location effects carbon is physically trapped. that 85% of the opportunity is located in the
• Storage capacity is not always available at the tropics.
source of CO2 emissions (Schrag, 2007). • Young, growing forests are the best sinks of
carbon.
• Most funding for forestry has been through
• Ensuring the timely and widespread voluntary markets and resultantly, the scale
deployment of CCS requires a new policy of investment in forest-carbon project start
framework encompassing a greenhouse gas up is small.
cap-and-trade programme, subsidies for R&D, • Forestry has not been popular under CDM
and financial support to plant developers to owing to high transaction costs. A solution to
offset the cost differential between conven- this problem will need to be found to allow
Regulation tional plants and those with CCS. broader development of forestry opportuni-
• CCS is not eligible under the Clean Develop- ties.
ment Mechanism (CDM). Funding from the • Increased funding flows will be necessary to
CDM or its successor regime needs to be incentivize developing countries to engage in
unlocked to incentivize deployment in devel- forestry projects.
oping countries. • Stern notes that links between forestry and
the broader carbon markets will need to be
carefully architected to avoid destabilization.
• Saskatchewan Power Clean Coal Project,
Canada, will become the world’s first ‘near
• Australia is engaged in a set of trial ap-
zero emission’ coal plant. It is due to be
proaches for improved monitoring of forestry
operational by 2013.6
projects in Indonesia.
Example Projects • The 100 MW power station will capture 90%
• Smaller, community-based forestry projects
of CO2 emissions that will be pumped to a
are being launched in tropical regions.
nearby oilfield for enhanced recovery.
• The plant has been backed by a regional $2
billion fund for CCS projects.
6
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.

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

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.
2
Pew Center on Global Climate Change: Regional Initiatives, 2008.

3
European Parliament: EU Emission Trading Scheme: use permit revenues to fund climate change protection, October 7th, 2008
4

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.

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.

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 supply-
ing the modules required for solar PV has remained high. The market is currently in tight supply, a state that is ex-
pected 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 bottle-
neck 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 cur-
rently 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 conse-
quently, 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
Autoblog green, June 13, 2008. Are high gas prices “forcing” Amercans towards ethanol?
2
10% ethanol by volume.
3
McKinsey & Co, July 7, 2008. Impact of ethanol blending on US gasoline prices.

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.

Disclaimer
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Investing in Climate Change 2009

NECESSITY AND OPPORTUNITY IN TURBULENT TIMES

Bruce M. Kahn, PhD

The necessity: Tackling carbon.

Years before present

i Investing in Climate Change 2009

ii Investing in Climate Change 2009

The opportunity: Low carbon prosperity.

iii Investing in Climate Change 2009

Complete whitepaper and individual chapters available online.

List of exhibits and boxes v

Part I. Necessity and Opportunity in Turbulent Times

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

VII. Carbon and energy prices 68

Part II. An Analytical Perspective

II. Government policies & regulation: An analytical framework 96

IV. Clean technologies: Deepening, broadening and developing 128

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

iv 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: The Four Pillars of Climate Change

Low carbon prosperity

Box 3.1: Energy security

Investment attributes of the climate change universe

Exhibit 5.1: Climate change: An integrated framework of mitigation and adaptation

v Investing in Climate Change 2009

Market sizing of the clean tech universe

Exhibit 6.1: Low carbon projected growth of renewable power generation

vi Investing in Climate Change 2009

Part II. An Analytical Perspective

Government policy & regulation

vii Investing in Climate Change 2009

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

The investor perspective: Risk & Return around commercial breakeven

Exhibit 3.1: Dynamics of commercial breakeven

Clean technologies: deepening, broadening and development

Appendix: The science of climate change

Appendix: Carbon Capture and Storage (CCS) & Forestry

viii Investing in Climate Change 2009

• The opportunity suits most asset classes.

II. What is new in climate change investing?

1 Investing in Climate Change 2009

III. Low carbon prosperity

Political support for a “low-carbon Industrial Revolution”

IV. The credit crisis and climate change investing

2 Investing in Climate Change 2009

V. Investment attributes of climate change

The investment attributes of climate change suit most asset classes:

3 Investing in Climate Change 2009

VII. Carbon and energy prices

Developments in coal, oil and gas prices

The dynamic interrelationship of coal, oil gas and carbon

4 Investing in Climate Change 2009

• Government policy in climate change remains active. Government priorities,