Making Money on Smog

I apologize for not posting in a week. I realize one needs to keep the copy flowing to keep the readers coming. But, I’ve been under the weather, flu-like symptoms with a sore throat. It’s funny, you really don’t think about the air or your breathing until it’s labored with a sore throat or out-of-breath lungs. But the fact is, we spend all our time in the air. Like fish swimming in the sea, our bodies exist surrounded by the air. And the air can mess you up, through heavy wind, rain or snow. But sometimes it’s the little stuff; the stuff in the air you breathe in and out every day. Some of that stuff, like carbon, is poison and can kill you

So, I found it a nice coincidence that as I spend my days contemplating the texture of the air on my throat more than usual, Xshares Advisors launched the first of its new family of ETFs, the AirShares EU Carbon Allowances Fund (NYSE Arca: ASO). Xshares says it’s the “first U.S. traded product that provides exposure to the fast growing carbon market by holding European Union Allowances futures contracts.”

True, but it’s not the first to track the European carbon market. Barclay’s came out with the iPath Global Carbon ETN, an exchange-traded note in June. It tracks the Barclays Capital Global Carbon Index Total Return, which measures the performance of the most liquid carbon-related credit plans. These are the European Union Emission Trading Scheme or EU ETS Phase II and Kyoto Protocol’s Clean Development Mechanism. But it hasn’t been a big hit. Since ETNs are unsecured debt instruments, not funds, investors have been shying away because of the credit risk. While Barclays seems solid, credit risk left investors in Lehman’s ETN holding in line to collect pennies on the dollar. Well, that and the fact, the fund is down 41% since its inception.

AirShares EU Carbon Allowances Fund is an interesting product very different from the ETN. Still, it’s not a true fund regulated by the Investment Company Act of 1940, the SEC regulation that governs mutual funds and ETFs. It’s an exchange-traded vehicle, but it doesn’t track an index. Rather, it’s a commodity pool, like most of the commodity ETVs, such as USO. Commodity pools are regulated under the securities acts of 1933 and 1934.

This one tracks the performance of a basket of exchange-traded futures contracts of European Union Allowances (EUAs) for carbon. A EUA is an entitlement to emit the equivalent of one metric ton of carbon dioxide into the air under the European Union Greenhouse Gas Emissions Trading Scheme (EU ETS).

The fund’s initial portfolio holds unleveraged long positions in ICE Futures (Intercontinental Futures Exchange) or European Climate Exchange Carbon Financial Instrument Futures Contracts (ECX CFI Futures Contracts). Each contract provides for delivery of 1000 EUAs at a specified price, says Xshares. These contracts will expire each December in the years 2009 through 2012.

Like any other futures contracts, in order to keep a position in the market, the fund will need to roll over the contracts. This means as the expiration approaches, the fund sells the contract and buys the next future in line. This rolling over process increases transaction costs. The fund charges an expense ratio of 0.85%, compared to 0.75% for GRN. The rolling process can also result in contango or backwardation. I wrote a good explanation of how contango can affect an exchange-traded commodity pool when the first oil ETF came out in Contango and Cash.

This ETF is a play on global warming and offers investors an entry into the world market for trading carbon. According to IndexUniverse, “Such so-called carbon emission credits are traded by companies who get tax breaks and other incentives for lowering pollutants into the air. These standards are designed to set limits on the amount of a pollutant that can be released into the atmosphere and allocate credits among companies creating emissions. Those that do not use all their emissions credits can sell them to companies that need them.”
“The global carbon market grew 81% to $87 billion for the first nine months of 2008 and is on track to clear $100 billion by year end, according to an October 2008 research report from New Carbon Finance. The report also noted that the carbon market has a very low correlation to other financial markets.

An addition to regular market risk there are a lot of other risks that don’t come with your typical ETF. First, there is currency risk. While ASO shares trade in dollars, the fund’s assets are denominated in Euros. So, on top of market risk, you have to worry about losses from currency fluctuation and of course, in this day and age, political and economic uncertainty. I don’t really understand how the dollar’s strength affects the shares, but Xshares says in its materials, “changes in the value of the euro relative to the U.S. dollar alone may cause the trading price of the shares to decline. Funds focusing on a single commodity generally experience greater price volatility than a diversified commodity pool.”

On top of that, Xshares says, “If the member states of the European Union fail to adhere to their obligations under the Kyoto Protocol or the EU ETS, the value of the shares may be adversely affected. Depending upon the performance of the fund, including the interest rate environment and the amount of interest the fund earns on its fixed income securities, the expenses of the fund alone could result in losses to your investment. Plus, there is a risk that the calculation of the NAV of the fund will not accurately reflect the realizable market value of such futures contracts.”

As we learned with exchange-traded notes and in the wake of the financial collapse of many structured instruments. These risks are not to be taken lightly.

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