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Hedge funds are fueling fast-growing emissions trading.

IN RECENT YEARS GLOBAL warming has been linked to everything from Hurricane Katrina to abnormally warm winters around the world. As debates about the issue have heated up, so too has hedge fund interest in the market that has emerged for trading credits to emit greenhouse gases.

Hedge funds are aggressively moving into "emissions trading" -- the trading of credits for environmentally harmful emissions, such as carbon dioxide and sulfur dioxide, that enable companies to emit a predetermined amount of such pollutants into the air each year. When a company's pollutants surpass its allowable levels, it is subject to hefty fines unless it can buy additional carbon credits from a business whose carbon emissions fall below the allowable level.

More than 40 hedge funds currently trade carbon emissions, according to New York°©based Global Change Associates, an advisory firm that tracks the environmental markets. And interest in the practice is rising. In early July hedge fund firms TradeLink Holdings and Kenmar Global Investment Management were two of the latest entrants.

"There are socially conscious investors who hold the philosophy that you can do well by doing good, and that group is growing," says Keith Bronstein, president of Chicago-based TradeLink and manager of its DigiLog Global Environmental Fund. He says his firm's move into carbon trading was driven by an increasing awareness among institutional investors of the need to participate in emissions trading to hedge the carbon risk of many of the companies they invest in.

Although still in their infancy, emissions markets are morphing from niche trading outposts into the fastest-growing commodity markets in the world. The global market for carbon trading tripled in 2006, to $30 billion, up from $10 billion a year earlier, according to the World Bank. Global Change Associates chairman and founder Peter Fusaro estimates that emissions trading will balloon into a $3 trillion market over the next 20 years.

Emissions derivatives are predominately traded in Europe, where the Kyoto Protocol helped establish a mandatory market for carbon that took effect in 2005. The U.S. did not ratify the treaty and therefore is not subject to Kyoto emissions-reduction targets. Nonetheless, with such regulations likely in the U.S., more than 200 U.S. companies, such as Armonk, New York°©based IBM Corp. and Midland, Michigan's Dow Chemical Co., have taken an active approach to ready themselves by joining the Chicago Climate Exchange (CCX) -- a voluntary effort launched in 2003 by companies pledging to cut their emissions by 1 percent a year.

London's European Climate Exchange, sister to the CCX, was launched in 2005 and now handles 80 percent of the European market for carbon emissions trading. Both markets are growing as more firms recognize their "carbon risk" under the new policy.

"When you look at the fundamental foundation for all of these markets, it's the assumption of risk," says Bronstein. "A risk exists, and those who have it would like to transfer it to someone else. This marketplace is needed and will continue to develop."

Bill Marcus, head of North American business development and sales manager with Chicago-based Calyon Financial, one of the biggest brokers in emissions, says the markets are attracting a strong mix of participants -- from utility companies and banks to hedge funds and proprietary trading firms. "Hedge funds are always looking for diversification, more opportunities and more instruments to trade," says Marcus. "Carbon may not be mainstream yet, but it's getting there."

Ken Shewer, co-CEO and co-CIO of Rye Brook, New York°©based Kenmar, believes that because the activity in the carbon market has picked up, the increased liquidity is coaxing more hedge funds into emissions trading.

"This is really the first time we're seeing capital going into public equity markets that are creating new technologies around the world," says Shewer, whose Kenmar Global Eco Fund invests in clean-energy technology firms and water-related companies, in addition to carbon trading. "It's not just because people want to do something better, it's that the opportunities are there."

TradeLink and Kenmar are not the only firms looking for the early-mover advantage in emissions trading. Chicago-based CE2 Capital Partners began trading emissions in 2003 and now trades everything from carbon to renewable energy credits. The firm's co-founders, Greg Arnold and Harold Buchanan, say that as regional markets, and eventually a national cap-and-trade market, are implemented, there is huge growth potential.

"The opportunities are tremendous in the U.S., as one of the largest emitters in the world," says Buchanan.