Opportunities to invest in carbon are increasing and the trend looks set to continue; supported by the recent Glasgow Climate PactGlasgow Climate PactAdopted at the COP26 UN climate conference in November 2021, the pact sees signatory countries increase climate ambition and action from the Paris Agreement in 2015, and sets out new rules to reduce greenhouse gas emissions including phasing down coal and a global carbon market. read more and the resolution of Article 6 now making the Paris AgreementThe Paris AgreementThe Paris Agreement is a legally binding international treaty on climate change. Its goal is to limit global warming to below 2°C, preferably to 1.5°C, compared to pre-industrial levels. read more operational. Currently investors can gain exposure to carbon primarily via the regulated side of the carbon marketCarbon marketA market where carbon emission allowances are traded. read more, for example, through the EU Emissions Trading Scheme (ETS)Emissions Trading Scheme (ETS)Also known as ‘cap and trade’, an ETS is a market-based, cost-effective approach towards reducing greenhouse gas (GHG) emissions. read more which is the largest and currently the most liquid.
As the dust settles after COP26, and with Article 6 agreed, it’s expected that more countries and territories will launch similar schemes. Continued investor interest is expected due to the attractive demand and supply dynamics of carbon permits embedded in these schemes, the historical low correlation with other asset classesAsset classA group of investments or securities which have similar financial characteristics such as equities, fixed income, alternatives and cash. read more and the possibility that carbon pricing can offer a hedge to inflationInflationThe rate at which prices increase over a period of time. read more. These attributes can make carbon a useful tool for multi-asset managers seeking to diversify and manage risk within their portfolios.
An overview of carbon markets
According to the World Bank, there are now 65 carbon pricing initiatives in operation globally, covering some 45 national jurisdictions and currently account for a total of 21.5% of global greenhouse gasGreenhouse gasThe six main greenhouse gases covered by the Kyoto Protocol: Carbon dioxide (CO2); Methane (CH4); Nitrous oxide (N2O); Hydrofluorocarbons (HFCs); Perfluorocarbons (PFCs); and Sulphur hexafluoride (SF6) read more emissions (2021).1 Most of these schemes have followed the EU “cap and trade” approach. Under this arrangement, existing polluters in certain industries are allocated a certain number of permits with a further amount put up for auction. Those with lower emissions can sell their surplus permits to others, which creates the traded market. In this same example within the EU, businesses in these same industries such as power generation, steel production and the airline industry must calculate the emissions that their businesses have produced at the end of the year and then deliver the requisite number of permits to the authorities as an offset. This can be more attractive than a carbon tax as it allows the market to expedite the lowering of emissions. By trading in emissions reductions, investors and regulators can help identify those with the “lowest cost of abatement” – essentially those businesses who find it easiest to lower their emissions. Encouragingly, there is strong evidence that this is working; sectors covered by the EU ETS saw emissions from stationary installations in all countries covered by the system fall sharply by 9.1% between 2018 and 2019.2 In addition to the emissions reductions, there are climate related benefits, where the proceeds from permit sales end up. All EU member states can auction into their markets but 50% of the receipts have to be reinvested in green or carbon reducing technologies and industries. This feedback loop could deliver real time impact via the delivery of further carbon reductions.
Within the carbon market, what is the role of financial investors?
As with many securities, the primary motivation for any investor is based on the understanding that the price or cost of a permit is likely to increase. In the case of carbon, there is increased confidence in this happening given the need to “offer an incentive” to industry to reduce emissions and invest into less polluting alternative technologies and methods of production (in other words increase the tax on pollution). The design of the various ETS’s will facilitate this. In the EU there is a progressive reduction (2.2% per year)3in the number of permits allocated each year and more industries are likely to be covered and be required to purchase permits. For example, under the EU’s ambitious “Fit for 55” plan agreed in the summer of 2021, the maritime industry is also likely to be added to the scheme. In California, auction prices for permits are required to increase at a rate of inflationInflationThe rate at which prices increase over a period of time. read more of 5% annually.4 For multi-asset wealth managers, like Tribe, there are three further characteristics that make carbon an interesting investment opportunity.
- Low correlation to other investible securities, in global equityEquityThe universe of traded company shares. Investments can fluctuate according to market conditions, the performance of individual companies and that of the broader equity market. read more and creditCreditSynonymous with fixed income – securities where the security issuer is obligated to repay investors the amount they borrowed plus an interest margin. read more markets, for example. The design of most of the ETS’s see either a forced reduction in supply or index linked pricing, therefore, the performance driver of carbon pricing should be somewhat removed (albeit not completely) from global economic forces. This is illustrated by taking a look at the 36 month historical study provided by Carbon Cap5 which shows a correlation of the four most liquid carbon markets at around 0.25 vs global equities.
- As a potential inflation hedge. The rally in carbon prices in Europe this year is in part due to supply issues with natural gasNatural gasNatural gas is a non-renewable hydrocarbon used as a source of energy for heating, cooking, and electricity generation. read more which has seen coal usage come back into the mix. The demand for allowances has soared as more are needed per unit of electricity generated from coal versus natural gas. Because energy prices are a key component of inflation pressure, this relationship could ensure that the price of carbon could be positively and quickly correlatedCorrelatedA measure of the proximity of performance between different investments. read more with inflation, and therefore, embraced as a useful tool in portfolio construction.
- Financial and impact incentives, given the imperative for investors to bring down both a portfolio’s carbon intensityCarbon intensityCarbon intensity compares the amount of emissions to some unit of economic output (e.g. GDP or per million £/$ of sales). read more and absolute carbonAbsolute carbonA reduction in absolute carbon refers to the total quantity of greenhouse gas being emitted. read more emissions. Increasing international and local climate risk disclosure and management regimes that are targeting the finance system mean that most investors will be looking to decarbonise their portfolios. Investor scrutiny on company’s carbon intensity and absolute emissions is likely to increase as an inevitable consequence of the wider adoption of carbon pricing and the greater transparency that may arise from changing disclosure regimes such as the Taskforce on Climate Related Financial Disclosure (TCFD) and the newly launched International SustainabilitySustainabilityMeeting today’s needs without compromising the ability of future generations to meet their needs, by working towards the attainment of the UN SDGs. read more Standards Board (ISSB) that brings together a range of initiatives including TCFD under an umbrella standard.
If the over-arching aim of these policy tools is to increase the price of carbon, shift the market into facilitating a low carbon future, and internalise the expense of transition within companies rather than onto the consumer, then some managers with particularly carbon intensive portfolios may choose to buy carbon allowances as a way to offset the carbon they own. We hope this will be embedded in an approach that sees managers moving to reduce absolute carbon emissions through engagement and by setting a Science Based Target.6 The attractiveness of carbon is likely to increase investor interest in the asset class. However, it’s still early days in the evolution of carbon pricing – including regulatory and political risk – and whilst there is increasing data available to analyse the performance of these markets and opportunities, there is a degree of caution that must be exercised by investors.
