Carbon Credit Investing
- Following the commitments undertaken by nearly 200 parties to the 2015 Paris Agreement, in order to reduce the expected rise in temperature to 1.5%, the level of greenhouse emissions will need to be reduced by c.50%.
- In order to achieve such dramatic reduction, the main polluters will need to dramatically reduce their emissions and/or purchase carbon credits.
- Over the next 10 to 30 years demand of carbon credits is expected to grow substantially, supporting further price appreciation.
Carbon Credit Prices (KRBN)
A carbon credit is a permit which represents the right to emit one tonne of carbon dioxide (CO2). Valuing and being able to purchase (or sell) a credit therefore places a cost on carbon emissions, which would otherwise remain a cost-free harm done by an emissions producer to the planet.
“Emissions trading” or “carbon trading” (noting that carbon is the dominant emission, if not the most polluting) first entered the vernacular with Article 17 of the Kyoto Protocol, which allowed countries that have excess emission capacity compared to their target to sell this to countries that are not able to meet their targets.
The possibility of buying and selling credits created a new traded “commodity”. To facilitate the trading of emission credits, trading schemes may be established at the national level and the regional level. Under such schemes governments set emissions obligations to be reached by the participating entities.
The European Union emissions trading scheme is the largest in operation. Transfers and acquisitions are tracked and recorded through the registry systems under the Kyoto Protocol, and an international transaction log ensures secure transfer of emission reduction units between countries.
To address concerns that parties could ’oversell’ units, and subsequently be unable to meet their own emissions targets, each party is required to maintain a reserve known as the “commitment period reserve”, which should not drop below 90 per cent of the party’s assigned amount or 100 per cent of five times its most recently reviewed inventory, whichever is lowest. The Kyoto Protocol also divides countries between industrialised and developing economies.
Annex I countries, classified as Industrialised Nations, operate in an emissions trading market which gives each country their own emissions standards to meet. Annex II countries, classified as Developing Nations, operate a separate Clean Development Mechanism (CDM) that issues carbon credits called Certified Emissions Reductions (CER).
Projects are eligible for carbon credits under the Clean Development Mechanism only if the emissions reductions are additional emissions of greenhouse gases that are reduced below what would have occurred anyway. CERs are issued to support sustainable development projects in developing countries and are tradeable. Compliance markets are legally bound by the goals of the Kyoto Protocol and legally recognised to ensure market integrity.
The Market for Carbon Credits
According to the World Bank’s Carbon Pricing Dashboard there are currently 64 carbon pricing jurisdictions worldwide, with a degree of alignment to the Paris agreement. China has also commenced operation of its Emissions Trading System (ETS).
While the Kyoto protocol continues to underpin what can be referred to as the regulatory carbon trading market, there is additionally a voluntary trading market. This can be accessed by any company or individual looking to offset their greenhouse gas emissions. Voluntary carbon credits also help to raise private financing for climate-action projects and investment into innovative technologies. However, the voluntary market is less transparent and regulated than the compliant market.
Carbon trading kicked off in significant volumes after the financial crisis, and has grown steadily since then, providing a trackable price for carbon credits. Carbon prices are now tracked by credible index providers e.g., IHS Markit and ICE. As an example, the ICE Carbon Futures Index Family is made up of pricing from the three most actively traded carbon markets in the world, the:
- European Union Emissions Trading Scheme (EU ETS), which started in 2005.
- California Cap and Trade Program, which started in 2013.
- Regional Greenhouse Gas Initiative (RGGI), which was established in 2009.
Together these markets represent some of the largest regional economies in the world, and the secondary futures market for those programs which trade on ICE’s futures markets make up much of the volume in all carbon-based futures contracts.
Spotlight on the EU ETS
The EU ETS, for example, is a market mechanism that creates a cost for CO2 emissions, and hence an incentive to reduce them. It is likely to have contributed to the reduction in emission from power-intensive sectors by c. 40% over the last 15 years or so.
Under this system companies are allocated allowances related to their emissions, making energy production from burning fossil fuels relatively more expensive compared to clean sources. This incentivises companies to become both more energy efficient and less polluting, as they can sell their unneeded permissions back into the market.
The EU ETS is a cap-and-trade approach, whereby the EU sets a cap on annual pollution, with companies required to hold European Emission Allowances (EUAs) for every tonne of CO2 emission, either by receiving them or buying them in the market. Companies can also buy additional credits from projects under the Kyoto Protocol’s Clean Development Mechanism in developing countries.
Companies are fined (currently 100 euros per tonne) of excess CO2 pollution not covered by their allowances, and this is likely to increase.
In 2020 “The European Green Deal” was announced, which has the aim of making the EU ‘climate neutral’ by 2050. The financing of policies set out in the plan will occur from the EU via the vehicle “InvestEU”, which forecasts >1tr euros in investment.
In June 2021 the European Union adopted new climate laws which create a stricter binding target of at least 55% greenhouse gas emission reduction by 2030. To meet its aims and objectives, c. >250bn euro / year in investment is likely to be needed by 2030.
Greenhouse emissions: current state of play and trends in shareholder activism
c. 1/3rd of man-made global greenhouse gas emissions are from 30 companies, which have not had to pay for the negative externalities in the past. The actual, full-cycle economic, cost of fossil fuel industries no longer makes sense, in comparison to renewables and alternatives, if the carbon-cost is included. Of the 30 largest carbon polluters, 10 are state owned and 21 are publicly listed (including 1 state owned/controlled). There are three main forces which will increasingly act on these companies:
- Of the listed companys, shareholders have and are continuing to vote their opinions.
- Likely more significantly, institutional investors beginning to speak via the cost of capital. There are now trillions of dollars in the green bond market which only invests in ESG (Economic, Social, and Governance) compliant companies.
- Political will legally forcing companies (such as Exon and Shell) to reduce emissions.
Previously the validity of a carbon credit was the key concern as the market was not properly regulated and did not have comparative integrity of credit creation.
In 1997 180 nations signed up to the Kyoto protocol. No countries met their targets for reductions of emissions. The projections for the current state of emissions were quite accurate. For example, China produces more carbon emissions from the concrete they create annually than the carbon emissions from every internal combustion engine in the world.
With the switch from boomers to millennials, the largest pool of capital ever will be increasingly directed with a ’stakeholder capitalism’ perspective. Consequently, ESG funds are the largest growing sector in bond market, with c. 25 times growth since 2013. The US has contributed < 5% of the capital, with the majority coming from the EU. Trillions of dollars of future investment will have ESG covenants.
In addition, there are c. 4,500 companies in western economies with > $1bn market cap, with c. 10% in last year introducing a ‘reduced carbon footprint’ plan. For example, an Apple press release indicated an intended 30k carbon credits / year would be created from a blue carbon (mangrove) project, at c. $20/ton for costs with a trade in value in Europe for c. 60 US equivalents, or >50euro in Canada.
We expect significant demand drivers for carbon credits in the medium term that are likely to be reflected in sustained price appreciation, albeit subject to significant volatility and potentially a high degree of correlation to economic growth and so broad equity markets. Currently, few if any mainstream brokerage/research/analyst houses include the cost of carbon emissions in their final NPV, CF, or NAV models.
Source of Demand for Carbon Credits
Under the 2015 Paris Agreement, nearly 200 countries have endorsed the global goal of limiting the rise in average temperatures to 2.0 degrees Celsius above preindustrial levels, and ideally 1.5 degrees. Reaching the 1.5-degree limit is estimated to require a c. 50% reduction in global greenhouse-gas emissions by 2030 and net zero by 2050. Consequently, regulatory targets are likely to have even more impact going ahead, and it is estimated that prices in the region of $150/t of CO2 would be needed to reach the 1.5 degrees global warming limit.
At a company level as well, we see increasing commitments to reduce emissions, driven in part by shareholders, lenders, consumers, general corporate responsibility obligations, and the management of public opinion. As an indicator of the trend, the number of companies with net-zero pledges doubled from 500 in 2019 to more than 1,000 in 2020.
If 10 of the 30 largest polluters (e.g., half of those listed companies in the top 30, assuming all the government-controlled entities do not change their practices, which is unlikely) reduce their emissions by 50%, the demand for carbon credits could increase by c. 20 times.
The resource industry in particular has been avoiding the cost of the negative externalities for over 50 years, and if the industry had the cost of carbon included cash flow models would produce a substantially different outcome. The only way to offset materially the large effect that accounting for the cost of carbon would have is by lowering the cost of capital.
For example, take a mid-tier copper company, producing a vital component for the ‘green revolution’, with c. 120m lb of production and a $1.5bn capex. The cost of capital (interest rate on debt) for such a mid-tier venture could be expected to be in the range of 8% to 12%, or sub-investment grade. However, having an ESG profile enabling it to access the green bond market could cut its cost of capital in half.
At c. $4/lb copper and 120m lb production, such a company might only return c. $50m in free cash flow. A halving of the cost of capital, via access to the green bond market by becoming ‘carbon-neutral’, would close to double its free cash flow. The only viable way to achieve this for a lot of highly energy-dependent companies will be via carbon credits.
Additionally, for many firms, eliminating or substantially reducing emissions is not viable in the short term. This can be due to the cost or investment required, lack of technology, or simply that some manufacturing processes are inherently highly emitting in nature, as in the example above.
For such firms, a credible near-term solution is to use carbon credits to offset emissions they cannot substantially reduce by other means. For example, the cement industry, based on current technology, will likely need to acquire carbon credits for many years if not decades to come close to net zero.
On the supply side, carbon credits cannot be reused, and cannot be generated liberally as they require credible and viable CO2 reduction projects to be undertaken and implemented.
These trends provide strong support for the trading of carbon credits and their price. The Institute of International Finance (IIF) estimates that demand for carbon credits could increase by a factor of 15 or more by 2030 and by a factor of up to 100 by 2050. Overall, the market for carbon credits could be worth upward of $50 billion in 2030 with the long-term opportunity worth up to $20tr.
Voluntary carbon markets are also progressing – a report from Ecosystem Marketplace indicates an expected annual market value of trades of c. $1bn in 2021, a growth of c. 60% on the previous year. The most active buyers are energy, consumer goods, and financial services companies. The carbon price of the EU ETS, has risen to €50 in May 2021, from €18 price in 2020. The IHS Markit Global Carbon Index, (which consolidates key markets) price trend shown here: https://indicesweb.ihsmarkit.com/Carbon/Home
The voluntary carbon market at present is less transparent, verifiable, and robust. The quality and limited amount of price data are key issues, and while there are a number of initiatives underway to improve voluntary markets, there is a risk that growth is impacted.
The variability of factors that determine the price of carbon credits is another issue – the types of projects, size and quality, level of caps and commitments, etc. Compliance carbon trading systems have pricing based on local economies and systems. The price of carbon can therefore vary widely and can make carbon credits complex and not as homogeneous as traded stocks or easily portable commodities.
At a higher level, carbon credits could be threatened by a move towards a carbon tax system. In this setup, emitters pay the government, who finances green projects, with no room for direct buying and selling.
Ironically, as global emissions reduce, so should the price of credits, albeit this may be substantially offset by increasingly tighter regulations and politically/regulatorily driven price floors. One benefit of a high carbon price in the medium term is that it should induce further efforts and investments in reducing and removing emissions – leading to a positive environmental outcome. During the period that emitters are under greater pressure to reduce than is matched by opportunities to reduce and green projects, carbon trading presents an attractive investment opportunity.
Similarly, as technology develops, emitters in the long run will likely find more cost-effective ways to achieve net zero than buying carbon credits. The cost of solar panels, for example, has decreased by a remarkable c. 90% since 2005 for example, and wind turbines have become much more efficient, and larger, on a cost-adjusted basis than in the past.
Specific Key Risks
Lack of Fundamentals
Carbon credits are an entirely ‘contrived’ commodity. They only have value because of the arbitrary regulatory and political framework which decrees their validity; i.e. they have no intrinsic utility.
Political / Regulatory Risk
As they are entirely a government created market these securities and their prices are strongly dependent on government policy, which might not necessarily be made so as to increase carbon credit prices.
Companies with high emission levels have two choices: buy carbon credits on the market or reduce their emissions. Reducing emissions is currently relatively difficult and expensive but is becoming easier and cheaper every year. This, combined with higher carbon emissions cost, will likely cap carbon costs at some point.
For example, as solar energy generation has decreased in cost by c. 90% in ten years, many power utilities are finding it more cost effective to invest in solar power for emissions reduction than to maintain fossil-fuel plants and offset the emissions with carbon credits.
An additional technological risk is in carbon sequestration. As carbon credit prices reach and exceed all-time highs substantial gains can be made from new sequestration or reduction technologies. A factor that could offset this risk is an acceleration by governments of cap reductions which could keep the market in balance and prevent carbon prices from falling too far.
Although the desire for uncorrelated assets, whether in terms of risk factors or prices/returns, is common for all portfolio investors, many advocates of the carbon credit investing consider its unsystematic/idiosyncratic factors to be so substantial as to make macroeconomic factors secondary in importance. We do not believe this to be the case.
A large and persistent economic downturn, and/or asset market downturn, would likely reduce carbon credit prices. An economic downturn will reduce the output from various carbon intensive industries, reducing demand for carbon credits. A significant market / asset price downturn, as in March 2020, would likely reduce the valuations of all assets, including carbon credits (which lost c. half their value from 2019 to 2020), especially if this were accompanied by a liquidity squeeze or crisis.
There is a risk of fraud in the carbon credit markets, both in the markets themselves (the creation and tracking of credits, which could tarnish the reputation of the market), and the vehicles available to gain exposure (which could directly harm investors). However, such risks are reducing with time.
There is some risk in low liquidity for some instruments, particularly ETF vehicles.
Long term, the investment rationale for carbon credits is strong, not least because most political and regulatory efforts will likely aim to keep carbon prices high and increasing to promote further reductions in emissions.
In addition, carbon prices should rise more or less in line with inflation during any future shock
Lastly, over the long term, carbon prices have and should continue to display a relatively low correlation to other asset, at c. 0.4 or below for both equities and other commodities, making carbon credits a good portfolio addition for diversification purposes.
Arguably COP26 does not necessarily have the same impact on, for example, the Chinese, Indian, and US population as it does on the European population. There also appear to have been some compromises whereby China and India have decreased the voracity of some of the criteria surrounding e.g., coal abatement.
Noteworthy is the lack of either desire or ability for some of the large automakers (especially Toyota and Volkswagen) to agree to a 2035 or 2040 zero-emissions target; Ford, for example, agreed. This indicates that long-term predictions on EV rollouts are less certain and likely to be pushed out further, but with little impact in the short term.
Similarly for coal, usage continues to decline in the US and the economic competitiveness of renewable sources is now on a par with fossil fuels. However, the likely outcome of COP26 is not an immediate boost to energy metals.
If the thesis is that government and regulatory policy will choose the mechanism of market forces to result in carbon net-zero emissions, with current technology carbon prices would need to increase by c. three to four times to incentivise the necessary investment into a low-carbon technologies.
If such a transition were subsidised the carbon price would not need to increase so much, but if it were to be funded by the industry then carbon prices could increase by substantially more. This could result in substantial economic, and so social, changes as well, creating both a substantial cost burden for society and opportunity for investors.
The two key questions regarding carbon neutrality are:
- will it happen? And if it happens,
- when will it happen?
One option is to focus on companies/commodities/portfolios likely to be most impacted (positively and/or negatively) by price disruptions to supply caused by substantially higher carbon prices or carbon emission restrictions.
For example, the ‘carbon cost curve’ for aluminium produces ranges from very low to very high, so investment in companies with a low carbon footprint would be an investment into a durable competitive advantage however the company choses to monetise it (e.g., selling product at a premium, needing to buy fewer offsetting carbon credits, or the ability to access certain markets closed to higher polluters).
Looking at related industries, such as technology and regulation (e.g., which companies will setup and run the exchanges or ledgers, how will carbon tracking be implemented, etc.) is another option.
According to Mark Carney, former Governor of The Bank of England and involved with the Taskforce on Scaling Voluntary Carbon Markets, around $100bn could be rotated into the carbon offset market by 2030. This compares to c. $300m in 2018.
A global benchmark for carbon offset price discovery is likely to involve a new range of carbon offset futures contracts traded on major exchanges. The CME Group and Xpansiv’s CBL platform have developed the Global Emissions Offset (GEO) futures contract, which was launched by the CME Group in March 2021 and represents 1,000 carbon credit offsets.
This was followed by the August launch of a CBL Nature-Based Global Emissions Offset (N-GEO) futures contract based off Verra’s Verified Carbon Standard for Agriculture, Forestry, and Other Land Use projects.
According to McKinsey, the carbon credit market could increase by c. 15 times by 2030 and be worth over $50bn, and up to c. 100 times by 2050.
There are four major greenhouse gas (GHG) crediting programs: Verra (which administers the Verified Carbon Standard (VCS) program, the Gold Standard, Climate Action Reserve, and the American Carbon Registry.
Those companies desiring authenticated projects (which could be e.g., reforestation or switching from fossil fuels to green energy) can invest in Verified Emissions Reductions (VERs) audited by third parties.
A Note on Instruments
One way to gain access to the carbon credit market is via ETFs which gain exposure via futures. Unfortunately, investing in futures requires awareness of the shape of the term structure, and the futures curves for carbon pricing appears to be relatively constantly in a state of contango, resulting in a constant loss when a fund must re-buy higher-priced future contracts as the near-term ones mature.
This structural tendency for loss can be offset by many multiples by spot price increases but is something that would likely generate persistent losses in a flat spot market.
This Time It’s Different?
There have been numerous attempts since the Kyoto protocol of 1992 to create carbon markets. Many failed as carbon projects tended to be financially unviable, difficult to track and verify, and shrouded with concerns over ‘double counting’ and fraud. In addition, there was little political and corporate governance focus in the 1990’s and early 2000’s. Consequently, such markets, when they did develop, were often illiquid and not fungible, being somewhat bespoke bilateral agreements.
From 2020 there are three major differences.
- Government political and regulatory intent.
- Corporate Governance and stakeholder support in the industry.
- Blockchain / distributed ledgers allows for tracking and accounting credibility and transparency.
The primary goal of the Paris Agreement of 2016 was to limit global warming to no greater than 2 degrees, and preferably 1.5 degrees, by 2050. Almost every country joined the agreement except for the US under the Trump administration, which has since joined under the Biden administration.
The key element of the agreement is Article 6, which favours the use of carbon credit systems for offsetting, with the goal of marketplaces to reduce the risk of double counting and increase transparency.
The recent UN Climate Change Conference of Parties (COP) 26 meeting in November 2021 saw countries agreeing the rules for implementation of Article 6, which sets the foundation for active and robust carbon credit markets.
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