Investing in Carbon Credits: Profiting from the Rising Price of Pollution

As regular readers know, I like to look for ways that we as ordinary investors can gain access to newer and very attractive areas to invest in, even though they don’t at first sight seem like they would be accessible through the stock market. I highlight my note on KR1 which is in fact a very successful listed venture capital firm in cryptocurrencies, Frontier IP which gives investors exposure to really early-stage technology companies coming out of universities and also my notes on gaining investment exposure to the incredible returns on offer in the not very well understood market for litigation funding.

As I look at the world right now, there are a number of risks and uncertainties. I tend to mainly invest in high quality growth companies with strong competitive positions and I have little doubt these will continue to prosper in a variety of economic scenarios. However, storm clouds are gathering as post-Covid economic growth seems to be weaker than market participants had expected, while markets are at high valuation levels. Within this context, I have recently been looking for places to invest which are less correlated with the overall equity market…

Today, I would like to tell you about why I believe investing in carbon credits could be attractive. To limit global warming to 1.5°C, in line with the Paris Agreement, we need to cut current greenhouse-gas-emission levels in half by 2030 and reduce them to “net zero” by 2050. But what about activities that can’t be made carbon-free? One answer is carbon credits. In a nutshell, by paying someone else to either reduce their emissions or capture their carbon, companies can compensate for their own environmental footprint.

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I believe that whatever happens to the global economy, it’s undeniable that pollution will remain a huge and growing problem, and therefore there is every chance that the price of carbon credits will move higher. In addition, I will explain how there is now a brand-new way of gaining this exposure as an ordinary equity investor.

The Challenges of Getting to Net Zero

Scientists worldwide have spent the latter part of the last century issuing warnings and explicit predictions about the effects of climate change on the global population. Still, most people didn’t think much of their warnings more than unfathomable numbers on a computer screen. However, that’s not the case anymore. In the last decade, people around the world are witnessing the effects of climate change themselves. From facing the hottest months in our planet’s history to flash floods and raging fires, climate change seems to be manifesting itself in disastrous ways. As an integral part of meeting this environmental challenge, the concept of carbon credits was born which simply represents a mechanism to limit and tax emissions by companies and countries and incentivise those initiatives that lower emissions.

Carbon Credits Explained

A Carbon Credit is an instrument that represents ownership of one metric tonne of carbon dioxide equivalent that can be traded, sold or retired. According to the Environmental Protection Agency, one metric tonne of carbon dioxide is equivalent to the emissions generated from approximately 2,500 miles driven by the average passenger vehicle or 113 gallons of gasoline consumed or about 1,100 pounds of coal burned. One metric tonne of emissions is also equivalent to one month of an average individual’s annual carbon footprint.

Carbon credits are tradable certificates or permits that let an organisation limit its carbon emissions or other greenhouse gas emissions to a specific amount. For example, if a company has a single carbon credit, it is allowed to emit one ton of carbon into the atmosphere.

How do Carbon Credits Help the Environment?

Carbon credits were developed as a part of a cap-and-trade programme designed to address the problem of companies that could not immediately become carbon negative or even neutral. Through these carbon credits, private companies get double incentives to reduce their carbon emissions, which leaves a positive impact on the environment. By reducing their carbon emissions, these companies can also sell their leftover credits to companies who need them and earn profit. On the other hand, they are penalised for carbon emissions outside of their limit by the need to buy further credits.

The overall intention of introducing this concept is to reduce the number of carbon credits available in the market over time so that companies look for innovative ways to curb carbon and greenhouse gas emissions.

History of Carbon Credits

The concept of carbon credits dates back to 1997 when it was first discussed in Kyoto, Japan, during the United Nations Framework Convention on Climate Change. Furthermore, the idea was put forward again in 2001, when countries like Germany, Japan, and Australia, among 191 others, ratified the cause. In this summit, the idea of a cap-and-trade marketplace, where financial incentives could increase carbon credits’ value, was put forward. Recently in 2015, the carbon credits discourse further evolved with new policies to be implemented from 2020. The main goals included the proper integration of carbon markets and linking global trading schemes so that companies create more ways to lower their carbon emissions.

The Way Carbon Credits Work

Currently, carbon credits are issued under the Kyoto Protocol. The system assigns a specific greenhouse gas quota that each country is allowed to emit. Further, every country can specify an allowance for one metric ton based on its Assigned Amount Units by the Kyoto Protocol.

This way, they can assign these single-metric ton carbon credits to companies and businesses in their countries to limit the carbon they can emit. Now, organisations are free to use their carbon credits in any way they like for their profit, which encourages new ways to combat excessive carbon emissions.

The Role of Carbon Credits as an Investment Portfolio Diversifier

If a carbon credit is nothing but a permit or certificate, how and why are investors worldwide buying carbon credits to diversify their investment portfolio?

It is clear that reducing carbon emissions is not easy for major enterprises, especially companies that produce energy from fossil fuels. That’s why, if these companies fall under the cap-and-trade system, they will have to pay for the carbon they emit by buying further carbon credits. We know that there is a cap to the number of carbon credits, so supply is limited. Obviously, companies who succeed in emitting less carbon than the credits they own can sell their credits to those who need them but other than that, any shortfall to reaching lower emissions has to be ‘bought’. Each carbon credit means the organisation owns a single metric tons of carbon dioxide and has the right to emit harmful gases under this limit. This way, carbon credits become tradable assets for companies working towards reducing their carbon emissions. It is clear that purely from a supply/demand perspective, investing in carbon credits seems attractive.

In terms of environmental impact, the marketplace of this nature further incentivises lowering carbon emissions by permitting the allocation, trading, selling, and buying of carbon credits among organisations.

Besides that, carbon credits are designed as tradable, exchangeable entities so that a sense of profitability and ownership is created. This makes them easier to implement than strict carbon restrictions and taxes.

In the aftermath of the Paris Agreement, carbon credits trading has become big business for the impact investment sector. Investors should consider that the carbon trading market has been a profitable investment venture since its advent. Billions worth of carbon credits are traded across the market. With that amount of money going around, there is ample liquidity for large investors looking for uncorrelated assets. The CEO of Climate Change Capital assured investors that this cause could make enough returns to match the profits from leading industries like infrastructure or real estate. By 2020, total EU carbon emission allowances trading activities were valued at over EUR201 billion, equivalent to over 8,096 million tonnes of carbon dioxide, an increase of over 19 per cent from a year earlier.

Disadvantages of Investing in Carbon Credits

Although carbon credits are highly beneficial for reducing emissions, they are not risk-free methods of investment. The most evident reason for this is that a carbon credit is not a real, tangible entity in its origin. Additionally, carbon or any other greenhouse gases have no intrinsic value, which can lead to large fluctuations in price.

To make the concept strong enough for trade, organisations have to strictly limit and regulate the emissions to make them tangible like any other investment asset. Restricting these emissions and limiting them to a specific range is quite tricky for governmental organisations.

Besides that, carbon credits are also given away for free to some companies, which leads to a drop in price with no positive impacts on the environment. Similarly, carbon offsets also target reducing carbon emissions in developing countries whose overall effectiveness is questionable.

Until now, there has been no standardized way to trade carbon credits and no way to verify the compensating activity behind them. Environmental groups say the process has been “fraught with scandals”, accusing some countries of having increased emissions just to get paid for cutting them. These and other allegations prompted the Financial Times to declare: “Carbon offsetting is shaping up to be the greatest mis-selling scandal since the Dominican friar Johann Tetzel sold pardons to redeem the dead.”

What’s Next? More Transparency

A new report from an international task force led by UN Special Envoy for Climate Action and Finance Mark Carney and chaired by Bill Winters, CEO of Standard Chartered Bank, has devised a draft blueprint for creating large-scale transparent carbon credit trading markets based on independent verification that the claimed reductions in CO2 are valid. The World Economic Forum is observing the effort.


Source: MSN Money (Price data as of 22.10.2021) Past performance is not indicative of future performance. Returns may increase or decrease as the result of currency fluctuations. Figures refer to price data between September 2021 and October 2021)

Investment Trust Description

WisdomTree aims to offer the most comprehensive range of commodity ETPs in Europe, with circa USD24.9 billion in assets under management across its platform. WisdomTree has last month re-introduced Europe’s only carbon exchange-traded product (ETP) to the market. The WisdomTree Carbon (CARB) is listed on the London Stock Exchange with a total expense ratio (TER) of 0.35%. CARB tracks the newly created Solactive Carbon Emission Allowances Rolling Futures index which offers exposure to the ICE Carbon Emission Allowances (EUA) futures contract.

“Climate change mitigation is front of mind for investors, corporates and policymakers alike, with many seeking to reduce their carbon footprint and align with the Paris Agreement. The importance of these initiatives cannot be understated and has driven demand for a vehicle that provides exposure to carbon emission allowances futures.” Alexis Marinof, head of Europe at WisdomTree

Initially launched by ETF Securities in 2008, CARB was forced to close in June 2020 after its swap counterparty, Shell Trading Switzerland, terminated the purchase agreement along with eight oil ETPs. This decision came following extreme volatility in oil markets with WTI trading below $0 a barrel for the first time in history in April 2020.

There are some differences between the old and new strategy. The newly-launched CARB will have two swap counterparties – Citigroup and Merrill Lynch – making it harder for the purchase agreement to be terminated. In addition, the old ETP did not track an index and was not fully collateralised.

The European Union Emissions Trading Scheme (EU ETS) is the world’s largest carbon market and is intended to support the EU in achieving carbon neutrality by 2050. Under the EU ETS, a cap exists which limits the amount of greenhouse gases that can be emitted by companies each year.

A fixed number of carbon emission allowances are issued each year, with companies required to hold enough allowances to cover their emissions and ensure they fall under the cap. Price increases in carbon emission allowances mean it gets more expensive for companies to cover their carbon footprint with the allowances and should incentivise them to invest in pollution abatement technology which could help drive change faster.

“Futures based on the European carbon market are the most liquid in the world and present an investment opportunity for investors looking to contribute to price discovery in this vital market. Further investor involvement could boost the futures liquidity, continue to improve this market and further this cause.” Nitesh Shah, director of research, Europe, at WisdomTree

The price of EUA is up 76% year to date, according to data from Bloomberg and WisdomTree, as natural gas shortages in the US and low domestic European production contribute to an increase in coal-fired electricity production across Europe. As a result, demand for carbon emission allowances has increased making it more expensive for companies to cover their carbon footprint, as well as a strong opportunity for investors.

“Investors have recognised the strong investment potential in EUA. The European Commission announced a legislative package in July which doubles-down on the ETS, giving scope to expand the programme and tighten the availability of allowances. Tighter allowances and greater demand are likely to be price positive for EUAs.” Nitesh Shah, director of research at WisdomTree

Commenting on the re-launch, Bernie Thurston, CEO of Ultumus, said: “It is interesting to see the resurgence of this ETP. Effectively, it looks as though CARB was ahead of its time. This seems like a product whose time has come and it has been relaunched with a more solid structure behind it.”

Conclusion

Carbon-emission allowances are still an esoteric market, but one that looks set to grow. Most economists seem to believe that economy-wide carbon pricing – such as the EU’s Emissions Trading System (ETS) – will be needed to shift our energy use to renewable sources and tackle climate change. If the scope of schemes like these continues to grow, it will push up the price of carbon-emission allowances – thereby helping to bring about change, but also creating an opportunity for investors.

In my opinion the newly listed Wisdom Tree Carbon ETP could be an attractive route to gain exposure for ordinary investors. This product launch is notable in that it is the first UK-listed exchange traded product to give investors access to this market. The WisdomTree Carbon ETP (LSE: CARB) tracks the ICE Carbon Emission Allowances (EUA) futures contract, which is the most liquid exchange-traded carbon futures contract globally. The most advanced carbon regime in the world is in fact Europe’s ETS. Total EU carbon emission allowances from trading activities were valued at over €201bn in 2020, equivalent to 8,096 million tonnes of carbon dioxide, an increase of 19% from a year earlier, according to WisdomTree.

ETS has a ratchet effect – over time the emissions allowed decline, forcing the industries to change their processes or pay what is in effect an excess carbon charge. Higher prices for allowances mean it gets more expensive for companies to cover their carbon footprint and incentivises them to invest in pollution-abatement technology. As Europe becomes greener at the policy level, the ratchet effect is intensifying. The existing target was a 40% reduction in carbon dioxide emissions by 2030 (from 1990 levels), but that’s now being raised to 55% for the 27 remaining EU countries by 2030, with a plan to eliminate net emissions by 2050. The emissions cap is being reduced at 2.2% per year between 2021 and 2030 and the 55% cap could raise that rate of reduction to 4.2% in 2024.

These pressures have already led to ETS carbon prices rising, but there’s also another factor at work: big institutions (and hedge funds) are waking up and buying into the ETS market. The combination of policy pressures and increased investor participation should be positive for carbon prices, reckon analysts at Morgan Stanley. They have raised their medium-term forecasts to €48 per tonne for the end of 2021, and to €58, €65 and €74 for 2022, 2023 and 2024 respectively.

Alongside this bullish scenario, it is important to understand that ETS has produced highly volatile carbon prices over the last decade. Most commentators reckon that too many free emissions were issued at the beginning of the scheme, resulting in a price crash in the early years. Sceptics also think that a higher EU carbon price might not achieve the desired objective – it could incentivise carbon-intensive industries such as steel to shift production to countries that don’t have carbon pricing. Some argue instead for a carbon border tax (which may be hard to implement under current global trade rules).

So it’s by no means certain that the EU’s approach will work, while the rising financial interest might result in a short-term overshoot in prices. Still, I feel the odds are firmly in favour of higher prices. Yes, there may be some volatility in pricing but this seems to be a genuine diversification opportunity into a non-correlated asset class that doesn’t really move around very much depending on the economic cycle. I’d also suggest that the direction of travel is clearly upwards and according to some supply/demand estimates, prices could reach €100 per tonne!

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This material is not investment research in accordance with the legal requirements designed to promote investment research independence and is also not subject to any prohibition on dealing ahead of the dissemination of investment research; and as such is considered to be a marketing communication.

All investments have the potential for profit and loss and your capital is at risk.

Past performance is not indicative of future results.

Performance can increase or decrease as a result of currency fluctuations.

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