Are You Ready for the Carbon Markets?
Global carbon markets are a nascent and growing asset class with structural tailwinds that are experiencing some growing pains. That aside, it is a legitimate asset class that touches multiple points of inflection, one of which would be what we call a ‘behavioral trend.’
This is evident in increased individual and institutional focus on addressing climate change and reducing greenhouse emissions. We are talking about the potential impacts beyond a company’s ESG score that investors can access through ‘broad’ exposure.
But, before you jump in with both feet, here are a few basics you should know:
What are Carbon Credits?
Governments (primarily) put a cap on pollution/emissions.
Why Carbon Credits?
Worldwide, governments are trying to reduce carbon emissions in the name of preventing/slowing/not worsening climate change. 196 countries signed the Paris Agreement in 2015, which among other goals, aimed to: 1) Hold the increase in global average temperatures below an increase of 2 degrees Celsius from pre-industrial levels; and 2) make finance flows provide a tailwind, reducing greenhouse gas emissions.
What Markets Exist?
- European Union Emissions Trading System (EU ETS).
- California Cap-and-Trade (CA C&T).
- Regional Greenhouse Gas Initiative (RGGI) represents ten states in the Northeast of the United States.
- Korean Emissions Trading System (KETS)
- Many other markets and programs that have developed recently.
How is it Measured?
Carbon emissions are measured through the ‘tonne’ of carbon dioxide equivalent (tC02e). The purpose of a carbon credit is to put a price on each unit of emissions.
Governments issue carbon allowances to companies (carbon emitters) either through grants or through an auction marketplace. Companies then must surrender one carbon allowance for every tC02e they emit. ETS allows companies to trade their carbon allowances in a marketplace based on their respective supply and demand needs.
What's an available proxy to follow?
The Kraneshares European Carbon Allowance ETF (KEUA) is an exchange-traded fund that seeks to provide a total return before fees and expenses. It seeks to outperform the IHS Markit Carbon EUA Index over a ‘complete market cycle. It serves as a proxy for the performance of European credit allowances.
We see the significant impact of the Russian invasion of Ukraine and the recent announcement by the German government of a delay in the increase of a carbon tax per tonne of CO2 emissions from January 1, 2023 to January 1, 2024. This highlights the influence government actions can have on this asset which is increasingly ubiquitous across the world.
However, in the long run, many factors lead us to believe this is a viable asset class that may provide low-correlated returns to investors. 196 countries have signed the Paris agreement providing a structural need to put a price on the emission of carbon. Add the structural reduction in the availability of carbon credits, and there is the potential to create scarcity, assuming there is a limit to how efficient emitters can become.
At the end of the day, carbon credits could be the closest, quantifiable asset [liability] in which investors can measure the impact of the world’s companies on the environment–potentially, even a better alternative to simply relying on an ESG score. The question is: Are we seeing the early stages of a meaningful point of inflection in the form of a change in human behavior as the world moves forward? We remain cautiously encouraged and will continue to research this asset class accordingly.
In the meantime, here is a short reading list if you’re interested…
Validus Growth Investors, LLC seeks to invest in companies at every stage of their growth. From startups to publicly traded companies, our research identifies inflection points that have the potential to produce meaningful growth and income for the clients we serve.
Investment Advisory Services are offered through Validus Growth Investors, LLC (“Validus”), an SEC Registered Investment Adviser. No offer is made to buy or sell any security or investment product. This is not a solicitation to invest in any security or any investment product of Validus. Validus does not provide tax or legal advice. Consult with your tax advisor or attorney regarding specific situations. Intended for educational purposes only and not intended as individualized advice or a guarantee that you will achieve a desired result. Opinions expressed are subject to change without notice. Investing involves risk, including the potential loss of principal. No investment can guarantee a profit or protect against loss in periods of declining value. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Opinions and projections are as of the date of their first inclusion herein and are subject to change without notice to the reader. As with any analysis of economic and market data, it is important to remember that past performance is no guarantee of future results.