Want to know more about the carbon markets, what we do as a company, or how we could partner with you? Check out our most frequently asked questions below. And if you still can’t find what you’re looking for please get in contact with us.
What is the investment thesis of the Global Carbon Strategy Fund?
If climate change is going to be successfully tackled and the Paris Agreement targets met, the price of carbon needs to rise substantially. As such, the outlook for carbon prices over the next decade is positive, although carbon markets can at times exhibit elevated volatility driven by a range of market and regulatory factors. Most equity/bond portfolios have exposure to complex and underestimated climate change-related risks. Carbon exposure may be negatively correlated to these risks and therefore offers hedging opportunities. Carbon markets are dominated by industrials and energy companies seeking to manage their carbon exposure, which provides alpha opportunities for financial investors. High volatility and market-specific pricing factors create opportunities to add value from research and risk management. The combination of a favourable political tailwind, high volatility, low correlation and alpha sources, lends itself well to an actively managed absolute return approach.
What are “compliance” carbon markets and why have they been established?
Compliance carbon markets have been established by governments to address climate change by providing a market mechanism to reduce carbon emissions. These "cap-and-trade" emissions trading systems (ETS) require companies to factor the cost of carbon into their production costs and have been successful at achieving meaningful reductions in emissions at low cost. The total amount of carbon allowances in each market is “capped” and the cap is reduced annually, guaranteeing emissions reductions. To cover their annual emissions, polluting entities must submit allowances which are either purchased at auction (or in the market) or received through allocation. Compliance is mandatory, and each entity is tightly monitored and audited, including penalties for non-compliance.
What is the difference between carbon allowances/credits and carbon offsets?
Carbon allowance, or sometimes referred to as carbon credit, represents the legal right to emit one metric ton of carbon dioxide or equivalent greenhouse gas. These allowances are issued to companies and organizations participating in a mandatory national or international carbon market (i.e., European Union, UK, California or Regional Greenhouse Gas Initiative in US Northeast). Depending on the speciﬁc market or trading scheme, carbon allowances are either purchased by regulated emitters (often by auction) or allocated for free based on forecast carbon emissions.
Carbon offset is generally outside of an emission trading scheme (ETS) or can be imported into an ETS. It also represents one ton of carbon dioxide or equivalent greenhouse gas. However, it is generated by a reduction in emissions made by a voluntary project designed speciﬁcally for that purpose. Typical carbon offset projects are located in developing countries and include building wind turbines or a solar farm, supporting methane reduction projects, planting trees or preserving forests.
What are the advantages of carbon allowances compared to carbon offsets?
Carbon allowances create emission reductions in a regulated, capped environment, therefore directly contributing to reducing emissions. On the other hand, the environmental integrity of (voluntary) offsets vary significantly, with the majority of offsets avoiding an emissions increase, but not actually reducing emissions.
Carbon allowances enable investors to invest in an asset that generates annual emission reductions like a “climate dividend”, and which can be divested later at a potential profit. In contrast, buying and retiring offsets is not an investment but a purchase/cost.
Carbon allowance markets are highly standardised, regulated and much more liquid than voluntary offset markets. They provide scale to have a meaningful impact.
What are the disadvantages of carbon allowances compared to carbon offsets?
For many investors, accessing for example the EU allowance (EUA) market is challenging. One access route is to buy the EUAs outright. However, this requires a registry account, market access and the handling of a regulated digital commodity, creating a high level of operational complexity. Most financial investors find the unconventional custody and settlement of EUAs challenging. In contrast, carbon offsets are widely accessible and easy to purchase.
How does a cap-and-trade system work?
Also known as an emissions trading system (ETS), cap and trade is a system designed to reduce pollution in the atmosphere by putting a price on emissions as well as a limit. The regulatory authority in the regional jurisdiction sets a cap on greenhouse gas emissions across a given industry or the entire economy. The total amount of the cap is split into allowances, each permitting a company to emit one ton of carbon dioxide or carbon dioxide equivalent. Regulators then auctions the allowances to companies. The cap gets stricter over time, decreasing the overall greenhouse gas emissions for the region and mitigating climate change.
The trade part is a market for companies to buy and sell allowances that let them emit only a certain amount of carbon dioxide and has supply and demand set the price. Companies that cut their pollution faster can sell allowances to companies that pollute more, or they can hold them for future use. This market system, informally called a carbon market, gives companies ﬂexibility. It increases the pool of available capital to make further emission reductions, encourages companies to cut pollution faster and rewards innovation.
Who are the entities that participate in the cap-and-trade system?
Typical participants include:
Emission trading schemes (ETS): European Union ETS, California Cap and Trade, Regional Greenhouse Gas Initiative, China National ETS, United Kingdom ETS etc;
Emitters: power plants, industrial plants, reﬁneries, transportation, agricultural businesses etc;
Capital market participants that create markets, provide liquidity and offer risk transfer (speculation).
Each market has its own characteristics regarding liquidity, regulatory regime, access, ESG factors and criteria relating to how well established the market is.
What are the price drivers of EUAs?
As in every (commodity) market, prices for EUAs are driven by supply and demand. The biggest price driver is therefore the annual emissions of covered entities in the system, as corporates need to buy allowances for these. Emissions in the EU ETS mainly change if the production of energy intensive goods changes (like cement, steel, refined products etc), or the power demand changes and therefore more/less fossil fuels are burnt to produce the power. In addition, however, demand can also be driven by stockbuilding or hedging, speculation or liquidation of excess allowances.
On the other hand, supply is largely fixed by the regulator. Any rumours or even decisions to change these laws can have a significant impact on prices.
Why does the EU use a cap-and-trade system instead of a carbon tax?
Carbon taxes do not set a budget for carbon emissions. If decarbonisation technologies do not develop quickly or cheaply enough, firms will continue to pollute, so they are difficult to calibrate to a net zero pathway. Cap-and-trade systems are more efficient as they allow money to flow to the cheapest carbon abatement technologies first. A tax falls equally on all participants, whether they are close to a carbon price that would incentivise a switch or a long way below.
What other types of carbon markets exist?
There are two generic types of carbon markets. The better known market is the “voluntary” carbon market. This is the market for carbon “offsets” that individuals and companies use to offset their carbon footprint. In this market, project developers create a project that reduces carbon emissions which receives third-party verification of achieved emission reductions. The carbon “offsets” are then sold by the developer to a wholesaler who sells them on to either a retailer or directly to the end purchaser. The sector is lightly regulated, and there is limited liquidity and no major secondary market. Atlhough the market reached a size in excess of 1 billion USD for the first time in 2021, this is still relvatively small compared to the larger compliance carbon markets which trade approximately 260 billion USD per year.
What is a carbon credit project in the voluntary carbon market?
A carbon offset project can be defined as any project, or set of deliberate activities that reduce the amount of greenhouse gas (mainly carbon dioxide) in the atmosphere. Offset projects must submit to at least three rounds of auditing by regulatory bodies, from methodology development, to specific project design, to monitoring of results. Only after an offset project has had its methodology and project design approved can it get monitored to earn credits. At regular intervals a third-party auditor will assess the project, monitor results and, depending on how many metric tonnes the project has reduced, that is how many credits the project is awarded.
Carbon offset projects get approved by reducing greenhouse gas emissions below a business-as-usual scenario. If a project can quantifiably and repeatedly produce less greenhouse gases than the current alternative, it will be eligible to earn carbon credits. For example, replacing a coal plant with a planned life of 30 years with a solar farm after year 5 would avoid 25 years of coal emissions. The difference is how many carbon credits the project would likely earn. Alternatively, taking land that is desertified and degraded, and planting millions of trees to bring it back to life and sequester carbon would pull more emissions out of the air than without planting millions of trees. Similarly, the difference between the baseline and new scenarios will determine how many credits should be awarded.
What type of investor will find carbon investments most useful within their portfolio?
Many investors may participate in global carbon markets in anticipation of a medium-term increase in the trading price of carbon allowances. Other investors may allocate to this sector if they believe that their conventional equity and bond portfolios are implicitly short the cost of emissions, therefore seeking a hedge against higher carbon prices and environmental regulations. Finally, ESG focussed investors may be looking to harness the opportunities arising from tackling climate change and emissions reductions.
What are the return and risk drivers in carbon markets?
Carbon markets have been established to reduce emissions. They are designed by policy makers and therefore policy decisions which change or update the rules of the market will affect the price. Some complaince markets have a price cap or price floor and most markets have supply adjustment mechanisms which allow the regulator to change the supply of carbon in the event of market imbalances, acting in some ways like a central bank.
There are also a wide range of other factors which impact carbon prices over the short run such as economic activity (demand for energy, emissions intensity of electricity supply), commodity prices, energy sources, technology developments, and additional policy features such as the rules governing free allowance allocation.
Over the longer term, three main drivers underpin a forward-looking risk premium.
Policy: carbon markets are designed to stimulate emission reductions through higher prices. As the price of carbon rises, it stimulates companies to find low-carbon solutions so policy makers, environmentalists and investors generally agree that they would like to see a higher carbon price.
Structure: carbon supply is reduced each year. This makes carbon unique among commodities since the supply declines yearly by a known amount while demand (linked to economic growth) has the potential to rise.
Increasing awareness: new scientific evidence and the increasing frequency and intensity of extreme weather events are driving increased awareness among policymakers and the public.
Are there any forecasts in relation to the future price of carbon allowances?
The compliance markets have been established by policy makers to reduce emissions by creating a financial incentive to invest in lower emission technologies. As the price of carbon increases, so does the incentive to switch to new production methods. Economists and environmentalists both calculate that in order to meet the ambitious targets set by the Paris Accord, the carbon price would need to rise from its current level. Forecasts for 2030 range from 100 USD to 200 USD per tonne. This backdrop, which is likely to receive increasing support from policy makers, provides an attractive context for investing into these markets.
Could exposure to carbon markets potentially hedge climate change-related risks within equity and bond portfolios?
Most equity/bond portfolios have exposure to complex and underestimated climate change-related risks. Increasing evidence of the impact on equity and bond portfolios is accumulating in academic research papers and many people forecast this will accelerate in the next decade. Carbon prices may be negatively correlated to these risks and their impacts and therefor offer hedging opportunities. Carbon markets are dominated by industrials and energy companies seeking to manage their carbon exposure providing alpha generation opportunities for financial investors.
The carbon price in the EU collapsed in 2008, could it happen again?
While it is accepted that a global recession may have a negative impact on carbon prices, modern carbon markets have enhanced policy features and adjustment mechanisms that provide greater market resilience. During the 2008/2009 recession, EU ETS GDP declined by around 10% and the carbon price declined significantly from a high of EUR 35 to a low of around EUR 10. Since then policy makers have generally implemented several key policy design improvements that would now reduce the impact of economic downturn on carbon prices and support the robust functioning of the market.