There’s only one thing as big as Mother Nature, and that’s Father Greed.1
~ Thomas L. Friedman

The pricing of carbon is creating financial incentives for companies to move toward cleaner and greener technologies. But individual investors can also profit from the global momentum toward reducing greenhouse gas emissions. Carbon allowances, as a tradeable commodity, may offer investors the potential for diversification, hedging opportunities, and enhanced returns. A complex topic with many facets; we’ll provide a high level overview for investors who are open to considering carbon in their portfolio.

The 2015 Paris Agreement marked a milestone in global cooperation to address the issue of climate change through government policy. Nearly 200 nations have signed on to the accord, including the United States, which rejoined the agreement in February 2021. The goals expressed in the Paris Agreement are to limit greenhouse gas emissions with the specific goal of keeping global warming below 2 degrees Celsius as compared to pre-industrial temperatures.

Many countries that are signatories to the accord are targeting an 80% emissions reduction from 1990 greenhouse gas levels by 2050 to achieve carbon neutrality. There are two main mechanisms by which policy makers are attempting to incentivize emissions reductions to achieve these goals.

  1. Carbon taxes set direct prices on greenhouse gas emissions or on the carbon content of fossil fuels. With this method, the price of carbon is pre-defined, but the emission reduction outcomes are not.
  2. By contrast, an emissions trading system (ETS) sets an overall cap on the total allowable level of greenhouse gas emissions within a specific geographic region and creates emissions allowances that can be traded by participants within the system. This establishes a system of supply and demand for the carbon allowances that sets a market price for carbon. Unlike a carbon tax, it is the emissions reductions that are pre-defined under an ETS while the price of carbon is not.
An ETS, also known as a cap-and-trade system, is an appealing framework as it allows for a market-based solution where companies that are best able to economically reduce their emissions are incentivized to do so. They can then sell excess allowances to companies that cannot do so economically, based on the then-current price of carbon. While the primary goal of these systems is to drive a reduction of emissions to reach carbon neutrality policy targets, there is an interesting byproduct for investors: the creation of a synthetic commodity around which new investment products are being developed, effectively allowing investors to express views on the direction of carbon prices and potentially profit from them.

How Carbon Allowances Work
Carbon allowances are effectively an asset that gives the holder the right, but not the obligation, to emit one ton of carbon into the atmosphere. Regulators generally set aggregate emissions targets – gradually ratcheting the targets down over time – then employ a mechanism to assign credits to companies within their jurisdiction. This is typically accomplished through some combination of auctions (companies competitively bidding on the allowances) or grants (specific industries receiving allowances for free). Once the allowances are assigned, companies can then trade them within the system. This allows for flexibility to reassign the allowances to companies with the most difficulty reducing their emissions output, and offers a potential revenue source for companies that have low enough emissions to be sellers of their allowances.

In theory, under such a market-based structure, the price of carbon over time should equal the marginal cost of emissions abatement within the jurisdiction. As this price rises, the most emissions-heavy forms of energy production are disincentivized as that carbon price is embedded into the costs. For example, coal is generally less expensive than natural gas, but natural gas emissions contain only 50% of the carbon dioxide present in coal emissions. With a high enough carbon price, the difference in emissions would actually make coal more expensive than natural gas, which would encourage the incremental adoption of natural gas for energy needs. As carbon prices rise even further, cleaner technologies such as wind and solar would begin to be economically attractive as the price of natural gas rises due to the embedded carbon cost. This structure creates financial incentives for participants within the system to adopt cleaner energy sources over time to reach regulators’ targets.

The European Commission, which regulates the European Union ETS, is working to usher along progress and innovation to ensure emissions targets are met. Currently the European cap-and-trade system reduces the cap on carbon emissions by 2.2% per year until 2030. This is a more aggressive rate than the 1.74% annual cap reduction in place from 2013 to 2020. Not only are carbon allowances shrinking annually, but a Market Stability Reserve has been put in place to reduce the number of surplus carbon allowances in the system to put a floor on the price of carbon.

Managing Supply and Demand
The purpose of the Market Stability Reserve, in operation since January 2019, is to make the trading system more resilient to supply and demand imbalances. Currently there is an excess of supply which accumulated during the Great Financial Crisis and coronavirus pandemic where economic growth slowed and industries didn’t use their carbon allowances. The European Commission is attempting to stabilize the price of carbon and increase the incentive to reduce emissions in three ways:

  1. Adding to the Market Stability Reserve. Allowances are added to the reserve according to pre-defined rules when total allowances in circulation exceed 833 million. With 1,579 million in circulation as of May 2021, the Commission will place 24% of that total (or 379 million) in the Reserve from September 2021 to August 2022.2
  2. Postponing auction volumes. The Commission postponed the auction of 900 million allowances scheduled from 2014–2016 until 2019–2020. But then, rather than auctioning them during the pandemic, they placed them into the Reserve.
  3. Destroying the allowances held in the Reserve. Starting in 2023, allowances held in Reserve above the previous year’s auction volume will be invalidated.
These supply constraints should act to keep the price of carbon stable and rising. In 2021, the price to emit a ton of carbon in the EU has risen consistently, nearly doubling by early October (Figure 1).

Figure 1 – S&P GSCI Carbon Emission Allowances Price (2/1/21–10/31/21)
Line chart shows carbon price rising from $146.98 on 2/1/21 to $289.57 on 10/5/21
Source: Factset

Investors attracted to the potential for higher carbon prices may want to consider adding a small allocation to their portfolio. Carbon (accessed through a growing number of ETFs) can round out a commodity allocation, act as an uncorrelated asset, or simply provide return-enhancing potential. For investors focused on ESG (Environmental, Social, Governance), carbon can help offset any residual carbon emissions from portfolio holdings and add a source of diversification beyond green bonds. With continued global momentum towards a reduction in greenhouse gas emissions, the carbon market is rapidly expanding and becoming more liquid. We think investors should educate themselves on the topic and determine if carbon deserves a role in their portfolio.
1 Thomas Friedman talks COP15, Mother Nature, and Father Greed

2 Communication from the Commission. Reuse is allowed, provided appropriate credit is given and changes are indicated.

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