How (and why) to invest in carbon allowances

Last updated on October 6, 2020

Betting in the carbon allowance market is a high risk play with possible high rewards. But does buying up carbon allowances actually push companies to pollute the atmosphere less? We believe so.

To take a stake in carbon markets, you need to believe 2 things:

1. Emissions trading systems work
2. The price of carbon is going to go up

What are emission trading systems and carbon allowances?

Carbon allowance markets, also known as emission trading systems, are a political tool to force polluters emitting large amounts of CO2 into the atmosphere to pay for their pollution. Industries pay to receive allowances for every tonne of CO2 they emit. The idea is that, if the price is high enough, companies will be forced to transition to more sustainable ways of producing because not doing so would hurt their profits.

An ETS generally works on the ‘cap and trade’ principle. Here is an example from the EU ETS:

A cap is set on the total amount of certain greenhouse gases that can be emitted by installations covered by the system. The cap is reduced over time so that total emissions fall.

Within the cap, companies receive or buy emission allowances, which they can trade with one another as needed. They can also buy limited amounts of international credits from emission-saving projects around the world. The limit on the total number of allowances available ensures that they have a value.

After each year a company must surrender enough allowances to cover all its emissions, otherwise heavy fines are imposed. If a company reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another company that is short of allowances.

Which emission trading systems are out there?

Besides the EU, about 10 countries now have an ETS, with many more developing or considering one.

The EU’s ETS is the oldest one, and the only one where there is really a lot of information out there about the efficacy of it. Work is on the way to link different carbon markets together, if they manage to recognise each other’s methods for measuring and certifying carbon off-setts.

Do emission trading systems work?

The EU ETS

A lot of ink has spilled over this question since the EU ETS started to operate in 2005. Criticism has been harsh, and deservedly so.

For instance, between 2008 and 2014, heavy industry across Europe earned €24 billion, by receiving more pollution permits under the EU ETS than they needed, which they could then sell off to other industries. In other words, EU citizens subsidised pollution.

A major issue has been the price, which has been at times volatile, but mostly just too low to incentivise industries to switch to less-polluting alternatives.

There have also been different types of scams. For instance, Chinese and Indian companies excessively produced extremely hazardous greenhouse gases, for which they received billions after promising to keep them out of the atmosphere.

On the plus side, in 2018, greenhouse gas emissions in the EU were down by 21% compared with 1990 levels, putting the EU on track to surpass its
target to reduce GHG emissions by 20% by 2020 compared with 1990. Whether that is down to the cap-and-trade system or not is a difficult question to answer.

But we can say that after the modifications to the EU ETS scheme over the last few years, it now seems to be working. That is, the carbon price is now high enough to hurt polluters’ bottom line, and there are less free allowances given out.

At about €25 a tonne, the carbon price is already high enough to have started to push coal off the electricity grid, with utilities switching to less-polluting natural gas or carbon-free renewables. The next stage, traders suspect, is for the carbon price to rise high enough — between €40 and €50 a tonne — to start forcing other sectors to invest in cleaner technology and fuels — good for the environment, but a seismic change for industry, the impact of which is not yet fully understood.

Critics of the ETS have warned that higher prices could encourage some industries to migrate to regions without carbon pricing regimes in place. However, official studies from the EU have revealed negligible evidence of so-called ‘carbon leakage’.

Other emissions trading systems

Emissions trading systems outside of the EU are really just in the beginning phases. What to say about Kazakhstan’s 1$ per tonne of carbon? Given the amount of corruption in such a country, you can easily imagine that funds for carbon off-set schemes that would plant trees end up in a Swiss bank account.

There is also political risk. A different government could make changes to the cap, or the amount of free allowances businesses get.

Will the price of carbon go up? To what level?

If carbon markets are to have any effect, the price has to go up. Here is what analysts have to say (from the FT).

“By 2022 the EU carbon price could easily reach €40,” says Florian Rothenberg at commodities consultancy ICIS. “But if financial investors and speculators believe this the price could easily reach much higher.”

Hedge fund manager Pierre Andurand, regarded as one of the most successful oil traders of his generation: “We’re comfortable over a 5-year horizon that the price has to go up — that’s pretty much a guarantee.” As long as the EU maintains this commitment to fighting climate change and utilising the carbon market, we’re confident prices will rise.”

Expectations of where the price may eventually settle vary widely. But in more than a dozen interviews with hedge funds, banks and investors active in the sector, not one said that they believed prices would fall significantly. The only differences were in how far they might rise, over what timeframe and how big the political risk might be should the mood in Brussels change.

You can check up on the price of the different emission trading systems at Icap. Despite the assurances above, understand that there is a lot of risk involved.

How to invest in carbon credits as a regular person?

If you are not an institutional investor or a big hedge fund trader, there is only one way right now: through KFA Global Carbon ETF, a US ETF trading under the ticker of ‘KRBN’ since 2020.

KRBN is benchmarked to IHS Markit’s Global Carbon Index, which currently covers the major European and North American cap-and-trade programs: European Union Allowances (EUA), California Carbon Allowances (CCA), and the Regional Greenhouse Gas Initiative (RGGI).

KRBN buys carbon credits, but since it is a synthetic ETF, it does also invest in other assets like government bonds, stocks and other ETFs.

So by investing in the KFA Global Carbon ETF, are you pushing up the price of carbon? Yes, but you are also investing in a lot of other things. Last time we looked, KRBN only held 20% carbon credits.

The fund’s operating expense is 0,79%.