Carbon ETFs: Making Money from Air
Is that sustainable investing?
July 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.
- Carbon credit prices vary significantly across markets
- The price increased by more than 100% since 2020, but it has been highly volatile
- Investors can get carbon exposure via ETFs, but applying trend following strategies is sounder
News about the environment is usually bad. Once in a while, we might see a fascinating video on LinkedIn about wolves being back in the Yellowstone National Park in the U.S. and rejuvenating the local ecosystem, but most posts and articles are about destructive events like earthquakes, floods, or tornados.
However, given that these events rarely affect us directly, we often, unfortunately, don’t care too much about them. 2022 is different as food prices have been rising globally, which can be attributed to the invasion of Ukraine, one of the largest agricultural and fertilizer producers, and extreme droughts in the US, Mexico, Europe, and other markets.
Both represent man-made disasters, where the former can be attributed to a single person, ie the Russian president Vladimir Putin, while the latter is borne by almost all of us as we have been contributing to global warming. Fortunately, investors, if they want to, can contribute to battling both issues, eg by selling Russian financial assets and allocating to ESG funds.
More mercenary investors who believe global warming will accelerate and the environmental situation will worsen, can invest in the carbon credits, which should become more valuable in such a scenario. However, carbon trading is a complicated space with unique nuances, which we will explore in this research article.
CARBON CREDIT BASICS
The carbon credit market is complicated as carbon gets traded via emission trading systems (ETS) in several countries and the price varies dramatically across these. For example, the price per tonne is EUR 84 in Europe currently, but only EUR 12 in South Korea (read ESG vs Low Carbon Investing).
A carbon emitter like an airline company can either implement processes to reduce their carbon emissions, or buy carbon credits on the market. Given different jurisdictions, there are different rules that result in heterogeneous prices.
Source: The World Bank, FactorResearch
PERFORMANCE OF CARBON PRICE
The EU ETS is the largest carbon trading scheme globally and the EU carbon price has a track record of more than 10 years. However, although the awareness of global warming has increased consistently over time, the carbon price has been highly volatile and not increased consistently as perhaps expected.
In the decade from 2008 to 2018, the carbon price ranged between EUR 10 and 20. An all-time low was reached in 2013 at EUR 3 per tonne, while the highest price was reached in February of this year at EUR 97. The recent rapid increase in prices can partially be attributed to resolving cross-border issues when trading carbon and adopting new rules to accelerate the fight against global warming, eg at the COP26 event in Glasgow in 2021.
VOLUME OF CARBON TRADING
We can also analyze the trading volume of EU carbon credits, which was highly volatile with a few dramatic spikes. Somewhat surprisingly, the volume has been decreasing in 2022, despite the carbon price still being significantly higher than in previous years. This would indicate only a moderate interest from carbon issuers or speculators, despite the increased attention to global warming.
This is even more perplexing when considering the consensus view that the demand for carbon will increase significantly. EY, a consultancy, expects the price for U.S. carbon credits to increase from USD 25 to between USD 80 and 150, and the volume to increase at least 20-fold by 2035.
PERFORMANCE OF CARBON ETFS
We focus on ETFs and ETNs trading in the U.S. market that provide exposure to carbon dioxide (CO2) credits or allowances, which is a universe of only 5 instruments currently. The combined assets under management are only $1.5 billion, where the KraneShares Global Carbon Strategy ETF (KRBN) dominates with an 80% market share. The fees are high with 0.79% on average, but in line with similar thematic products.
Given the diversity of carbon credits, ETF issuers have launched products for the U.S. (California), Europe, and the world. The correlation between the markets is not particularly high, eg 0.3 for European and U.S. carbon credits, which reflects the divergent evolution of local regulations. Although countries may sign legally-binding agreements on climate change such as the Paris Agreement in 2015, these can be negated by new leadership, eg when Trump withdrew from the agreement in 2017 (try Finominal’s Security Analyzer for ETF or mutual fund analysis).
DIVERSIFICATION BENEFITS FROM CARBON CREDITS
Carbon credits represent a commodity like oil or gas that can be traded directly via futures, or indirectly via ETFs and ETNs. Although some commodities are correlated to the business cycle, many of them are not and are uncorrelated to stock markets, which theoretically makes them attractive candidates for portfolio diversification (read Building a Diversified Portfolio for the Long-Term).
The largest impact on the carbon credit price is regulation rather than the global economy. Given this, the correlation to the stock markets as represented by the S&P 500 was only 0.1 in the period between 2008 and 2022.
Although carbon credits are attractive from a diversification perspective given the low correlation to stocks, adding an allocation as a long-term holding is unlikely a wise strategy. Commodity prices have been declining over the long term as our technologies continue to evolve and improve our lives and the global economy. We can expect the same for carbon prices.
Naturally, there will be bull and bear markets in commodities, which includes carbon credits, but it is more sensible to exploit these via trend following than long-only strategies.
An Anatomy of Thematic Investing
Thematic Indices: Looking at the Past or the Future?
Thematic Investing: Thematically Wrong?
ABOUT THE AUTHOR
Nicolas Rabener is the Founder of Finominal, which empowers investors with data and technology to analyze and improve their portfolios. Previously he created Jackdaw Capital, an award-winning quantitative hedge fund. Before that Nicolas worked at GIC and Citigroup in London and New York. Nicolas holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon).
Connect with me on LinkedIn or Twitter.