Carbon ETFs and You: Credit Where Credit May Not be Due

Whether you should invest, however, requires more consideration. But the premise for profit is simple: it’s the currency of a trading system designed to have a declining supply, the government runs it, and demand persists.

What Are They?

Put simply, a carbon credit is a permit that allows the owner to emit a certain amount of carbon dioxide or other greenhouse gases. It’s pretty much permission to pollute – up to a limit. How this works in business is companies and businesses that pollute are given a certain limit (or cap) on how much they are allowed to pollute – the carbon credit.

“The credit gradually declines over time as companies are expected to reduce their emissions by ever-increasing amounts,” explains Clark Barr, director of climate solutions methodologies at Sustainalytics, a Morningstar Company.

If a company pollutes more than its cap, it must buy additional carbon credits. If it pollutes under the limit, it can make money by selling the extra credits. This is a cap-and-trade scheme.

A carbon pricing policy aims to create incentives for emitters to reduce their greenhouse gas (GHG) emissions and improve further upon it, says Guru Durairaj, CFA, assistant vice president, natural resources & pipelines at DBRS, another Morningstar company.

“The system also creates economic incentives for additional voluntary projects that could result in additional GHG reductions or removing GHG emissions,” he adds.

Voluntary markets involve the use of carbon offsets, which differ from carbon credits, notes Luke Oliver, head of climate investments at KraneShares.

“Carbon offsets also help companies counterbalance their emissions through projects like planting trees or building wind/solar farms,” while carbon credits offer more transparency and a standardised supply and pricing mechanism, he says.

“Essentially, it turns capitalism onto the problem of climate change.”

Some of the largest secondary markets for carbon credits include those within the EU Emissions Trading System (EU ETS), or California’s cap and trade system. 

How Do They Work?

Retail investors and funds can get exposure to carbon credits by buying ETFs, such as the KraneShares Global Carbon Strategy ETF (KRBN) launched in 2020, which now has assets  of around $1.4 billion. Since then, a variety of carbon credit ETFs and mutual funds have entered the fray around the world, including recently in China.

“There has been growing investor awareness about carbon credits in recent years and along with it, a desire to capture that demand by fund providers,” says Nick Piquard, portfolio manager and options strategist with Horizons ETFs.

Horizons ETFs launched Canada’s first such ETF, the Horizons Carbon Credits ETF (CARB), which offers exclusive exposure to the EU emissions trading system through the use of European Union Allowance (“EUA”) futures.

KraneShares also offers US-listed targeted exposure to EU (KEUA) and California (KCCA) carbon credit futures. “Last year, the futures in these markets traded [US]$683bn, over 100% growth from the previous year,” says Oliver.

Are They “ESG” Investments? Not Really...

A legal necessity and good intentions can make carbon credits an attractive investment, but questions remain around whether the underlying mechanism is actually “ESG”.

Putting a price on carbon is tremendously important, says Morningstar’s Bobby Blue, senior analyst for multi-asset and alternatives, but “I don’t think it’s an ESG investment at all,” he notes. How many investors buy and hold forever? “You are buying these credits and, ultimately, what you're going to do is sell it to an emitter,” says Blue.

And the effectiveness of the system, in practice, isn’t always ideal. According to CFA Institute literature on ESG investing:

“If the scheme is too restrictive it may encourage offshoring of industries into jurisdictions with fewer constraints (a phenomenon known as "carbon leakage"), and thus fail to reduce emissions.”

Another issue arises when governments issue too many carbon credits, and the price of emissions is too low to incentivise decarbonisation.

“The EU approach resulted in a very low price of carbon for a period between 2012 and 2018 as companies received generous credits and had a lot of easy wins for reducing their own emissions at a relatively low cost,” says Barr.

“However, this started to change and the price has been increasing from 2018 onwards as the allotment of credits have continued to decline and the mitigation options for companies get more expensive.”

“Climate policies are becoming more stringent and countries around the world are adopting new tools to reduce emissions,” agrees Adriana Alvarado, senior vice president, Sovereign Ratings - Global Sovereign Ratings for DBRS Morningstar, and co-author of a recent commentary on carbon pricing and potential credit implications in Europe.

Putting a price on carbon, however, can be problematic for companies. “Carbon pricing has the potential to increase financial pressures on regulated companies, through higher costs,” notes the report. And some companies will do better than others.

“From an investor perspective,” says Barr, “this uncertainty over the costs to buy credits going forward and the increase in prices of carbon results poses a risk to companies that currently exceed their carbon credit allotment in cap-and-trade systems.”

And Your Portfolio?

If you’re okay with selling credit to a company still in carbon transition, what kind of role might carbon credits play in your portfolio?

“It can have some diversification benefits within a broad commodity portfolio,” says Blue.

However, when it comes to pinning down exactly how carbon behaves, you’re also entering uncharted territory – so allocate accordingly.

“It's difficult to justify as a standalone. Carbon credits are a very niche space and require a pretty in-depth understanding of the market and what's driving it,” says Blue.

“The challenge is you have to really be opportunistic about rebalancing. You could have a 40% price rise over the course of two months, and when it happens, it’s quick. You need to take immediate steps, and it's tough to be tactical like that,” he notes, adding that good rebalancing rules and thresholds help allow the asset to shine – potentially with a role to play in periods of inflation as the price of commodities rise.

And what if a recession follows inflation? Well...

It Could Go Wrong

"A recession could have an impact on fossil fuel demand and thus carbon credit prices," says Piquard, and Blue agrees.

"If we were to see a recession, you can imagine it hurting the price of carbon," he says.

Blue considers how falling carbon prices would manifest in the market. "Retail flows are fickle. If performance starts to decline, and if investors don't fully understand what's moving that drop in price, they are going to bail."

While a sudden selling event may lead to increased supply on the market, Piquard notes that carbon credits are also unique in that their supply is determined by a regulatory body. This, however, also leads to political risk.

"If governments deem it appropriate to suddenly add a significant supply of carbon credits, the price would likely go down," notes Piquard.

"But with an international, multi-country body like the EU ETS, with a defined vision of 55% lower emissions by 2030, and a growing economy over time, I don’t think such a drastic change would be on the horizon."

Ultimately, Blue and Oliver both see politics as the greatest risk to carbon markets.

"The rising price of carbon could see some push back from industries or consumers incurring higher costs," says Oliver.

"In the US, Virginia’s Republican governor has tried to remove his state's participation in carbon cap-and-trade auctions. However, his attempts have been challenged by the state’s Senate Democrats and are unlikely to make much headway without a struggle." 

There are two other “good” possibilities to consider with carbon credit investments. Oliver identifies innovation risk, whereby industries adopt capturing technology that significantly reduces emissions at a faster rate than the supply of carbon allowances.

“However, this is 1) a long-term positive for climate goals and 2) a cap, and trade programs would most likely adjust their cap and pricing mechanism to account for significant changes in demand,” he says.

The other "good" outcome, potentially for everyone, Blue considers: lock your carbon credit future [or ETF] contract up in a vault if you want. Retire it. Your own financial carbon capture.