Carbon as an impact investment
ESG investing promised the opportunity to combat climate change while also earning strong returns for investors.
However, over recent years investors and regulators have questioned whether financial products under the ESG umbrella are actually helping the economy decarbonise. Meanwhile, greenwashing claims coupled with a political backlash, particularly in North America, has meant many investors have become disenchanted with the theme.
In contrast to some of the dubious claims peddled by ESG themed financial products, purchasing physical EU emission allowances (EUAs) is one of the few ways that investors can have a high degree of confidence that their actions are having a direct impact on the climate.
By buying one EUA, investors are withdrawing a carbon allowance from the market. This reduces the supply available to obligated emitters, preventing them from using it to emit one tonne of carbon into the atmosphere. At the margin, buying one EUA helps to drive up the cost of the remaining allowances, increasing the incentive to invest in decarbonisation.
The SparkChange Physical Carbon EUA ETC (CO2) was launched on the London Stock Exchange in November 2021 and was the first opportunity investors had to gain direct exposure to physical EU carbon allowances. SparkChange subsequently launched the fund on exchanges in Mexico, Italy and Germany. At the end of May 2023 the fund held almost 1,450,000 EUA’s.1
At the end of 2022, Kakubi was the first company to offer access to physical EUAs using blockchain technology. One KKB token equals one physical EUA. As of June 2023 Kakubi has vaulted just over 6,000 EUAs.2
The total supply of EUAs that can potentially be used to meet compliance in a given year is known as the TNAC - the ‘Total Number of Allowances in Circulation’. On 15th May, the European Commission published data showing the TNAC for 2022 amounted to 1,134,794,738 EUAs.
The Market Stability Reserve (MSR) gradually withdraws 24% of the EUA’s from the TNAC every year, with a minimum of EUAs 200 million placed in the MSR each year. The MSR will continue to reduce the number of EUA’s entering the market until the TNAC falls below 833 million.
Overall, the number of EUA’s held within these funds represent a tiny fraction (0.128%) of the TNAC.
However, as the TNAC diminishes in size, and the EU ETS cap on emissions gradually declines towards zero in the 2030’s, the value of EUA’s held off the market by investors to those obligated emitters seeking to meet their compliance requirements is expected to increase.
Of course, unless investors wish to hold their physical EUA’s for perpetuity then at some point they are going to offload some or all of their holdings into the market. This additional supply of EUA’s will enable obligated emitters to emit carbon, and so you could argue that investing in physical EUA’s is merely delaying emissions, not stopping them completely. However, by restricting the supply, even by a little bit, investors are acting to encourage obligated emitters to cut their emissions sooner rather than later.
The argument for investing in the EU carbon market using futures is much more nuanced.
In conventional commodity futures markets, speculators perform a much needed service for physical traders: providing a source of liquidity, while taking on risk from producer hedges. The reason why this works is that commodity producers tend to be on the short side (hedging their future production), while speculators dominate the long side.
In contrast to commodity markets, commercial activity in the carbon market is focused on the buy side - obligated emitters such as utilities and energy intensive industries look to the futures market to hedge their future carbon risk exposure. By buying and holding a EUA futures contract an investor is contributing to price discovery and is also in competition with both other investors and obligated emitters looking to hedge.
Buying an EUA futures contract allows an investor to benefit from appreciation in the EU carbon price (the negative roll yield notwithstanding), but they can’t claim that they are preventing carbon from being emitted into the atmosphere (see The arc of carbon’s curve: What does the carbon futures curve tell us and why is it important?).
Investors may ask why do I need to invest in the EU’s emission allowance market when one tonne of carbon emitted into the atmosphere has the same impact whether it is emitted in Europe, North America or Asia? Why not buy physical elsewhere in the world instead, perhaps where allowances are trading for a fraction of the price of those traded in the EU?
Although carbon dioxide is the same wherever you are in the world, emission allowances are not necessarily comparable. Investors in the EU carbon market can be confident that the total supply of EUA’s will not be diluted in the future.
Although there are mechanisms for dampening extreme price movements (i.e., Article 29a) and European member states recently agreed to to use the EU ETS to help fund REPowerEU, both of these mechanisms involve borrowing from future EUA supply. They do not involve the creation of additional EUA supply.
Remember that carbon markets are ‘The Currency of Decarbonisation’. Other carbon markets such as California’s, Australia’s, and others around the world are typically priced at a steep discount to the EU ETS to reflect the risk that policymakers will renege on their promises.
If you want to be sure your investment is having an impact on the climate then it pays to invest in the strongest ‘Currency of Decarbonisation’ there is. The EU ETS.
https://www.hanetf.com/product/30/fund/sparkchange-physical-carbon-eua-etc
https://kakubi.com/audit