ESG investment backlash hits nature-based carbon credit prices
Vanguard’s sudden exit from the Net Zero Asset Managers (NZAM) initiative appears to be behind a sharp drop in the price of carbon credit futures.
The Nature-Based Global Emissions Offset (N-GEO) futures contract fell to an all-time low of close to $3 per tonne on Wednesday, down some 40% on the week and 80% below the all-time high early in 2022.
The $7.1 trillion passive investment giant, the second largest global money manager after Blackrock, announced on Wednesday 7th December that it was pulling out of the NZAM initiative.
The alliance of financial institutions was launched in December 2020 and aims to “galvanise the asset management industry to commit to a goal of net zero emissions.” Consistent with this goal, NZAM signatories agreed to the following commitments:
Set interim targets for 2030, consistent with a fair share of the 50% global reduction in CO2 identified as a requirement in the IPCC special report on global warming of 1.5°C
Take account of portfolio Scope 1 & 2 emissions and, to the extent possible, material portfolio Scope 3 emissions
Prioritise the achievement of real economy emissions reductions within the sectors and companies in which we invest
If using offsets, invest in long-term carbon removal, where there are no technologically and/or financially viable alternatives to eliminate emissions
As required, create investment products aligned with net zero emissions by 2050 and facilitate increased investment in climate solutions
The decision has dealt a major blow to the global alliance who, up until this week at least, had 291 signatories and $66 trillion of assets under management (AUM). The move may well prompt further departures, particularly from other US based institutions eager to distance themselves from the current anti-ESG investment backlash.
The Vanguard announcement coincided with one of the worst trading periods in the relatively short history of the carbon credit futures market. The N-GEO futures contract began last week trading at $5.20 per tonne, however over the following few days the price crashed ~40%.
Chart 1: Carbon offset futures, continuous front-month contracts
The Global Emissions Offset (GEO) and N-GEO futures contracts were launched in August 2021, and up until the end of September last year they both traded around the same price level. Beginning in October, the N-GEO contract subsequently went on to double in value, reaching a peak in late January 2022 of almost $16 per tonne, almost twice the value of the GEO contract.
The premium for N-GEO over GEO reflected the perception that nature based offsets are of a higher quality than the offsets underpinning the GEO contract, while also reflecting buyer preferences for a visible signal that they are offsetting their emissions through carbon removal. However, the premium for nature based offsets - which had remained close to 100% even as both contracts declined in value - fell to ~25% last week as the N-GEO futures price collapsed (see GEO versus N-GEO: Investing in the VCM futures market).
The nature-based carbon credit market is particularly sensitive to the strength of net zero commitment (or lack of it) shown by the financial sector. To see why sentiment in the sector is so important to the N-GEO price, you only have to look at where the demand for nature based carbon credits is coming from.
The financial sector accounted for a quarter of all credits retired in 2019, according to analysis by Trove Research. Chemicals and petrochemicals (including oil and gas) were responsible for one-fifth of credits retired, while the power generation and biotech sectors accounted for between 5% and 10%. All other sectors, including manufacturing, aviation and utilities accounted for less than 5% of carbon credit retirements.
Although the data represents retirements in 2019, and the demand for carbon credits has grown rapidly since then, the share of financial services is thought to have remained broadly unchanged.
While most sectors use a range of carbon credit types, nature-based solutions account for ~85% of those used by financial services. Overall, around half of all nature based carbon credits are used by the financial services sector.
Given that the financial services sector are by far the largest users of carbon credits and that their favoured carbon credit is nature-based, any sign that demand from this sector is slowing is likely to be immediately felt in the N-GEO contract price.
In March 2021, Vanguard and it’s passive investment competitor Blackrock joined the NZAM initiative. Managing over $15 trillion in assets between them, the decision by the investment giants to join the growing list of NZAM signatories was seen as a pivotal point for meaningful net zero action within the asset management sector. In turn, pressure from shareholders and the potential for dirty industries to face higher capital costs would help move the global economy on a faster decarbonisation trajectory (see The emerging marginal buyer of carbon).
Vanguard’s decision at least partly reflects increased scrutiny by financial authorities, on both sides of the Atlantic. In March, the Securities and Exchange Commission (SEC) announced that it was going to prioritise uncovering exaggerated ESG advertising and performance claims made by financial institutions. Meanwhile, at the end of May, German authorities raided the offices of DWS, a fund manager owned by Deutsche Bank as part of an investigation into greenwashing by the finance industry.
Some analysts have suggested that Vanguard was never serious about addressing climate change anyway, and that their continued membership of NZAM was blocking other signatories from pushing for stronger progress towards net zero. For their part, Blackrock have reaffirmed their committed to the NZAM initiative in light of Vanguard’s decision.
This whole episode demonstrates why monitoring changing net zero sentiment is critical to understanding the voluntary carbon market. The price of nature-based carbon credits are inextricably linked to the markets perception of commitment from the financial services sector to net zero.