Getting off zero: Institutional investment likely to give carbon markets the short squeeze

Getting to net zero means getting off zero.

As of 2021, institutional investment in carbon markets is very low. That will need to change if the largest investors in the world want to hedge the biggest uncovered short position in their portfolio.

Two factors that have limited the level of investment in carbon markets up until now include structural obstacles (e.g. small market versus assets under management), and a lack of visibility on underlying market dynamics and future trends (e.g. political uncertainty).

The four largest compliance carbon markets (CCMs) had a market value of over $100 billion in 2020. Even despite the growth in the value of CCM markets during 2021 (as the price of carbon has increased), carbon markets remain tiny in comparison to the $19 trillion in assets under management in 2020 by the world’s top 100 institutional investors.

Note: In comparison to CCMs, the voluntary carbon markets (VCMs) were estimated to be worth a mere $0.3 billion in 2020. The VCM enables organisations to purchase carbon offset credits from projects located across the globe outside of the formal government CCM. The idea being that by outsourcing the carbon reduction it is achieved in the most efficient way possible, thereby reducing costs for the organisation seeking to meet net zero. Although too small for institutional investors to worry about at the moment they have the potential to be much bigger than the CCMs over the longer term. I will be delving into the VCMs in much more detail in subsequent articles.

Estimates by Lawson Steele of Berenberg suggest that non-fundamental buyers of EU emission allowances (EUAs) totalled some 5 per cent in mid 2021. These are included under the umbrella of the term ‘speculators’ but they could include both short and long term investors in the carbon markets. There is clearly room for growth should institutional investors decide that carbon markets are an appropriate hedge.

Crucially the EU is keen for the carbon price (the centrepiece of EU climate policy) to increase in order to incentivise the technological investments required to meet its net zero targets. That is likely to mean that long term carbon investors will be required to drive the necessary price discovery. Price appreciation is also supported by the dwindling supply of allowances over time. The Market Stability Reserve (MSR) gradually reduces the supply of carbon allowances over time (24% of total allowances each year until at least 2023), which should in theory result in higher carbon prices.

In North America, most carbon pricing developments in the United States are taking place on the subnational level. For example, the state of California, as well as nine New England and mid-Atlantic states have a cap-and-trade system in place. Launched in 2013, California’s emissions trading scheme is among a suite of major policies the state is using to lower its greenhouse gas emissions. Unlike the EU ETS, California’s carbon price growth has been significantly more stable, due in part to an auction price that increases at inflation plus 5 per cent per annum.

Where is the growth in CCMs?

In 2021 the roll out of carbon pricing gained momentum when China, the world’s largest CO2 emitter launched its own emissions trading scheme (ETS). The scheme initially targets carbon intensity, and will only later introduce an absolute cap on emissions in the same way that the EU ETS does for example.

The scheme initially focuses on the power generation sector, of which some 2,200 firms contribute 4 billion tonnes of carbon dioxide per year (around twice the size of EU ETS in terms of CO2 covered). The Chinese ETS is expected to expand to other energy intensive sectors of the economy including steel, petroleum and non-ferrous metals in the future. Overall coverage is expected to reach over 70 percent of the country's total carbon emissions by 2025. Earlier pilot schemes in China were not particularly encouraging, revealing that emission reductions occurred more because of pressure from authorities than because of the price of carbon.

Elsewhere in Asia, South Korea has had an ETS in place since 2015. Other countries known to be either trialling systems or under consideration at the time of writing include Japan, Indonesia, Vietnam, Thailand and the Philippines.

It’s not clear at this stage to what extent institutional investors will be able to access other CCMs as they are launched. As with the EU ETS regulatory certainty is fundamental to ensure that all investors have confidence in the likely future path of carbon prices. Other, newer CCMs should note the value that investors bring to carbon markets in incentivising carbon abatement and investment in new technology.

What role can carbon markets play for institutional investors?

Carbon markets might be an attractive opportunity for long-term investors looking for high and consistent real rates of return. Christian Gollier from the University of Toulouse calculated that carbon prices need to rise to $173 per tonne by 2035 to ensure that the EU meets its 2050 climate goals. Based on prices in 2020 of around $60 per tonne (~€50 per tonne), this equates to an expected real return over the subsequent 15 years of around 6% per year.

Carbon markets also offer hedging opportunities. For example, energy and mining sectors in particular, as well as countries such as Canada and Australia companies are likely to face large transition costs under a carbon constrained future, especially one in which the price of carbon is very high. An investor wishing to hedge against the costs of transitioning towards decarbonisation may want to consider being exposed to higher carbon prices.

In a joint report from GIC, McKinsey, Vivid Economics and the Singapore Economic Development Board, Putting carbon markets to work on the path to net zero: How investors can help decarbonise the economy, the analysts found that carbon allowances could provide downside protection and enhance risk adjusted returns in scenarios involving immediate or delayed climate actions:

On average, a carbon allowance allocation of approximately 0.5 to 1 percent could mitigate the negative impact on the returns of a 60/40 reference portfolio. In scenarios involving immediate or delayed climate action, a hypothetical 5% carbon allowance inclusion in the 60/40 reference portfolio could enhance annual return by 50- to 70- basis points (versus the expected return for a regular reference portfolio of approximately 4 percent) over 30 years while volatility would improve by 30- to 50- basis points (versus the expected volatility for a regular reference portfolio of approximately 9.8 percent). In a scenario where no new climate policies are introduced, by contrast, the inclusion of carbon allowances in the portfolio led to diminished returns. This is just one action investors can take to hedge against climate transition risk.

Carbon markets have increasingly offered investors access to non-correlated returns. As the rules underpinning the EU ETS have become stricter, the correlation between carbon prices and other fundamental factors (e.g. natural gas and coal prices, economic activity, etc.) has declined. These non-correlated returns are likely to become even more evident over the next 3-5 years as carbon prices become the tool to price in the much more challenging task of decarbonising Europe’s industrial sector - something that will require significantly higher carbon prices.

As of late 2021 the EU ETS is the best available means for institutions to get off zero. Other parts of the financial and industrial economy are also looking to cover their uncovered short position on carbon. The short squeeze on carbon prices has only begun.