Investors have a new way to help the environment

How can investors make a credible, technology agnostic and profitable difference to climate change?

Up until now the only way that investors felt they could make a difference to the environment was to divest their holdings from companies thought to be responsible for climate change. Divestment, as its known, might look good, and it might make shareholders and employees feel better about themselves, but it does nothing to influence better environmental outcomes. In fact, it can make actually things worse, especially if less ethically conscious private capital fills the void.

Other more effective options remain. For example, lobbying the management of the companies they are invested in to improve practices has been found to be more effective at driving change than investors washing their hands. Investing in companies that are innovating smarter solutions to solve challenges in renewable energy, the electric vehicle rollout, etc. is another. But this comes with its own risks, namely how to know what technology or business will ultimately be successful in solving these challenges, and be commercially viable too.

Now, for the first time investors can directly impact the cost paid by polluting industries in Europe. Before I get to how investors can play their part, here’s a quick intro to carbon pricing and the EU’s emissions trading scheme.

Recall that a price on carbon helps shift the burden for the damage back to those who are responsible for it and who can do something about reducing it. But instead of dictating who should reduce emissions, where and how they do it, a carbon price provides an economic signal through a price mechanism. Polluters then decide for themselves whether to stop their carbon emitting activities, act to reduce their emissions, or carry on regardless but pay for it via the carbon price. In theory the overall environmental goal is achieved in the most flexible and least-cost way to society. Carbon pricing incentivises innovation while also facilitating healthy competition between different technologies. In that sense carbon pricing is technology agnostic.

The EU Emissions Trading Scheme (EU ETS) is a cap-and-trade schemes whereby a group of industries is mandated to a cap on their emissions. This is achieved through the issue of allowances, a kind of certificate that is denominated in tonnes of carbon. If an obligated company emitted more than their allowance they would have to go into the market and buy allowances.

In response to the earlier oversupply of allowances, the European Commission (EC) introduced the Market Stability Reserve (MSR) which began at the start of 2019. This mechanism 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. Meanwhile, the scope of emissions covered by the ETS is also expected to rise from utilities and industrial companies to also include sectors such as shipping. This should result in an increase in demand for allowances as other sectors become subject to the scheme.

The EU ETS has been successful in encouraging the power sector to move away from coal generation, and towards more gas and renewable electricity generation. The high cost of carbon emission allowances works by squeezing the margins of coal powered generators until the point that they are replaced by more profitable and cleaner gas or renewable generation. As the rules of the EU ETS are tightened over time the price of carbon should also increasingly reflect the fundamentals of supply and demand in the difficult to abate industrial sector.

One way for investors to play the trend is via the KFA Global Carbon exchange-traded fund (KRBN), which tracks the performance of carbon allowances. It began trading in July 2020 is benchmarked against IHS Markit’s Global Carbon Index, which tracks the three most widely traded carbon futures contracts. Around two-thirds of the weighting is the EU ETS with the remainder mainly North American carbon markets.

Alternatively, investors can play the EU carbon futures market via IG. They provide a spread-betting contract linked to the nearest dated contract. As with any leveraged contract its important to be careful with your total risk exposure.

As with normal commodity futures markets buying a carbon futures contract does not reduce the quantity of carbon allowances available to the market. Speculators help with price discovery through their trading, but they are ultimately a passenger in the market.

Investors in carbon futures markets face the additional risk of a contango market structure. This happens when the futures curve is upward sloping and the expiry of one contract results in investors having to buy the next dated contract at a higher level.

In early November a new fund launched that enables investors to gain direct exposure to the physical carbon allowances traded on the EU ETS. The SparkChange Physical Carbon EUA ETC (CO2), launched on the London Stock Exchange on Thursday 4th November.

By buying the carbon fund investors are withdrawing carbon allowances from the market, reducing the supply available to obligated polluters. This should then help to drive up the cost of the remaining allowances, helping to stop emissions from occurring in the first place and incentivising the investment in new technology. Meanwhile, a physical carbon contract eliminates the basis risk from futures contract rollovers.

The price of EUAs have increased by 60% since my article in February to a little over €65 per tonne by mid November. With the supply of carbon allowances set to dwindle even further the coming few years due to the MSR, this new fund looks set to restrict supply even further, adding to the bullish upside.

Investing in EU carbon allowances means that investors can make a positive difference to the environment and make a profit at the same time.