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Carbon is an emerging asset class, but what is it?
“The best performing commodity in the world.”
This is how most media stories about carbon markets start off, at least in recent years. Carbon, lumped together as part of the commodity markets.
But is that really the right way to be thinking about carbon markets? And if not a commodity, then what is it? Is it even an entirely new asset class?
The distinction is more important than mere semantics as it helps give us, as investors, a framework for thinking about valuation. Without this structure we might be guided by past rules of thumb as to how carbon should behave, when in reality its moved on to exhibit very different asset characteristics.
The price of carbon quoted in the media typically refers to that traded on Europe’s regulated compliance market, known as the EU ETS. Although often listed next to the price of natural gas, thermal coal and electricity, regular readers will know that the price of carbon refers to the compliance cost for obligated EU ETS emitters of releasing a tonne of carbon dioxide.
In that sense it is not a commodity in its own right, it’s a form of variable taxation required to meet a regulation. You could argue that it is only listed next to gas, coal and power because cap-and-trade schemes such as the EU’s tend to focus on the power generation sector first, before they target industrials, airlines, transportation etc. Should it really be lumped with commodities when these more difficult to decarbonise sectors become the focus of the carbon markets? Some of which will involve commodities (e.g. hydrogen), but most often they won’t.
The compliance carbon market does have some commodity like characteristics. In the early days of the EU ETS the system was plagued by an oversupply of credits. Coupled with weak economic activity during the 2008/09 GFC and subsequent debt crisis, carbon prices languished close to zero. However, since mid-2018 (the announced introduction of the Market Stability Reserve) and late 2020 (after the first Covid lockdowns), carbon prices have gradually increased as market participants have sought to price in future allowance scarcity.
Unlike ‘commodity’ markets though, the impact of the compliance carbon market only works via demand, by disincentivising emissions. In the past, carbon prices have helped incentivise the switch from thermal coal to gas fired power generation. Much higher carbon prices in the future should provide the incentive for decarbonisation elsewhere in the economy. As the supply of allowances is fixed and is set to fall over time, there is no way for supply to respond like a conventional commodity would.
If carbon isn’t a commodity, does framing it as a currency offer a better way of describing its asset characteristics?
It took many years for the ECB and other central banks to establish their credibility in fighting the economic ills of the day. From the move towards independent central banks and inflation targeting during the latter part of the 20th Century as a commitment tool in the fight against inflation to “Whatever it takes”, the three words from ECB President Draghi in the midst of the Eurozone debt crisis of 2012,
That hard won reputation can quickly lose its shine should (heaven forbid) politicians seek to splurge on new projects, cut taxes and surreptitiously devalue the currency as a reward for the support of influential backers.
If the foreign exchange market loses trust in a country’s currency, that trust may never be won back.
The European Commission (EC) has established credibility in the EU carbon market by ensuring that the cap on emissions allowances declines over time, that free allocations are gradually phased out, and that obligated emitters are highly incentivised to comply with the rules (i.e., the legal requirement + penalty). The tightening in the supply of allowances results in higher carbon prices, is aligned with the EU’s long term goals and so provides an economic incentivise to decarbonise.
It has taken many years, and lots of blood, sweat and tears for the EC and the EU’s member states to establish credibility in their carbon market.
However, just as politicians are tempted to slash taxes and increase borrowing, or to lean on their ‘independent’ central bankers to lower interest rates or print money in order to avoid difficult economic situations, the same political temptation might apply to ETS schemes. Politicians might be tempted to grant more free allowances, or reduce the slope by which the supply of allowances is cut.
Endless money printing devalues fiat currency, and with it the case for long term investment. Reversing course on the rules of the carbon market devalues the carbon price, and with it the case for decarbonisation.
If the carbon market loses trust in the EU’s carbon market, that trust may never be won back.
In the same way that trust in individual currencies supports investment, innovation and trade, trust in carbon market helps to bring about the capital, skills and long term planning that is required to help meet decarbonisation goals. The carbon market is a utility of the state by which it can influence the private sector case for decarbonisation.
The carbon price is ‘The Currency of Decarbonisation’. A strong carbon price is a signal that investors, businesspeople and citizens trust their government’s commitment to combat climate change.
Once you see the carbon price as a currency of decarbonisation you see it everywhere. The EU ETS has a very strong carbon exchange rate versus California’s and other regulated compliance schemes. In turn, compliance markets versus voluntary carbon markets (VCM) have their own set of carbon exchange rates reflecting the uncertainty, risk and lack of regulation. Even within the VCM there are various degrees of trust reflecting the nature of the offset schemes.
The carbon price really is the best performing currency in the world. It’s a currency whose economic anchor is the trust that the market places on government commitment to decarbonisation.