Carbon Credit ETF’s: Big Green Returns?

As the winter season hits this week, the US is dealing with unseasonably warm temperatures while Europe is in the midst of a cold snap that is sending energy prices soaring. More than the cold, the continent finds itself pressed for natural gas due to the fact that a few French Nuclear reactors are also offline because of potential cracks to one and a strike at another. Prices hit almost €400 per MwH ($452) in some countries, compared to the US average of about $142.

Source: energylive

The U.K. is not immune as energy prices break records there as well. Unusually cold weather is seeing energy needs spike there. Much of what these countries turn to in a crunch like this is natural gas. Speculators or strategic investors looking to profit from a situation like this may turn to natural gas spot or futures investments to try and capture the run up in prices. Like all commodities however, natural gas is highly correlated with the ups and downs of global supply and demand, not to mention that some people may not feel as comfortable nowadays investing in something they know is polluting the air and contributing to global warming.

Enter Carbon Credits

So what is a socially conscious, yet knowledgeable investor to do? One alternative is to move into the space of investing in carbon credits, which can now be done for any investor through the KraneShares Global Carbon ETF (KRBN).

It helps to understand what this credit is, why is has value and how it plays into making sure national governments push big polluters towards meeting their ambitious climate goals.

Basically carbon credits are the cap and trade scheme you may have heard about in regards to polluters. The government is in charge of regulating pollution overall. So the government, should it want to for something like meeting climate targets, puts a cap on the overall pollution that industry as a whole can generate. Those that have invested in green technology won’t need all of their carbon credits and those that burn more dirty fuel won’t have enough. So what has developed is a market for the credits that works much like a commodities market. The government gets the cap it wants but it lets the free market allocate towards who will and won’t pollute.

Source: KraneShares

With these credits, businesses can then forecast how they will allocate future expenses towards credits and towards investing in green technology to reduce emissions. This inherently will require a futures market to develop as business will prefer to set prices at a future date to some known amount. Due to this, futures trading desks have popped up at companies that deal in many of these credits such as at utility companies burning natural gas.

Yet if the cap stayed at the same level, some companies may be happy to just pollute away cheap energy and keep buying credits. In order to gradually reduce these emissions and increase the pressure on the large polluters, governments have promised to reduce the supply of credits in the coming years and thus increase the price of the carbon credits. This can be seen in the way California auctions off new credits with a price floor increasing at 5% plus inflation as well as decreasing the cap by 4% a year until emissions are reduced to 60% of 1990 levels by 2030 and carbon neutrality is achieved in 2045.

Source: KraneShares

The result is a market for a product that continually increases in value year after year with an explicit inflation hedge built in. This is what has contributed to a 28.5% annual return for the benchmark since it’s inception.

Source: KraneShares

The Market

It’s important to put that figure in context however. KranShares offers 3 ETF’s in this space, all of which track the major markets for carbon credits. The first and most liquid ETF, KRBN, tracks credits across 3 markets. These are the EU, a consortium of states in the Northeastern US and Canada and California. The EU has the largest and deepest carbon market so the ETF is dominated by prices here. KraneShares also offers separate ETF’s which just focus on the EU and California markets exclusively.

The important takeaway is that the market is large enough to be liquid but certain segments are small. The EU market is worth almost $252 billion while the California market is only $5.5 billion. This has its positives and negatives. It means that small investors can gain access to a small niche market that a large asset manager may not have access to but it also increases the chances of high volatility and price manipulation by insiders.

All of these markets are expected to grow, with price floors and limited supplies increasing the price of carbon credits across markets. The performance has a low correlation to stocks, bonds and commodities, making it attractive as an alternative asset.

The Product

Yet the way that KraneShares tries to track this market is through an ETF that holds futures contracts which has its drawbacks. Holding futures contracts has its own issues as holders of the US Oil find ETF (USO) found out last year. Any ETF using futures will have to consistently roll over its contracts and this can get expensive when certain market conditions exist.

When markets are in contango, (the futures price is higher than the spot price) these ETF’s will have to consistently roll over their holdings into new more expensive contracts. Each time that happens there is a loss produced for shareholders. Gains are only realized as contracts move closer to expiration and futures prices converge on the spot price. Unless that spot price is yet still above the purchased futures price, there will be a loss. Even if there is a gain, the gain experienced may not be the size of the move in the spot price. This is why funds like USO have underperformed the spot index of Brent Crude over time. They are vehicles meant for short term traders, not for long term investors.

This is the primary pitfall of KRBN, that it isn’t properly set up to capture the long term price rises in the actual carbon credits but is built for more short term speculation. The best longer term investors can hope for is a piece (not a full piece) of the upside of the increase in value along with all the volatility of the spot price. You will note this on the disclaimers within the performance charts I shared above. They note that investing in the index is not possible currently. Due to the rollover costs of futures I have mentioned, we shouldn’t expect this ETF performance to match the return of the index either.

The industry has apparently headed this observation by creating the first “physical” carbon credit ETF, meaning an ETF that holds the actual credits themselves. SparkChange is behind this one and has cleverly made its symbol traded on the London Stock Exchange CO2. Yet here there may be an issue as well. If investors are holding the credits for the purpose of price appreciation, then those credits aren’t getting used by the companies that need them the most, further restricting the supply and raising costs for energy consumers overall. This creates the risk that the government may ironically intervene to stop investors holding these credits themselves under the guise of lowering prices for electricity consumers, while at the same time raising the prices themselves on the auction end.

Additional Risks

The other risks to this market include the wild price volatility that the market sees. That 28.5% annual return that the index posted came with 29.6% standard deviation of returns, more than double the volatility of the S&P 500 over the same period but I guess you can say it’s conservative compared to Bitcoin which has a standard deviation of over 73% in its annual returns.

The other risk to note in this market is that it’s created and highly controlled by national governments and international accords. This leaves the market highly exposed to political risk. Will governments be willing to endure high energy prices and continue to reduce the supply of carbon credits even when their voters are feeling the pain as they are in Europe right now? Will innovations in the markets allow exchanges to cross sell credits? ie a company in Italy can buy credits from a company in California some day based on an agreement between California and the EU? These types of unknowns could have a huge effect on the price of these credits and may be one contributor towards why the prices are so volatile in the first place.

Conclusion

For my own purposes, I personally would not recommend the KraneShares ETF’s for anything outside of short term conviction trades and pure speculation on energy markets. The physical carbon ETF is more attractive and if you have access to UK based investments, may make an interesting addition to the riskier portion of your portfolio. For now I will wait until a similar version of CO2 becomes available in the US market before dipping my toe in.

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