Many countries have set emissions reduction targets as part of their climate policies, leading to the creation and expansion of cap-and-trade systems whereby carbon credits are in demand. For investors, one of the attractive traits of carbon credits is that they tend to have low correlation with traditional assets like stocks and bonds, offering portfolio diversification. Lenka Martinek, Managing Partner at Montreal-based Sustainable Market Strategies, which performs market analysis for investment managers, institutional investors and investment advisors, recently sat down with Canadian Family Offices to discuss the outlook.
For readers who may be relatively new to investing in carbon, can you give us a quick overview of the landscape?
Tradeable carbon credits were born out of a desire to put a price on harmful emissions that were being released into the atmosphere and whose cost had not previously been taken into account.
There are two kinds of tradeable carbon markets. The first is carbon allowances, which are credits issued by governments in cap-and-trade systems—that is, regulated carbon. The second is the voluntary carbon market, on which carbon offsets are bought directly from project developers or brokers/intermediaries. These offsets are intended to balance an entity’s carbon footprint by investing in projects that reduce or remove emissions.
Investors are increasingly recognizing that the quality of carbon offsets—the voluntary market—is extremely heterogeneous and fraught with risk because of the lack of regulation. The value of the voluntary carbon market has dropped significantly due to reputational and credibility problems. Yet, for all the attention it receives, the voluntary market is very small compared to regulated markets.
Conversely, existing regulated carbon markets are already well-functioning, liquid and of a high standard. For these reasons, we believe investors should focus their attention here.
What is driving the price of carbon in regulated markets?
Regulated carbon markets are cap-and-trade systems that set emissions limits for specific industries, including oil and gas production, transportation, electricity distribution utilities, and large industrial facilities. Funds raised through auctions are then used to finance the development of low-carbon economic activities.
The main feature of regulated carbon markets is that they are intended to create scarcity for the right to emit carbon, and this scarcity intensifies over time via a decreasing cap. For example, in the California system, the distribution of allowances is set to be reduced by one-third in 2030 from its 2021 level.
In addition, in most cap-and-trade systems, the floor price—i.e., the minimum price at which a carbon allowance may trade hands—increases each year by law. These two factors—scarcity by design and minimum pricing—mean that there is a strong likelihood carbon prices within the system will increase over time.
What factors drive market prices for regulated carbon?
Like all traded financial instruments, the price of carbon in various cap-and-trade systems has not moved up in a straight line. Traded carbon allowances are subject to the basic laws of supply and demand, and a few factors tend to affect the underlying price on a cyclical basis.
The first is industrial demand. When economic output is strong, carbon emissions rise and hence more allowances need to be purchased, positively impacting demand and putting upward pressure on prices.
A second factor is weather patterns, at least in some jurisdictions. In California, for example, periods of drought force utilities to switch from hydroelectricity production to production of electricity from natural gas. The latter requires utility companies to purchase additional carbon allowances, once again putting upward pressure on carbon prices.
Regulation is another factor. As with any market dependent on government intervention, a change in the regulatory backdrop can create price volatility. Scheduled removal of carbon allowances aims to create scarcity in the market, but political pressure can force lawmakers to alter the pace of carbon allowance removal. That can change market participants’ expectations about the price of credits.
Finally, other markets can have knock-on effects on regulated carbon markets. We’ve seen the voluntary carbon market come under quite a bit of scrutiny during the past 18 months, and there can be contagion to regulated carbon from the negative sentiment on voluntary carbon. It’s similar to how, in the broader financial markets, ‘risk on’ trades tend to be tightly correlated despite often having different underlying drivers.
How are these factors playing out now?
Over the past year, all four factors worked as headwinds in the Quebec-California cap-and-trade system, which is the main one in North America.
In the area of industrial demand, manufacturing output has stagnated throughout 2023 and 2024, decreasing the need for enterprises within the cap-and-trade system to purchase credits.
There have also been weather impacts. Rainfall in California has been above average recently, so annual hydropower generation has increased significantly, reducing the need for utility companies to purchase carbon offsets.
In the regulatory realm, a significant negative shock to the Quebec-California carbon price came this past July when the regulatory body that oversees the cap-and-trade program in California announced a delay in the implementation of its updated (and more stringent) regulations.
And then, to further complicate the picture, 2023 was a disastrous year for voluntary programs as scandal after scandal rocked the market. Clearly, this adversely impacted any budding interest in the regulated market from financial players.
Looking ahead, however, we think the bulk of the bad news for North American regulated carbon is likely behind us, and we could be seeing the beginnings of a more bullish trend.
Why should investors look to carbon as an asset class?
Investing in regulated carbon markets offers two important financial properties. The first is inflation protection. In the Quebec-California cap-and-trade system, the minimum price (or floor price) increases each year by a set amount plus the annual rate of inflation. The second important property is that the regulated market tends to have low correlation to other markets. Even though carbon prices are somewhat positively correlated to the business cycle because demand for credits increases when economic activity is accelerating, the other factors I talked about above mean that prices tend to have a beta of less than one and, importantly, display low correlation to other financial assets.
So, we believe regulated carbon markets should occupy a growing place in investors’ asset allocation. For those looking for attractive financial characteristics as well as real-world impact, participating in regulated carbon markets is one way forward.
DISCLAIMER
Lenka Martinek does not personally hold any position in any securities that may have been mentioned in this article. Nordis Capital, a sister company to Sustainable Market Strategies, holds a long position in KraneShares California Carbon Allowance ETF (KCCA).
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