How to Invest in Carbon Credits
Carbon prices are on the verge of a bull-market, as the European economy re-opens and the E.U. pursues ever more ambitious emission reduction targets. Technicals suggest now is the time to buy.
Carbon market is in a structural deficit
Carbon prices have been in a clear uptrend since 2016, after the EU took steps to create a structural deficit in its Emissions Trading Scheme (ETS). The EU cares about high carbon prices, because it encourages polluters to cut their emissions of green house gases, and rewards green energy companies.
- Every year, the EU reduces the total number of allowances by 1.47%.
- In 2015, the EU established a mechanism known as the Market Stability Reserve (MRS) to remove surplus allowances. In 2020 alone, the MRS reduced the 2020 auction volume by 35%. Source: EU
This deficit prompted a 14% rise in carbon prices over the course of 2020, despite a 14% fall in emissions. Carbon prices fell around the same time as the March 2020 sell-off, but recovered once vaccines were announced, and rose further in December when EU leaders agreed to more ambitious emissions reduction targets. The price of carbon reached a new all-time high in early February 2021, around 38 Euros / ton.
Price of front year EUA contract on the Intercontinental Exchange (ICE) in 2020
How the EU carbon market works
The EU carbon market works on a 'cap and trade' principle. A 'cap' is set on the total amount of certain greenhouse gases, and companies receive buy or sell allowances. Heavy polluters buy carbon allowances from cleaner companies. Rather than trade physical tons of carbon, market participants trade futures that each represent a ton of carbon,.
The EU's carbon market is the oldest and largest carbon market in the world. However, it is small in comparison with other commodities. It is limited to just 11,000 heavy energy-using installations in industries hand-picked by the EU (e.g. power stations and heavily polluting industry, for now).
Fundamentals are in place for a bull market
A higher carbon price is a pillar of the EU's emissions reduction policy. And all signs point to a bull-market in 2021 and beyond as demand rises further, and supply falls, driven by the EU's more ambitious emission reduction targets.
Demand will rise as:
- The economic recovery is ahead of us, with Covid vaccinations on the rise.
- By June 2021, the EU Commission will make proposals that could expand the EU ETS to more sectors and more gases. It has already stated its intention to include the maritime sector. Source: EU
- By June 2021, the EU is expected to announce a carbon tax at its borders. This will further strengthen demand for EU carbon credits and prevent "carbon leakage". Source: EU
Even as supply falls further:
- The EU has announced that it will increase the pace of annual reductions in allowances to 2.2% (up from 1.47%) starting in 2021. Source: EU
- The EU has announced that it will double the number of allowances put in the Market Stability Reserve until 2023. Allowances in reserve will expire faster, further restricting supply. This could have the greatest impact on supply, judging by the 35% reduction in allowances achieved in 2020 alone. Source: EU
Carbon price above 100 Euros?
Institutional investors are confident that the price is on a clear upward trend. Andurand Capital Management, which successfully bet on oil prices after the 2020 crash, expects that carbon will "hit 100 Euros ($121) per metric ton of carbon emissions, possibly as soon as later this year". If their forecasts are accurate, we'd see carbon prices rise 160% above their current levels.
Per Lekander, fund manager at London-based Lansdowne, sees carbon prices between 50 Euros and 100 Euros per ton within a year or two, partially boosted by demand from steel, cement and airlines. Anything below 50 Euros would be too low to meaningfully influence any industry outside the power sector, he said.
Northlander Commodity Advisors also predicting a surge this year to 50 Euros and 70 Euros by 2025. According to its Ulf Ek, chief investment officer at Northlander, "It’s the best time to invest since early 2018".
A slower EU vaccine rollout than is already priced in by the market, could weigh on prices in the first half of February 2021. However, it’s hard to see how it could be any slower, as the EU is poised to approve the one-shot Johnson & Johnson vaccine. This is why we believe that now is the time to buy.
KRBN: KFA Global Carbon ETF
The KRBN ETF is the best way to go long carbon. This actively managed ETF aims to exceed the returns achieved by the IHS Markit Global Carbon Index. To this end, it invests primarily in EU and, to a lesser extent, Californian carbon allowance futures. Its factsheet and presentation provide more information about its strategy and holdings. It has an 0.79% expense ratio, which is towards the low end for actively managed funds and small in relation to the potential upside.