Carbon markets are growing: Here’s what you need to know

Climate change poses an existential threat to our societies and economies. To mitigate its impact and restrict global warming to 1.5 C, the world must cut greenhouse gas (GHG) emissions by 43 percent by 2030 .

One of the most cost-effective ways of incentivising emissions reductions is to assign financial value to them, thereby putting a price on pollution. This is the role fulfilled by the carbon markets, a growing sector where emission credits are purchased and sold, and derivatives are traded.

“Creating an economic incentive for reducing emissions encourages investments and business strategies that prioritise cleaner practices while stimulating innovation in decarbonisation,” says Stephen Metcalf, head of sustainable investing at RBC Wealth Management in the British Isles and Asia.

As carbon markets become more established, consistent and liquid, investible opportunities for institutional and retail investors are also emerging. These provide investors with an opportunity to invest in a way aligned with their values whilst further diversifying their portfolios with a new asset class.

But before we assess the investment case for carbon markets, it’s important to understand the basic concepts of how these markets work. This knowledge can help support your analysis of the asset class.

What are carbon credits?

Carbon credits are perhaps the most well-known aspect of the carbon markets. Carbon credits are a commoditised product that permit companies to legally emit greenhouse gas – at the rate of one tonne of CO2 or GHG per credit.¹ The credits enable carbon to be tracked and traded like any other commodity.

Carbon credits are traded within compliance carbon markets, also known as “emissions trading systems (ETS)” or “cap-and-trade programmes.” The European Union launched the world’s first international ETS in 2005 – the European Union Emissions Trading System (EU ETS) – and it has proven to be highly successful. Since its introduction, emissions have been cut by around 43 percent  in the sectors covered by emissions trading, and almost one-fifth of global emissions are now covered by these systems.²

Almost a fifth of global emissions are now covered by a carbon market

Under an ETS, a government or regulator sets a carbon allowance cap on the total amount of GHG that can be emitted by the companies covered by the scheme – typically firms involved in power generation, oil and gas refining, chemical manufacturing, mining and steel production, pulp and paper processing, cement and transportation.

On one hand, some companies release more GHG than their allowance permits (resulting in a credit deficiency). On the other, some release less than their cap (yielding a credit surplus); these excess credits can then be bought and sold in primary carbon markets by companies needing to meet their obligations.

Other market participants, such as banks and asset managers, can transact in secondary carbon markets, where a growing number of derivatives contracts , such as carbon futures, are now available to investors. This enables market participants to hedge their exposure to future price increases. “If companies have to pay more for carbon, it hurts their bottom line,” says Metcalf. “Carbon futures can sometimes be an effective hedge against these carbon price risks.”

Ultimately, the compliance carbon markets incentivise companies to reduce their GHG emissions in two ways: they have to spend money on extra credits if their emissions exceed their allowance or they can make money by reducing their emissions and selling their excess credits.

The government or regulator of an ETS generally reduces the number of credits over time to limit availability and drive the overall amount of emissions down.

How carbon markets operate

What are voluntary carbon markets and carbon offsets?

We’ve seen how carbon credits are traded within compliance carbon markets, but there are also voluntary carbon markets, where carbon offsets are purchased.

Carbon offsets are tradeable certificates generated by projects that avoid, reduce or remove CO2 from the atmosphere, such as renewable energy, forestry, carbon and landfill gas capture. The voluntary carbon markets – which are not centralised under a governing body like the EU ETS – enable individuals, companies and other entities to buy the offsets from project developers as a way to nullify their own emissions footprints.

Voluntary carbon markets are relatively small in comparison to compliance carbon markets, with approximately €1.5 billion worth of carbon offsets traded in 2021.³

The case for investing in carbon markets

For investors looking for avenues to support the transition to net zero, the carbon markets are a natural point of interest, says Metcalf.

“Well-functioning and expanding carbon markets can be a key tool in supporting both companies and countries to make meaningful inroads into their greenhouse gas emissions,” he explains. “As they continue to mature and benefit from increased regulatory and corporate support, the investible opportunities in the market will grow and investors will look to companies actively trying to reduce or offset their emissions.”

So, what investible opportunities do carbon markets currently present?

For individual investors, perhaps the most attractive attribute of carbon markets is their low to near-zero correlation to equities, which means they can be a useful way of diversifying your investment portfolio. Investors can gain exposure to carbon via an increasing number of exchange-traded products, making the regulated carbon markets an accessible option.

We’ve also seen how carbon futures can be used as a hedge against carbon price risks. Investors could, for example, buy European Union Emissions Allowances (EUAs) futures contracts on the world’s biggest regulated carbon market, the EU ETS.⁴

But Metcalf sounds a note of caution. “We’ve incorporated structured notes (a type of derivative ) linked to EUAs into our clients’ discretionary investment portfolios before. Despite it being a useful way to gain exposure to the carbon markets and diversify your portfolio, these are sophisticated financial products and carbon prices can be volatile, so working with an experienced investment manager is advised.”

¹ _{European Commission}

² _BloombergNEF

³ _{Carbon Markets Year in Review 2021, Refinitiv}

⁴ _{EU Emissions Trading System}

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