Carbon Markets

By Patrick Donley and Shawn O'Malley, edited by Robert Leonard · October 04, 2022

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Welcome back to We Study Markets! 

?? After 47 years, the investing icon Ray Dalio is finally stepping aside from his successful hedge fund, Bridgewater Associates. Dalio has built his organization into a "machine," and we have no doubts that it will continue to flourish after his departure. 

Congratulations on the great run.

In other news, job openings declined sharply in August, falling by over one million. 

?? This is a sign that Fed rate hikes are finally reaching the labor market as part of its plan to tame inflation, and markets are hoping this means the Federal Reserve will reduce its plans for future interest rate increases.

Here's the market rundown:

MARKETS

*All prices as of market close at 4pm EST

Today, we'll discuss Brazil's contentious elections, a warning about the global oil supply, new developments in battery technology, and a word on investing in carbon markets.

All this, and more, in just 5 minutes to read.

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IN THE NEWS

???? Brazilian Presidential Elections Go For Round Two (FT) 

Explained: 

• Brazil is caught in a polarizing political election run-off vote between its president Jair Bolsonaro and challenger Luiz Inácio Lula da Silva. Lula won 48.4% of the vote, yet to declare victory, a candidate must receive at least 50% of all ballots cast.
• Bolsonaro is seen to be more nationalistic and socially conservative, and his showing in the first round of elections was considerably stronger than anticipated. 
• Fears are mounting that the election will boil over into a contested outcome following the second round result, as the controversial Bolsonaro seemingly works to undermine the public's faith in the election's legitimacy.

What to know: 

• Bolsonaro has made it clear that he will not accept the final election results, and observers warn that he may galvanize his supporters into violence to dispute the results should he lose, as he's projected to, in the second round.
• The run-off vote will occur on October 30th, and until then, the political tension is expected to become particularly nasty
• The Brazillian real rose 5% against the dollar after the election on hopes that Bolsonaro's strong performance will force the heavily left-leaning Lula to moderate his policies. 

?? Saudi Aramco Sounds Alarm Over Global Oil Capacity (FT)

Explained: 

• Chief executive of the world's largest crude oil producer, Amin Nasser, has warned that global oil markers remain incredibly tight. 
• As we wrote about yesterday, the comments come at a time when OPEC+ is expected to dramatically cut oil production. Nasser believes, though, that the recent fall in oil prices, which has sparked the possible production cuts, is due to "short-term economics rather than supply fundamentals."
• Nasser's argument is that for years, the global community has massively under-invested in its capacity to produce oil so as to foster the green energy transition, yet now we find ourselves desperately in need of the commodity (i.e. the European energy crisis).

What to know: 

• He adds further that China's long-running and highly restrictive covid-19 limits have artificially weakened one of the largest sources of demand for energy, but if and when the Chinese government drops these economic restrictions, there will not be enough spare capacity in oil production to re-adjust.
• Saudi Aramco is one of the few major oil producers looking to boost its maximum production capacity, and Nasser says that this is because it will take the rest of the industry a long time to invest in greater capacity once the global oil shortage becomes more apparent. 

? Renewable Energy Battery Startup Raises $450 Million (WSJ)

Explained:

• Form Energy Inc. is developing iron-air batteries that could store renewable power for several days.
• The private funding round will more than double the total equity raised in its short five-year history, and investors' appetites were fueled, in part, by a number of tax credits for battery storage and renewables set in stone by the Inflation Reduction Act. 
• New battery technology is badly needed to enable more widespread use of solar and wind power, as current lithium-ion battery tech struggles to store energy during long periods when the wind isn't blowing or the sun isn't shining.

What to know:

• Investors ranged from large steel producers to the Canada Pension Plan Investment Board and Bill Gates' Breakthrough Energy Ventures. 
• The company hopes to dramatically cut battery prices with an aim for commercial production to begin in late 2024.
• The space is ripe with competition as a number of other startups, like Ambri Inc., all develop unique solutions to renewable power storage that may better foster the transition away from fossil fuels. 

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DIVE DEEPER: INVESTING IN CARBON MARKETS

In a world where carbon dioxide emissions are increasingly regulated, taxed, and monitored, the price of carbon itself becomes quite important, especially to companies who feel pressure from all sides to reduce CO2 output as much as possible. 

That is, the cost for businesses, governments, and even individuals, to emit a certain amount of greenhouse gases into the atmosphere and/or offset those emissions. 

In essence, this is what carbon markets seek to accomplish.

Breaking it down

Under a regulatory regime, carbon credits refer to the total amount of emissions that may be permitted to an industry by a government regulator, and companies must comply, though they can trade excess credits amongst each other in a private market through "cap and trade" programs. 

One credit typically corresponds with the right to emit one ton of carbon dioxide. 

In a voluntary system, companies can use credits to track their emissions while seeking so-called offsets, such as forest planting or conservation that helps remove carbon from the atmosphere, so that companies can meet their emissions goals. 

When one entity verifies that it has removed a unit of carbon from the atmosphere, it can generate a corresponding carbon offset that could be sold to other companies to reduce their carbon footprint. 

State of the markets

Right now, carbon markets primarily exist for credits in Europe, California, and the northeastern United States. As of the end of last year, the global price per ton of CO2 was $51.45.

In California, for example, the Cap-and-Trade Regulation, "establishes a declining limit on major sources of greenhouse gas emissions throughout California...Each year, fewer allowances are created and the annual cap declines."

As the supply of these carbon allowances diminishes, prices will likely rise until they reach a sufficiently painful level such that entities are incentivized to cut back their emissions. That's the goal at least. 

According to climate change targets and emissions goals from the internationally signed Paris Agreement, adopted by 196 countries, voluntary carbon markets may need to grow 15-fold by 2030. 

In other words, total carbon emissions are set to decline by 8% per year on average to reach the agreement's goals which squeeze the value of remaining carbon emissions upwards, as demand for the limited credits booms with more and more companies every year either volunteering to buy carbon offsets or being regulated into using credits.

Carbon credits and offsets, then, have the potential to form an entirely new asset class, as market participants seek to reach their various emissions target goals and comply with regulations. 

How to invest in credits

One popular approach to investing directly in carbon credits is via futures contracts held in exchange-traded funds like KraneShares' Global Carbon Strategy ETF (KRBN).

Futures are financial instruments that establish an agreement today for a transaction to occur between two parties at a future date. 

So futures markets around carbon credits facilitate the interchange of carbon allowances between businesses with either an excess or deficit of credits.

Another reason for businesses to enter these futures contracts, though, is to hedge against rising carbon prices. 

By setting a price for future emissions today with a futures contract, they can lock in their rate over a period without concern for whether the price of credits they need will jump during that time.

What to know about KRBN

And a bet using the ETF, KRBN, is a bet that the value of these futures contracts will increase as demand for carbon allowances grows over time.

According to KraneShares, carbon futures markets can provide useful portfolio diversifying characteristics given their relatively low correlation to traditional financial assets. Since its inception in 2020, the KRBN fund has returned approximately 100%.

The European carbon credits market is by far the largest, and this means that the European Union (EU) wields sizable influence over products like KRBN, because they control the supply of allowances each year which shapes the value of the corresponding futures contracts.

So, this does pose a meaningful risk to investors, since bets on these credits are inherently political and contingent largely on the actions of a single governing body. 

That said, the fixed supply of credits has desirable attributes for investors willing to bet on the EU's commitment to pushing carbon prices higher and thus orchestrating a forced transition away from fossil fuels for companies who find carbon emission costs increasingly prohibitive. 

Investors can also use the KCCA ETF to focus only on California carbon markets, though this merely shifts the political risk to a different governing body. 

Investing in offsets

Until recently, investing in carbon offsets, as opposed to emission allowances through carbon credits, was not possible for most investors.

KraneShares has another ETF ticker: KSET, which "seeks to provide investors access to validated instruments for the growing global voluntary emissions market."

Validated instruments are projects that have been verified by third parties to address climate change and reduce greenhouse gases in the atmosphere. This fund is an order of magnitude smaller than its peer KBRN (roughly $8 million net assets versus $770 million respectively). 

Issues

Unlike carbon credit markets, where governments have an incentive to artificially constrain supply and force the carbon price higher, there are a lot of organic incentives for entities to produce as many carbon offsets as possible. 

And given the lack of central regulation for these voluntary markets, it's essentially the wild west. 

But it's not always clear whether carbon offset projects, such as forest conservation, are actually offsetting any new marginal carbon emissions. 

If, for example, a forest wasn't truly in danger of being cut down, and carbon offset sellers say that it was, then companies purchasing the offsets have a free pass to emit CO2 without really offsetting their actions.

So there are very real conflicts of interest in the burgeoning voluntary carbon markets, yet they may have greater market size potential than the regulated credits market.

Given that this fund has been around for less than 6 months and is highly concentrated, it's far too early for most investors to consider KSET, and the same may be true for KRBN.

Wrapping up

For investors looking to speculate on, and participate in, the global push away from fossil fuels with the hopes of lowering emissions, carbon markets are an excellent way to do so. 

While others may find the low correlation to conventional assets and unique exposures to be intriguing for their portfolios. 

Whether you'd prefer to invest in the regulated carbon credit space, or the voluntary carbon offset markets, we think it'll be quite interesting to see how these different strategies unfold over time. 

Tell us readers — What do you think of carbon investing? 

Any preferences between the carbon offset market and the carbon credit market?

Check out Trey Lockerbie's podcast interview on commodity trading and carbon credits for more. 

For full transparency, your authors do hold a small and speculative position in KRBN. 

SEE YOU NEXT TIME!

That's it for today on We Study Markets! 

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