Time to Invest in Carbon Allowances?

I have reached topic #6 in my series on the investment themes that make up the spine of our investment strategy. I will write about carbon allowances today – a programme which was first introduced by European governments to address ever-rising CO2 levels in the atmosphere. I have decided to write about carbon as a natural follow-up to my piece on graphene last month, as one could argue that a successful rollout of graphene could quite possibly solve the climate crisis and thus eliminate the need for limiting carbon emissions. Therefore, longer term, it may be difficult to make a respectable return on graphene and carbon allowances at the same time. We obviously won’t run out of CO2 from one day to the next, but it is a factor worth keeping in the back of your head.

Allow me to start by pointing out the difference between carbon allowances and carbon credits, as some investors assume they are one and the same thing, but they are not. While often used interchangeably, the allowances market is driven by regulation, whereas the carbon credit market is voluntary.

Carbon allowances are permission slips from a government or governmental agency that allow a company to emit one tonne of CO2, or CO2?equivalent (CO2e). Governments set emission targets in advance and gradually reduce them over time, as they attempt to meet the Net Zero target.

Carbon credits, also known as carbon offsets, are traded between private parties in the voluntary carbon credit market. They are issued by various carbon schemes and represent the reduction, removal or avoidance of one tonne of CO2e. Carbon credits are issued, tracked and cancelled by means of an electronic registry. We have never invested in carbon credits and do not intend to do so unless/until it becomes more institutionalized. Any mention of carbon in the following refers exclusively to carbon allowances.

The four main investible carbon markets are EUAs (EU carbon allowances), UKAs (UK carbon allowances), CCAs (Californian carbon allowances) and RGGIs (regional greenhouse gas initiatives) – a ‘consortium’ of 11 northeastern US states that participate in the RGGI programme. The Chinese carbon allowance market is the largest but is only open to domestic compliance entities. In the following, I will focus on EUAs, partially because it is the most liquid allowance programme, partially because it is better researched and partially because it is more diversified geographically, making it less sensitive to single-country ‘idiosyncrasies’.

Despite all the initiatives taken so far, CO2 emissions are not at all under control. The latest numbers provided by NOAA suggest that the annual increase in CO2 levels in the atmosphere reached a new all-time high last year. Between North America and Europe, annual CO2 emissions amounted to 12-13 billion tonnes – a number that peaked at almost 15 billion tonnes back in the 1980s. However, China now emits as much as North America and Europe combined and, globally, nearly 40 billion tonnes were emitted in 2023. Assuming governments stick to their Net Zero target, the inevitable implication is that current rules and regulations will be further tightened.

The problem is that CO2 emissions caused by China are as much a problem to the Europeans and North Americans as it is to the Chinese, i.e. the fact that emissions have started to fall in our part of the world has little effect. Unless everybody takes this problem seriously, it will get progressively worse. This logic is behind the EU’s latest initiative, the so-called CBAM programme (sometimes referred to as border tariffs), where the objective is to introduce a cost of carbon for businesses operating in countries that do not currently employ one.

The price on EUAs peaked in March 2023 at nearly $100 per tonne; however, it has since declined substantially and troughed at about $52 per tonne in February of this year. Although it has since recovered some of its losses, it still trades more than 30% below the peak – currently at $68-69 per tonne. The sharp fall has had two effects. Firstly, it has lowered the appetite to reduce emissions (it has become cheaper to pollute) and, secondly, funds available to finance the green transition have dropped significantly. Most of the revenue intake from the EUA programme is distributed to EU member countries to finance the green transition, and the 30%+ drop in EUA prices is equivalent to a loss of over €40Bn in revenues.

EUA prices are closely correlated to the relative prices of natural gas and coal, and the logic is simple. Most power stations, if fuelled with gas (as most are), switch to coal if gas becomes relatively expensive. Given that coal releases twice the carbon for the same energy output as gas, an increase in gas prices relative to coal prices will in turn increase demand for, and prices of, carbon allowances. This has created a powerful link between natural gas prices and EUA prices.

Following Russia’s invasion of Ukraine, as we entered the 2022-23 heating season, European gas prices were extremely high. In the winter of 2022-23, that had a meaningful impact on the European economy. As we approached the 2023-24 heating season, gas suppliers made sure gas inventories were plentiful. As we entered the 2023-24 European heating season, European gas inventories were 30% higher than the average over the last 10-years and the highest they had been for more than a decade. However, the 2023-24 heating season turned out to be anything but normal. A very mild winter resulted in gas consumption well below average, and the combination of high inventories and low demand led to a virtual collapse in European gas prices. This resulted in a 30% decline of EUA prices.

Looking forward, the road to Net Zero by 2050 is getting steeper and steeper (see chart). Therefore, governments will have no choice but to tighten the rules further, unless they decide to shelve/defer their plans. Tightening the programme can be achieved in different ways. One can:

(i)??????? reduce annual allowances;

(ii)?????? include more industries in the programme (maritime has just been included); and/or

(iii)???? expand the CBAM programme to ‘encourage’ other countries to roll out a similar programme.

Given that excessive CO2 emissions are a global problem, (iii) is almost a certainty, although I think a combination of all three will probably be introduced, leaving carbon prices with an upward bias over the longer term.

Although coal is being phased out, it still accounts for a meaningful proportion of the energy being used for electricity generation in Europe. Therefore, I would not entirely dismiss the possibility of further fuel switching, particularly in Germany, Poland and the Netherlands – the three EU countries with most coal-fired power capacity – and that would limit the near-term upside potential in EUA prices. Adding to that, starting in 2025, global LNG supplies should tilt gas markets into oversupply and, in turn, put further pressure on European gas prices. All else equal, it is therefore possible that gas prices will be relatively weak over the next few years, and that could potentially drive EUA prices down as well. Having said that, there are two factors that may upset this forecast:

1.??????? Russia has ‘always’ accounted for a significant proportion of gas consumption in Europe and, for as long as the war in Ukraine is raging, there is a structural undersupply of gas in Europe.

2.??????? Gas prices and carbon prices do not always correlate – the tide will turn when lower gas prices can no longer incentivise more fuel switching to coal.?

In summary, you should not just buy and hold carbon. You need to be relatively active. In the short term, there are powerful arguments in favour of both lower and higher prices. However, in the longer term, there is a strong bias towards higher prices. One last point: carbon prices continue to be very lowly correlated with both equities and bonds, effectively offering an attractive opportunity to improve risk-adjusted portfolio returns.

See you next month, where I will talk about batteries, one of the most critical ingredients in the green transition.

Niels