Hey everyone,
Hope this finds you well!
Back again to share something I’ve been looking into this month.
TL;DR version if you’re short on time:
The carbon trade/investment seems uncorrelated to the volatility of the stock market so far and as governments all around the world commit to reducing carbon/greenhouse gas emissions in the decades to come, it could be one of the best performing investments. Check out KRBN ETF if you’re interested.
If this interests you, read on:
So, what are carbon markets?
Carbon markets exist to regulate emissions by setting a price on carbon emissions. Basically, it creates a financial incentive to reduce carbon emissions. Currently, only a few parts of the world have such a market - Europe, North America, New Zealand, South Korea and most recently China.
How does this whole thing work?
If you’ve been following global news on climate change, you’d have read that the world is moving towards net-zero emissions (amount emitted = amount taken out of the atmosphere) by 2050.
One way governments try to achieve this is by setting a cap (or limit) on the nation’s emissions based on its emission reduction target. This limit is then translated to the various industries in the economy in the form of carbon allowances (generally we can think of carbon allowances and carbon credits as the same).
Every year, companies under such jurisdictions will need enough carbon allowances to cover their carbon emissions. For example, if a company produces 30 tonnes of carbon dioxide equivalents, it needs to ensure it has enough carbon allowances for the 30 tonnes emitted.
If emissions are more than the carbon allowance allotted, companies will need to buy additional carbon allowances from the carbon markets. If these conditions are not followed, companies face fines and penalties from the government. On the other hand, if companies’ emissions are lower than the carbon allowances allotted to them, they’re able to sell the extra allowances in the market.
This entire mechanism is usually referred to as cap and trade.
What’s the investment thesis for us?
In 2018, the European Union reformed the carbon market as it was largely ineffective in cutting emission levels in Europe. The price of carbon was very cheap prior to 2018 (they were 5-6 euros/ton of CO2 equivalent). They reformed the carbon markets by simply reducing the supply of carbon allowances every year (read the full story here).
With rising demand for carbon allowances and reducing the supply of it, the price of carbon has never looked back. As recently as November 2021, the price of carbon has surpassed 70 euros/ton, which means the price of carbon has increased more than 10 times since 2018 in Europe.
According to IHS Markit, as of December 31, 2020, the global price of carbon was $24.05 per ton of CO2. It is estimated that carbon allowance prices need to reach $147 per ton of CO2 to meet a 1.5°C global warming limit.
So, as long as the supply of carbon allowances continue to shrink and demand remains the same or even increase, the price of carbon will appreciate.
Let’s take a deeper look at both the supply side and demand side.
Supply-side:
Governments. As long as governments continue to remain committed to tackling climate change and unless they come up with better ways to incentivise companies financially to reduce carbon emissions, the supply of carbon allowance should continue to shrink over time.
Demand-side:
Based on BP’s annual statistical review of world energy, 2020 saw a decline in primary energy consumption year over year mainly due to the pandemic. Perhaps a better picture of the global energy consumption would be the report from 2019 where the global primary energy consumption hit a 10th consecutive record year. 2021 and beyond should revert back to an uptrend as the world gets back on its feet.
However, even in the decline of 2020’s primary energy consumption, the 2 largest share of energy sources still is oil (31%) and coal (27%). Pure renewables, nuclear and hydroelectricity only account for 17% share (see full stats here). According to BP, renewable energy will only take over as the main energy source in 2040 based on the projected growth trajectory.
On the premise of oil and coal energy sources being directly linked to carbon emissions and barring an exponential growth in renewable energy’s share of the total energy sources, the demand for carbon allowances should continue to remain elevated.
How does the retail investor (us) get in on this investment idea?
KRBN ETF
The KRBN ETF tracks the IHS Markit Global Carbon Index, which tracks the most traded carbon credit futures contract mainly in Europe and North America.
Since its inception in mid-2020, it has significantly outperformed both the S&P 500 and NASDAQ 100 ETFs (SPY & QQQ).
One has to note that KRBN ETFs tracks carbon credit futures contracts which means the price and value appreciation of KRBN is tied to the price of carbon credits/allowances increasing in future years.
Would be keen to see if they add China’s carbon credit futures contracts into its portfolio soon as China is slated to be the world’s largest carbon credit market.
Hope this piece has given you value. Any thoughts, comments and feedback are welcomed! We learn together.
Big shoutout to Roger Hirst and Real Vision for their influence on this piece.
Have a great week,
Justin
(ps: for all the resources I’m using & learning from, click here)