This was a much better hedge than any standard credit default swaps with a lower cost of carry and a much greater upside and eventually made us over ten times the capital at risk. The drawback: this trade inflicted enormous financial damage globally.
Today, I am looking at another portfolio hedge that can make multiple returns, this time with the potential of benefiting our beleagured planet.
Carbon will be the most important investment arena between now and 2030. It is essential to understand and prepare for it.
Over the next three years businesses and investment managers will face increasing pressure from stakeholders by legal liabilities from regulators/governments, and perhaps even their consciences, to invest in carbon credits. Once that happens investors need a strategy to rebalance or sell when the prices overshoot.
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The 2015 Paris Agreement saw participating nations agree to limit global warming to 1.5°C above pre-industrial levels to avoid irreversible climate effects. A carbon offset or credit is an instrument which represents the reduction or removal of one tonne of CO2 equivalent. These can be netted against companies' emissions, allowing them to reduce their net emissions profile or even reach net zero targets.
There are two types of carbon credits - mandatory and voluntary - aiming to make polluters innovate to reduce their emissions while encouraging financially viable carbon absorbing projects.
‘Compliance' or ‘mandatory' carbon markets are primary policy instruments combating climate change, key to reducing CO2 emissions and effectively a tax for doing business in places like California, Europe or the UK. This mechanism allows governments to reap revenues but avoid political stigma by blaming the market for prices. The goal is to drive carbon prices higher, forcing polluters to implement more efficient ways to operate.
These schemes work on the 'cap and trade' principle. A cap limits the total amount of certain greenhouse gases that can be emitted by the companies covered by the system. The cap reduces over time meaning total emissions fall. Within the cap, companies buy or receive tradable emissions allowances. Each year participants must surrender enough allowances to cover their emissions or pay heavy fines. If the company reduces its emissions, it can keep surplus allowances to cover future needs or sell them in the secondary market.
Important policy mechanisms have been developed to facilitate the smooth operation of mandatory markets. As these are constantly tweaked it is imperative participants understand and monitor them. For example, the annual auction supply reduces annually, new industries are being brought under the rules, while hard and soft price floors can be imposed at auction. In a deliberately constrained market, it is unsurprising if prices rise.
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Voluntary markets are for those who for commercial or regulatory reasons have committed to lower their carbon footprint. Offsets are key to financing projects responsible for CO2 avoidance or removal. Once a project is verified and audited, offsets are issued on a public registry. The buyer must retire offsets on the registry to claim an emissions reduction. Prior to retirement carbon offsets trade on secondary markets making them an investible asset class and preventing double counting of emissions.
Projects can be nature-based, industrial or technological. Reforestation is a nature-based example while renewable energy or fuel-switching are industrial and technological projects. Crucially their abatement costs are currently a fraction of solutions like carbon capture and storage. Voluntary offsets are a highly attractive, cost-effective, tool in our ongoing fight to reduce emissions.
Voluntary markets are more complex than the fee-paying mandatories but that does not explain the 85-90% discount between them, especially since the risk of prices falling due to government interference has dissolved. Currently, open interest in mandatory futures is over $40bn in Europe whereas the secondary market in voluntary credits was just $250m in 2020 growing to $1bn last year. Fast growing but still much smaller, hence the discount.
The direction of travel in these expanding markets is clearly upwards. Understanding and remaining on top of mandatory carbon markets is vital for all businesses. For shareholders, carbon and carbon-related costs will continue to be an extremely important line item as prices appreciate and will have a significant impact on profit margins.
Every investment firm needs to be able to calculate their exposure to rising carbon prices. The SEC recently introduced new rules in the US, followed by the UK, while Europe has increasingly onerous reporting requirements. Telling your stakeholders you don't know your exposure won't be acceptable.
What will happen to carbon prices if the investment management industry invests just 0.25% into carbon? Prices skyrocket and the discount between voluntary and mandatory will tighten, maybe down to 30-40% as the market matures. If mandatory prices double from $90-180 then voluntaries will rise more than 10 times. The prices will overshoot as latecomers scramble to catch up, making them a significant driver of future returns.
Carbon prices will be one of if not the most important driver of returns in the coming years. Investors need to understand the impact, to prepare and rebalance their portfolios accordingly.
Lee Robinson is founder and CIO of Altana Wealth