There is noteworthy diversification potential in carbon allowances as a non-correlated commodity within portfolios. For advisors wanting to better understand carbon markets before investing, arguably the best place to start is with the EU carbon allowances market.
The European Union Emissions Trading System (EU ETS) is the oldest and most liquid global carbon allowance market. The market also just passed aggressive emissions reductions plans that could create positive underlying price pressures and opportunity for investors.
Eron Bloomgarden, founder and partner at Climate Finance Partners, and Oktay Kurbanov, partner at CLIFI, wrote a paper recently reviewing global carbon market performance in 2022.
“Geopolitical, inflation and economic uncertainty rattled global markets in 2022,” the authors wrote. Despite this volatility, however, “carbon allowance markets have demonstrated their resiliency and diversifying value.”
EU Carbon Market Overview
Europe’s carbon allowance market works as follows: Any entity that emits a certain level of pollution within the allotted industries in the EU must participate. Allowances are sold by the regulating agency at auctions to market participants and other interested parties. One carbon allowance equates to one ton of carbon dioxide or equivalent greenhouse gases.
At the end of each year, market participants must surrender enough allowances to compensate for their emissions that year. Those with an excess of allowances can sell them, and companies that come up short must buy more or pay substantial fines.
The EU ETS is comprised of more than 12,000 participants, and industries covered include industrial, agricultural, power, and aviation. Emissions within the EU ETS dropped 36% since the market’s inception, and new regulations are set to increase reductions more rapidly.
Between 2021 and 2030, the EU anticipates that 57% of allowances will be auctioned to market participants. The remaining 33% are distributed free of charge to industries, but these free allowances will be eliminated by 2034.
“This will increase transaction volume and liquidity,” the authors wrote. Current recipients of free allowances will be forced to purchase allowances in the future either from auctions or a secondary market.
EU Carbon Market Mechanics Reduce Volatility
To reduce market volatility and create stronger price stability, the European Commission created the Market Stability Reserve (MSR). It’s a mechanism that moves allowances into and out of the market as volume spikes or drops. When there is high volume, the MSR withholds allowances at the next auction. These allowances are kept aside and then injected back into the market should volumes drop.
“There is no predetermined price floor or ceiling,” for the MSR, the authors explained. “However, this mechanism creates stability in the market and improves resilience to future spikes in supply/demand.”
What’s more, recent regulations (“Fit for 55”) set a more ambitious emissions reduction path for the bloc. The EU ETS will tighten supply by reducing allowances at auctions in 2024 and 2026, and also reduce the annual cap faster. This means there will be fewer allowances at a faster rate than previously planned, with a goal of 62% emissions reductions by 2030 compared to 2050 levels.
These reductions should lead to more scarcity in allowances and have a two-fold benefit. In theory, it will aid in “driving up the price and making carbon emissions more expensive,” according to the authors.
The World’s Most Liquid Carbon Allowance Market
The European Union cap-and-trade program is the most liquid carbon allowances future market globally. In 2022, the EU ETS had roughly $630 billion in total notional trading volumes and more than quadrupled since 2018.
Over the same period, EU ETS allowances experienced noteworthy price performance gains. Despite macro market volatility last year, EU carbon allowance futures ended the year fairly flat. It’s a commodity class worth strong consideration, given the price potential and inherent volatility mitigation measures.
The KraneShares European Carbon Allowance ETF (KEUA ) offers targeted exposure to the EU carbon allowances market and is actively managed.
The fund’s benchmark is the IHS Markit Carbon EUA Index. This benchmark tracks the most-traded EUA futures contracts, the oldest and most liquid carbon allowances market. Currently, the market covers roughly 40% of all EU emissions, including 27 member states and Norway, Iceland, and Liechtenstein. KEUA has an expense ratio of 0.78%.
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