Bank turmoil, Fed interest rate hikes, sticky inflation, geopolitical tension, economic recession — you can name almost any of the major risk factors, and markets and investors have had to contend with the possibility or reality in the last year. A major risk that often gets overlooked however, but that will have an outsized impact on global markets and portfolios in the next two decades, is the risk of climate and the role that carbon will play in changing the investing landscape.
I recently had the chance to sit down the Luke Oliver, managing director, head of climate investments and head of strategy at KraneShares, to talk about why climate investing matters now, and what opportunities exist for savvy advisors and investors looking to get on the right side of decarbonization through carbon allowance investing.
Karrie Gordon, staff writer at VettaFi: Luke, thank you so much for chatting with me today. So, let’s start big, and then we can dig into some of the details. Tell me about climate investing and why KraneShares believes so strongly in carbon as a mechanism of change.
Oliver: What we like about our entire climate suite is that these ETFs are designed to play the biggest capital cycle and the biggest change in our economy that’s ever occurred, as it occurs over the next 20 years. Believe it or not, the risk to the global banking system that people are focused on is smaller than the story that we’re backing.
Increasingly the global economy is pricing carbon and is using carbon markets to materially decarbonize over the next 20 years, something that is going to take $140 trillion in investment. We believe carbon will be engineered to move higher as the primary policy tool to reduce emissions, and the supply will be reduced which applies price pressure. That in turn creates the incentive to decarbonize.
Gordon: Carbon allowances were the foundation of this strategy that has since grown to an impressive ETF suite. I know you were the first issuer to offer an ETF with exposure to carbon allowances back in 2020, the globally focused KraneShares Global Carbon Strategy ETF (KRBN ). So why carbon allowances? What is it that makes them such a pivotal part of the climate transition and why should investors allocate to them?
Oliver: So many people think carbon pricing is anti-businesses or a war on oil companies. It’s not, it’s an opportunity for smart people to do what smart people do, which is innovate and beat the competition. If you don’t put a price on carbon, there isn’t a problem until the atmosphere is completely poisoned.
What carbon pricing is doing is putting a cost on polluting the atmosphere, and as soon as there’s a cost for that, we can optimize around it which will create another massive wave of productivity and economic impact, which is this capital cycle that’s happening now. If you’re a good company, you’re going to make more money than ever because you’re going to be the ones that innovate in this space —humans have always innovated when incentives are aligned.
Outlook for Carbon Markets in 2023
Gordon: Alright, let’s get into the specifics. What is the outlook for carbon markets this year, given the current global macro environment?
Oliver: Most of the focus goes to the European and California carbon markets, they’re 60% and 30% of the global benchmark, respectively, and the main drivers in the market.
Europe is the big story for me here. Europe just passed tightening measures and we now have clarity on the market that we were lacking at the end of last year. In 2020 and 2021 Europe had a massive performance, and in 2022, the performance wasn’t bad relative to global markets. Most of the downside that U.S. investors experienced was on the euro weakening, not on carbon weakening — carbon held up well, it traded sideways, though did experience volatility.
Now we have quite a lot of certainty on how the REPowerEU program is going to work, with some concessions made to ease the prices through the energy crisis through front-loading supplies. Any extra supply that is used to soften prices to get through the energy crisis will actually come out at later auctions. As we’ve seen stress in the market, we’ve actually steepened the curve coming out of this point. This is great for U.S. investors because the higher the price gets, the more valuable green innovation is and the faster we see scaling in green solutions.
California also came out with a round of tightening which isn’t fully priced in yet. We have talked to those close to the matter who believe that California will be able to execute its aggressive plans, a current concern in the market. If the market is pricing at a discount because of this perceived risk and we’re hearing from the very top of the chain that California is committed, it means there is a great opportunity.
We do think California’s assumptions about where their decarbonizing will come from is a little too aggressive, which could ultimately push prices higher. We don’t think they’ll cut pollution as quickly as they want. The easiest thing when decarbonizing is to switch from coal to gas like what Europe is doing, but California has already done that. They have also set mileage reduction goals that I don’t think they will be able to meet, which means the price of carbon will go up even faster, which could in turn help create the catalysts to create the reductions.
If they’re failing to meet their goals, the price will go up faster. If they’re doing it right, the price will go up modestly and stably, and you’ll have this great investment. If it’s not working, the price will rise even faster and force change. We’re on the right side of all of that, and it’s worth mentioning that California also has a floor that goes up 5% plus inflation.
Allocation and Weighting in Portfolios
Gordon: Both of these narratives seem compelling this year. Why does KRBN weight more heavily towards the European Union carbon market than the joint California and Quebec one? And what alternatives for weighting could you see in investor portfolios?
Oliver: KRBN is 60/30 Europe/California with 5% each to UK and RGGI markets. Europe’s 60% allocation represents the markets depth and maturity and it’s advancing opportunity. We have high confidence on 20-30% type annual returns for the next year or two, with California potentially seeing a plus 50% leap albeit with less certainty on timing.
We certainly have investors, and you can see it in our flows, who came down on KRBN and up in the KraneShares California Carbon Allowance Strategy ETF (KCCA ) last year. Maybe the 60/30/5/5 allocation is a great base position, with investors tilting towards 50/50 EU and California using KCCA and the KraneShares European Carbon Allowance Strategy ETF (KEUA ) could be the other end of the spectrum, but we have strong feelings about having both and being diversified in these markets.
California is the question mark with the most upside. Europe is less of a question mark but less upside, still more than anyone’s forecasting for equities — more than anyone’s forecasting for any other asset class, so it’s pretty exciting.
What About the Risk?
Gordon: Luke, this has been really fantastic. One last thing to touch on before I let you go, you can’t talk about investing these days without talking risks. What kinds of risks are there in carbon allowances investing that you foresee this year?
Oliver: We always say there are two main risks: innovation and political risk. Innovation risk is that we solve carbon issues and decarbonize more quickly than currently anticipated, and while that would be a great problem to have, it simply isn’t realistic. Global industry is behind and it’s not moving fast enough — if it does happen, for example someone rolls out a modular nuclear reactor that we can ship around the world by the fall, carbon prices will come down. The carbon programs will step in, however, and say “oh, all of our demand assumptions have changed materially so now we change our supply modeling,” and that’s it. It’s unlikely that’s a real risk.
Political risk was one area that remained a concern but we’ve had such great proof of point in 2022 of how these markets perform during higher risk. We had a borderline invasion of Europe, we had a massive energy crisis, we had runaway inflation in the U.S. and despite the stress and rhetoric and the swings in all the markets, Europe came out of it with a stronger program and California came out of it with a stronger program and commitments to continue strengthening.
Within RGGI, North Carolina signed up as a possible addition. New York is now talking about doing an economy-wide market. The state of Washington added its own program. China launched its program in 2022. So there’s the answer. In the one year where you would have forgiven people for backpedaling, they didn’t. They pedaled even faster.
You can find the second part to the conversation covering offsets, equities, and commodities on Monday.
For more news, information, and analysis, visit the Climate Insights Channel.