Exposure to carbon as an asset class has gained in popularity in recent years, making it essential for investors to understand how to enhance the risk/return fundamentals of their investments.
While many investors may currently have exposure to either European Union Allowances (EUAs) or California Carbon Allowances (CCAs), balanced exposure to both can offer better risk/ return fundamentals. According to Oktay Kurbanov, Partner at Climate Finance Partners (CLIFI), exposure to both CCAs and EUAs delivers superior risk/reward ratios versus concentrated regions while offering an attractive level of returns.
EUAs have looked very attractive in recent years as prices more than tripled between 2019 and 2022, but CCAs still add considerable value to portfolios.
The IHS Markit Carbon EUA Index, tracked by the KraneShares European Carbon Allowance ETF (KEUA ), returned 35.4% annualized from August 2014 through July 2023, according to Kurbanov. During the same period, the IHS Markit Carbon CCA Index, tracked by the KraneShares California Carbon Allowance ETF (KCCA ), returned 10.3% annualized.
When looking at returns, it’s important to also consider volatility. EUA’s stellar performance over the years came with high volatility risk.
According to Kurbanov, compared to CCAs, EUAs realized three times higher volatility of 43% with a worst 12-month return of negative 47% during the period (November 2016) versus more tolerable volatility of 14% for CCAs, with a worst 12-month return of negative 19% (November 2022).
Balancing Carbon Exposure to Optimize Risk/Return Fundamentals
In a CCA-only portfolio, adding about a third of EUA exposure (35%) almost doubles the annualized return to 19.1% versus 10.3% per Kurbanov. Notably, while returns are nearly doubled, volatility increases by less than a third, from 14% to 18% per annum.
A 35% addition of EUA exposure produces a superior risk/reward ratio of 1.03, a 40% improvement from the CCA-only portfolio, according to Kurbanov.
On the other hand, EUA-only portfolios can see considerable benefits from the addition of CCA exposure. In an EUA-only portfolio, adding about a third of CCA exposure (35%) decreases volatility risk by a third, from 43% to a much lower level of 29%, according to Kurbanov.
While the reduction in volatility risk means returns would decrease from 35.4% to 26.4%, the risk/reward ratio improves by about 11% per Kurbanov.
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