Reaching net-zero with Carbon Credits ETFs

Exchange-traded funds under the Carbon Transition theme were amongst the top-performing ETFs in the thematic universe for the third week of August. The Horizons Carbon Credits ETF (CARB) posted 8.44% of gains, only to be followed by the WisdomTree Carbon (CARP) and the Ninepoint Carbon Credit ETF (CBON) which managed to register 7.88% and 7.42% of weekly returns, respectively. 

These ETFs allow global investors to access an emerging asset class where the global carbon credits traded reached USD$851 billion in 2021, a 164% increase year on year, according to estimates by the financial data provider Refinitiv. 

It is becoming increasingly evident that the broad investment community must play a fundamental role in the pursuit of net-zero goals. Adopting the Carbon Transition, exchange-traded funds stepped up to help them do just that. By investing in these ETFs, global investors can actively participate in transitioning the economy to a greener and more sustainable one by reducing greenhouse emissions and supporting business innovation and initiatives. And that is without accounting for the benefits of adding carbon credits, allowances, and offsets to any portfolio. It is understood that environmental commodity markets trade according to their specific supply-demand dynamics and exhibit historically low correlations with other asset classes.

Why invest in carbon credits market?

Industry pundits believe that carbon credits offer an alternative investing solution with growth potential to global investors and benefit them with better diversification. Carbon credits and their futures contracts have shown a low correlation with the broader financial market. This could potentially provide resilience against climate transition risk and a natural hedge against any adverse market movements for any portfolio. According to Wood Mackenzie, this market segment is expected to see exponential growth, especially since the global emissions trading market is estimated to grow to USD$22 trillion by 2050.

Driving forces behind carbon credit prices

The price of carbon credits is driven by supply and demand fundamentals, like any other market. For instance, governments set caps on carbon credits as a determining factor on the supply side. The higher the cap, the higher the supply, which eventually depresses carbon credits prices. Additionally, compliant carbon offset projects and international trading play a role in influencing carbon credits’ supply.

Similarly, numerous factors can impact the demand for carbon credits. For example, higher economic activity will result in higher demand for emission allowances. Of course, the opposite holds true; the lower activity, the lower the demand. In fact, this is what happened when nationwide lockdowns and travel restrictions were in effect following Covid-19’s outbreak. It is worth noting that energy prices and weather conditions can influence demand. On the brink of the Russian invasion of Ukraine, power companies were enticed to switch to coal power generation over fears of increased gas prices in the region. This has led to an increase in the demand for carbon allowance. 

According to ClearBlue, there is no one price for a ton of carbon. Prices can range from a low USD$2 per ton in voluntary markets to around USD$150 in compliance markets. A combination of policy, strong investor interest, and other fundamental factors have resulted in the EU ETS seeing pricing around a high EUR90, with WCI near USD30 and RGGI below USD15.

Anatomy of carbon credits

Carbon credit offers its holder a license to emit greenhouse gases and carbon dioxide, where a single credit allows one metric ton of carbon dioxide emission. This is equivalent to a vehicle's emissions travelling 3,300 kilometers, the distance between London and Istanbul. 

But not all credits are born equal, there are two types of markets for carbon credits: compliance and voluntary. Compliance markets, also known as involuntary markets, are created by governments where they set a cap on how many tons of emissions certain sectors can release. For example, if an energy company exceeds the prescribed cap, it must compensate by purchasing new credits or using saved ones. In contrast, if that same company stays below the cap, it can either save or sell its credits. The process is called cap-and-trade, where emitters must trade to remain within the cap limits. The European Union’s Emissions Trading System (“EU ETS”), the Western Climate Initiative (“WCI”) between California and Quebec, and the Regional Greenhouse Gases Initiative (“RGGI”) in some Eastern states in the U.S. are amongst the most successful markets. For compliance markets, global investors can directly invest by opening accounts or go to the secondary market and trade.

In the voluntary markets, credits are created by any project undertaken to drive emissions reductions beyond what is required. Companies employ greenhouse gas reduction claims as part of their net-zero strategies. Individuals or companies can buy those credits through an intermediary or those directly capturing the carbon. Bilateral transactions are not uncommon in these markets, but standardized contracts on exchanges are increasingly getting noticed.

The compliance markets have had the lion’s share out of the global carbon markets that have more than doubled throughout 2021. In contrast, the voluntary markets made up a smaller portion of the total but have shown a strong growth potential, having increased four-fold in the same period. 

The idea of imposing a price on carbon will spur innovation and investments in initiatives to reduce emissions. This becomes especially true since the set prices will be reflected in higher costs of energy and carbon-intensive goods, and, hence depressing the consumption.

Thematic investing in carbon transition

For investors who would like to have an environmental impact and express their view on carbon credits, ‘Carbon Transition’ is the theme to look at. The theme belongs to the ‘Climate Change’ trend capturing the investment opportunity in the following three megatrends: ‘Rising Urbanization’, ‘Environmental Changes’, and ‘Demographic Shift’. 

Trackinsight's Thematic ETF Screener identifies 27 Carbon Transition ETFs currently available to global investors. Of these, 24 ESG-rated offerings adopt Sustainable Development Goal (SDG) 13 ‘Climate Action’. Together they hold USD$4.3 billion of assets under management.

Horizons Carbon Credits ETF (CARB)

CARB, launched on February 9th, 2022, is a passively managed ETF that trades on the Toronto Stock Exchange. It seeks to replicate the performance of the Horizons Carbon Credits Rolling Futures Index (Excess Return). It is Canada’s first ETF offering that provides exposure to carbon credits through futures contracts or derivative instruments. 

CARB is Carbon Transition‘s most successful ETF for the week between August 15th and August 19th. It posted 8.44% gains during that period and generated 5.59% returns since the beginning of the year. Its assets under management reached USD$6.2 million. The fund currently holds single security, which is the European Union Allowance’s ("EUA”) “Carbon Credits December 2022”. 

CARB costs 0.75% per annum to own while adopting a capitalization dividend policy where it reinvests income generated by its holdings.

WisdomTree Carbon (CARP)

CARP is a passively managed ETF that was introduced to the market on August 18th, 2021. It aims to track the Solactive Carbon Emission Allowances Rolling Futures Index. It currently manages USD$370 million of assets and secures the second top performer spot in the Carbon Transition [1] theme. It jumped 7.88% over August’s third week, having generated 6.35% on a year-to-date basis. CARP is designed to enable investors access to synthetic exposure to total return investment in EUAs. In other terms, by owning its shares, global investors earn the return of the index indirectly using a fully funded swap – a contract with a financial institution that delivers the return of the index.

CARP costs 0.35% to own per year while adopting a no-income dividend.

[1] Data for this article is as of August 19th, 2022.