What is carbon credit investing? An intro into what drives this novel asset class | Invezz

The topic of climate change is growing ever more prominent as the planet creaks under humanity’s growing footprint. For financial markets, the effects are also on the rise; the impact of ESG investing is expanding, love it or hate it, while the Biden administration’s Inflation Reduction Act (IRA) of 2022 is arguably the most impactful piece of US climate legislation ever. 

Yet despite all this, the last couple of years have also brought some worrisome developments for those concerned about climate change. The energy market boomed last year, with the top five oil companies shattering records. The quintet banked close to $200 billion of profits, or $22.4 million per hour, as energy prices went vertical in amid the war in Ukraine. 

Throw in a world economy emerging from a once-in-a-generation (hopefully) pandemic, and fossil fuel demand spiked. This all provides an intriguing backdrop for carbon credit investing, an emerging asset class which is beginning to get more mainstream coverage. 

The Kyoto Protocol of 1997 and the Paris Agreement of 2015 implemented internationally agreed targets and regulations around carbon emissions. The social side of this is well covered, but one fascinating development has been the emergence of a market for carbon emissions themselves, which have in a way been turned into a commodity, much like the underlying element itself. 

This is because carbon credits (as well as carbon offsets) can now be bought and sold on the market. Therefore, carbon credits are a market-based solution for the pernicious impact of emissions on our planet. Another way of looking at this: a carbon credit is the market-agreed price for the future impact of one ton of carbon emissions on the planet. 

How does the market price carbon credits?

Carbon credit markets are still finding their level. This is for a variety of reasons, but none more so than the simple fact it is immensely challenging to quantify the damage that a specific amount of carbon will cause to the planet down the line.  

But I wanted to dive in and analyse how prices have moved, despite only having a short period of data to work with for this asset class. And as we will shortly see, it is not so simple as a blind assumption that the price of credits will rise as regulators reduce the cap for emissions going forward. 

We can look at ETFs to get a good gauge of how the market has moved. The KraneShares Global Carbon Strategy ETF (KRBN) tracks a benchmark of the most traded carbon credit futures contracts (from Europe and North America). The below chart shows how it performed during 2021 and 2022, which I plotted against the S&P 500 for perspective.  As described above, this has obviously been a particularly volatile period for energy, as well as markets as a whole. 

Carbon credit investors have evidently fared well, especially in late 2021 (power demand surged, buoyed by a harsh winter in Europe). But as I touched on previously, this is not as efficient a market as many established asset classes. Let’s look at it this way: if the price of fossil fuels falls, consumption should rise and therefore the price of carbon credits should also rise as a result. We should see a very strong inverse relationship, right? 

Well, that is not what has transpired to date. I used the price of coal as a proxy for the cost of emissions in the following chart (not ideal but it is indicative), regressing it against the Carbon ETF mentioned earlier to illustrate the relationship. Forgive the axes crime, but it demonstrates that while there is certainly a correlation, it’s not as tight as you may expect (the volatility of coal is also on a whole other level). 

Or perhaps plotting the correlation directly is more illustrative. Without betraying my love of correlations and maths too much, there are a bunch of different measures one could use here (I have plotted the Pearson 60-Day on a rolling basis here). The below shows that while the correlation resides reasonably close to -1 for a lot of the period analysed, there are also significant deviations. 

Clearly, there are other factors at work here beyond the price of fossil fuels. While one can daydream about a scenario whereby the price of carbon credits rises as the cost to pollute goes up, most likely due to regulator actions, this is not the case. The data clearly shows that there is something else driving the price action of carbon credits. 

Madeline Hume, Senior Research Analyst at Morningstar, put together an excellent research report on the asset class last September, and also encountered this riddle.

The betas – which consider the level as well as the direction of return relationships – of the European-only S&P GSCI Carbon Emissions Allowances Index typically fall below 0.5 against the commodity markets that we surveyed. That’s because over six-month rolling periods during the past five years, the EU’s carbon credits actually moved with energy prices just as frequently as they moved against it

Madeline Hume, Senior Research Analyst at Morningstar

While Hume’s report was clearly more in-depth as it focused on a range of commodities rather than just my quick charting of the correlation against coal, the conclusion is the same. The price of carbon credits is not converging to the cost of pollution as much as it should be, at least from a regulator’s point of view. 

This is mainly due to the heavy hands of compliance and ever-changing policies. Governments hold massive say over the supply, while emissions reduction and adherence to international goals vary hugely from country to country (the EU are the teacher’s pet here, but other regions have been far less diligent). 

Even regulators themselves can impact things by changing which companies fall under the cap. Remember, regulators mandate which businesses are required to fall under these emissions cap, which has a key impact on the market for credits. 

So, it is not so simple as to say “the price of carbon credits must rise because regulators need to increase the cost of emissions in order to achieve climate targets”. This may make conceptual sense, but we live in the real world, and political and regulatory factors greatly affect markets – especially when one ventures this far out into such “novel” asset classes (just ask a cryptocurrency investor how regulation can shake things up!).  

Clearly, carbon credit investing is an emerging asset class with a capital E, and hence laced with risk for investors. This piece is merely an introduction to it, and I’m already looking forward to getting into the meat of it and truly diving into the data to see what is driving demand here, how liquidity is, and what the future could hold in this wacky corner of the financial markets. 

For now, investors need to be wary that like a lot of things in the experimental realm, carbon credit investing is laced with risk. On a side note, I have long wondered what is the criteria for referring to something as an “investment” rather than a “gamble”. A riddle for another day, perhaps?