COP 26, the global meeting of governments to discuss climate change, was held at the end of last year. One of the key hopes of climate activists was to see a price put on emissions of greenhouse gases.

By now we’re all familiar with a variety of doomsday climate change scenarios. In David Attenborough’s “A Life On Our Planet” he predicted that (with no action) the world could be four degrees warmer in the 2100s causing large swathes of the Earth to be uninhabitable. However, if we meet Paris Climate Agreement targets, we could be well on our way to a sustainable future by then.

Carbon pricing is a term for any policy used to add a cost to greenhouse gas (GHG) emissions to discourage emissions. This is seen as a key step to achieve “net zero”: reducing greenhouse gas emissions to zero by 2050 or offsetting the residual emissions that can’t be eliminated.

Reaching net zero is a challenging task because of the extent to which we rely on energy, goods and services that emit GHGs.

In 2019 the UN estimated we needed to cut emissions by 7.6% every year to meet the 1.5°C target set out by the Paris Agreement. At that rate, emissions in 2030 would be 55% lower than in 2020. However, the latest report from the UN Environment Programme predicts that the updated Nationally Determined Contributions ahead of COP26 only took 7.5% in total off predicted 2030 emissions, well short of the 55% target.

Where does carbon pricing come in?

If there is a cost to emitting greenhouse gases, it would eat away at companies’ profits, thereby encouraging them to find ways to decarbonise. The two primary carbon pricing mechanisms are

• a carbon tax – a fee imposed on companies that burn fossil fuels;
• an Emissions Trading System (ETS).

An ETS seeks to use a market mechanism to reduce emissions in the most efficient way possible.
Allowances under the scheme are either auctioned or given to companies that come within the regulations on emitting GHGs. Each allowance permits the company to emit one tonne of CO2, or its equivalent amount of other GHGs.

The ETS allows companies to trade their emission allowances. If an energy company has made progress against its climate targets it may be able to sell some of its allowances to another firm who would, otherwise, emit more than they are permitted.

Those companies that are most able to change the way they operate to reduce emissions have an incentive to do so. Companies for whom it would be extremely costly to change production methods have to pay for the right to emit.

The governments managing an ETS will slowly reduce the supply of emission allowances, increasing the price of carbon emissions for companies. Over time, this gives an increasing incentive to invest in new ways to produce that have lower or no emissions.

The EU ETS is the largest tradable ETS in the world. It has been in place, in various forms, since 2005. The price of each allowance has seen significant price increases hitting over 87€ for the first time in 2021 (see chart). Since the turn of the new year the price has continued to spike, now topping 95€ for the first time.

It is also worth noting that the UK launched its own ETS in January last year.

Source: Bloomberg

So, will carbon pricing actually help?

Many commentators think that a carbon price is a key way to reduce GHG emissions. The IMF has suggested that there should be a globally agreed minimum price for emitting offending gases. A form of carbon pricing was included, in principle, in the Paris Climate agreement and there were hopes that the practicalities could be sorted out at COP 26, but this hasn’t been possible.

Countries and regions that put a price on GHG emissions increase the costs for companies operating there. Some of these costs are likely to be passed onto their customers through higher prices. The risk is that their customers, where they can, will source cheaper goods from other countries that don’t have a price on emissions. To mitigate this, it’s likely we’ll see import taxes on “high-emitting” goods from countries that don’t tax GHG emissions in some way. In fact, the EU already has plans to introduce a border tax to the current ETS in place.

It seems the financial incentives are moving into place so that carbon prices will lead to significant emission reductions.

Can you invest in emissions allowances?

EU Emission Allowances (EUAs) are the most established tradeable CO2 instrument. They are the allowances that are used to meet EU emissions regulations for companies affected by the EU ETS (this is EU companies in the power sector, manufacturing industry or airlines). They can be purchased by investors looking to profit from a rising price either directly (with difficulty) or via an Exchange Traded Fund.

Why invest in Carbon?

The main benefits are:

• correlation with other asset classes is low, therefore it could be a useful diversifier;
•  the price of carbon emissions is likely to rise if climate targets are to be met;
• it may act as a hedge against climate transition risk. Other parts of your portfolio could be negatively affected in scenarios where the price of carbon emissions rises; and
• directly investing in EUAs may have a tangible environmental impact. Purchasing EUAs has multiple impacts:
  • Reducing emissions – each EUA is one tonne of CO2 or equivalent that cannot be emitted while you hold the allowance.
  • Delaying emissions – emissions later are better than emissions today. If the EUAs are held sufficiently long before being sold, they will likely be used for emissions that are hard to eliminate e.g., emissions from aviation (assuming we are on or close to a net zero pathway). We may even have carbon removal technologies in future making the net impact of the emissions nil!
  • Driving change - by purchasing EUAs investors reduce the supply to companies covered by the EU ETS, this drives the price of the EUAs up. Eventually, innovation for renewable technologies may become cheaper than purchasing the required number of EUAs.

Potential risks of investing in carbon

• Price is directly related to the demand for emissions, if companies de-carbonise well ahead of schedule (something we would most likely welcome) demand for emission allowances, and therefore the price of emitting, could fall.
• Historically, the price has been highly volatile making it generally unsuitable for most institutional investors.
• If emissions markets become popular with investors, the market may not function as intended. If this increases costs significantly for emitters – and ultimately their customers – there may be political pressure to change or even suspend the system.

It is possible for institutional investors to gain exposure to this market through exchange traded funds, futures and options or by creating an account on the EU exchange and directly purchasing carbon credits (this is a long and complex process and would likely incur significant costs).

Conclusions

In this market, regulation can have a huge impact on prices! It took 14 years for the price floor to be introduced in the EU and only now are we seeing the impact as prices have soared following this change.

Carbon taxes and emissions trading schemes are likely to be used increasingly by governments to meet their commitments to reducing emissions of GHGs.

Regulation on carbon pricing and the price of carbon seems to be heading in one direction. Currently, we believe carbon credits could be held by investors comfortable allocating tactically as a very small proportion of their assets via an allocation to a multi asset manager. We believe the asset risk return expectations are not yet sufficiently defined for investors to include it as part of their strategic asset allocation, and at present it has characteristics closer to a speculative asset.

A study by Kempen in June 2021 suggests the global equity market could receive a 20% shock if the global carbon price was to reach $75. Whilst we are some way off a $75 carbon price across the world, prices in Europe are soaring and this is definitely an area to keep an eye on. Despite the long term outlook for carbon prices, it is worth noting the risks of political impact on these markets remains high, and prices are likely to be volatile.