Mainstream investors eye big returns from carbon allowances

With inflation set to stay higher for longer and rates poised to rise, bonds look like a value trap and equities expensive. Investors’ search for new sources of yield and return is becoming desperate.

This is clear in allocations to cryptos and to illiquid private credit, as well as to high-yield.

NN Investment Partners (NN IP), the asset management subsidiary of the Dutch insurer NN Group now being sold to Goldman Sachs, has found an alternative.

“We have started to invest in European carbon pricing,” Ewout van Schaick, head of multi-asset, revealed in a presentation of the firm’s outlook for 2022 in London during the first week of COP26. “We treat it as a commodity, as an in-put into the production process.”

NN IP sees prices of European emission allowances (aka EUA – European Union allowances) rising from the prevailing level of around €60 per tonne, as the new and much more ambitious reduction target of -55% of emissions by 2030 – compared with 1990 levels – translates into changes to the existing EU emissions trading scheme (ETS) for electricity generators, energy intensive industries and commercial aviation.

If newly proposed EU legislation is passed – which is not certain – the overall supply of emission rights will be reduced, as will grants of free ones. Demand will rise as new sectors, notably maritime transport, are added to the existing ETS scheme. And a new scheme will start for fuel used in road transport and for building.

This could mark a step-change.

EUA futures are on their way to being a new financial asset class and a way for investors to take exposure to the EU’s greater climate ambitions without the risk of trying to pick the stocks of individual winners.

“It’s a nice hedge to have in your portfolio,” says Van Schaick. “It’s an interesting diversifier.”

And, as with crypto, there is the promise of big long-term gains. Some analysts suggest that the price per tonne could be closer to €400 in the run up to 2050.

Allowing buyers, sellers and traders to set through spot and futures markets a clearing price for emission allowances – high enough to incentivize emitters to reduce their pollution and to reward companies that have invested in cleaning themselves up and that can therefore sell their allocations – is not a new idea.

Euromoney recalls the excitement at the Chicago Board of Trade (CBOT) almost 30 years ago. In 1993, chief economist Richard Sandor, who had pioneered interest-rate derivatives through Treasury bond futures in the 1970s, developed a new market in allowances for sulphur dioxide emissions granted by the US Environmental Protection Agency (EPA).

It was a different era. Futures were traded on the exchange floor by people, not by algorithms. The pit traders immediately dubbed the new contracts smog futures.

That kind of cynicism persists today among environmentalists who dismiss the modern version of smog futures as greenwashing.

Much talk in Glasgow has centred on carbon markets and hopes for some kind of breakthrough on Article 6 of the Paris Agreement to set common rules on carbon pricing as part of each country’s commitments.

The hope is that scaling up global carbon markets could force the pace on transition, establish a price impossible to avoid that properly incentivizes decarbonization, cut the costs of a hugely expensive process by trillions of dollars during the next 30 years and fund new clean technology.

Gregory Barker, executive chairman of En+ Group, spoke for many in a panel on the side of the conference when he complained: “There are currently 69 carbon prices. We need a more coherent, joined-up pricing framework, not a mish-mash or kaleidoscope.”

Others count closer to 25 legislated carbon markets.

The EUA market is the grandfather of carbon pricing, even though it was born more than two decades after smog futures.

Vicky Pollard, deputy head of the economic analysis unit in the EU’s directorate-general for climate action (DG Clima), points out: “The EU ETS has existed since 2005. It’s a cap-and-trade system that sets a cap on emissions. It has been revised a number of times. What’s important is that it is working. There has been a 42.8% reduction in emissions [from covered sectors] in the first 15 years of its life. And it is expanding under the EU green deal.”

The sectors covered by the EU ETS today account for 41% of the EU’s total emissions. The latest proposed revision will require them, along with the newly included maritime transport sector, to reduce by 2030 61% of their 2005 emission levels. “The linear reduction target increases from 2.6% per year to 4.2%,” says Pollard.

The scheme has come with free allowances to prevent carbon leakage – emissions being expanded outside the EU to negate the progress inside the EU. But these free allowances will be cut back as the EU moves instead to a carbon border adjustment mechanism: a tax on imports from companies that have not reduced their carbon footprints.

A couple of things seem obvious. More sectors need to be covered by the scheme and forced to pay a steeper price if they do not reduce emissions.

If allocations are cut and the carbon price rises, some means to avoid leakage is also essential; either a series of carbon border taxes or, perhaps better yet, agreements among a wider club of countries than just the EU on similar targets for reduction and shared rules around regulated allowance schemes that may then lead to convergence on carbon pricing.

That in turn might bring a more liquid secondary market in allowances and a bigger role for banks and financial players in contributing to efficient price discovery.

Voluntary markets have been a sideshow to all this, but they are generating all the headlines in Glasgow for the simple reason that governments have failed to legislate and impose binding and effective carbon pricing. Some companies are trying to do the right thing on their own: others hope to be seen to be doing the right thing, even though they know they are not.

Cynics rightly dismiss voluntary markets where so-called “offsets” change hands for $10 or less. The price of long-term carbon removal is probably $100 per tonne or more and by some estimates far higher. Companies aren’t volunteering to pay $100 right now. But there are high-quality programmes, too.

Elizabeth Sturcken, managing director at the Environmental Defense Fund, says: “We are not moving fast enough. We need to halve emissions in the next 10 years. Regulated markets aren’t cutting it, and we can’t wait. Companies want to move forward. They are mostly data-driven and innovative and there are high-quality carbon offsets that can be a great tool for companies to decarbonize alongside their work to reduce their own emissions. Voluntary markets may lead to legislated markets.”

There is no way to net zero without carbon capture, storage and removal. The environmental lobby is split. Some see this as a distraction from the main task and want to leave it to the end of the emission reduction phase, which should peak in 2035-2040. Others see a direct link from removal to highly beneficial nature-based solutions: better, they say, to put efforts now into restoring forests and mangrove swamps while they still exist.

It seems to Euromoney that the elephant in the room is that none of the schemes directly pass on or make apparent to individuals the cost of the carbon in the petrol they put into their cars, their holiday flights or other consumer products. The draft EU legislation on emission allowances for road transport imposes the cost upstream on fuel suppliers and not on motorists directly.

Of course, some of the price, as with any other in-put in the production process, will be passed on to households.

Would it be better to be transparent and disclose the full carbon price to consumers and to voters and have them pay it directly? Or would that make legislated carbon markets less likely to emerge?

Dirk Weinreich, head of the working group on emissions trading at the German federal ministry of the environment, says: “The transition needs everybody’s effort, so everybody has to be addressed by the carbon price.”