Is carbon ready to be an asset class?
In early November, I attended a webinar hosted by Carbon Pulse that explored the notion that carbon allowance and offset markets should be treated as an asset class. At The Climate Trust, we have supported this concept through the launch of our pilot carbon offset fund in 2016. The fund was predicated on the investment thesis that carbon is underpriced. The fund’s ten year, US based offset portfolio has, to date, exceeded our original expectations. We project the portfolio returns will be at or above 14%.
Although carbon markets have been around in some form since the mid 1990s, they are still looked at as niche or “bleeding edge.” This opinion belies the statistics. According to a recent CFA Institute report, in 2019 the traded value of the world’s three major carbon trading programs – EU Emissions Trading Scheme, Northeast’s Regional Greenhouse Gas Initiative, and the California Cap and Trade Program – was more than $250 billion. The CFA Institute also reports carbon transactions are currently over $1 billion per day, including the futures and options market. A recent study by Vivid Economics predicts the carbon offset market could reach $1.4 trillion annually within 20 years. To put that in context, that’s about the size of the oil and gas industry in 2019.
Still, institutional investors have taken a pass on carbon because it is deemed too risky, too small, or not generating attractive risk-adjusted returns. Typically, institutional investors set high-level investment allocations based on asset class preferences, so if the carbon markets want to attract institutions, they should be able to offer significant tradable volumes, liquidity, good risk adjusted returns, and low correlation with other asset classes. On all four counts, carbon is making the grade.
Tradable volumes are addressed above. EU and California carbon allowances and offsets are highly liquid. Increasing numbers of financial buyers have voluntarily joined mandated participants in the California allowance auction. Buying and selling allowances is as simple as picking up the phone and talking to a broker. According to Carbon Cap Management LLC’s analysis, carbon generated an annualized return of 22% since 2012. As for correlations, The Climate Trust ran an analysis that showed little or no correlation with traditional asset classes. Carbon Cap reports likewise.
We know the planet is getting hotter and the climate is changing. This year will likely be tied as the hottest year ever. Every day, it seems like another global company announces carbon neutrality goals, which means that in addition to reducing their carbon footprint, they will need the carbon markets to hit their goals. The US will thankfully be rejoining the Paris Agreement in late January. A recent report by the Taskforce on Scaling Voluntary Carbon Markets projects that the voluntary carbon market will need to increase 15-fold by 2031 to meet the Paris goals. With that level of projected demand, the pieces seem to be in place for carbon to become its own asset class.
News + Resources
CFA Report: Carbon as an Emerging Asset Class
Bloomberg article re: carbon removal vs oil and gas industries