Kristen Kleiman, The Climate Trust
October 5, 2017
On August 15, 2017 a group of graduate students in finance from Portland State University (PSU) presented a report to Climate Trust Capital (an independent firm of the mission-driven nonprofit The Climate Trust) that was the culmination of a months-long project that analyzed the financial characteristics of carbon investments. In particular, the graduate students looked at risk-return correlations and price history in various carbon and environmental markets; constructing a model showing carbon offsets’ role in a portfolio of blended traditional assets. The PSU team also looked at methods for creating an index to track the performance of carbon offsets, so that investment managers could compare their results to a benchmark.
Over the summer 2017, the PSU team conducted eleven interviews with carbon investment and other institutional investment professionals, delved into the price history of carbon offsets (both European and North American), canvassed data sources for relevant information, and used financial analytical tools to assess carbon investing as an ‘asset class.’ The main problem faced by the team was carbon investing’s short history. In traditional asset classes, analysts have decades of data to work with. This is important because it shows the behavior of assets in both up and down cycles. Carbon offset investing has only existed since 2005 (starting with the EU’s Emissions Trading Scheme or ETS), and California’s cap and trade system has been operating since 2014. Both price series are far too short to be considered a business cycle.
Another hurdle was the price floor of the California carbon market. In traditional assets classes, there is no floor. Stocks can go to $0, bonds can default. But in the California market, a price floor is set on allowances (admittedly, allowances and offsets are not the same thing, but are highly correlated) thereby creating an artificial construct for both, given their interconnectedness. The price floor, therefore, is an important driver of price that exists outside the market, which detracts from the traditional supply and demand price drivers.
Despite the dearth of price data and the price floor, the team concluded that the price history of carbon offsets is largely uncorrelated with traditional asset classes over the past three years, and offset investing increases returns without increasing risk. Although we are heartened by these preliminary conclusions, we understand that the caveats surrounding them are too important to state these as anything but preliminary findings. Perhaps more important than the conclusions themselves, was the creation of a replicable, logical methodology that will allow Climate Trust Capital to continue correlation and efficient frontier analysis as carbon markets mature. PSU team members wrote five white papers documenting their work on this project. All will help our work in promoting the benefits of carbon investments in an investor portfolio.
In their interviews with carbon market participants and impact investors, the team found that uncertainty about the size of the carbon market was a principal concern, followed by regulatory concerns about invalidation risk (carbon projects need to remain certified for decades). The first point is particularly timely in light of the July 2017 passage of AB 398, which extends the California cap and trade program until 2030. AB 398 significantly reduces the amount of carbon offsets usage from the current limit of 8% to 4%, with projects making up half of that 4% required to deliver direct benefit to California. Climate Trust Capital has conducted its own analysis of post-2020 carbon offset supply and demand, wherein we believe the market for new in-California carbon offset projects will be $1.9b from 2020-2030, with more demand expected from out-of-state projects. The post-2020 market looks smaller, but possible linkage with other cap and trade programs may increase that figure significantly. Most importantly, AB 398 reduces program risk and enshrines into law that California’s cap and trade system will exist until at least 2030. In regard to the concern raised over invalidation, only 0.125% of projects under California’s cap and trade system have been invalidated, according to California Air Resources Board’s compliance offset program website. And although the past in not necessarily a prelude to the future, we expect that trend to continue, and as it does, this risk factor should play a more minor role.
A final recommendation of the PSU team was in support of Climate Trust Capital’s goal of providing data transparency and consistency in carbon investing. To that end, Climate Trust Capital has a long-term goal of providing data to inform a “carbon index”—which would be based on carbon investors and managers voluntarily submitting price (and possibly return) data to aggregate industry-wide data for future investors. We believe this would go a long way in providing the necessary investment information institutional investors need in order to make carbon investing its own ‘asset class.’
We are grateful to the PSU graduate team’s commitment to this project. It was not easy. The issue is complex and suffers from a vexing lack of data. It took both determination and creativity to finish this project. PSU’s work is valuable to Climate Trust Capital as it strives to educate investors and helps our mission of making environmental credit investing credible and attractive to the world of institutional investors.
Image credit: Flickr/Eric Prado