Across the globe, governments are setting more and more ambitious targets for carbon reduction. The European Union is aiming to be carbon neutral by 2050, while the Biden administration is proposing to halve emissions in the United States by the end of the decade. It is therefore hardly surprising that the cost of emitting carbon dioxide is on the rise. Carbon markets are rallying, pricing in those increased ambitions and aggressive reforms.
A surge like this is unavoidably attracting the attention of savvy financial actors. According to David Sheppard and Camilla Hodgson at the Financial Times, carbon has now become “one of the world’s hottest commodities.” Most environmentalists are cheering the development and arguing that higher carbon prices are just what is needed for a rapid transition towards cleaner fuels. There are, however, also concerns that the pace of the rise is faster than companies can absorb and adapt to. One way or another, the increasing participation of investors and speculators is clearly affecting the evolving carbon market.
ETS Has Come a Long Way
Launched back in 2005 to serve as one of the European Union’s key tools in reducing emissions, the EU emission-trading system (ETS) took years to start functioning as a proper market. The gigantic bureaucratic structure hardly reduced emissions during its first decade of existence and was severely criticised for over-distributing free emission rights. Finally, after stricter conditions were introduced in 2018, the system has begun to function as intended. It is now the world’s largest and most heavily traded carbon platform, accounting for almost nine-tenths of the global market.
The mechanism is quite simple: the European Commission grants credits to countries, which then auction them to the polluters that are required to buy credits for the carbon they emit. The demand comes mainly from three groups of participants. Power and heating utilities buy allowances to cover the emissions from current projects or to hedge against future price increases. Then there is the heavy industry. Most industrial firms receive, however, some free permits, so that the ETS does not encourage producers to move abroad. The third, and growing, source of demand is financial firms, including banks and hedge funds.
Why Investors Care
Investors, of course, buy carbon allowances not because they are required to hold them, but for a host of different reasons. Apart from the obvious one – to profit as the number of allowances is expected to fall and their price to rise – they are also hoping to benefit from a diversification benefit. Carbon prices are namely largely uncorrelated with those of other assets. With inflation scare on the rise, financial actors consider carbon as a hedge, too; higher carbon price is generally accompanied by higher consumer prices.
There is, however, one more important reason why sustainable-minded long-term investors might be tempted to enter the carbon emission market – as an earnest attempt to help advance decarbonisation. By buying and holding carbon allowances, they hope to restrict the supply to the rest of the market and force industrial emitters to choose between paying higher prices for permits or investing to reduce their own emissions.
The Offset Alternative
Investing in decarbonisation for the sake of the planet is not a new concept, of course. There are plenty of projects around the world aiming at reducing carbon emissions or simply avoiding their increase. Impact investing is, fortunately, on the rise.
The market for carbon offsets, too, has been an important tool in the fight against global warming for a long time now. Offset credits directly finance emissions-reducing activities. By purchasing electronic certificates, issued by projects that negatively impact emissions, investors can mitigate the continued act of polluting elsewhere.
At SparkChange, a technology platform aiming to simplify investing in carbon instruments, Head of Research Jan Ahrens provides helpful insights about the difference between the carbon allowance and the carbon offset markets. Calling them “the Batman and Robin of decarbonisation”, he makes it quite clear that all carbon markets were not born equal.
For one, the carbon allowance market is highly uniform and standardised. It is a ‘cap-and-trade’ market, meaning that the number of entities issued by regulators each year is finite. Offsets, on the other hand, come in many different shapes and colours; from carbon removal units, which finance activities that capture CO2from the atmosphere and store it permanently, to forestry and agriculture projects. Theoretically, the number of offset credits can grow as long as there are new projects to feed into the market.
The proliferation of issuers and the lack of standardisation in the offset market means that buyers need to carefully evaluate projects issuing the credits and hope that they avoid potential pitfalls like later discovery or non-additionality. In fact, concerns over the environmental integrity of some offset credits led the EU in 2013 to question their compliance with the ETS.
Whether trading offsets or allowances, directly or through the derivatives markets, financial players seem to be warming up to the carbon trend in general. Meanwhile, the consequences of their growing involvement have not been mapped completely.
Short-term, there are concerns that speculators’ increased activity is causing an unwelcome rise in carbon price volatility. On the other hand, some investors rejoice at the much-improved liquidity which allows them to test an otherwise unapproachable market.
On a more fundamental level, while some sustainability experts cheer the rising carbon prices for pushing companies to accelerate the pace of their transition to cleaner fuels, others worry that the steep rise might become counterproductive at some point.
There are rising concerns that the price rally might be punishing unfairly relatively well-behaved European companies in the steel, cement, and power industry. Feeling the pressure, these companies are now complaining that they are facing a competitive disadvantage compared to their global peers and calling on the EU to accelerate plans to implement a carbon border adjustment tax for imports from countries outside the scheme.
Some long-term investors also see a potential conflict of interest when buying and holding on to carbon allowances and thus forcing companies they themselves invest in to pay higher prices for carbon. They argue that engagement and stewardship might be a subtler and more constructive way to affect change.
Whether these concerns are justified or not, financial actors’ glut for carbon is not likely to diminish any time soon, affecting markets and prices. Companies, investors and regulators are well-advised to pay attention and assess the consequences.
 Last year the value of global carbon markets hit a record €229bn, a five-fold increase from 2017. A total of 41 OECD and G20 governments have announced either a carbon tax or a cap-and-trade scheme, or both.
 The first, and so far, largest, carbon offset market, the United Nations’ clean development mechanism (CDM) was set up under the 1997 Kyoto Protocol, through which around 190 countries agreed on country-by-country emissions reduction targets.