Our carbon framework for sustainable investing: part two

The urgent need for action on climate change and likely policy responses means that investors should think about carbon in their portfolios. And they should do so from multiple perspectives.

To help investors do this, we have developed a carbon framework.

In this second article of a two-part series, we revisit the four pillars of the framework and focus on the second two pillars that investors can use to directly gain access to carbon-related exposure in their portfolios.

Introducing the carbon framework

We have focused on four pillars of activity in the investment economics of carbon. The first two pillars represent policy research pillars; an understanding of these first two pillars helps investors assess the risks and opportunities that face their portfolios. A misunderstanding of the policy, corporate and consumer landscape could cause investors to fall behind in their understanding of the evolution of the sustainable investment landscape, exposing them to greater sustainability risks¹.

The second two pillars represent the asset market pillars. Investors can buy and sell tangible assets associated directly with carbon. However, the investment and sustainability rationales for investing in these carbon-related assets differs markedly for the two pillars.

Pillar 3: Compliance markets for carbon, or carbon allowances

To reduce the amount of CO2 added to the atmosphere, we need to reduce the CO2 emissions from existing activities. One way to do this is through the use of carbon allowances to incentivize emissions reductions. Markets for carbon allowances, otherwise known as compliance markets for carbon or emissions trading systems, are growing rapidly as attempts to incentivize companies to decarbonize intensify.

Typically with emissions trading systems (ETS), policymakers decide to cap certain sectors’ emissions (typically energy intensive industries, e.g. the UK ETS applies to the power generation sector and aviation) by auctioning or giving out allowances. Each year companies must hold sufficient allowances to cover their emissions, either by using free allowances that are handed out, by buying them in the market or, even better, by reducing their emissions. There is a growing market for such allowances, and they can be traded by investors through futures and ETFs. The ability to trade allowances incentivises companies to emit less, since their excess allowances can be sold.

If a company has too many or not enough carbon allowances, they can be traded on the open market. For example, in April 2021 it was announced that VW in China would buy carbon allowances from Tesla.

The largest system today is the European Union’s Emission Trading System (EU ETS), which was launched in 2005, but there are now over 30 others, the largest of those being California and the Regional Greenhouse Gas Initiative (RGGI) which applies to the east coast of America. Today 16% of global greenhouse gas emissions are covered by emissions trading systems, with an additional 8% covered by carbon taxes.

The proceeds from carbon compliance markets go to individual governments that operate them. In the EU, 50% of the proceeds must be spent on sustainable/green projects, according to EU law. The overall system has an annual emissions cap that limits the number of emission allowances given out each year, which is centrally controlled. This cap falls over time in order to reduce global emissions. Figure 2 shows the expected EU emissions trading system cap assuming the new legislation to reduce the cap further comes in by 2024. Currently the EU ETS cuts the emissions cap by 2.2% every year but this linear reduction factor will be increased to 4.2% in 2024 following the European Green Deal ‘Fit for 55’ package.

From the investor’s standpoint, we believe there is both an investment and sustainability case for using carbon allowances within portfolios. The investment rationale is based primarily on policy and societal pressure for decarbonization, combined with the powerful tailwind from a falling supply of allowances. This is reflected in the forward curve for European carbon allowance futures. In April 2022 the spot price of European carbon allowances was €80 and the forward curve suggested a price of €104 in December 2030, suggesting a forward looking annualized return of around 3%.

Since the creation of the European ETS, carbon allowances have had a volatility of around 50% p.a. with a return of around 10% p.a., making them less risk-efficient than most other asset classes. However, the scheme has had a couple of false starts and a tumultuous early life. As climate transition momentum picks up speed in the coming years, demand and supply dynamics could settle into a more predictable behavior pattern.

In addition to assessing the standalone investment characteristics of carbon allowances, we must also consider them in a portfolio investment context. Figure 3 shows, using a clustered dendrogram², carbon emissions are most closely correlated with commodities, but broadly cluster with equities.

The sustainability case is somewhat more nuanced. By buying carbon allowances, investors do not directly contribute to the decarbonization of society. We are simply holding back these allowances until we sell them to a counterparty seeking their use. In that regard, we contribute to a market mechanism which incentivizes decarbonization by making it costly to emit carbon, and reducing the overall available supply of allowances.

If the world was already on a trajectory consistent with the goals of the Paris Agreement, the carbon allowances price mechanism would be ineffective. If that were the case, then by buying carbon allowances we would be expecting decarbonization to slow or indeed fall (demand for carbon allowances would be expected to rise), and we’d benefit from a lack of progress towards decarbonization. But the world is not on a trajectory consistent with the Paris accords. Decarbonization progress is behind the curve globally, so action is required to push the global economy onto a sustainable trajectory. Market-based incentives such as carbon pricing won’t be the only form of action required, but there is evidence that reductions in emissions caps lead to falls in emissions. For example, the EU ETS coincided with a 35% fall in emissions between 2005 and 2019. Combined with fiscal-based measures such as carbon taxation and decarbonization subsidies, we believe that a higher price of carbon in cap-and-trade systems globally will be instrumental in meeting the Paris goals.

Pillar 4: Voluntary markets for carbon, or carbon offsets

To reduce the amount of CO2 already in the atmosphere, it needs to be removed from the air. There have been many technological innovations that help to do this, but undeniably the greatest ‘inventions’ – the tree and the ocean – are the most powerful. The function of carbon removal from the atmosphere has been served since time immemorial by nature itself – not just by trees and oceans, but by other forms of land and sea vegetation. These functions are part of the carbon offset market, and while the function of carbon offsetting has been around forever, the idea that humans can claim, own and manage the function of carbon offsets is relatively new. Since humans voluntarily emit CO2 into the atmosphere, a market for voluntarily offsetting those emissions has developed. That’s why the market for carbon offsets is often called the voluntary carbon offset market.

Importantly, we believe that offsets ‘rank’ below efforts to reduce emissions in investee assets, so should only be used where other opportunities to reduce emissions have been exhausted. These are the residual emissions that can be offset while new technologies and new methods of emissions reduction are developed. Practically, that means investors should seek to reduce their portfolio emissions to a point where further reductions would place too much pressure on the investment integrity³ of the portfolio. After that point, offsets are appropriate. The market is also yet to be scaled to the size it would need to be in order to fully support climate action on a large scale.

Carbon offsets are instruments which reflect an emissions reduction of one metric ton of CO2. This reduction can come about either through emissions-reduction (polluting at a lower level), emissions-avoidance (stopping an activity that would have released emissions), or the removal of CO2 from the atmosphere (such as planting trees which sequester carbon naturally). Carbon offsets allow investors to voluntarily pay for the cost of their portfolio’s emissions.

Voluntary markets are unregulated by an official government body, setting them apart from compliance markets. The lack of regulation leads to large variations in the price of offsets currently set by the project developers. They can range from as little as a few cents to as high as several hundred dollars per ton. The price of an offset depends on several factors:

• The nature of the project (local community projects typically command higher prices)
• The type of project (removal has a higher price versus reduction and avoidance)
• The volume of offsets being traded at the time (higher volume tends to have a lower price)
• The vintage (older projects are cheaper).

Despite no globally consistent, binding regulation, there are processes in place to certify the quality of offsets. Independent bodies called ‘standards’ are responsible for verifying the quality of carbon offsets that are traded in the voluntary markets (such as the Verified Carbon Standard or Gold Standard Verified Emissions Reduction). COP26 also included provisions to strengthen the offset market through renewed regulation and government focus, designed to ensure quality in qualifying activities and to limit risks of double counting savings (this occurs when a government claims the benefits of reductions while also selling the offset to an international company to do the same).

While compliance markets are aimed at tackling carbon emissions on a company level, voluntary markets enable both individuals and companies to offset their carbon footprint. We have identified two stages of the carbon offset lifecycle where investors could get involved: financing the development of carbon offset projects and purchasing the offsets themselves.

At the project development stage, private or corporate capital can fund the development of carbon offsetting schemes, such as afforestation on an otherwise barren plot of land. Investment at this level has a lot of attractions, given the prospect of much stronger demand for offsets (and therefore the assets that generate them) in the future. Such investments could benefit financially from sustainable forestry (the sale of timber) and the sale of carbon offsets associated with trees left in the ground. Assessment of whether these trees would have been left in the ground anyway is a common topic of debate in the world of carbon offsets; that is, are those trees additional to what would have happened anyway? That debate – covering the topic of additionality – is the fundamental basis of offset quality, and we believe the bar will keep rising in this regard.

But such investments are also illiquid and may not be suitable for many types of investors. For example, carbon offsets are unlikely to be suitable for a defined contribution pension fund or late stage defined benefit pension fund due to the liquidity risk. Crucially, we believe that for these investors, buying the carbon offsets later in the lifecycle is not equivalent to project development funding earlier in the lifecycle. This is because carbon offsets, once bought, must be retired in order to ‘lock in’ the offset. Since that removes any possibility of selling the offset, the purchase of carbon offsets is not attractive from a purely investment point of view. There is a danger that investors will take less stringent steps to limit emissions from the assets in which they invest when using carbon offsets. Despite this, for the most part, investors (or households, or corporates) purchase offsets purely for the sustainability benefits. In that regard, we believe offsets are more helpful as a tool outside portfolios, such as at the share class level of a fund, or in the treasury account at the company or entity level.

Summary

The second two pillars of our carbon framework represent carbon-linked assets that investors can tangibly buy and sell. The two types of tradeable markets – compliance and voluntary – are very different from the investor’s point of view. We believe there is both an investment and sustainability rationale for using carbon allowances, making them suitable for use inside a portfolio.

For carbon offsets, we believe the sustainability rationale is strong, but the investment rationale depends on the stage of the lifecycle that the investor is involved. There is an investment case at the project development level for those that can take on the size and illiquidity risk, but for investors buying offsets later in the lifecycle, we think such purchases should be made outside of portfolios, and the outlay regarded as a cost, rather than an investment.

System-wide decarbonization could happen in a non-linear and unpredictable way, with many twists and turns along the path. Markets for carbon-related assets can provide investors with opportunities to directly protect their portfolios against carbon price risk and take advantage of opportunities created by the transition, and in doing so also reduce their net contribution to climate change.

¹ Net zero and multi-asset: what the transition means for portfolios, Schroders, October 2021.

² A clustered dendrogram shows correlation using Ward’s linkage method. This is a bottom up approach where an asset starts in its own cluster, then the two most closely correlated clusters are merged to form a pair. These pairs of clusters continue to be merged further up the hierarchy, with the purpose of identifying any potential reduction in breadth of trades.

³ By investment integrity we mean that considerations of net zero should not compromise a portfolio’s financial goals or diversification.