While most asset classes are recording double-digit losses this year, one corner of the market is holding its own: European emission rights. Global ETF provider KraneShares sees its carbon allowance ETF stand year-to-date at a positive 0.26 percent.
“This market also looks very comfortable for the next 10 years,” said Luke Oliver, who heads the Climate Solutions strategies at KraneShares. The positive result of the KraneShares European Carbon Allowance Strategy ETF is remarkable given the red figures on the global stock exchanges. The Russian invasion of Ukraine caused the price to drop by half as recently as the beginning of March.
The price of carbon allowances plummeted in Europe against the backdrop of the escalating Russian-Ukrainian war, lowering the cost of carbon emissions for the EU’s most polluting companies. That fall has since been rapidly reversed.
Cost per metric tonne of CO₂ emissions allowance in the EU
Supply down, price up
Europe has a ceiling on carbon dioxide emissions, set in stone by a limit on the number of carbon permits. Every year, the EU auctions the right to emit 1.6 billion tonnes of CO₂ emissions. In the so-called cap-and-trade system, governments set a limit on total emissions that is tightened annually. In the EU, this is done at a rate of 4.2 percent per year. Large emitters of carbon dioxide have to buy these pollution permits to stay under the set ceiling.
The income from emissions auctions is used to achieve the Paris climate targets in the European Union. By raising the price, companies will have to look for cheaper, sustainable production methods. This encourages a flow of capital towards innovation. As the supply of emission rights decreases, polluting companies will have to innovate quickly. If they don’t, they will have to pay more and more for the rights that are becoming scarce. This will cause prices to rise.
“People are rightly wondering what will happen to this market, as politicians plan to bring the entire emission allowance issue to zero. The price of emissions will, for the time being, rise as much as the supply of emissions is reduced. The maximum number of allowances to be issued will stabilise at a certain point, but that will not stabilise the price,” Luke Oliver told Investment Officer.
According to Oliver, as a global economy we will not reach carbon neutrality in the next 10 years. “We want to reduce emissions by 55 percent by 2030, while in the most optimistic scenario we will not be where we want to be with our carbon emissions until 2050. Between now and 2030, it is “pedal to the metal” in the battle to reduce those emissions dramatically. But, figures show that we haven’t necessarily reduced emissions in recent years,” said Oliver. “This market looks very comfortable for the next 10 years.”
Asymmetry
Oliver argues that there is a certain asymmetry in this corner of the market. If there is a recession, he said, demand for emissions may fall because of reduced production of goods, but the reduction in supply to which the emissions market is subject every year will dampen that price drop.
“Since 2019, governments have been buying up parts of the allowances from auctions to reduce carbon emissions. For two years now, 24 percent of allowances have been withdrawn from auctions by the European Union. On top of that, there is a linear decline in the maximum allowances to be issued of 4.2 percent per year,” Oliver.
The only risk of a “bearish” effect, according to Oliver, is governments raising too much money to accelerate the reduction of allowances. “That’s great for the environment, but it could lead to an unexpected amount of money being injected into this market by governments. More liquidity injections could push the price down, and so countries would lose some of their revenue, but the market is not reacting vehemently to this so far.”
KraneShares European Carbon Allowance Strategy ETF
The KraneShares European Carbon Allowance Strategy ETF (ISIN:US5007675615) has over 26 million in net assets and tracks the IHS Markit Carbon EUA Index, which tracks the most traded EUA futures contracts. The total annual cost of the fund is 79 basis points and it is available to institutional investors. The ETF is listed on the NYSE. KraneShares is still looking for opportunities for a European Ucits solution in the near future.