There are many hazardous consequences due to the presence of
greenhouse gases in the earth's atmosphere. Some of these are ozone
layer depletion, climate change, global warming and a rise in sea
levels. This has resulted in many global initiatives taking shape,
in order to urge nations to cut down on their carbon emission
levels.
Thanks to this, many industry-oriented economies are facing a
dilemma, since curbing pollution levels would result in a reduction
of industrial activities. This, in turn, would result in a
reduction of income and output for the economy in question, thereby
hampering economic growth, not exactly a popular stance to take
when seeking to get reelected (see
Clean Energy ETFs In Focus
).
In order to mitigate some of these concerns while still
attempting to control emissions, investors have witnessed the birth
of the emission trading (ET) industry. With the increasing
participation of nations in the guidelines of Kyoto Protocol (KP)
and rising social accountability, the emission trading industry has
the potential to emerge as a major global industry, despite
non-ratification of the Kyoto Protocol by the U.S.
Overview of the Kyoto Protocol (KP)
In 1997, the Kyoto Protocol was adopted by a host of
participating countries. However, these countries were divided into
two broad categories:
1) The developed industry-oriented economies responsible for a
majority of GHG (Greenhouse Gas) emission were categorized as
Annexure 1 countries (developed European nations, Japan, Australia,
New Zealand, etc.) and 2) Developing nations as Non-Annexure 1
nations (China, Brazil, India, etc.)
The basic premise of the KP was to reduce emission of GHGs with
specific emission reduction targets being assigned to the countries
by the year 2012 (with an average of 5% leeway).
In addition to conventional and scientific methods of reducing
emissions, countries also welcomed market-based mechanisms for the
compliant Annexure 1 nations in order to meet the specified
targets, including:
1) Emission Trading (ET) i.e. countries that have emission units
to spare, can sell their units to countries in need for those
units.
2) Clean Development Mechanisms (CDMs) which facilitated
Annexure 1 countries in setting up
"green"
projects in Non-Annexure 1 countries. These projects earn tradable
Certified Emission Reduction Credits (CERs) issued by the United
Nations Framework Convention on Climate Change (UNFCCC). One CRE
equals one ton of carbon dioxide which would be counted towards
meeting the targets.
3) Joint Implementation (JIs), which is an initiative by the
Annexure 1 and Non-Annexure 1 nations, to set up emission reduction
or removal projects in developing nations in order to earn Emission
Reduction Units (ERUs) which also would be counted towards the
target.
Therefore we see that these 'instruments' have been given an
economic value having demand and supply, with potential buyers
being the industrial firms in the Annexure 1 countries and
potential sellers being the firms who obtain carbon certificates by
reduction in their emission levels (see more on ETFs at the
Zacks
ETF Center
).
This has given rise to the carbon trading market and these
certificates are being categorized as an investable asset class.
These certificates have been trading in major exchanges throughout
the world and have been categorized as
commodities.
The major players in the market are manufacturers, spot market
intermediaries, arbitragers, commodity financers and
investment/fund managers.
Risks involved in investments
Investments in these instruments usually involve supply side
risk. The prices of these instruments are influenced by a variety
of factors such as the supply of emission credits, energy prices,
global-economic growth rates, and most importantly, government
policies.
Given the above factors it is prudent to note that supply-demand
mismatch can be either natural (i.e. lack of certificates being
issued by UNFCC on account of emission not being reduced), or
manmade (i.e. big supplying nations holding back supply in order to
increase prices artificially). Therefore the prices can be
influenced by major players in the market as well.
Products targeting this space are largely influenced by
geopolitical issues. Any negative development can result in a
significant decrease in prices. Therefore political risk is quite
high in this type of product, especially considering the nations
involved (see
Greek ETF Plunged on Election Results
).
However, it is not easy for retail investors seeking exposure in
this asset class to enter and exit the market directly. Therefore
an ETF approach-or at least for the current market, an ETN
technique-- to investing in these complicated segments is really
the only way to go for most retail investors at this time.
While the market is sparse, there is currently one choice that
is available, thanks to an exchange-traded note from iPath:
iPath Global Carbon ETN (
GRN
)
Launched in June of 2008, GRN seeks to replicate, before
expenses, price and yield performance of
Barclays Capital Global Carbon Total Return Index.
The index measures the performance of the most highly traded carbon
related credit plans and serves as an industry benchmark for carbon
investors. The ETN charges investors 75 basis points in fees and
expenses and has total assets of $1.12 million (read
Hard Times In Soft Commodity ETFs
).
Presently the note holds around 90% of its total assets in
future contracts of EXC Emission Reduction Units (ERUs) and the
remaining 10% in future contracts of EXC Certified Emission
Reductions (CERs). The product had faced tough times last year,
basically due to a recessionary environment in the Euro zone - the
largest buyers of carbon credits.
Moreover, the political turmoil in many parts of the continent
also was responsible for such dismal performance, as prices of such
products are very much dependent on political decisions and reforms
as they relate to the number of credits outstanding in the
marketplace.
Beyond this, investors should also be concerned about the volume
and tradability of the note. Currently, there is just over $1
million in assets invested in the product while daily average
volume is below 1,500 shares (see
charts of GRN here
).
Given this, and the uncertain outlook for both the euro zone and
the carbon credit market, many investors might want to stay away
from this product at this time. While carbon investing might sound
trendy or profitable, there are arguably too many credits out on
the market and demand for these seems likely to sink lower,
especially if the euro zone debacle intensifies.
This suggests that for investors concerned about the
environment, the best way to play the trend is via energy
efficiency ETFs or those that target segments such as wind or
solar. The carbon ETN, unfortunately, isn't a very good option,
especially during this current market cycle.
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