Carbon Markets Heating Up: How to Invest

Carbon markets have been heating up recently (climate change pun intended) thanks to new regulations, the rising number of emission trading systems, and the growing desire on Wall Street to provide retail investing options. In this article, we’ll look at the types of carbon markets and how to invest in them.

Carbon markets

Carbon markets were created to provide carbon offsets, credits, or allowances that are measured in metric tons of carbon dioxide or equivalent. One credit equates to the reduction, sequestration, or offset of one ton of carbon dioxide or the equivalent amount of different greenhouse gases, which include:

• Carbon dioxide (CO₂) is a product of cellular respiration, you breathe it out, and plants absorb it.
• Methane (CH₄) is the principal constituent of natural gas and cow burps.
• Nitrous oxide (N₂O) is also known as the laughing gas and is used as a rocket propellant.
• Perfluorocarbons (PFCs) are man-made compounds containing only carbon and fluorine that have historically been a by-product of the electrolysis process in aluminum smelting.
• Hydrofluorocarbons (HFCs) are man-made compounds containing fluorine and hydrogen that are frequently used in air conditioning and refrigeration.
• Sulfur hexafluoride (SF₆) is naturally occurring but primarily mad-made and is used in the electrical power industry as a gaseous dielectric medium, in semiconductor manufacturing, and in the casting of magnesium.

The Two Types of Carbon Markets

When discussing carbon markets, two very different systems are often mistakenly merged. One is mandatory, the other is voluntary and they operate very differently.

The much smaller of the two is the voluntary carbon market (VCM), in which individuals, corporations, or governments can voluntarily purchase carbon offsets/credits or invest in projects that mitigate greenhouse gas emissions. For example, some companies offer their customers a carbon offset up-sell related to their products or services, such as airlines like American Airlines, Delta, and United Airlines. Other companies such as Xerox and Walmart by 2040 and Microsoft and Apple by 2030 are choosing to become carbon neutral. They are working towards this goal through investments in projects and/or purchases of carbon credits.

Additionally, Puro.earth, the world’s leading carbon crediting platform for engineered carbon removal, aims to help companies globally in their science-based journey to net-zero by bringing them together with suppliers of carbon net-negative technologies, enabling climate conscious companies to neutralize their emissions with CO2 Removal Certificates (CORCs), a revolutionary new carbon removal credit (disclosure: Nasdaq owns a majority stake in Puro). This process begins with Puro.earth identifying suppliers with negative net emissions, meaning they remove more carbon from the atmosphere than they emit. Then, the sequestered carbon is scientifically measured and independently verified by a reputable third party. After accounting for the supplier’s own emissions, only the net negative emissions are turned into CORCs. Once the CORCs are issued, companies can buy the carbon removal credits from accredited suppliers or a Puro.earth partner to neutralize the carbon emissions they could not avoid or reduce. 

• The voluntary market had an estimated size ranging from $306 million to around $2 billion in 2020 (or over $1 billion in 2021), depending on the source.
• The voluntary market is not regulated, is opaque, difficult to verify, and lacks consensus on its size.
• Anything in the VCM is not approved by IIGCC pension funds, which account for around $33 trillion in AUM and 250 pension funds globally.
• A company may choose to offset as little or as much of its pollution, and the efficacy of the offset can be difficult to verify.

The much more significant market is the set of mandatory carbon markets referred to as Emissions Trading Systems or ETS. Jurisdictions making up 55% of global GDP use emissions trading systems, and an ETS covers 17% of global greenhouse gas emissions. These market includes the EU Emissions Trading System (EUAs) and schemes in Mexico, California, Oregon, Washington, Quebec, the United Kingdom, Kazakhstan, Japan, and China.

• This market utterly dwarfs the voluntary carbon market, with governments globally raising a record of over $63 billion from the sale of carbon allowances in emission trading systems in 2022. As of 2023, 28 ETSs are operating globally, covering an estimated 17% of global emissions.
• The purpose of the market is to reduce pollution by reducing the annual supply of allowances every year through 2030.
• It is a regulated market with high visibility and is easily verified.
• This mandatory market is approved by the IIGCC and is designed to be tradable through futures contracts.
• Remember that these are not credits; they are allowances that allow a company to pollute a specified amount.

How does an Emissions Trading System (ETS) work?

To understand how an ETS works, let’s look at the European Union’s ETS, which like all ETSs, follows a “cap-and-trade” approach wherein the EU sets a cap on how much CO₂ can be emitted. Companies in industries under the scheme must surrender enough allowances each year to cover their total emissions. The EU ETS currently covers emissions from over 10,000 power plants and factories in the EU, energy-intensive heavy industries (such as oil refineries and producers of iron, aluminum, cement, and paper), and airline flights within the EU. Since 2005 the emissions within the scope of the system have declined by 34.6%.

Every year on April 30th, industries in the EU under the scheme must deliver to their government the same number of EU Allowances (EUAs) as tons of carbon they have emitted over the prior year. If they fail to do so, the fine is €100 per excess ton, but it doesn’t end there (else the price of EUAs would be capped at €100): the company must deliver EUAs for the uncovered emissions in the following years. So, if a company is short 200 EUAs, it will pay a fine of €20,000 and must deliver an additional 200 EUAs the following year on top of enough EUAs to cover that year’s emissions. To put this into perspective, in 2022, BASF (BFFAF) reported 18.4 million metric tons of greenhouse gas emissions (Scope 1 and 2), down from 20.2 million in 2021 and 20.8 million in 2020.

Some allowances may have been given to the company by the EU for free, but if a company pollutes more than the allowances given, it needs to buy more in the allowance auction market. From 2013 to 2020, around 43% of total allowances were given to companies for free. The manufacturing industry received 80% of its allowance for free in 2013, falling to 30% by 2020. Most power generators are given no allowances for free and must purchase all their needs, excluding those in a few EU member states. Between 2021 and 2030, the overall number of emission allowances was previously set to decline at an annual rate of 2.2% to cut all greenhouse gas emissions by at least 40% from 1990 levels by 2030. Then came the Fit for 55 package.

Impact of New Regulations

In mid-2021, the European climate law came into effect, which increased the binding target of net greenhouse emission reductions by at least 55% by 2030 (compared to 1990 levels) versus the previous target of 43%. In December 2022, the European Parliament, member state governments in the EU Council, and the European Commission reached a deal to reform the existing Emissions Trading Systems and to add an additional system for transport and heating fuels. Whereas the overall number of emission allowances was previously set to decline at an annual rate of 2.2%, the new reduction factors are 4.3% from 2024 to 2027 and 4.4% from 2028 to 2030. In addition, shipping industry emissions are to be included, and the free allocations to aircraft operators are to be phased out. The bottom line is that the supply of allowances is now set to decline at a faster pace, and the demand for mandatory allowances is expanding.

How can you invest?

Much of this voluntary market is project-driven, and most of the offerings are about investing in without having an intention to or path to cashing out. However, in recent years Wall Street and industry players have been working to make the voluntary system more accessible. These are some of the companies operating in the space.

• NCX, formally SilviaTerra, hosts a Natural Capital Exchange market and is one of the companies paying forest owners not to cut down their trees. The idea is that the longer a tree grows, the more carbon it can pull from the atmosphere. Investors in the company include Salesforce (CRM) CEO Marc Benioff, Union Square Ventures, and Microsoft’s Climate Innovation Fund. In late 2020, BP (BP) acquired a controlling stake in one of NCX’s competitors, Finite Carbon.
• The private equity firm TPG (TPG) is investing $300 million towards its goal of raising $1 billion for a new company, Rubicon Carbon, which is intended to provide a more effective way for buyers to invest in carbon credits.

Other options include:

• Native Energy, founded in 2000, became a certified B Corp Best for the World Company in 2017 and a Public Benefit Corporation in 2018. It offers a range of project options for individuals and companies.
• terrapass was launched in 2004 and offers monthly subscriptions for individuals and businesses.
• Carbon Checkout started in 2007 and launched its Shopify app in 2015. It is a plug-in software app that integrates into existing e-commerce stores so customers can invest in carbon offset during their purchase.
• The United Nations Carbon Offset Platform is an e-commerce platform where companies or individuals can purchase carbon credits to compensate for greenhouse gas emissions or to support climate action. It is primarily based on projects in developing countries that are intended to reduce, avoid, or remove greenhouse gas emissions.
• Other carbon offset providers include Sustainable Travel International, Green Mountain Energy, and Cool Effect.

There are also a few ETF investing options.

• The KraneShares Global Carbon Offset Strategy ETF (KSET) tracks the S&P GSCI Global Voluntary Carbon Liquidity Weighted Index, which provides broad coverage of the voluntary carbon market by tracking carbon offset futures contracts. These futures contracts include Nature-Based Global Emission Offsets (N-GEOs) and Global Emission Offsets (GEOs), which trade through the CME Group.
• While not directly investing in carbon markets, the BlackRock US Carbon Transition Readiness ETF (LCTU) “provides broad exposure to large- and mid-cap US companies tilting towards those that BlackRock believes are better positioned to benefit from the transition to a low-carbon economy.” Blackrock also offers the BlackRock World ex US Carbon Transition Readiness ETF (LCTD).
• Harbor Energy Transition Strategy ETF (RENW) is similar to the BlackRock offering in that it does not invest directly in carbon markets but instead tracks the Quantix Energy Transition Index, which tracks futures for commodities Quantix deems to be the “building blocks of the accelerating energy transition.”

Due to its transparency and mandatory nature, investing in the mandatory markets is different. Carbon trading markets are designed to allow for the buying and selling of the right to emit a ton of CO₂ (or equivalent). These allowances can be bought and sold by anyone, but ultimately, they are used to cover regulatory compliances by companies obligated to do so, which tends to impact volatility. For example, trading can get wild in the EU ETS market in the three months leading up to the April 30 compliance deadline every year.

Futures exchanges exist to facilitate transactions for spot and future deliveries of allowances. Trades can occur between two willing companies, people, carbon brokers, or in the options markets. Individuals can purchase carbon-credit futures in much the way investors can purchase futures in general, but an easier strategy would be to invest in ETFs.

• KraneShares Global Carbon Strategy ETF (KRBN) was created in 2020 and tracks carbon-credit futures contracts.
• KraneShares European Carbon Allowance Strategy ETF (KEUA) is benchmarked to the IHS Markit Carbon EUA Index, which tracks the most traded EUA futures contracts.
• KraneShares California Carbon Allowance Strategy ETF (KCCA) provides targeted exposure to the California Carbon Allowances (CCA) cap-and-trade carbon allowance program. KCCA is benchmarked to the IHS Markit Carbon CCA Index, which tracks the most traded CCA futures contracts.
• Barclays offers the iPath B Carbon ETN (GRN) that tracks the performance of the Barclays Global Carbon II TR USD Index, whose objective is the provide exposure to the price of carbon as measured by the return of futures contracts on carbon emissions credits from the EU ETS.
• For those looking to combine carbon markets with blockchain technology, there is the Kakubi token (KKB). Each token is backed by a European Union Allowance, and the price of KKB is pegged to the EUA price.

Bottom Line

The bottom line is that governments, corporations, and individuals are increasingly concerned with the impact of carbon emissions on the environment. While the government of the European Union has focused more on regulatory reform than the United States, voluntary and mandatory markets are seeing accelerating growth, and the use of Emissions Trading Systems is expanding. These systems are helping ensure that the actual cost of producing goods or delivering services is reflected in a company’s cost structure, which impacts producers and consumers alike.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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