Climate Investing Series Part II: Carbon & Your Portfolio
From carbon footprint to carbon credits, the concept of decarbonization is fundamentally changing the way investors approach investment strategies. As the world shifts towards a low-carbon economy, companies are being pressured to reduce their carbon footprint, and investors are looking to prioritize investment in companies that are making progress in this area.
In recent years, environmental, social and governance (ESG) factors have come under particular scrutiny by fund managers and investors. Decarbonisation has emerged as a key issue in the fight against climate change, prompting the fund management community to place it at the forefront of their concerns. This has given rise to a new asset class, between commodities and capital market instruments, carbon credits, which offer companies a capital market solution to offset their carbon emissions. The growing importance of decarbonisation in ESG factors is evident from the increasing number of funds that are incorporating it into their investment strategies.
Carbon credits: Tackling climate change with capital market instruments
The carbon credit system puts a price on carbon emissions on the principle that every action we take generates a carbon footprint. While individuals generate an average of 4 metric tonnes of carbon per year, companies in industries like shipping, aviation, power generation, and manufacturing generate much more. The purpose of the carbon credit industry is to counteract the positive carbon footprint of polluters by purchasing credits from companies or organizations that have a negative carbon footprint. This includes providers of clean power such as hydro, solar, wind, and nuclear, as well as organizations engaged in reforestation, marine protection, and other environmentally supportive activities. However, decarbonization goes beyond carbon credits and involves reducing carbon emissions to net zero. For instance, some companies are transitioning towards renewable energy or other sustainable projects to achieve this goal.
The offer is expanding and gaining transparency
Carbon markets are divided into two main categories: compliance and voluntary markets. Compliance markets are government-regulated, with the EU having the largest market, while other countries such as the US, Canada, and China are developing their own. These markets tax and reduce emissions through a cap-and-trade system, with companies being able to buy and sell carbon credits. For instance, Tesla generates most of its revenue from selling carbon credits. On the other hand, voluntary markets operate differently and offer several advantages, also for the ordinary citizen to contribute to the deodorization such as the option for passengers to offset their carbon footprint by paying a small fee when purchasing travel tickets for airlines, trains, or buses. Companies aiming to be carbon neutral may also buy credits on the voluntary market, which trade at a lower level than compliance credits. Carbon offsetting is a valuable option for industries like aviation, shipping and mining which have limitations when it comes to reducing emissions. It provides carbon-positive companies with a financial incentive and tradable market instruments to reduce their carbon emissions.
As a result, investors have now access to a large variety of market instruments, to include decarbonization themes in their portfolios to both support sustainable practices and potentially earn financial returns. This shift towards decarbonization is reshaping the universe of portfolio strategies and driving the development of innovative investment products that cater to this growing demand.
The demand increases the pressure
The demand side of the market is witnessing robust growth drivers that are holding companies accountable for their environmental impact. For example, tech giants Apple and Google are under pressure to source metals for their mobile phone batteries from non-polluting sources. Large investors like BlackRock and Vanguard are also enforcing ESG principles by refusing to invest in public issuers that don't comply. While ESG principles are still in development, carbon footprinting has gained significant attention in recent years. The carbon footprinting of a company covers a broad range of activities, including supply chain, processing, and executive travel. Decarbonization, which has been in the background for many years, is now taking centre stage also in corporate risk management. As a result, companies across industries are frequently announcing their commitment to offsetting their carbon footprint and going carbon neutral, while others have fully integrated it into their operational risk management and disclosed it in their annual statements.
Markets mechanism: credit generation, vintage, quality and co-benefits
The generation of credits varies between Compliance and Voluntary Markets. Clean energy sources such as renewables and nuclear power are common examples of credit generation in the Compliance Markets. On the other hand, nature-based solutions, such as reforestation, are a significant source of credit generation in the Voluntary Markets, often supported by global corporations.
Compliance markets operate on a straightforward supply and demand basis and are mainly traded by hedge funds and other types of companies. In contrast, voluntary markets are more complex, with credits being traded based on their vintage, meaning the year in which they were generated.
Notably, some older credits, which were generated before stringent standards were introduced, may not meet the same quality as newer credits that adhere to current standards.
Moreover, the concept of co-benefits also comes into play, as companies consider the marketability of specific credits in terms of public and investor relations. All these factors influence the price of credits, which can vary significantly.
Still facing some challenges
The market is evolving at a rapid pace and becoming increasingly competitive and efficient. During its early days, the Voluntary Markets encountered numerous challenges such as a lack of transparency and competing standards that are common in all new industries.
Although a globally accepted set of standards is still some years away, the corporate world has become more comfortable with participating in the Voluntary Markets. Today, it's difficult to find a major corporation without a carbon offset plan, and many of these plans involve purchasing credits annually on the Voluntary Markets. Although a globally accepted set of standards is still some years away, the market has developed to a stage where reputable supranational organizations have edited a set of standards for most verification and measurement processes. As a result, corporations have become more comfortable with participating in the market. Today, it is challenging to find a major corporation that does not have a carbon offset plan that involves purchasing credits every year from the Voluntary Markets. The industry has progressed in ways that few could have predicted a decade ago.