Covid pandemic created a mandate for governments around the world to take actions against climate change by reducing the environmental pollution.  Never in history before there was an urgency for a globally aligned vision to tackle climate change.   Green energy, renewables, electric batteries, electric vehicles and infrastructure are some of the hottest topics receiving significant traction in the media and investment landscape.  Today, when you ask the question in a forum -“what is the best way to play the green revolution”, following, are some of the common answers you hear from the crowd:

  • Solar energy
  • Wind energy
  • Natural Gas
  • Electric cars and  Batteries
  • Uranium & Nuclear energy
  • Material Miners
  • Infrastructure Investments

There are many companies working on cutting edge technologies and trying to provide solutions to tackle climate change. Some of the companies focusing on these areas will have a brighter future in years to come. But, as an investor, I am still unsure which company or the solution will become the biggest winner in the next decade. Nevertheless, in this article, I want to bring your attention to a different kind of investment opportunity to play the green revolution. In fact, this opportunity is very unique in the sense that you are not betting on a specific company, technology, solution, material/resource or entire sector as a whole, but on a  policy.

Carbon Credit Market

The carbon credit market is an ingenious behavioural incentive system set up by policymakers to reduce carbon emission to tackle climate change by putting a price on carbon.  Europeans were the pioneers of implementing these policies which goes all the way back to the year 2005. This European system is known as the European Union Emission Trading System (EU ETS). EU ETS is the biggest carbon credit system in the world. Apart from EU ETS, there are several other systems operating or under development in United States, China, Canada,  New Zealand, South Korea, Switzerland and Japan.  When the Chinese trading system function at its full potential, it will become the biggest market as they are the largest carbon emitter in the world. However, in this article, I will be focusing on the European carbon credit market as it is the most established highly liquid market.  Moreover, EU ETS provides a unique incentive system that has a reducing supply;  like some cryptocurrencies that you are already familiar with.

First of all, let me get you up to speed by introducing EU ETS and some of its key terminologies. All this information can be obtained from the EU ETS website.

Cap and trade System

In Cap and trade system the governments set a predefined target to reduce carbon emission by setting up a cap on the amount of greenhouse gasses that can be emitted by installations within the trading system. Within the Cap,  various complying entities can buy or receive “carbon allowances” which they can trade among themselvesves. Carbon allowances are fixed emission limits received by complying entities (power plants, industrial and regulated polluters) from policy-making authorities. These allowances are registered in a Carbon Bank (central authority similar to the central bank) and every year installations need to submit allowances to cover their carbon emissions in the previous year.

1) Pollutor who emitted more than their allocated allowance need to buy more allowances in the open market. Otherwise, they must pay hefty penalties.

2) If there is an installation that took good measures to reduce emissions and they have allowance surplus, then they can trade them in the open market for a profit.

EU ETS System

As the ultimate goal, EU  aims to be carbon neutral by 2050. But as an intermediate goal, they want to reduce greenhouse gas emission by at least 55% by 2030.  EU ETS has been modified over three phases before and at present, we are in the fourth phase.  During Phase 1 in 2005, EU ETS was in the test phase and it really kicked off in 2009 during phase 2. But, for many years carbon prices were low due to the oversupply of allowances in the market. This oversupply did not give enough incentive to reduce carbon emission. There have been some policy changes happened along the way to improve the system.  Since the beginning of Phase 3 (2013-2020), the emission cap was set for the entire EU as a whole. During the third phase, cap for stationary installations set to decrease linearly 1.74% per year.  However, carbon prices remained low during the 2013-2018 period. During this period excess allowances from the first and the second phases got cleared out from the system. In 2018 carbon prices tripled and there onwards,  prices started to rise significantly.  The fourth phasese represents  2021-2030 time period. According to the EU ETS system, in this phase, the cap will be decreased by 2.2% annually.

Total Number of Allowances in Circulation (TNAC)

Current TNAC is limited to 833 million tonnes of carbon.  At the beginning of the system, there were free allowances provided for entities to promote the system.  During the trading period of 2013–2020, 43% of allowances were freely allocated, and the other 57%  of total allowances were auctioned in the open market. Most of these free allowances in the market were from previous phases. However, going forward, these free allowances are ceasing and the market needs to completely depend on auction and existing supply. Another question you might have is, “what will happen when most of the EU entities reduce greenhouse gas emissions significantly?”. Will it increase allowance-inflow to the market, reducing carbon prices?   This can be answered with the  “market stability reserve”.

Market Stability Reserve (MSR)

At the beginning of 2019 system has adopted a codified method to manage the supply to control the volatility. In 2019-2023, If TNAC exceeds more than 833 Million then an annual reduction of 12% (24%over 2019-2023) applies for cumulative surplus. However 2023 onwards, surplus allowances are to be invalid.

If ETS prices rise quickly, Article 29a kicks in, where members of the committee convene to consider the injection of a new supply. However, in order for this to happen ETS prices need to stay above three times the average over the two preceding years for more than six consecutive months.

In other words, prices need to remain above  EURO 75 ( compare against 2019 JUL prices- EURO 25).  At this point, It is not clear if members want to consider Article 29a in the future, given that higher ETS prices are needed to incentivize green projects to move forward.

Similar to EU ETS, the California Cap & Trade System has a goal to reduce carbon emission below  40% of the 1990 level.  Interested readers can find more information about this system at California cap and trade.

We will see more opportunities in other markets as we move forward. However, we need to spend time assessing other markets as they are still in the infant stage. I will come up with another piece when I have more information on opportunities available in other areas of the world. But, as a trader, currently, I am more focused on EU ETS as it’s the most structured and liquid market with a longest history.

Source – International Carbon Action Partnership (ICAP) Status report 2020

Why I like this Trade

  • EU ETS is an ingenious behavioural incentive system set up to drive up carbon prices by reducing the supply.
  • It is an indirect way of playing green revolution without owning specific commodities, stocks, or equity-linked ETFs. It is somewhat uncorrelated to general markets.
  • You are not fighting the authority rather they are on your side.
  • ESG will be a major theme in the 2020s and  Europeans are leading other nations when it comes to climate change initiatives.
  • In the short term  (12 months ), a massive reduction of MSR  in 2021 will be a favourable catalyst for prices to explode higher.
  • Post pandemic re-opening is still in progress and many of the industries still have to compete for credits such as terrestrial transport and aviation  industries.
  • Policy mandates are in place for extreme volatilities.  In terms of position sizing this gives me enough confidence to allocate meaningful capital.
  • With article 29a in place, the exit point is somewhat clear to me.

How to play it

  •   KRBN  ETF is a mix of both EUA futures and California carbon allowance futures. It’s the easiest way to play as a retail investor.
  •   GRN is a pure-play of EU ETS, but it’s an ETN.
  •   For futures traders, EUA futures trade on ICE  can be used as the cleanest expression of the idea.

I already bought KRBN and GRN in April 2021. In my portfolio, KRBN has a slightly larger weight compare to GRN because it’s an ETF.  There is a high chance that KRBN will include other countries in their holding mix in the future. Recently, GRN  ETN had a 5:1  split which is currently trading around $20. This is a bullish signal given that GRN price action is in an uptrend.

Risks

  • Carbon Tax System – There is a possibility that some of the countries will migrate or use a carbon tax system, moving away from the cap & trade system. This is a risk that one cannot overlook.
  • Market correlation – Even though trade is technically uncorrelated to other assets, during a risk-off event, the trade might get a hit as leverage investors and hedge funds are taking part in this market.
  • Short term spikes to the upside are somewhat limited by article 29a. At this point, It’s hard to make a judgement about Article 29a because it has never been initiated before, and it’s a policy acting against the EU’s original will.

Final Note

Considering risk-reward and the way the incetive system is structured, carbon trade is my second highest conviction trades after BTC & ETH. If  Crypto is not around, I would have allocated most of my trading capital into this trade.  Going forward, I will be allocating more capital into this trade as I average out my crypto profits. In addition, considering the risk factors I have mentioned earlier,  it seems like a decent trade to me to hold on for at least the next 12-18 months.

Disclaimer – ” I am not a financial advisor and this article is a construct of my personal views on various markets and the economy. Therefore, information and trade idea shared in this article should not be used as investment advice by the reader. ”

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