Investing in the Pivotal $900 Billion Compliance Carbon Market

Investors may have heard about carbon markets, carbon allowances, or cap and trade, but few are aware of the intricacies of the evolving carbon marketplace and the unique investment opportunities that this area represents. We may hear about the global environmental and sustainability conferences of Davos, UN's COP28, and many others that seem to propel discussion and action towards net-zero carbon emission goals, but many have no idea about the astonishing example of Capitalism and accelerating innovation that happens by putting a price or value on carbon and pollution.

Within the compliance carbon cap and trade markets, governments regulate the supply of carbon allowances, which drives the economic incentive to decarbonize and adopt more innovative, clean technology. Now, there is a price and a value to any invention that reduces or captures carbon. There is a large amount of money going into these efforts that just was not there. This act of pricing has created that "invisible hand" in the carbon marketplace and spawned a $900 billion market that many investors still know little about.

To delve into the compliance carbon markets and the unique investment opportunities they offer investors today, we were introduced to Luke Oliver, Managing Director, Head of Climate Strategy at Krane Funds Advisors, LLC - a specialist investment manager that seeks to provide innovative, high-conviction, and first-to-market strategies in carbon, climate, and other uncorrelated assets. We asked him questions to learn the hows and whys behind creating the KraneShares Global Carbon Strategy ETF (NYSE: KRBN), which is the first, largest, and most liquid publicly listed global carbon allowance ETF in the world.

Hortz: What was your motivation for launching your KraneShares Carbon Suite and Global Carbon Strategy ETF?

Oliver: Energy transition has become one of the biggest emerging trends of our generation. We felt that rather than try and pick the companies or the countries that will do that transition successfully - as there will be winners and losers - we thought the purest way to participate in this transition was to focus on the agent of the transition, which is the price of carbon. And so, we launched our ETF carbon suite from there.

There are four major reasons for offering these investments. Number one, the performance story is driven by this generational opportunity from the energy transition. We are in a single cycle of tightening carbon prices that are going to drive a repricing of compliance carbon between now and 2030 and beyond. We firmly believe that it is going to create multiples of returns that we are conservatively estimating at around 100 to 200% returns.

Secondly - and this is a really important point to make here - we are not talking about forest and seaweed projects or any of the kinds of carbon offset projects that we read in the headlines. We are focused primarily on the compliance carbon markets, which are a robust, regulated, transparent liquid market valued at about $900 billion last year. This distinction is important to emphasize because so many clients say, oh, I have heard about carbon markets, but go on to talk about saving wetlands or growing trees or corruption in a developing country. It is none of that. The compliance carbon market is issued by governments, regulated by governments, completely standardized, completely transparent, backed by law, and driven by policy. These mandated carbon programs have been around since just before the great financial crisis and have become the major policy tool of global governments to decarbonize and drive innovation within their economies.

Thirdly, investors are already exposed to the rising price of carbon in their portfolios. The energy transition and expansion of carbon pricing is happening whether you like it or not, whether you agree with it politically, or believe in it passionately. Regardless, policy and spending in almost all major global governments is geared towards owning and winning the race to decarbonize our energy and all of our major industrial processes. Because of this, it is our contention, regardless of your political persuasion, that you must ensure your portfolio is at worse protected and at best positioned to benefit from this rising price of carbon.

I would even add a fourth point that carbon also represents an asset with historically low correlations and is largely driven by tightening policy, not global macro. The asset class provides great portfolio characteristics and, while volatile itself because of that low correlation and high expected return, actually lowers the volatility of portfolios. We have modeled that in our presentations on the carbon markets.

Hortz: Can you explain to us what the global carbon markets are? What exactly is being traded here?

Oliver: A key distinction to make is that there are two carbon markets. One of them is the compliance carbon cap-and-trade market (otherwise known as an emissions trading system) that is run by governments. Companies within sectors covered by a compliance market, by law, must buy these carbon allowances to cover their emissions output. Think of them like permits to pollute one ton of carbon dioxide. Governments manage the supply of those allowances in order to manage the region's emissions and drive the price higher, which creates all the economic incentives to drive down pollution and accelerate innovation. For regulated entities, carbon allowance can be an additional profit source as they can sell unused credits or hedge the market. Compliance carbon is now a $900 billion market and yet the average person probably never hears about it.

The other carbon market that nearly everybody has heard something about and, unfortunately, at times, in a negative way is the voluntary carbon offsets market. It is tiny and negligible-- trading as high as an approximately $3 billion market ever in its whole history—and yet it is the one that gets the headlines. Offset credits are project-based, where people are preserving mangroves in Africa or growing forests in South America. These carbon-negative practices are quantified, and their emissions reductions, capture, or avoidance can be registered as offset credits to then be sold to corporations trying to hit their carbon footprint targets. So, it is fascinating, with lots of opportunities, but not yet standardized. There are thousands of different projects doing hundreds of different things, meaning that every credit is different, and there is no central clearinghouse or exchange. There is no government regulator overseeing it, and no one has to buy any of them. They are both interesting markets, but when it comes to putting your retirement assets into an investment, compliance carbon is ready for prime time. Carbon offsets are less so.

Hortz: What are the major forces that affect the pricing of carbon allowances?

Oliver: The supply and demand dynamics of the market dictate carbon pricing. The demand is the amount of pollution. All of us in the market are constantly trying to establish how much pollution is happening today, how effective companies are at reducing their pollution, and how pollution is changing over time. Then, we look out for things like weather patterns, where a mild winter or cooler summer can affect heating and air conditioning use and, therefore, energy consumption needs.

On the supply side, we model government policy. Is the government talking about tightening the program? Will they move the goalposts on the allowance cap? How will new policy initiatives impact the market? During the Ukraine invasion, for example, the EU decided to frontload allowances from future scheduled auctions to raise additional revenue to fund REPowerEU, an initiative designed to ease their energy crisis and accelerate renewable capacity.

To forecast prices in the future, we take the modeling of supply, which is the policy, and we take the modeling of the demand, which is the pollution, and we can predict the relationship between them and determine if the demand/supply imbalance is growing or shrinking. The major markets that we focus on are all entering their tightening phase, which is one big cycle rolling over from here to 2030 and beyond. This tightening supply and structural upside is why we think investors need to look at carbon today.

Hortz: How does going long the price of carbon potentially support responsible investing and incentivize pollution reduction?

Oliver: Mainly through price discovery. When talking to people, we do not start by saying to invest in carbon because by doing so, you are saving the environment. Instead, we emphasize that this asset is grossly undervalued. It is structured for prices to rise with low correlations to other markets and has inflation protection sometimes explicitly built into it. Number one, it is a compelling investment story. That is how you get real capital to move because there is a real financial incentive; it is not just about being nice. By buying these credits, we are not only providing liquidity but are also actually creating the price discovery. These markets are open not just to power, gas, and steel companies required to participate. They are open to everybody for a reason. Speculators and hedgers are needed to have a functioning market. If it was limited to just the compliance companies controlling this market, then they would want prices to be cheap to keep their costs low.

If you can see that something should be priced a hundred percent higher than it currently is, it is our job as financial players to make it happen by participating in the market. And so, our service is to increase the price of carbon to its true value. Now, why does that make a difference?

Well, it does three things. It increases the government revenues that go toward R&D and climate programs. Two, it creates fuel switching, so as the price goes up, things like coal just become too expensive to use. It does not matter what the price of coal is; the credits are going to be too expensive. Any dirty fuel is going to get handicapped by this rising price of carbon and shifts people to clean energy. All the power stations in Europe are getting off coal and going to gas because of this program. Thirdly, it creates innovation. There Is now a price and a value to any invention that reduces carbon or captures carbon. There Is a huge tidal wave of money going into innovating new products and solutions that just was not there before because there was no money in it. It is an enormously powerful accelerator.

Hortz: What exactly is the genesis and composition of the IHS Markit's Global Carbon Index, and how does this index play an instrumental part in the deployment of your investment approach?

Oliver: The IHS index was bought by S&P Global, so it is now the S&P Global Carbon Credit Index. That said, the index was originally designed with the help of Climate Finance Partners (subadvisor on our KRBN ETF) to reflect the global price of carbon, and it establishes a benchmark that the industry can reference. It weights the carbon markets in terms of size and liquidity, with specified ceilings and floors for each region to create an optimal global weighted basket.

What we do in our flagship fund, KRBN, is we match the index. So, what the index includes, excludes, or rebalances is what the fund tracks. We are seeking to deliver the benchmark. And, while we do have a view on managing it ourselves, in this market where there is so much potential upside, there is something to be said for just having a beta exposure and making carbon accessible. Up until this point, it has mostly been institutional and family offices investing in this space. Through this index and our ETF product, we created an easy way for every investor to access this asset. So, for us, giving access to that benchmark is more important than over-engineering the weights in the fund.

Hortz: Can you explain your overall investment strategy in this space?

Oliver: We designed a core allocation to global carbon allowances to provide investors with access to what we view as a completely underinvested asset class that should be in every portfolio. We first launched our global carbon allowance strategy ETF, which is comprised of the largest, most liquid markets. Currently, KRBN includes the European Union, the United Kingdom, California, and the Northeast US power market (RGGI). These are all separate programs, where the carbon credits are non-fungible and run on their own distinct supply and demand dynamics. Each region has its own climate, weather, energy mix, and industrial mix—all of which affect the price of carbon. Their uncorrelated nature, therefore, provides diversification with this basket approach.

Our first phase was rolling out access to these carbon allowances, but we certainly have views on over and underweighting to the markets. We launched European and California specific ETFs (KEUA and KCCA, respectively) to offer investors a way to customize their exposure. We also have filings with the regulators to potentially launch funds for some of the other carbon markets to further fine tune allocations.

Each of these markets has its own cap and trade program. Much like countries or economies can manage their interest rates and their currency, these economies need to manage their emissions, but more importantly, manage their own innovation and competitiveness in energy transition innovation. So, they need to own their own price on carbon to create those dynamics.

Hortz: Any other thoughts you can share on how advisors and asset allocators can best position this carbon investment approach with their clients and their portfolios?

Oliver: Just like currency hedging or commodities, you cannot have a well-diversified portfolio without this asset class. It is not a luxury to decide whether you want to add carbon pricing to your portfolio, as every portfolio is inherently short carbon. In other words, carbon is already in portfolios, but the exposure is on the wrong side of it. The companies that you own have to pay the price of carbon. Some are hedged, the smart ones, but this is where the risk is.

As the carbon price rises, it is going to become a challenge for some companies. More and more of your portfolio is going to be exposed to the short side of the price of carbon. We believe investors need an allocation to carbon just to neutralize that. Through analyzing portfolios' carbon footprint, generally, we see something in the region of 4 to 5% as the appropriate allocation just to neutralize your inherent portfolio exposure to the price of carbon, though it varies by developed versus emerging markets allocations.

When it comes to discussions with clients, it is important to start by clarifying what the carbon market is to differentiate compliance carbon allowances and its specific investment story, as we have discussed. When people hear about the asymmetric returns, declining supply balances becoming tighter and tighter by design, and price targets out to 2030 much higher than today's levels, many find it very compelling. However, some are unsure if this new asset is too much of a leap to add to their portfolio or simply where it fits within their existing allocations.

I have answered these questions with: It is a classical alternative. If you have commodities or thematic investments, you know where this goes. I summarize that carbon investing is a generational opportunity, institutional quality, and a robust market; portfolios must be at least protected against or positioned to benefit from this rising price of carbon, and the portfolio characteristics of carbon position it as a strong alternative investment.

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