Compliance and Voluntary Carbon Markets: What is the Difference?
Reducing global emissions may help to address climate change. To help facilitate a reduction in carbon emissions, two markets that put a price on carbon have emerged – the compliance and voluntary carbon markets. What are the goals of each of these markets? What are their differences? And what is the distinction between a carbon allowance and a carbon offset?
Putting a Price on Carbon Emissions
The aim of carbon markets is to put a price on greenhouse gas (GHG) emissions to encourage participants to reduce their emissions and invest in and develop low-emission or no emission alternatives.
The Compliance Carbon Markets
The compliance carbon markets are comprised of emissions trading systems (ETS) in which a regional, national, or subnational jurisdiction sets a cap on the total annual GHG emissions that can be generated by certain industries. The cap, or permitted emissions, declines annually to achieve the intended climate goals set.
Carbon allowances equal to the emissions cap are then freely allocated and/or auctioned to emitting companies by the governing entity. Companies within the ETS may then purchase or sell these allowances based on need.[1]
The Voluntary Carbon Markets
As the name implies, participation in the voluntary carbon markets is voluntary. It allows corporations, organizations, and individuals to purchase carbon credits to compensate for their emissions.
In this market, carbon credits, or offsets, are created by projects that avoid, reduce, or remove GHG emissions beyond a “business-as-usual” scenario. Projects include the restoration of a forest, improved forest management, or development of renewable energy in a developing country. These projects must be “additional”, in that the project would not exist in the absence of the economic incentive provided by the sale of carbon credits.
Most voluntary carbon credits today are issued by distinct issuing bodies, known as the voluntary carbon standards. Each carbon standard has unique rules that all projects must follow in order to be certified. The issuing, transferring and retiring of carbon credits is executed through a registry maintained by a standard body (e.g., Verra, Gold Standard, American Carbon Registry, and the Climate Action Reserve). Once the credits have been issued, market participants can then purchase these credits. A credit is considered “retired” once it has been used to offset emissions and then it can no longer be traded. You may have been offered the opportunity to purchase carbon credits when purchasing an airline ticket to offset the emissions generated by your flight.
Market Size
Currently, the voluntary markets represent a small portion of the total carbon market, with approximately $2 billion traded in 2021, representing 493.1 million tonnes of carbon dioxide equivalent (CO2e) in carbon credits.[2] In comparison, global compliance markets traded $899 billion in value representing a volume of 15,800 million tonnes of CO2e in 2021.[3] The voluntary markets currently trade less than 1% of the value and less than 5% of the volume of the compliance carbon markets.
Where Does KARB Invest
The Carbon Strategy ETF (KARB) is an actively managed exchange-traded fund (ETF) that aims to provide exposure to the global compliance carbon markets. KARB uses as a reference index, the Carbon Streaming BITA Compliance index, which is a rules-based index that tracks the performance of the compliance carbon markets through an allocation into a series of futures contracts that track various regional compliance carbon markets.
KARB does not provide any exposure to the voluntary carbon markets.
Positive Price Potential for the Compliance Carbon Markets
Each ETS determines the number of carbon allowances to be allocated or auctioned each year. In most ETSs, the number of new allowances is set to decrease each year to meet the emission reduction goals of the governing jurisdiction(s). According to the International Energy Agency (IEA), carbon prices need to reach $130/ton by 2030 and $250/ton by 2050 to meet net-zero goals. However, the global weighted average carbon price is only $28/ton.[4]
Thus, future contracts on carbon allowances provide investors with exposure to potentially rising carbon prices.
Investors looking to participate in the global compliance carbon markets may want to consider an investment in KARB.
[1] Please see our blogpost Understanding the Compliance Carbon Markets for more information
[2] Ecosystem Marketplace “State of the Voluntary Carbon Markets 2022 Q3”, August 2022.
[3] Refinitiv, Carbon Market Year in Review 2021 (2021: $1 = 0.845 euros).
[4] Please see the KARB Investment Case for more information
Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, visit https://karbetf.com/investor-materials. Read the prospectus carefully before investing.
An investment in the Fund involves risk, including possible loss of principal. There is no assurance that the Fund will achieve its investment objectives.
The investments held in the Fund’s portfolio may experience sudden, unpredictable drops in value or long periods of decline in value. Cap and Trade Risk*. There is no assurance that cap and trade programs* will continue to exist. Cap and trade may not prove to be an effective method of reducing greenhouse gas emissions. As a result, or due to other factors, cap and trade programs may be terminated or may not be renewed upon their expiration. Investment Capacity Risk. If the Fund’s ability to obtain exposure to carbon credit futures contracts, which are commodity futures contracts linked to the value of emission allowances (“Carbon Futures”), consistent with its investment objective is disrupted for any reason including, limited liquidity in the Carbon Futures market, a disruption to the Carbon Futures, or as a result of margin requirements or position limits imposed by the Fund’s FCMs, the CME, or the CFTC, the Fund would not be able to achieve its investment objective and may experience significant losses.
*An emissions trading system, sometimes referred to as cap-and-trade program, is a regulatory program designed to limit, or cap, the total level of emissions of greenhouse gases, particularly carbon dioxide, by companies in regulated industries, such as manufacturers or energy producers. The regulator, such as a governmental entity or supranational organization, allocates and/or auctions a limited number of annual emission allowances that allow companies to emit a certain amount of greenhouse gases. Companies are then penalized if they are unable to offset their emissions with enough emission allowances. If a company reduces its emissions levels, it can sell, or “trade,” unused emission allowances to other companies on the open market. Over time, regulators lower the number of emission allowances available each year, thereby lowering the total cap on emissions, making emission allowances more expensive, thereby incentivizing regulated entities to reduce their emissions.
The Carbon Streaming BITA Compliance Index is jointly owned by Carbon Fund Advisors Inc. and BITA GmbH, and is calculated, administered, and disseminated by BITA GmbH.
While the Carbon Strategy ETF utilizes the Carbon Streaming BITA Compliance Index (the “Index”) as a reference index, it is an actively managed fund and is under no obligation to follow the rules of the Index or invest in the underlying holdings of the Index and may not track the performance of the Index.
The Fund expects to gain Carbon Futures exposure by investing in a wholly owned and controlled subsidiary of the Fund organized under the laws of the Cayman Islands (the “Subsidiary”). The Subsidiary is not registered under the 1940 Act, and, unless otherwise noted in the prospectus, is not subject to all the investor protections of the 1940 Act.
The Fund’s investment exposure to futures instruments will cause it to be deemed to be a commodity pool, thereby subjecting the Fund to regulation under the CEA and CFTC rules. Registration as a CPO imposes additional compliance obligations on the Advisor and the Fund related to additional laws, regulations, and enforcement policies, which could increase compliance costs and may affect the operations and financial performance of the Fund.
Shares are to be bought and sold in the secondary market at market prices. Although it is expected that the market price of Shares will approximate the Fund’s NAV, there may be times when the market price of Shares is more than the NAV intra-day (premium) or less than the NAV intra-day (discount) due to supply and demand of Shares or during periods of market volatility.
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