Understanding the Compliance Carbon Markets
As a way to address climate change, many governments are looking to limit carbon emissions. Carbon pricing, through the compliance carbon markets, is one mechanism by which governments are looking to achieve this goal. What is the compliance carbon market? How may investors potentially gain exposure to these markets?
What is the Price of Pollution?
Carbon pricing puts a cost on emissions to incentivize emitters to shift away from high-emissions processes and products to low-carbon or no-carbon alternatives. It can take different forms and shapes, such as a carbon tax on fossil fuels or in the form of emissions trading systems (ETS). Carbon pricing is often expressed per metric ton of carbon dioxide equivalent (CO2e). Carbon dioxide equivalent converts other greenhouse gases (GHGs), such as methane and nitrous oxide, into the amount of CO2 which would have the equivalent global warming impact.
The ABCs of an ETS
An ETS, also sometimes referred to as a cap-and-trade program, is a system where regional, national, or subnational jurisdictions set a cap on the total annual GHG emissions to be generated by specific industries. The cap, or permitted emissions, declines annually to achieve the climate goals of the jurisdiction(s).
Carbon allowances, also known as emission allowances, equal to the emissions cap may then either be freely allocated and/or auctioned to emitting companies by the governing entity. Companies within an ETS may buy or sell carbon allowances based on need, as illustrated in the figure below. For example, a company with lower emissions may choose to sell allocated carbon allowances to an entity with higher emissions. Emitters with an insufficient amount of allowances to offset their emissions at the end of the reporting period incur penalties.
What is the Purpose of an ETS?
In an ETS, the number of allowances is set and reduced each year so that climate goals are met. The supply and demand for these allowances establishes a market-based price for emissions. Carbon pricing aims to incentivize companies to find the most cost-effective means of reducing carbon emissions. When the price of carbon allowances is sufficiently high, companies have an incentive to invest in lower-cost green energy alternatives.
What are the Potential Benefits of an ETS?
- Puts a clear price on emissions by establishing a market for carbon allowances.
- Sets a cap on emissions that can be tailored to each jurisdiction’s climate goals.
- Provides companies with the flexibility to decide how to meet their obligations.
- Incentivizes companies to invest in lower emission alternatives when allowance prices exceed the cost of the investment.
- Provides revenue to jurisdictions from the auctioning of allowances and payment of penalties, which is often used to further climate action.
Investment Potential
According to the International Energy Agency, carbon prices need to reach $130/ton by 2030 and $250/ton by 2050 in advanced economies to meet net-zero ambitions. However, the global weighted-average carbon price is still only $28/ton.[1]
Thus, carbon prices have the potential to appreciate.
How May Investors Gain Exposure to the Compliance Carbon Markets?
The Carbon Strategy ETF (KARB)
The Carbon Strategy ETF (NYSE: KARB) is an actively managed ETF to provide investors with access to the global compliance carbon markets. It uses as a reference index the Carbon Streaming BITA Compliance Index, which is a rules-based index that tracks the performance of the compliance markets through an allocation into a series of carbon allowance futures.
KARB may provide investors with an attractive vehicle to gain exposure to carbon prices.
[1] Credit Suisse, Carbon Markets: The Beginning of the Big Carbon Age
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.
Distributor: Quasar Distributors, LLC.