Carbon as an asset class

As more and more jurisdictions around the world implement carbon emissions trading schemes, carbon allowances have become a liquid, fungible asset. So much so that a full-fledged derivative market has developed, with carbon allowances as the underlying asset of futures, forwards, and options. In this post we’ll look at carbon allowances as a financial instrument: how they behave on financial markets, how they compare to other assets, and why they’re an interesting product to hold from a financial perspective.We’re going to focus solely on EUAs, or European Union Allowances: While they cover only 3% of global emissions, they accounted for 90% of trading volume on compliance carbon markets in 2021.

TL;DR : EUAs form a highly liquid asset class which has witnessed 50% year-on-year growth over the past 5 years, has low correlation to other asset classes, relatively high volatility, and by design has a tightening supply which increases their scarcity value. Therefore, they have a very exciting financial profile for medium-to-long term investors.

Financial Performance

The European Union Emissions Trading Scheme (EU ETS) exists since 2005. Its trading unit, the European Union Allowance (EUA), is exchanged on the market between industrial polluters. It represents the right to emit 1 ton of CO2. The higher its price, the more polluters need to pay for each ton of CO2 they release in the atmosphere.At time of writing, EUAs trade at around 85€ per unit. Their price has known tremendous growth over the past 5 years: in November 2017, they were valued around 8€ per unit. That’s a 10x growth in five years, or over 55% per year.

While the ETS has known many phases as you can see from the price chart above, it has progressively evolved into a more sophisticated and mature market capable of sustained price appreciation. While we don’t expect the growth rates we’ve witnessed to continue at this level - they were linked to the market reforms of 2018 - we do expect double digit annual growth to align the market with the EU’s environmental ambition.

Low positive correlation

Correlation is the measure of how one asset behaves in relation to another. It ranges from -1 to 1. For example, if assets A and B have a -1 correlation, it means that when A increases, B decreases by the same amount.EUAs have a low correlation to major asset classes as you can see on the scale. That means they behave rather independently. Therefore, it’s a good asset to hold to diversify your portfolio and limit your risk.We’ll cover what are the value drivers of EUAs in a future post so you get a better sense of how their price fluctuates and why.

Liquidity

The EU ETS is the largest emissions trading scheme in the world. It covers 45% of all of the EU’s CO2 emissions, representing more than 10.000 installations - power plants, manufacturers that produce chemicals, cements, or steel, or airlines that operate within the EU. All these installations need to purchase 1 EUA for each ton of CO2 they emit.Given this scope, EUAs are a highly liquid asset: the trading volume in 2021 was close to 700 billion dollars. This means that there is no significant liquidity risk associated with holding EUAs: you can buy or sell at any time, at market price.The trading volume has surged in recent years, and with the combined effect of:

• The progressive implementation of new carbon markets;
• The extension of the coverage of existing markets;
• Rising carbon prices;

It could continue to do so. If all compliance carbon markets traded at the level of the EU market, the global trading value would be over US$ 4 trillion.

Volatility

Volatility is the measure of how an asset’s value changes in a short time period. The higher the volatility the more erratic the price movements, and the lower the volatility the more stable the asset.EUAs are more volatile than stocks or bonds, but less than other energy commodities. Their volatility puts them in the ‘“risky asset” category, as price fluctuations can be important (2.9% intraday volatility on average). To dampen the volatility effect, we consider EUAs to be a medium-to-long term asset, to be held for several years. This also increases their environmental impact

Pricing carbon is generally agreed to be the fairest and most efficient way of curbing emissions at scale. In spite of initial set-backs and market design issues, compliance carbon markets have empirically demonstrated their ability to deliver on that promise. As they become ubiquitous, they are forming a new, exciting investment class for climate conscious investors looking for assets designed for both impact and returns. And our mission at Homaio is to make them easily accessible.

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