Carbon trading: a slow burn for investors

If you’re an investor in the carbon market, are you helping the planet? Or are you just a ruthless speculator? 

Since 2021, it’s been possible for UK retail investors to buy exchange traded funds that track the price of carbon in the EU’s emissions trading system. By requiring polluters to hold an emissions allowance (EUA) to emit a tonne of carbon dioxide, the idea is that as the price rises, companies will be incentivised to cut emissions, for example by investing more in renewable energy. Companies that don’t need their permits — ideally because they are emitting less — are free to sell them on the open market.

There are two main products available to UK-based retail investors: the WisdomTree Carbon ETC and the SparkChange Physical Carbon EUA ETC. (A third, also from WisdomTree, was set up in April this year and tracks the much smaller carbon market in California.)

The investment case for buying a fund linked to the price of carbon is that it is expected to go up. The EU plans to release fewer EUAs in the coming years with the intention of raising the price to the point where it affects capital expenditure decisions by power companies and other polluters — and cutting the number of free allowances it has handed out to placate industry. It also plans to extend the scheme to cover more sectors. At the moment, it mainly applies to power companies and energy-intensive industries. 

Having hit €100 in February — a price that could focus the mind on changing behaviour — the price is now at €95 after a steep climb in the past two weeks. Performance of the exchange traded commodities (ETCs) was muted in the 12 months to early June, according to Morningstar data. At 4 to 5 per cent, this significantly underperforms the major stock markets. 

The investment case for buying a fund linked to the price of carbon is that it is expected to go up. The EU plans to release fewer EUAs in the coming years

Nonetheless, analysts predict the price will rise well beyond its present levels in the coming years. By 2030, they expect it will hit €144 on average, according to a poll by Carbon Pulse, though they forecast only €102 by 2025 — not far off the level reached in February this year. 

Volatility is high — a SparkChange fund fact sheet shows that while EUA prices rose by 28.5 per cent in 2020, for example, volatility was more than 51 per cent. The previous year, volatility was still 41 per cent but the rise in price was just 1 per cent. That compares with volatility levels for equity indices that tend to be in the mid-teens.

The price of EUAs is closely tied to the gas price, which this month saw a huge rise of more than 100 per cent, leading to a corresponding surge in carbon prices from €78 to €95. Mark Lewis, head of climate research at Andurand Capital Management, a hedge fund, says this “has been one of the most volatile periods we’ve seen since last summer”.

For some wealth managers, these swings take the products off the table for retail investors. “These products are kind of speculative, we don’t really know what will happen with them, and they’re new,” says Peter Sleep, a senior portfolio manager at 7IM. 

But is either of these ETCs a sustainable investment?

SparkChange argues that as a physically-backed fund, its product has a greater environmental impact than a futures-based product, because the fund actually holds the EUA, taking it off the market and restricting supply for polluters. Handelsbanken, for example, holds the ETC in its sustainable portfolio for investors on these grounds. 

The case for the sustainability of the WisdomTree ETC is a bit different. The fact sheet focuses on the potential for returns linked to the case for carbon increasing in price, saying that the fund is “designed to provide investors with a total return exposure to carbon futures contracts”.

Where it can contribute sustainably is by introducing more liquidity into the market, WisdomTree argues: a more liquid market will in theory lead to better, more efficient prices. “The social cost of an underpriced carbon emission allowances futures contract is the overproduction of carbon,” it says in its investment case for the fund. 

Billal Ismail, head of sales at SparkChange, says most of the investors in its ETC are institutions including wealth managers and pension funds, which are holding it for the longer term. He argues that the volatility in the carbon price — driven partly by weather fluctuations, partly by the fact that utility companies are the biggest buyers of EUAs and are price agnostic — means that for longer term investors the dips are buying opportunities. 

Carbon markets also do their own thing: they have a low level of correlation with other asset classes, so may appeal to investors looking to balance their portfolio. Cormac Nevin, a fund manager at You Asset Management, says this is one key reason why he holds the fund across various multi-asset portfolios including a cautious one.

Still, Tara Clee, a sustainable analyst at Hargreaves Lansdown, says both ETCs are held in very small quantities by clients on the trading platform. “Until the price of carbon rises substantially, and most sectors are included in ETS, the effectiveness of the scheme in sustainability terms is up for debate,” she says, but adds: “These products would be good for clients who want exposure to decarbonisation, and it’s clear that global regulatory tailwinds will only increase the use case for these ETFs.”

Investing in carbon markets will probably not appeal to sustainability purists in the same way that buying shares in Shell, in the hopes of pressurising it to cut emissions faster, also does not appeal. Some investors prefer not to be tainted at all by oil and gas companies. Others may take the view that engaging with the carbon market can help to expand it.

Others still see it as an energy transition play: you don’t have to value sustainability to see that there is a good investment case in this area. But with the price still linked to regulatory decisions and the market relatively illiquid and volatile, only brave retail investors should dare to enter.

Alice Ross is an FT contributor. Her book, “Investing to Save the Planet”, is published by Penguin Business. Twitter: @aliceemross