Part One – Cap-and-trade – the regulated market
While recent speculation that we are in the early stages of a ‘commodities super-cycle’ seems to have cooled, one commodity at least continues to heat up: carbon credits.
To describe carbon credits (CCs) as a commodity at all may seem strange. They aren’t tangible, like gold or pork bellies, or fungible, with multiple distinct types available. In some ways, carbon credits appear to be closer to crypto than corn. However, as this short series will argue, there may be a lot to be gained – both for investors and for the planet – by finding imaginative ways to engage with carbon credits as an investment proposition.
This first article will unpick the principals of the regulated market and the problems it addresses. Further articles will go into more detail on key aspects, exploring the potential for carbon both as a commodity and investment class, and finally laying out some proposals to facilitate the realization of this potential.
Cap-and-trade schemes have emerged largely as a response to governmental commitments to reduce emissions. They may exist at various jurisdictional levels: state (e.g. California ), national (e.g. UK ), or pan-national (e.g. EU ). The precise details of implementation vary, but the basic premise is modelled on previous schemes targeted at tackling a now largely-forgotten menace – acid rain. The role of cap-and-trade schemes in that success might give cause for optimism. However, it should be noted that the problem of CO2 (and other greenhouse gas) emissions may be more intractable. Unlike sulphur dioxide (the emission responsible for acid rain), which was produced only by specific and easily identifiable industrial sectors, CO2 emissions are produced by a far broader base.
The approach of cap-and-trade is to identify major emitters – typically larger industrial concerns – and to issue them with carbon credits signifying a license to emit CO2 up to a pre-determined limit. The emitter is incentivised to cut emissions; if it does so effectively, it will not use all its credits and can then trade them for cash with emitters who have been less successful and exceeded their cap. Ideally, the government lowers the number of credits issued each year, encouraging investment into emissions-reduction technology. This is intended to be a gradual, shock-free process that allows large, capital intensive businesses to plan for decarbonisation, and can act as a ‘stealth tax’ by passing on costs to consumers.
A number of criticisms have been levelled against cap-and-trade. From an environmentalist perspective, this gradual pace simply isn’t urgent enough to address the pressing concern of climate change, and encourages the offshoring of emissions to low tariff regions. Additionally, this steady and predictable weaning-off of credits may actually slow the pace of technological innovation to tackle emissions. The inherently artificial and politically-guided nature of this system leaves open the possibility of emissions limits not being reduced sufficiently or even being revised upward. Indeed, at various times the European emissions trading scheme (ETS) has issued more credits than have ever been used by participants.
In the cap-and-trade system, governments and regulatory bodies are the ultimate generators of credits. The issuance of these credits by central authorities, which represent a permission to emit, is the primary action in this scheme. Carbon reduction activities are secondary to the production and use of credits. As opposed to offset credits (below), cap-and-trade credits do not represent any inherent removal of carbon or reduction in emissions. Emissions reductions are anticipated, but are an indirect effect of these credits, and this should not be the case.
Furthermore, because CC supply and the cost of exceeding emissions limits is predetermined, price pressure to reduce emissions is essentially set at a regulatory level, rather than by market forces. Although the final price of these credits when traded is discovered in an active market, it is not set by it. Thus, whatever the punitive tax on excess emissions is, will be the ultimate determinant of the final credit price.
This means that in addition to the criticisms of the cap-and-trade system and its associated regulations stated above, there are more fundamental issues. Because they are a permission for specific entities to emit, cap-and-trade credits can never reflect the demand of the wider economy for decarbonisation, and cannot inherently drive decarbonisation. In a suitably liberal Emissions Trading Scheme with low penalties for overemission, it would be possible to buy every cap-and-trade credit in the world, without removing one gram of carbon from the atmosphere.
Why does this matter?
Because in creating structural barriers to an interconnected and representative carbon pricing market, the value of certain types of offsetting becomes defined by their operation within cap-and-trade schemes, rather than by their intrinsic capacity to remove carbon. As a result ETS credit prices oscillate wildly – from as high at €13/tonne to as low as €6.35/tonne, purely in response to changes in supply.
Nevertheless, the cap-and-trade credit approach has one major advantage that must not be understated: the centralised issuance and regulation of these credits lends them a guaranteed recognition which, as will be seen, other forms of CCs struggle to achieve.
This piece was originally published in the Oxford Business Review