Retail investors have jumped into funds that are actively trading carbon credits/allowances, and have been handsomely rewarded.
The carbon credit market has also been attracting investor cash from environmentally conscious funds that are looking to invest in the transition away from fossil fuels.
Let’s find out whether investing in carbon credits the right move for you.
What are carbon credits/allowances?
Carbon credits or allowances are issued by the government, and allow companies to emit a certain amount of carbon dioxide a year. This credit is part of a cap and trade system that is aimed at incentivizing lower emissions.
A cap and trade system provides economic incentives for meeting emission targets. Typically, cap and trade system follows this general format:
- The regulating authority (eg. city/state/federal government) sets an aggregate emission cap per year which can decrease over time.
- The regulated parties (eg. power plants, oil producers, or even individual households) have to obtain allowances for emissions they generate in a particular year.
- Emission allowances, adding up to the total cap, are allocated to each party. This allocation could be based on historical emissions and/or via an auction.
- Parties can trade allowances. An effective “carbon tax” then emerges as the market price at which these carbon allowances trade.
Companies that exceed their carbon cap are fined. This results in companies having to reduce their carbon emissions, or having to purchase carbon credits from other companies who do not need them.
This system incentivizes companies to cut their carbon emissions as they can sell their excess carbon credits.
Investing in Carbon Credits
This cap and trade system has been in place since 2005, and there are futures markets for the carbon credits. For example, each futures contract could be an allowance to emit one ton of carbon dioxide by a particular date. Companies who don’t need their credits can sell them, and companies who need extra credits will buy them.
These futures contracts are how people are investing in and profiting from carbon credits. As an individual investor, you can purchase exchange traded funds that are buying/selling futures contracts on these carbon allowances.
Carbon Credit Investment Funds
Two of the best carbon credit investment ETF’s are the KraneShares Global Carbon ETF (symbol: KRBN) and the iPath Series B Carbon ETF (symbol: GRN).
Both ETF’s operate in a similar manner, so let’s take a close look at just KRBN to give you an idea of how it works. With KRBN, the ETF invests in carbon allowance futures contracts in the European Union, California, and some additional regional credits.
These markets cover the bulk of the most traded carbon credit futures contracts.
As the cost of carbon emissions rise, KRBN typically increases in value.
When investing in carbon credits, you need to realize that it can be a risky investment that is highly linked to government regulations. The fund only makes money if the price of carbon futures contracts goes up.
Trading in futures contracts is considered speculative and can be extremely volatile. Any changes in the cap and trade trade system can dramatically affect the value of futures contracts, so make sure that you are well diversified.
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