How to Get Exposure to Carbon Markets
Decoding Carbon Markets: The Seamless Dance of Futures and Physical Allowances
In the constantly evolving landscape of global finance, carbon futures are not only becoming increasingly significant but are also offering intriguing investment opportunities. As the planet grapples with the challenges of climate change, financial mechanisms like carbon markets provide an avenue to both combat global warming and present valuable investment avenues.
The Nexus of Futures and Their Underlying Markets
At the very core, futures contracts are inherently linked to their underlying markets. For many commodities or assets, the futures market is essentially the de facto market. This relationship is amplified when it comes to physically settled futures contracts, like those of carbon. Here, the maturity of the futures contract sees a tangible transfer of carbon allowances from sellers to buyers. This ensures a persistent alignment between the price of the futures contract and that of the physical carbon allowance.
Driven by this, there's a continuous arbitrage at play. This involves trading futures against their underliers, ensuring a seamless pricing equilibrium between futures, the carbon allowance auctions, and the secondary market. The outcome? Remarkable consistency in performance and volatility, held in check by market mechanics. For investors, futures present an enticing option, courtesy of their liquidity and cost efficiency.
The Grandeur of the European Union Allowance (EUA) Market
If one were to spotlight this concept, the EUA market shines brightest. It stands as the behemoth of carbon markets. Consider the statistics: In 2022, the EUA futures market registered a trading volume of a staggering $628.9 billion. When juxtaposed against a primary auction cap of around €136.1 billion ($149.1 billion) and a circulating allowance count of €102.1 billion ($111.9 billion), the futures market's liquidity and price discovery prowess become evident.
European carbon auctions, occurring multiple times weekly, are set at a single price each day. In stark contrast, US carbon markets only orchestrate four auctions annually. The European carbon futures, however, buzz with activity, witnessing intraday trades every business day. While the auction and futures prices might diverge daily, consistent arbitrage ensures their convergence over time.
For the data aficionados, the relationship can be elucidated further. Figure 1 illustrates the minute average price difference, calculated using the daily returns difference between futures and physical contracts. Delving deeper, Figure 2 paints a picture of a strong positive correlation of 97% between futures and physical markets, signifying near-identical price movements.
Busting Myths: Volatility and Futures
Contrary to popular belief, futures markets aren't more volatile than their physical counterparts. A consistent 45% volatility is observed using daily data, with monthly data showing similar figures for futures (37%) and physical auctions (35%). Concerns around the so-called "cost of carry" or "contango" can be laid to rest. Figure 4 demonstrates the minimal price discrepancy between auctions and the forward price.
Interconnectivity in Carbon Markets
The synergy between futures and physical markets isn't mere coincidence. It's the result of their mutualistic relationship within the carbon liquidity ecosystem. Their operations are so intricately linked that their price signals become reciprocal. And this isn't just theoretical. In practical terms, each futures position is bolstered by physical allowances in the market.
This symbiotic relationship is exemplified in three primary scenarios:
An investor buys a future, with a bank on the opposite end. The bank, now short, hedges by purchasing physical allowances.
A natural hedger, such as a power station, counters the investor. They essentially transfer their physical risk to the investor.
A naked short seller positions against the investor. Even in this rarer scenario, the underlying physical position remains steadfast.
Collectively, these pathways strengthen the market position, as seen in the KraneShares suite of carbon ETFs, which fortifies the carbon allowance market by a commendable $900 million.
Positive Impact on the Horizon
The congruence of futures and physical markets underscores their pivotal role in driving climate-positive actions. By bolstering price discovery, these markets make pollution more costly, incentivizing rapid decarbonization. Holding strategic long positions in allowances ensures that polluters face heftier prices to obtain allowances, prompting them to curtail emissions swiftly.
Carbon ETF Opportunities
With the inextricable link between futures and physical markets established, the next step is clear: participation. The KraneShares suite of carbon ETFs offers a gateway into this dynamic realm. The flagship fund, the KraneShares Global Carbon Allowance Strategy ETF (KRBN), provides a composite of the most liquid carbon markets. For those seeking specificity, the KraneShares European Union Allowance Strategy ETF (KEUA) and the KraneShares California Allowance Strategy ETF (KCCA) focus on the EU emission trading system and California program, respectively.
