Back in 2007 Redshaw Advisors’ founder Louis Redshaw’s exciting prediction was quoted by the International Herald and Tribune and the New York Times. Since then a lot of people have jumped on the carbon investment bandwagon and created a number of products to help people take advantage of some of the opportunities that this new market creates. There have been some truly ground breaking efforts. Yet, as we describe below, there are some who have used the quote above to legitimise investment products that are ground-breaking for the wrong reasons. We in the Tov Energy Ltd dedicated to helping people that might be tempted to invest to understand more about carbon credits.
GOOD CARBON
Good carbon markets are characterised by a government regulatory requirement to account for a company’s greenhouse gas (GHG) emissions by submitting a suitable number of carbon emissions ‘certificates’, ‘credits’ or ‘permits’ to the government. Consequently what constitutes compliance with this regulation-based objective (and what does not) is generally clear cut. For example, in the EU Emissions Trading Scheme the base ‘currency’ is the EU Allowance (EUA), while in California it is the California Carbon Allowance (CCA). Both types of credit are generated and issued by governments. This clarity of purpose and provenance, coupled with a need from the regulated end-users (e.g. power companies and heavy industry), creates trading liquidity. A market is said to be liquid if it trades a large volume on a daily basis, has a low spread between offers to buy and sell, has a large number of creditworthy participants, substantial volumes can be traded without moving the market, price availability is high and transaction costs are low. The EU ETS is the world’s largest emissions trading system and liquidity is exceptionally good for the EUAs that are its currency. For an investor good liquidity means that they can invest in those carbon credits at relatively little cost and that if they change their mind they can reverse the trade for a similar cost.
In sum, good carbon investments are made in carbon markets where an investor can form a view that carbon credits will be scarce in the future and, crucially, they can change their mind for a relatively small transaction cost.
At a glance: official carbon trading systems and their ‘currencies’
| EU Emissions Trading Scheme | EUAs (offsets: CERs, ERUs) |
| US RGGI | RGGI credits (offsets: none) |
| US California | CCAs (offsets: CCOs) |
| New Zealand | NZUs (offsets: CERS) |
BAD CARBON
In regulated carbon trading markets, other types of carbon credit can sometimes be used in place of the base ‘currency’. These carbon credits are typically referred to as ‘offsets’ and originate from carbon reductions outside of the regulated industries. The offsets that can be used are clearly identified by the technical regulations and the number of offsets that can be used are restricted. In recent years, the EU ETS market has been flooded by Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs), consequently these offsets currently trade at around 2% of the value of EUAs. These carbon credits can also be issued by governments (or the United Nations (UN) in the case of CERs) and liquidity can be good. Yet, because there is less long term certainty about the supply and demand for offsets, investment in them is risky and best left to specialised carbon companies.
Any other kind of carbon credit is measuring something that is not part of a regulatory system. Because the certification processes for these credits aren’t mandated by laws there is less certainty about the validity of the carbon certificate, and there is no regulatory requirement for those certificates. This means that there is unreliable demand for the certificates and markets in them suffer from poor liquidity so investors can’t tell whether the price they are being offered to buy or sell is a good one, for the average investor they are often almost impossible to sell.
There is a case for emissions reductions taking place outside of regulated systems. There are also some companies doing excellent work in this space – such as the Gold Standard Foundation which is a standout example. However the demand for these kinds of credit is not from government regulated emissions trading systems but from corporate offsetters that want to manage their carbon footprints. Consequently liquidity is much less dependable than in compliance driven markets as they trade infrequently thus investment involves more risk for investors. Because liquidity is low price transparency is low, transaction costs are high and the large variety of project types makes any reported prices potentially meaningless if you’ve got the wrong kind of carbon credit. So while there is some kind of market for this type of carbon credit, it is not a liquid one, and for this reason they make a bad investment proposition for all but the most specialised companies.
The objective of a carbon market is simple: control and ultimately reduce GHG emissions. There are a large number of gases that contribute to global warming and can be classified as greenhouse gases. The UN Kyoto Protocol legislates for six gases, of which the leading contributor to anthropogenic climate change is carbon dioxide (CO2). Indeed the global warming potential of other GHGs is measured in terms of carbon dioxide equivalent (CO2e). Consequently most discussions relating to reducing GHGs tend to default to CO2 or “carbon” emissions even when other gases are involved. There are two ways to control GHG emissions: command and control (ie regulating individual sources of carbon at the smokestack) or market based mechanisms that provide a financial incentive to reduce emissions. Thanks to the EU’s pioneering Emissions Trading Scheme governments around the world are increasingly concluding that well designed market based mechanisms are by far the most efficient method to achieve emissions reductions. The global carbon markets are on the cusp of a rapid and large expansion as China, the US and other countries such as South Korea wake up to the need for a solution to anthropogenic climate change.
UGLY CARBON
The lack of price transparency and liquidity of ‘bad’ carbon investments, coupled with the large variety of carbon credits on offer, provides a fertile ground for less scrupulous financial advisers and sales people. They buy the carbon credits that no-one else wants for next-to-nothing and pass them off as mainstream carbon credits that can be (or soon can be) used for compliance in the regulated markets.
Some of these companies have used the quote at the top of this page as a thin veil for worthless carbon credits that they attempt to offload to less experienced investors, this very fact is the motivation for writing this article. Investment in any carbon credits is speculative but unlike compliance driven carbon markets, where sensible supply and demand analysis can be done and a view taken, analysis and price views of the offset market are very unreliable. Couple this with there not being a liquid market to cash in an investment and ugly carbon markets are a very risky proposition. Private investment should be avoided. To underline this point, despite being seasoned professionals in the carbon market, Redshaw Advisors do not have any investments of its own in un-regulated carbon markets.
