As well as helping to mitigate our impact on the environment, carbon credits form a prudent investment. This article by Oliver Harris a senior analyst at Strategic Carbon Solutions provides an overview of everything you ought to know about carbon investments prior to entering the market.
Within the investment community, carbon credits are very much in vogue, thanks to their propensity for generating generous returns. The fact that they also boast impeccable green credentials doesn’t hurt either. Is the carbon market a serious proposition, or is it another bubble that’s set to burst?
In spite of what some brokers would have you believe, there are no guaranteed returns on carbon credits. As brokers such as Strategic Carbon Solutions Ltd frequently stress, the market has its plus points, but it has its drawbacks too. When used correctly, however, carbon credits can provide substantial returns.
The history of the carbon market
The carbon market was essentially conceived in 1997 as part of the Kyoto Protocol, under the stewardship of the UN. The goal was to address climate change via the creation of a global commodity market. In the subsequent years, this market has grown exponentially, luring investors from around the world, all of whom have been eager to capture their piece of the pie.
With 190 national signatories, the Kyoto Protocol formed a global agreement that aimed to monitor, mitigate and reverse climate change. It had long been recognised that greenhouse gases play a crucial role in controlling our atmosphere.
When the Kyoto Protocol was conceived, its focus was understandably on capping the emissions of the worst polluting nations. Working within a capitalist framework, it was accepted that the best way to incentivise developed nations to reduce their emissions would be via a system that included financial incentives for doing so.
A comprehensive system was subsequently devised for rating all of the various greenhouse gases in terms of their effect on the atmosphere. A standard unit was conceived for the purposes of measuring greenhouse gas emissions. Recorded in metric tonnes, once carbon credit equals one tonne of carbon dioxide - or similar greenhouse gas - that is prevented from being released into the atmosphere.
Businesses are able to participate in approved projects that help achieve emissions reductions. These may take the form of certified projects such as reforestation or replacing carbon-intensive energy sources with hydro or wind-powered equivalents.
Each tonne of CO2 or similar greenhouse gas that is sequestered equates to one carbon credit, as awarded by the United Nations Framework Convention for Climate Change (UNFCCC). These credits can then be sold on like any other asset.
Businesses who fail to reduce their emissions to an agreed level, either willfully or through not taking sufficient action, can avoid being penalised by purchasing carbon credits. These essentially offset the environmental damage caused by their general business operations.
The offsetting of pollutants and transference of carbon credits for this purpose forms the Clean Development Mechanism (CDM).
By purchasing such credits, companies can offset their emissions. At the point of purchase, the emissions are ‘retired’. The company that has acquired them can then state that it has financed the offsetting of a specific number of tonnes of carbon.
If a company that produces 10,000 tonnes of carbon per year were to neutralise its emissions, it would have to purchase 10,000 carbon credits which would represent 10,000 tonnes of carbon emissions. In doing so, it would become carbon neutral.
Before entering any financial market, it pays to take due diligence to understand its peculiarities and inherent risks. Investors eyeing the carbon market should first come to terms with the differences between the various carbon markets. Understanding these is crucial to understanding how to profit from trading carbon credits.
The UN carbon credit scheme is divided into a number of regional markets in which companies are compelled to buy credits. Within a zone such as the EU, companies are assigned a maximum quota of pollutants that they are entitled to emit. If the company ‘under-pollutes’, it will be awarded credits, while if it ‘over-pollutes’, it will be obliged to purchase credits to compensate.
This constant supply and demand is what drives the carbon credit market. There are a number of types of mandatory credits available, including EUAs (European Union Allowances) as well as Certified Emissions Reductions (CERs), which are derived from the Clean Development Mechanism (CDM). All of these mandatory credits are traded within the compliance market.
There have been a number of bold - veering on wildly optimistic - predictions made about the future performance of the carbon market, buoyed by the promise of government-imposed ‘floor prices’ that will result in higher prices. The majority of brokers who are emphasising this, however, will be selling Voluntary Emissions Reductions (VERs), which are traded differently.
The hype that some brokers have applied to the carbon market is unnecessary, because the voluntary market in which they operate is performing well. Investors seeking to make their first tentative steps into the carbon market would do well to consider VERs as a prime point of entry.
Before making a firm commitment to the carbon market however, there are pitfalls that every would-be-investor would do well to heed. Brokers such as Strategic Carbon Solutions Ltd endeavor to provide complete disclosure on the risks that may be inherent with investing in the carbon market.
Two primary markets
Across the globe, there are a number of zones where mandatory emission control systems are in place. Large companies who emit pollutants are obliged to purchase carbon credits to mitigate these greenhouse gases. For smaller firms, however, there is no obligation to offset their emissions. Nevertheless, some of these small businesses choose to purchase carbon credits for a number of other reasons.
For one thing, offsetting carbon emissions is seen as socially responsible. For the purposes of CSR, many businesses are happy to be seen offsetting their emissions voluntarily. Other businesses choose to offset their emissions in readiness for anticipated legislation that will oblige them to do so sooner or later. VERs are also seen as an attractive investment option in their own right, further enhancing their appeal.
Businesses can achieve their environmental and social goals through purchasing VERs. Voluntary carbon credits come in a number of forms, and are derived from a range of suitable project types.
Anyone seeking to invest in the carbon market would do well to acquaint themselves with the attributes and idiosyncrasies of the voluntary and compliance markets. It would also be prudent to learn the manner in which different carbon credits are priced.
Voluntary projects can be derived from a number of renewable energy projects including biomass, hydro and wind turbines. When the project has reached a phase where a suitable level of emissions has been achieved – or has generated enough power to lower the demand for a fossil fuel alternative – carbon credits are awarded.
Awarded on a one-to-one ratio, each credit equates to a tonne of CO2 or equivalent greenhouse gas that has been removed from the atmosphere. At this point, the project owner can sell these credits to a polluting corporation, government or to an individual investor. Whereas businesses and other entities participate in the compliance market because they are obliged to do so, their participation in the voluntary market holds no such stipulations: anyone can choose to purchase VERs, irrespective of their status.
As a carbon brokerage Strategic Carbon Solutions Ltd acts as, a broker negotiates the sales of carbon credits, acting as a middleman who can liaise with the polluting company that is selling them and potentials buyers. Top brokers such as Strategic Carbon Solutions Ltd will have extensive experience of sourcing the best projects and credits. They will have a proven track record of helping investors to profit from the carbon credit market. In addition, good brokers will have close links with a range of carbon offsetters from whom they can acquire credits.
By purchasing credits at wholesale prices, the broker can then sell these on to interested parties, thereby creating a fluid trade. Carbon credits within the voluntary market are traded over the counter (OTC) i.e. there is no fixed rate for them. This means that the value of any trade will be based upon a price that the broker believes to be achievable.
Brokers blessed with a wealth of industry contacts will be in a position to secure the best possible prices on the credits they acquire on behalf of their clients. Most brokers will generally aim to make a fixed profit as a percentage of the sale, although this rate may vary depending on a number of market conditions.
Market regulations
The spot trading of commodities is largely unregulated by the FSA. Because carbon credits are classed as commodities, they similarly fall into this category, and are subject to little regulation. This may cause some putative investors to steer clear of the carbon market altogether. However, just because a market isn’t regulated by the FSA doesn’t mean that it should be avoided – after all, the property and precious metals markets don’t involve the FSA, and yet both can yield generous returns.
Carbon brokers who are affiliated with the FSA are generally perceived more favourably, as FSA regulation indicates a high standard of due diligence. Some carbon brokers elect to entrust their portfolio to an account held by an FSA-regulated company. This company then becomes the legal custodian of the clients’ carbon credits. The advantage with this is that in the event of the carbon brokerage failing, the clients’ credits will still be safe.
Some carbon credit brokers are affiliated with SIPP providers who are regulated by the FSA. That SIPP providers should consent for their pension assets to be invested in the carbon market indicates the level of faith that it commands. Ordinarily, profits generated from the sale of carbon credits would be taxable as capital gains. However, individuals who elect to purchase these credits within the SIPP framework will be able to enjoy tax exemption.
VERs can of course accord to a number of standards, including the Verified Carbon Standard (VCS). This popular carbon standard is viewed as the benchmark that carbon credits should adhere to. In 2010, the VCS was the top carbon profile, with 34% of transacted volume. The vast majority of this (some 86%) occurred in developing countries.
The gold standard is another popular carbon standard. It attracts a premium on the basis that it applies more rigorous standards to the environmental projects it approves. As well as assessing the environmental credentials of the project in question, it considers the impact that the project will have on the local community.
In recent years, there has been a tendency to shun the compliance market, with investors lured by the more attractively-priced voluntary market. The voluntary market is easier to enter, and more affordable than its compliance counterpart.
The carbon market is a unique market – one in which huge environmental benefits are manifested. However, that is not to say that all investors will harbour strong environmental credentials. Many will simply be looking for the best possible return on their investment.
Spot trading voluntary carbon credits is now a thriving industry that attracts speculators from across the globe. As carbon brokers throughout the City start to show a profit, speculators are seeing a return on their investment. When the broker sells credits for a higher price than they were purchased for, a profit is generated.
As a commodity, the demand for carbon credits appears to be showing no signs of letting up. Credits have a tangible value to businesses who engage in offsetting, while investors view the same credits as a potentially lucrative opportunity.
When contemplating an investment in the carbon market, it is important to choose which brokerage company to work with. Not all companies can be relied upon to provide complete transparency about the risks that are inherent to any investment. Any investor should take the time to understand the risks that may be associated with the carbon market prior to acquiring a portfolio of credits.
If the investor is fully aware of the pros and cons of the carbon market, they will be able to invest with confidence, knowing that they are fully prepared for every possible eventuality. With the right approach, it is possible to enjoy a substantial ROI within the carbon market.
The future
Provided global governments continue to limit the amount of carbon that companies may emit, demand for credits will remain strong. Based on current trends, the carbon market looks set to continue enjoying steady growth.
One of the most interesting trends of late is for social responsibility to be seen as the driving force that is determining corporate policy. Provided the broker is honest and frank about the level of risk associated with the carbon market, it is an attractive proposition that investors would do well to consider.
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