Can EUAs protect your portfolio against inflation?

Inflation threatens portfolios as it diminishes purchasing power of money over time. It can be seen through many facets of our life -  groceries, energy markets, investment... And European Union Allowances (EUAs) are here to help. 

Hedging in finance is a tool to mitigate such risks by diversifying investments across different assets, industries, or geographic regions. EUAs can be a great hedge against inflation due to their unique characteristics as a financial asset. Driven by regulatory decisions and broader energy market dynamics, EUAs are effective for diversification and are uncorrelated with many traditional financial indices. Researchers confirm that EUAs are a reliable hedge against unanticipated inflation movements, thanks to their market engineering.

• Is inflation a threat to my portfolio? 
• What is a financial hedge in investment? 
• Why are EUAs a good hedge against inflation?

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Is inflation a threat to my portfolio? 

What is the definition of inflation? 

Inflation is the rate at which the prices of goods and services rise over time, reducing the purchasing power of money. For example, if inflation is 3% per year, an item that costs $100 today will cost $103 next year. This means that the same amount of money buys less than it used to, affecting everything from groceries and gas to rent and salaries. Central banks aim to control inflation to ensure the economy remains stable and that people can plan their household expenses for the future.

How is inflation affecting my financial returns?

Inflation can affect your investment returns by eroding the purchasing power of your money over time. When the rate of inflation exceeds the rate of return on your investments, the real value of your returns decreases. Moreover, high inflation may prompt central banks to raise interest rates - this has a negative impact on traditional fixed-income investments like government bonds. 

Inflation and financial markets

Like we mentioned above, inflation can be detrimental to fixed income traditional assets, as the purchasing power of their fixed interest payments decreases. On top of this, inflation can influence stock market performance, with some sectors facing increased costs and reduced profitability. 

Inflation and energy markets

There is a correlation between energy prices and inflation - the energy component plays an important role in driving inflationary pressures. For example, following the onset of the war in Ukraine in 2022, inflation in the EU reached its peak, and this was almost simultaneous with the peak in gas prices. 

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What is a financial hedge in investment? 

Definition of a hedge in finance

A hedge in finance is a strategy to reduce the risk of price movements that can be detrimental to one’s portfolio returns. We can see it as an insurance policy against potential losses. For example, an investor might believe that the services sector is about to enter a period of decline, and may want to “hedge” their portfolio against this particular risk.

How does hedging work? 

Hedging an investment involves acquiring another financial asset with the intention that any losses incurred by one asset can be balanced out by gains in the other. This strategy aims to mitigate the overall risk exposure of the portfolio by diversifying across different assets. This is what we call “diversification” - the strategy of spreading investments across various asset classes, industries, or geographic regions to mitigate risk. 

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Why are EUAs a good hedge against inflation?

EUAs and investment diversification 

The price of EU Allowances (EUAs) in carbon markets are influenced by regulatory supply and demand decisions within the European Union's emissions trading system (EU ETS). Other factors like fluctuations in gas and broader energy markets, industrial activity, and weather patterns also play a role. As investors seek to diversify their portfolios with green investments, EUAs stand out - they have a proven impact on emissions reduction, and are reliable when it comes to the environmental integrity of investment portfolios. EUAs are not correlated with most major traditional financial indices and play a good role for diversification purposes.  

EUAs as a hedge against inflation

“EUAs are able to provide a hedge against unanticipated inflation rates.” is the main finding of a research paper by Angel Pardo published in 2021. In their earlier work, Medina and Pardo, also characterize EUAs as a “new asset class” as they sometimes act like a commodity, but are also subject to regulatory changes - this makes them a good tool for diversification. Both studies suggest that carbon allowances are a good inflation hedge, especially against unexpected inflation moves, thanks to their structural engineering (mix between policytool and free market dynamics). 

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Key Takeaways 

• Inflation can threaten investment portfolios by eroding purchasing power over time.
• Hedging in finance helps mitigate risks by diversifying investments.
• EU Allowances (EUAs) are an effective hedge against inflation due to their unique characteristics.
• They offer diversification benefits and are uncorrelated with most traditional financial assets and indices.
• Inflation reduces the value of money, prompting central banks to control it.
• A financial hedge reduces the risk of price movements. It involves acquiring new assets to balance potential losses.
• EUAs contribute to emissions reduction and serve as a good hedge against inflation.

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