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European Union Allowances (EUAs) stand apart from traditional assets and have a unique diversification advantage. Adding carbon allowances to an investment portfolio can not only lower financial risk but also play a crucial role in the global fight against climate change.
European Union Allowances (EUAs) stand apart from traditional assets and have a unique diversification advantage. Adding carbon allowances to an investment portfolio can not only lower financial risk but also play a crucial role in the global fight against climate change.
Unlike traditional financial assets such as stocks or bonds, EUA prices are driven by a multiplicity of factors unique to the carbon market, like regulatory decisions, energy market fluctuations, weather conditions... There is no other market that is built with a mission - decarbonization - and that is influenced by such a combination of diverse elements. This distinctiveness makes EUAs often operate in a world of their own, often resulting in a low correlation with conventional assets. For instance, in 2023, the correlation between EUAs and other assets was notably low, with coefficients such as 0.0943 with coal, 0.0453 with US treasuries, and -0.1202 with gold.
EUAs can act as a hedge against inflation, which is an important consideration to have for investors. When gas prices rise, inflation tends to increase as well, due to higher energy costs being a significant factor in inflation calculations. And this, in turn, erodes purchasing power. However, rising gas prices can also push up EUA prices higher. This dynamic can help preserve or even enhance the value of an investment portfolio during inflationary periods, making EUAs a useful tool for managing inflation risk.
Diversification involves spreading assets across different investments to minimize risk. By including assets with low or negative correlation to traditional investments, such as stocks and bonds, investors can reduce the impact of poor performance in any one area. EUAs are particularly suited for this purpose since they are driven by factors that are distinct from those affecting traditional financial markets, as mentioned above.
Historically, EUAs have shown low correlation with traditional assets. However, there have been instances where this correlation increased temporarily. For example, at the end of 2023, EUA prices exhibited a strong correlation with gas prices due to overlapping factors affecting both markets, such as shifts in energy prices and fuel switching dynamics. Such periods of heightened correlation are usually short-lived and fall back down once EU ETS market participants focus back on carbon fundamentals. In the long run, the European cap-and-trade scheme is designed for price appreciation.
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