What is a carbon ETF and why are spot EUA investments better?

The European Union Emissions Trading Scheme (EU ETS) is a policytool aiming to fight against global warming. It is a cap-and-trade system with a primary and secondary market for European Carbon Allowances. There are different financial assets and derivatives related to the EU ETS like spot contracts or futures. Participating in EU carbon allowance futures markets can be challenging due to logistical and regulatory barriers. So, EU carbon allowances ETFs have facilitated investor access to these markets by “encapsulating EUA futures contracts” and offering exposure to their price movements. However, it's important to note that participating in the EUA futures markets through ETFS is solely for financial speculation objectives and lacks direct environmental impact. 

• Understanding EU Carbon Allowance ETFs : Back to the basics
• Why Invest in EU Carbon Allowance ETFs?
• EU carbon allowance ETFs are not green investments

How do carbon ETFs work?

What are EU Carbon Allowances? 

European Union Allowances (EUAs) are the financial assets (as defined per the Mifid II regulation) used within the EU Emissions Trading Scheme (EU ETS). The system is the backbone of the bloc’s climate regulation policies. The purpose is to make it expensive for industrial plants to release carbon emissions and incentivize them to invest in decarbonization technologies instead. Compliance actors must buy a sufficient number of allowances to match their CO2 emissions volumes, and the total number of available allowances is engineered to gradually decrease over time. EUAs are issued by regulators and can then be traded on the secondary market. 

What is an ETF?

ETFs are a financial instrument. They can be seen as investment baskets, where an entity gathers various financial assets into a single package. The value of this package, or ETF, tracks the movements of its underlying components. For instance, if an ETF is evenly composed by Apple and Tesla stocks, and Apple rises by 20% while Tesla falls by 10%, the overall performance of the ETF would be +10% on that day. 

Can you invest in carbon with ETFs?

EU Carbon Allowance ETFs allow investors to gain exposure to the carbon market price fluctuations. The idea is to create a “capsule” allowing investors to benefit from potential upsides in EU Carbon Allowance Futures upside, or make them incur losses if there are market downsides.

What are the carbon ETFs?

Various ETFs track different carbon-related products, not all of them are focusing on the EU ETS. Here are some examples:

• The KraneShares Global Carbon Strategy ETF provides exposure to global cap-and-trade markets, including EUAs, CCAs, RGGIs, and UKAs, 
• The KraneShares California Carbon Allowance Strategy ETF focuses solely on the California carbon markets. 
• There are also ETFs that track voluntary carbon markets, such as the Global Carbon Offset Strategy ETF. 

Given their nature as a financial tool that can be structured depending on the creator’s objectives, ETFs can integrate different markets at the same time. However, all currently existing EU carbon allowance ETFs enable investors to get exposure to EU ETS Futures price fluctuations, and not the spot markets, as discussed further. 

Why Invest in EU Carbon Allowance ETFs?

EU Carbon Allowance ETFs to get financial exposure to carbon

EU Carbon Allowances ETFs offer investors a way to access EU ETS Futures prices through a “financial asset capsule”. Given the logistical challenges of directly participating in carbon markets, the existing ETFs provide a means for investors to track the performance of EU carbon markets Futures markets. By investing in those instruments, individuals can gain exposure to a market engineered for price appreciation, as seen below.

EU Carbon Allowance ETFs and Futures Markets

As discussed in other articles, there is a distinction between spot and futures assets within the EU ETS. While participating in the futures market lacks direct environmental impact, engaging in the spot market contributes to EU decarbonization efforts. It's worth noting that EU carbon allowance ETFs accessible to individual investors primarily track futures markets (involving transactions solely with futures contracts on the side of the ETF issuer). So, there is no impact on the cap (or carbon budget available to industries), no limitation of the carbon budget available to the European industrials, no environmental impact. The primary goals of investors in EU carbon allowance ETFs are financially driven, aiming to capitalize on market fluctuations and generate returns from their investments. 

EU carbon allowance ETFs and historical financial returns 

The EU ETS is designed to see its prices rise, serving as a crucial policy tool for decarbonization efforts. This appreciation is evident in the upward trajectory of EUA prices, which have been steadily increasing since the scheme's inception. A decade ago, prices hovered around €5, whereas presently, they exceed €50, as shown on the graph below. You can find a full explanation of the EUA historical price moves here. 

So, broadly, carbon-related ETFs that offer (an at least partial) financial exposure to the EU ETS have generated positive returns. For example, over the past five years, KRBN has shown a performance of +42.71%. However, not all such financial assets have proven to be profitable, depending on their underlying components - for example, RENW, an energy transition strategy ETF having a part related to carbon markets, decreased by 42.9% over the past 5 years. 

Diversification and Risk Management Benefits

ETFs are a financial tool and respond to different trading and speculation objectives. One of those can be portfolio diversification - carbon markets do not behave like traditional stocks and bonds markets. 

By including carbon ETFs in their investment strategy, investors can spread risk across different sectors - once again, participants in the EU carbon allowance futures ETFs do not seek positive environmental impact. 

EU carbon allowance ETFs are not green investments

As highlighted, existing EU carbon allowance ETFs solely engage with the futures market, lacking direct environmental impact. These ETFs do not involve transactions of actual carbon allowances, do not have a holding effect, nor any direct impact on spot EUA prices through an increase in demand. Therefore, investing in EU carbon allowance ETFs is predominantly a financial decision rather than an environmentally friendly one, emphasizing personal choice and priorities in investment strategies.