An Introduction to Carbon Markets

By Adam Solomon, Go-to-Market Strategy and Planning for Xfinity Growth.

Carbon Markets Overview

Carbon markets are quickly making their way to the forefront of Environmental, Social, and Governance (ESG) investing, as well as the finance community as a whole. The Kraneshares Global Carbon ETF, (Ticker: KRBN) (who’s holdings I’ll dive into shortly) was one of the top 5 performing ETF’s in 2021 on a % return basis (Ferringer, Best performing etfs of the Year - etf.com). However, it doesn’t appear that 2021 was a one-hit wonder for Carbon Markets, but instead, the beginning of a new and very real trend.

Whether we’re analyzing the private sector, or the most powerful governments in the world, it’s safe to say that the push for “net-zero emissions” and carbon-friendly policies is one that will continue to crescendo into the latter half of the decade and beyond.

In the private sector, some of the largest companies in the most carbon-intensive industries (from a greenhouse gas emissions perspective) have already publicly declared their net-zero targets. These industries include Oil and Gas (e.g., Shell, BP, Total, Chevron), Utilities (e.g., Engie), Steel (Nippon Steel), Cement / Construction Materials (Holcim, Boral), Automotive (e.g., Ford, General Motors, Volkswagen), and Beverage (e.g., Coca-Cola) (Geck, Seven major companies that committed to net-zero emissions in 2021 2021), (Murray, Which major oil companies have set net-zero emissions targets? 2020), (Our net zero climate pledge 2021), (Huebach, Auto industry's push for net-zero emissions 2021).

The private sector is not in this endeavor alone. There continues to be a substantial push from the public sector with the most powerful world leaders driving their economies towards net-zero emission targets and/or carbon tax policies. Countries with policies already in place include the United States, China, Canada, the UK, the Eurozone, Argentina, Mexico, Columbia, Chile, South Africa, and Kazakhstan (Map & Data).

Given the incredible collaboration between the private and public sectors to drive these new industry standards and policies, there are three subsequent questions a skeptical investor might ask:

1. Are carbon markets capable of solving the issue of greenhouse gas emissions?
2. What is the forecast / outlook for carbon markets?
3. How can retail investors allocate capital to carbon markets?

The Acid Rain Case Study (EPA, Acid Rain Program)

Let’s tackle the first question – Are carbon markets capable of solving the issue of greenhouse gas emissions? – using the famous acid rain case study.

The acid rain program began in 1995 in the United States, and was developed for the purpose of removing Sulfur Dioxide (SO₂) and Nitrogen Oxides (NO_X) from the atmosphere. SO₂ and NO_X are the two primary pollutants that drive acid rain. The initiative called for a ten million-ton reduction in SO₂ emissions, and a one million-ton reduction in NO_X emissions by the year 2020, using the 1980 emission levels as a starting baseline.

Similar to the carbon emission markets of present day, the SO₂ and NO_X markets leveraged a strategy that combined government policy with drastic changes to private sector operations. More specifically, there were two major components to this strategy, which resulted in the SO₂ and NO_X markets coming to fruition. The first component of this strategy was the emission reduction targets previously mentioned. These emission reduction targets were set by the United States government in collaboration with the Environmental Protection Agency (EPA). The second component of the strategy was the creation of the SO₂ and NO_X Cap and Trade Program. The Cap and Trade program laid the groundwork for establishing a market exchange that facilitated free-market pricing of SO₂ and NO_X (a detailed explanation of how Cap and Trade markets function can be found in the following sections).

The SO₂ and NO_X Cap and Trade program has been wildly successful. In short, the program resulted in a 93% reduction in SO₂, and an 87% reduction in NO_X as of the year 2020, all but wiping out the acid rain issue throughout the entire United States. If the SO₂ and NO_X cap and trade program can be replicated for carbon, it would appear that markets do have the ability to resolve the carbon emission problem domestically, if not globally.

Compliance Carbon Markets: The Carbon Cap and Trade Program

The carbon cap and trade market for trading carbon allowance credits (futures) is effectively identical to the SO₂ and NO_X cap and trade markets which successfully combated the acid rain issues across the United States. A visual of how this market functions for Carbon can be viewed in Figure 1 (Carbon Streaming Corporation, Compliance credits).

Local, state, or federal policy will dictate maximum emission limits (otherwise known as emission caps). For example, the California carbon allowance allocation for the year 2021 was just over 164 million metric tons (California Air Resources Board). A full breakdown of the various allocations that make up the 164 million metric tons can be viewed in Figure 2. From there, carbon emitters have the ability to buy or sell carbon allowance credits (futures) based on how many metric tons of carbon their operation emits into the atmosphere. Operations that emit more than the cap amount would look to buy carbon allowance credits from an organization who emits less than the cap amount. Operations that emit less than the cap amount would look to sell their carbon allowance credits to an organization that is emitting more than the cap limit. This market system incentivizes carbon emitting operations to reduce their carbon footprint. If they are unable to reduce their carbon footprint, they’ll be forced to pay for carbon allowance credits from organizations whose carbon emissions are below the government mandated cap. Additionally, there are various penalties (in the form of fines) that would be enforced if an organization does not meet the net cap limit, either organically through decreasing their carbon footprint via operations, or inorganically through purchasing carbon allowance credits.

Figure 1: Carbon Cap and Trade Diagram

(Carbon Streaming Corporation, Compliance credits)

Figure 2: California Carbon Allowance Allocation (measured in metric tons)

(California Air Resources Board)

Voluntary Carbon Markets (Carbon Streaming Corp, Voluntary credits)

The second portion of the modern-day carbon market is known as the Voluntary Carbon Market (or voluntary carbon offset credits). Voluntary carbon offsets are a new innovation to Carbon markets that were not part of the acid rain SO₂ and NO_X cap and trade program.

Voluntary carbon offsets can be generated by voluntarily financing /executing projects that reduce greenhouse gas emissions beyond an operation’s business as usual setup / jurisdiction. Carbon offset credits generated by such projects can be broken out into two categories.

The first project category is avoidance / reduction, such as forest conservation or greenhouse gas emission capture. The second project category is removal / sequestration, such as reforestation, wetland restoration, or direct air capture technology (Carbon Streaming Corp, Voluntary credits).

Carbon offset credits can be purchased by governments, public / private entities, or individual investors via some market or exchange. However, once a carbon offset credit is used to reduce the net greenhouse gas emissions of the operation to which it is being applied, those credits can no longer be traded (bought or sold), or applied again elsewhere to a different entity / operation. This holds true for both compliance carbon credits and voluntary carbon credits.

There are registries run by independent organizations that (i) verify voluntary carbon offset credits generated through “green” projects, and (ii) track the application of these carbon offset credits against an operation’s greenhouse gas emission levels such that offset credits cannot be re-used. The first organization of its kind to carry out this mission is the American Carbon Registry (American Carbon Registry, Our mission). Another highly reputable organization which carries out the same function is Verra (Verra 2022).

Investing Opportunities and Outlook (Katusa, Katusa Research 2021)

Finally, let’s tackle the second and third question posed earlier in the paper – What is the forecast/outlook for carbon markets, and how can retail investors allocate capital to carbon markets?

The following four charts from Katusa Research (Katusa, Katusa Research 2021) do a magnificent job of sizing up the Carbon market, as well as the market forecast/opportunity in the coming decades.

The first chart (Figure 3) shows a count of the companies pledging to go “carbon neutral” or “net zero emissions” as of mid 2021. The chart also shows the companies (reported) scope 1 emissions, measured in billions of metric tons. This data was aggregated from Bloomberg Company Filings. Scope 1 emissions are any greenhouse gas emissions produced directly from a company’s operations (Makeev, What are Scopes 1, 2 and 3 of carbon emissions? 2021). The detailed definitions for scope 1, scope 2, and scope 3 emissions can be found using source 13. The year-over-year trend of companies pledging to go “carbon neutral” is increasing rapidly.

The second chart (Figure 4) shows the value of green bond issuance, year-over-year, measured in billions of USD. This chart indicates two very important trends. First, the bond market is demonstrating their belief in the growth of the green economy. Second, by combining the trend of companies pledging to go “carbon neutral” with the trend of green-bond-issuance, one can deduce that markets agree that the weighted average cost of capital (WACC), or cost to borrow, will continue to be tied to a company’s carbon emissions for years to come (Katusa, Katusa Research 2021). In other words, companies who are able to decrease their carbon footprints will be rewarded with lower borrowing costs, directly increasing margins and EBITDA.

The third chart (Figure 5) shows approved green stimulus packages by governments as of March 15^th, 2021 (Katusa, Katusa Research 2021). Given the success of the SO₂ and NO_X cap and trade program, and the re-application of this strategy to carbon markets, it is likely that these values, as well as the number of participating governments, continues to grow.

The forth chart (Figure 6) shows a forecast for the size of the carbon market, compared to other substantial commodity markets. This chart also illustrates the growth of the carbon market from present day, to the year 2030, and ending in the year 2040. (Katusa, Katusa Research 2021). The potential growth of this market is startling, especially when compared to the oil market, which has been the predominant energy / commodity market globally for 100+ years.

Figure 3:

(Katusa, Katusa Research 2021)

Figure 4

(Katusa, Katusa Research 2021)

Figure 5

(Katusa, Katusa Research 2021)

Figure 6

(Katusa, Katusa Research 2021)

Next, let’s discuss just a couple of the investment opportunities for retail investors.

The Kraneshares Global Carbon ETF is the most accessible investment vehicle for investing in carbon markets. This ETF trades on the New York Stock Exchange (NYSE) under the ticker KRBN. This ETF is made up of a variety of carbon allowance futures from various regions and vintages, as well as cash. The specific holdings for the KRBN ETF can be viewed using source 14 (Kraneshares Global Carbon Strategy ETF: KRBN).

Another avenue for investing in the future of net-zero is through a company called Carbon Streaming Corporation. Carbon Streaming Corporation is one of the world’s first publicly traded companies that finances projects which generate carbon credits in the voluntary carbon market. They are listed on the Neo Stock Exchange in Canada, under the ticker NETZ. They also trade via Over the Counter (OTC) markets under the ticker OFSTF. The company plans to list on a major US stock exchange during the year 2022 (Carbon Streaming Corp, Company profile). The company’s mission is as follows:

“……Carbon Streaming is focused on acquiring, managing and growing a high quality and diversified portfolio of investments in projects and/or companies that generate or are actively involved, directly or indirectly, with voluntary and/or compliance carbon credits. By offering innovative financing solutions, the Company aims to accelerate the world’s transition to a net-zero carbon future by bringing capital to projects that might not otherwise be developed. Many of these projects may also have significant social and economic co-benefits in addition to reducing emissions as the Company aspires to make a sustainable impact beyond climate action with certain investments.” (Carbon Streaming Corp, Company profile)

Like any up-and-coming asset class / investment opportunity, there are significant risks and challenges that must be overcome in order for carbon markets to effectively combat greenhouse gas emissions globally. However, if we as a society are going to have any chance at solving this problem, it’s time to stop talking about the change, and instead, start being about the change.

The opportunity for investing capital to drive innovation in this industry is readily available. Like any risky investment, those who are willing to take the risk deserve the reward in the form of profits and shareholder returns. Do your own research, and learn about the risks before allocating capital, and don’t ever doubt the power of free markets and capitalism to optimize the resources we have at our disposal. If the juice is worth the squeeze, free market capitalism always finds a way.

Sources Cited:

1. https://www.etf.com/sections/features-and-news/best-performing-etfs-year?nopaging=1
   1. Ferringer, J. (n.d.). Best performing etfs of the Year - etf.com. Retrieved February 9, 2022, from https://www.etf.com/sections/features-and-news/best-performing-etfs-yea…
2. https://www.unpri.org/pri-blog/seven-major-companies-that-committed-to-net-zero-emissions-in-2021/9197.article
   1. Geck, M. (2021, December 20). Seven major companies that committed to net-zero emissions in 2021. PRI. Retrieved February 9, 2022, from https://www.unpri.org/pri-blog/seven-major-companies-that-committed-to-…
3. https://www.nsenergybusiness.com/features/oil-companies-net-zero/
   1. Murray, J. (2020, December 16). Which major oil companies have set net-zero emissions targets? NS Energy. Retrieved February 9, 2022, from https://www.nsenergybusiness.com/features/oil-companies-net-zero/
4. https://www.holcim.com/climate-energy
   1. Our net zero climate pledge. Holcim.com. (2021, December 15). Retrieved February 9, 2022, from https://www.holcim.com/climate-energy
5. https://industrytoday.com/auto-industrys-push-for-net-zero-emissions/
   1. Huebach, H. (2021, July 28). Auto industry's push for net-zero emissions. Industry Today. Retrieved February 9, 2022, from https://industrytoday.com/auto-industrys-push-for-net-zero-emissions/
6. https://carbonpricingdashboard.worldbank.org/map_data
   1. Map & Data. Carbon Pricing Dashboard | Up-to-date overview of carbon pricing initiatives. (n.d.). Retrieved February 9, 2022, from https://carbonpricingdashboard.worldbank.org/map_data
7. https://www.epa.gov/acidrain/acid-rain-program
   1. Environmental Protection Agency. (n.d.). Acid Rain Program. EPA. Retrieved February 9, 2022, from https://www.epa.gov/acidrain/acid-rain-program
8. https://www.carbonstreaming.com/about-carbon/compliance-credits/
   1. Compliance credits. Carbon Streaming Corporation. (n.d.). Retrieved February 9, 2022, from https://www.carbonstreaming.com/about-carbon/compliance-credits/
9. https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program
   1. California Air Resources Board. Cap-and-Trade Program | California Air Resources Board. (n.d.). Retrieved February 9, 2022, from https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program
10. https://www.carbonstreaming.com/about-carbon/carbon-offsets/
    1. Voluntary credits. Carbon Streaming Corporation. (n.d.). Retrieved February 9, 2022, from https://www.carbonstreaming.com/about-carbon/carbon-offsets/
11. https://americancarbonregistry.org/about-us/mission
    1. Our mission. American Carbon Registry. (n.d.). Retrieved February 9, 2022, from https://americancarbonregistry.org/about-us/mission
12. https://subscribers.katusaresearch.com/reports/generational-opportunities-go-public-financing/
    1. Katusa, M. (2021). Katusa Research. Retrieved February 9, 2022, from https://subscribers.katusaresearch.com/member-area/latest-issues/
13. https://plana.earth/academy/what-are-scope-1-2-3-emissions/
    1. Makeev, D. (2021, November 24). What are Scopes 1, 2 and 3 of carbon emissions? Plan A Academy. Retrieved February 9, 2022, from https://plana.earth/academy/what-are-scope-1-2-3-emissions/
14. https://kraneshares.com/krbn/
    1. Kraneshares Global Carbon Strategy ETF: KRBN. KraneShares. (n.d.). Retrieved February 9, 2022, from https://kraneshares.com/krbn/
15. https://www.carbonstreaming.com/about-us/company-profile/
    1. Company profile. Carbon Streaming Corporation. (n.d.). Retrieved February 9, 2022, from https://www.carbonstreaming.com/about-us/company-profile/
16. https://verra.org/
    1. Verra. (2022, February 7). Retrieved February 9, 2022, from https://verra.org/

All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.

About the Author:

Adam Solomon was born and raised ~30 minutes north of Detroit, MI in a town called Birmingham, MI. I attended Earnest W. Seaholm High School, and then Michigan State University, where I obtained a Bachelor’s of Science in Chemical Engineering, graduating December 2013. I completed two internships during my chemical engineering curriculum with Freeport McMoran Copper & Gold Inc. at one of the worlds largest copper mines in Safford, AZ. After graduating, I worked two years as the Lead Process Engineer and Project Manager at Remuriate Technologies, a hydrochloric acid manufacturing startup based in Birmingham, AL. From there, I transitioned to a Sr. Process Engineering role at Corning Inc. working at the largest optical fiber manufacturing facility in the world based in Charlotte, NC. While living in Charlotte, I was accepted to the University of North Carolina (Chapel Hill) Kenan-Flagler Business School, where I obtained an MBA in Finance. During my time at Kenan-Flagler, I also completed the Kenan-Flagler Leadership Development Program.

After my MBA, I moved to Philadelphia, PA where I currently work in Go-to-Market Strategy and Planning for Xfinity Growth. I am also a certified Six Sigma Green Belt – I really enjoy solving complex process-oriented problems. Aside from my professional endeavors, I am active in weight-lifting, ice hockey, golf, and tennis. My other hobbies include studying Mandarin Chinese, and Macroeconomics, with areas of emphasis including commodities / natural resources, carbon markets, agricultural real estate, and options trading strategies. I am happily married for just over 3 years to wife Mia.