Carbon pricing and carbon allowances

_  Carbon emissions are one of the biggest market failures as the damage caused to current and future generations and nature is not accounted for by entities causing emissions. A carbon tax or a cap-and-trade market internalizes this negative externality into business and investment decisions. Carbon pricing is a business opportunity, is a cost efficient and effective policy for cutting emissions and can be designed to be fair to all stakeholders^[1].

_  After many years of dormancy, global carbon markets have sprung to life with Europe at the heart of this awakening. EU carbon prices^[2] hit an all time high of EUR90/tonne, a 355% increase since March 2020. EU carbon allowances were by far the best performing asset class in 2021. We also find that carbon returns are normally distributed, have declining volatility, but, may not yet offer significant equity portfolio diversification benefits

_  Despite the risks of a price reversal after such a powerful rally, structural forces are likely to drive prices even higher over the medium term as carbon markets become an even more important tool for net zero targets. We project the EU price will stay around ~€80 for the next two years, reaching €100 in the second half of the decade 2030. Policy intervention risk does exist, but could undermine market confidence and the price and hurt decarbonisation efforts.^[3]

_  Governments are strengthening carbon markets: China launched its national market last year, Europe plans to require importers of major manufactured products to buy carbon allowances and a new global carbon market agreement was reached at the UN climate summit COP26, which could help revive the international traded market in carbon^[4]

_  However, less than 4% of global emissions are regulated by a carbon price above US$40 per tonne CO_2e which is at the bottom range of what is deemed to be required to meet the Paris climate agreement^[3]. The Bank of England has warned companies to be ready for US$150/t carbon price^[5], while some companies internally^[6] use US$200+/tonne. The cost of developing carbon capture and storage technologies may require carbon prices to be higher still^[7]

_  Institutional investors can access the EU carbon market through an exchange traded commodity (ETC) backed by EU allowances, that could be used to complement a net zero focused public equites fund. Investors also have a role to play encouraging governments to strengthen policies and encouraging companies to lobby in favour of carbon markets

_  Compared to offsets and futures on carbon allowances, buying EU allowances may create a real-world emission reduction through a price effect and allowance cancellation through the EU Market Stability Reserve. Three different reports^[8] conclude that holding one EU allowance for ten years permanently prevents 0.82 to 1.48 tonnes of CO₂ although no assurance can be given that any forecast or target will be achieved.

_  This report focuses on the EU Emissions Trading Scheme, explores EU carbon allowances as a distinct asset class and examines actions by governments, companies, and investors.

We are also publishing an accompanying report which is an all you need to know guide to carbon markets. And in future months we will examine the carbon price implications in real estate and infrastructure, whether stronger carbon prices and policies are reflected in equity market valuations and the relevance of carbon markets for bond investors

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