An ongoing rally in the price of carbon futures has led to massive gains for a commodity ETP that targets the sector.
WisdomTree’s ETFS Carbon has gained 294.0% over the past two years.
The ETFS Carbon, which was taken over by WisdomTree as part of its acquisition of ETF Securities’ European ETP business in 2017, has posted a gain of 294.0% between 26 August 2017 and 27 August 2019, making it one of the best-performing commodity ETPs over the past two years.
Carbon ETPs track the price of carbon permits or allowances that are issued by governments, as represented by futures contracts. These permits allow the holder to discharge a specific quantity of carbon over a specific time period.
Polluters that want to increase their emissions must buy permits from others willing to sell them, thereby representing a market-based approach to controlling pollution.
In the case of ETFS Carbon, the ETP uses swaps to provide a total return exposure to movements in the price of ICE European Carbon emissions allowance futures contracts plus a collateral yield.
The ETP trades on London Stock Exchange in euros and pound sterling under the tickers CARB LN and CARP LN respectively. It comes with a management expense ratio of 0.49% and has approximately €25m in assets under management.
ETFS Carbon performance (26 August 2017 – 27 August 2019)
Carbon tailwinds
In a research note, Nitesh Shah, Director of Research at WisdomTree explains that carbon’s impressive recovery reflects the low base that the price of carbon allowances sunk to following the impact of the 2007/2008 Financial Crisis – carbon prices fell from over €30/tonne in 2008 to a low of less than €5/tonne.
Due to an oversupply of permits in the market, the EU has been steadily trimming allowance availability since 2013 by 1.74% per annum.
Yet the EU is under pressure to do more, having signed up to the Paris Accord – an agreement that promises to limit global temperature gains to 2 degrees Celsius. It has thus pledged to reduce the supply of carbon allowances by 2.2% per annum between 2021 and 2030.
Shah writes, “The European Commission is akin to the European Central Bank but instead of managing the money supply to target a level of inflation, it is responsible for adjusting the carbon allowances under the EU’s Emissions Trading System to target the appropriate level of carbon and other emissions to limit temperature gains.
“However, there is one clear difference we see – the European Commission will not be loosening policy in the near future because the target itself is likely to get more aggressive, unlike the inflation target which has not changed since it became a concept. We see policy tightening in the EU’s Emissions Trading System for the foreseeable future.”
While this outlook bodes well for further gains in the price of carbon, Shah highlights two key risks that may act as headwinds.
Firstly, Brexit adds a degree of uncertainty as the UK is a current participant in the EU’s Emissions Trading System. In the case of Britain undergoing a disorderly exit from the EU, Shah notes that allowances held by UK institutions might flood into the market, increasing supply.
Secondly, populist movements such as the Yellow Vests that began in France is piling pressure on governments to reject the basis of climate management for the pursuit of cheaper energy and, thereby, raise the living standards for the less skilled and economically marginalized.
On both counts, however, Shah also highlights key mitigating factors.
On the first point, he writes, “Brexit contingency planning has already begun. The UK government claims it is firmly committed to its international climate change agreements and thus is unlikely to exit in a manner that will undermine the EU ETS system.”
On the second, “Equally likely is a ‘green uprising’. The recent EU elections saw Greens take the highest votes in Berlin, Dublin, and Brussels. Some political commentators predict that Greens will become “kingmakers” in the decision process. That is likely to keep environmental policies high on the agenda.”