Nothing quite like a crises to catalyse change
The 2021 United Nations Climate Change Conference (COP26) has come at an opportune time. A crunch in fossil fuels has highlighted the pitfalls of the world’s current energy mix. Remember it was COP21 in 2015 when the historic Paris Agreement was signed. But two key things have changed since the Paris Agreement. First, the urgency from policymakers to act has increased. And second, green technologies – which will enable the transition to a cleaner world – have moved from the margins to the mainstream. These two shifts are more prominent today than ever before.
And while the Paris Agreement was a landmark achievement in determining the direction of travel, what the world needs now is a roadmap to get there. In Europe, policymakers are favouring the use of carbon pricing as one of the key tools for reaching the desired destination.
As a near-term goal, the European Commission aims for a 55% reduction in greenhouse gas emissions by 2030 compared to 1990 levels. By 2050 the European Union (EU) aims to be carbon neutral.
The European Union Emissions Trading Scheme (EU ETS) is the world’s biggest carbon market and the foundation of EU’s policy to mitigate climate change and reduce greenhouse gas emissions. The scheme is intended to support the EU in achieving carbon neutrality in the region by 2050. Under the EU ETS, a cap exists which limits the amount of greenhouse gases that can be emitted by companies each year. A fixed number of carbon emission allowances are issued each year, with companies required to hold enough allowances to cover their emissions and ensure they fall under the cap. Price increases in carbon emission allowances (see figure below) means it gets more expensive for companies to cover their carbon footprint with the allowances and incentivises them to invest in pollution abatement technology which could help drive change faster.
The focus is only likely to grow…
In July 2021, the European Commission released its ‘Fit for 55’ legislation package, supporting its commitment to reduce net greenhouse gas emissions by at least 55 per cent by 2030. A central pillar in this package is the enhancement of the EU ETS. The legislative changes are likely to:
- Reduce overall emissions more aggressively: The cap on greenhouse gases (GHGs) under the EU ETS declines by a predetermined amount each year. Between 2013 and 2020, this reduction happened at a rate of 1.74% each year. From 2021-2030, the reduction will happen at a rate of 2.2% (i.e., emissions are supposed to be cut every year at a higher rate). The proposal is to go as far as reducing annual emissions by 4.2% under the new legislation. This means that total supply of carbon emission allowances will reduce at a faster rate.
- Expand the scope of regulation: Currently, the EU ETS only covers energy utilities, industrial emitters, and intra-EU aviation. In total, only 41% of GHGs are covered by the ETS. The Fit for 55 proposal seeks to increase coverage to the shipping, buildings, and transportation sectors. With more sectors coming into the fold of the regulation, demand for carbon emission allowances will rise as more will need to hold allowances against their emissions.
- Encourage innovation to decarbonise: The European Commission is also calling for changes to the ‘modernisation fund’ that supports power-sector modernisation in poorer member states, using a small percentage of EU ETS auction revenues.
- Combat carbon ‘leakage’: Carbon leakage has always been a problem for the European Union. If they make the cost of operating a business in the European Union too high, internationally mobile companies would move out of the EU and export their goods back into the EU. The greenhouse gases they emit into the atmosphere would still be produced, but just outside of the EU’s jurisdiction. A carbon border adjustment mechanism (CBAM) – a tax on companies bringing their goods into the EU – is being proposed to level the playing field.
The above list highlights some of the key proposals but is not exhaustive. Nevertheless, the prospect of this new legislation coming into effect, something that has not happened yet, has already caused the price of European Union Carbon emission allowances (EUAs) to rise significantly this year. If the legislation passes, there is likely to be further upside.
Carbon as an emerging asset class, therefore, presents a unique proposition given its supply is expected to be tightened by design to reduce emissions and demand likely to grow as the scope of carbon regulation expands. Investors can gain access to the asset class through a variety of ETFs which track the underlying EUA futures market. Investors in the asset class not only gain an exposure to carbon’s promising fundamentals, but also contribute towards helping achieve environmental goals.
Source: All details of the EU ETS have been sourced from the European Commission website.
IG’s view: how to gain exposure to carbon
There are an array of exchange traded funds (ETFs) for investors to choose from to gain direct exposure to carbon and also funds that include a carbon offset, essentially overweighting companies with low carbon emissions relative to higher carbon-emitting peers. A collection of these ETFs, that are available on IG’s share dealing platform, can be found in the table below.
Credit: www.ig.com – Source link