Carbon Markets: An Emerging Derivatives Class

• Derivatives linked to the price of carbon could bring added transparency and liquidity to carbon trading, which may help investors make long-term decisions and support the growth of carbon markets.
• Futures linked to the price of carbon have registered positive risk-adjusted returns over the last 11 years with low correlations to traditional asset classes, including commodities.
• Many investors have looked to the carbon market to play a significant role as they seek to manage carbon risk within equity portfolios by using derivatives to hedge against carbon price risks.

Compliance carbon markets have grown to a value of USD 270 billion,^[1] which has placed it on the radar of institutional investors. The carbon market is now tracked and traded like any other commodity, which prompts us to present various applications and use cases for investors to consider.

Carbon’s relative performance and risk

The market value of global carbon credits traded on emissions-trading systems (ETS) was around USD 851 billion in 2021. EU ETS accounting for about 90% of the entire global carbon credits turnover, marking it as the most liquid and developed ETS system in the world.^[2] For this reason, we focus on the EU ETS carbon market in this blog to evaluate the various risk and return characteristics of carbon assets.

We referenced exchange-traded futures to measure the return and volatility of carbon assets, and then compared them with various commonly known commodities and other asset classes. As shown in the exhibit below, EU ETS carbon assets produced outsized returns in 2018, due primarily to the anticipation of strict reforms, and in 2021, on the post-pandemic economic recovery, EU Green Deal and Phase IV ETS reforms. And while carbon assets have been volatile throughout the years, 2022 year-to-date has proven to be the most volatile period (other than 2013), driven mainly by uncertainties in the current global macroeconomic environment.

Return and volatility of EU ETS carbon prices

Sample period: Jan. 18, 2011, to May 31, 2022. Based on a 12-month constant-maturity future prices for carbon (EU ETS).

Carbon’s correlation to other assets

Our research indicates that carbon assets provided comparable risk-adjusted returns and exhibited low correlations to many asset classes over the long term, as shown in the following exhibits. However, among the assets detailed below, carbon had been the most volatile (51% over the sample period).

A comparison of risk-adjusted return

Constant-maturity futures performance does not take into account the basis or futures spread in rolling futures from one fixed maturity to another. Sample period: Jan. 18, 2011, to May 31, 2022. We used 1-month constant-maturity commodity future prices for gold, natural gas, copper and Brent crude oil. For carbon (EU ETS), we used 12-month constant maturity future prices.

Correlation with commodities and other asset classes

Sample period: Jan. 18, 2011, to May 31, 2022. We used 1-month constant-maturity commodity future prices for gold, natural gas, copper and Brent crude oil. For Carbon (EU ETS), we used 12-month constant-maturity future prices.

Managing carbon risk within equity portfolios

Equity investors have significant exposure to the price of carbon through various climate opportunities and risks, such as the potential impact of various climate-policy scenarios (e.g., 1.5°C, 2°C, 3°C of warming), with the accompanying financial sensitivity measured by the MSCI Climate Value-at-Risk. On the left-hand side of the exhibit below, we illustrate the trajectory of carbon prices, while the chart on the right details the net transition cost by sector for the MSCI ACWI Index for different policy scenarios.^[3]

Carbon price trajectory and net transition cost by sectors

Carbon prices are weighted global averages. Source: IIASA NGFS Climate Scenarios Database, REMIND model and MSCI as of March 31, 2022.

The energy sector, as an example, showed a net transition cost^[4] of 63% under a "Divergent Net Zero" scenario,^[5] which means the sector would require a significant increase in spending to achieve a net-zero scenario by 2050. Therefore, investors may consider overlaying carbon futures to potentially hedge against these expected adverse movements in the carbon price under each scenario, particularly for high carbon-emitting sectors such as energy, as well as utilities and materials.^[6]

Applications of compliance carbon-market derivatives

As more companies chart their path toward a net-zero initiative, derivatives may play a critical role in helping investors manage carbon price risk, just as they have in managing risk exposures and facilitating cost-effective hedging strategies against common financial risks (such as credit, interest-rate and default risk). Entities mandated under ETS can make use of carbon futures that typically provide economic exposure and may not have any direct “real world” impact.^[7] Carbon futures are traded on various exchanges and may have various use cases including being a carbon price reference. Policymakers may refer to carbon spot and future prices to measure the effectiveness of their policies and strategize the way forward. Carbon can also be a diversifier in long-only applications by using carbon futures as part of an investor’s long only portfolio as an asset class. Another use case is hedging climate value at risk. Regulated entities can hedge their future emissions costs several years in advance. Investors can also use carbon futures as a hedge to mitigate carbon price risk resulting from net-positive emissions exposure in their portfolio.

Growth with a purpose

The role of compliance carbon markets is to provide a marketplace that facilitates decarbonization of the global economy by putting a price on carbon and incentivizing polluters to reduce their emissions in their journey toward net-zero. Hence, these growing markets serve as an important policy tool for regulators and policymakers to ensure that they are serving their intended purpose. While banks, institutional investors and secondary markets promote liquidity and provide depth to the market, investors may look to use carbon derivatives to diversify their portfolios and work to efficiently manage carbon price risks.

¹ Jiang, Betty, et al. "Carbon Markets: The Beginning of the Big Carbon Age." Credit Suisse.

² “Carbon Markets Year in Review 2021.” Refinitiv.

³ Network for Greening the Financial System, “NGFS Climate Scenarios for central banks and supervisors,” June 2021.

⁴ For more details on net transaction cost please refer to Climate Value-at-Risk Methodology Part 2 - Policy Risk

⁵ Divergent Net Zero scenario reaches net zero around 2050 but with higher costs due to divergent policies introduced across sectors leading to a quicker phase out of oil use.

⁶ The Monash/C2Zero Real Carbon Price Index. as of April 29, 2022.

⁷ Long-Short ESG Investing: Best Disclosure Practices

Further Reading

Introducing the Carbon Market Age

ESG and Climate Derivatives in Equity Exposure Management