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Can you generate attractive returns with emissions trading?

October 25, 2022

reading time: 4 minutes

by Andreas Vetsch (LGT Capital Partners)

Can you generate attractive returns with emissions trading?

Emissions trading was conceived as a way to reduce greenhouse gas emissions, and is attractive from both an investment and a sustainability perspective. 

New ideas are often met with doubts, for example: can market-based mechanisms really be effective in helping to fight climate change? And if so – how can investors benefit? To answer this question, let’s first take a look at the matter from an economic perspective.

In economics, a cost arising from an economic decision that is suffered by a third-party market participant is referred to as a negative externality. This cost is not borne by the party who caused it, and thus constitutes a market failure. Greenhouse gas emissions are a classic example of this. The costs of pollution are often not borne by the emitter, but by the entire planet.

Emissions trading: Putting a price on CO2

The costs of pollution are often not borne by the emitter, but by the entire planet.

In order to counteract this market failure, emissions must be priced. One way to do this is by trading in emissions rights, known as carbon allowances. These CO2 allowances are issued by governments and allow the holder to emit one metric ton of carbon dioxide, for example. They are an important policy tool for reducing emissions.

In some countries, CO2 programs have been in place for years, and they are becoming more and more common around the world. China launched a CO2 program last year and India is preparing to roll out a national program.

Currently, there are a total of 65 regional, national and multinational CO2 initiatives covering 23 percent of global emissions. Of these, 32 initiatives are so-called emissions trading schemes (ETS), while the rest are carbon tax initiatives: More in the Carbon Pricing Dashboard of World Bank

In Europe, CO2 allowances now cover around half of greenhouse gas emissions. Different emissions trading systems exist, such as the EU Emissions Trading System (EU-ETS), the UK Emissions Trading Scheme (UK-ETS) and the Swiss Emissions Trading Scheme (CH-ETS).

Energieintensive Zementproduktion (Photo: © KEYSTONE/Laurent Gillieron).
Energy-intensive cement production (Photo: © Keystone / Laurent Gillieron).

Companies operating in energy-intensive industries such as power generation, cement production or aviation participate in all of these systems. They are no longer allowed to emit carbon dioxide into the atmosphere without submitting the corresponding CO2 allowances. If a company reduces its emissions, it can keep the surplus allowances to cover its future needs or sell them to another company that is short on allowances. As a result of this process, CO2 emissions are given a price that is established based on supply and demand.

Sustainability is part of LGT

LGT was early to commit to sustainability; long-term thinking and actions have always been among the company’s core characteristics. That’s why LGT has been working for many years now to further strengthen their commitment to sustainability both in terms of its operations and its core private banking and asset management business. LGT wants to ensure that its activities make a positive contribution to the environment and society. Find out how LGT achieves this here

How emissions trading works

The total supply of allowances is defined annually by the regulator, and the cap is continuously lowered.

Like in other trading systems, the EU emissions trading system is a “cap and trade” scheme. The total supply of allowances is defined annually by the regulator, and the cap is continuously lowered. This ensures that CO2 becomes an increasingly scarce and thus more expensive commodity. As a result, the incentive to ensure more climate-friendly manufacturing increases.

In addition to buying physical allowances, there are now several other ways to participate in the emissions market. Exchanges are expanding their range of sustainable investments, and this development includes carbon trading. Various emissions-based ETFs, futures and options contracts are also available. Access to the market has become easier and it is no longer just energy-intensive companies that are active in it. Investment banks and dedicated carbon funds now also count among the players. And the additional trading activity means that price determination and market liquidity are also improving.

Scarce supply and new market participants cause prices to rise

The reasons to invest in the emissions market are not limited to just sustainability. These investments can also be quite lucrative.

Emissions prices will increase in the coming years in order to support the achievement of global climate targets. Governments’ systematic price increases at auctions are a key driver of returns. In addition, the growing number of market participants – especially those from the investment community – is leading to a reduction in the supply of allowances. This is pushing prices up even further. But will CO2 emissions soon peak?

There is still plenty of upwards potential, as CO2 prices will have to rise significantly in order for certain industries to decarbonize completely. However, many companies are already being forced to reduce emissions and are looking for sustainable alternatives. In this respect, the system is having the desired impact.

However, it should not be forgotten that emissions trading is controlled by governments and therefore entails certain political risks. That being said, the sale of CO2 certificates has become a good source of revenue for governments. Abolishing or weakening trading would result in significant financial losses. In addition, reducing greenhouse gases with the help of CO2 certificates is becoming standard practice in a growing number of countries.

Header Visual © Keystone / akg-images / Stefan Schilling.

An attractive investment for sustainable portfolios

The importance of emissions trading has increased in recent years. It has established itself worldwide as a political instrument to reduce emissions. At the same time, it is attracting increasing interest from investors. Improved market accessibility and greater market liquidity are supporting this trend. And thanks to the attractive expected returns and their sustainability aspect, they are now highly sought after by many investors. This asset class helps to reduce emissions and achieve global climate targets, and is therefore a good addition to portfolios with a focus on sustainability.

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