Welcome to the third issue of our monthly newsletter, Carbon Market News Roundup, the goal of which is to introduce our audience to a new asset class market in the making: the carbon market. Our previous issues, along with the rest of our commentaries, may be read here.
In order to meet their net-zero emissions pledges, global firms turn to carbon credits to offset their unavoidable emissions. Carbon credits represent CO2 that has been reduced, avoided, or removed from the atmosphere. Projects that reduce, avoid, or remove carbon from the atmosphere can generate credits and sell them to polluting companies, who then ‘retire’ the credits to offset their emissions. Already, the carbon market is worth over $900 billion and is expected to reach $2.68 trillion by 2028.
Last issue, we focused on the importance of decarbonization and how carbon markets can assist, the investment opportunities in the new asset class, and a summation of important developments from the UN climate summit, COP28. This issue, we will explore the dynamics that drive capital investment in decarbonization efforts. We will also examine the significant developments underway in regulated carbon markets around the world.
Where Will Green Capital Come From?
The Fourth Big Force: Climate Change
Ray Dalio, Principles Perspectives
This $20 Trillion Climate Theme Is Trouncing Other Strategies
Tim Quinson, Bloomberg
Climate change may cost the world up to 5% of global GDP, money which would be put toward efforts to decarbonize, adapting to the changes hotter temperatures and more volatile weather will bring, and paying for damages from the increased occurrences of extreme weather events. An ounce of prevention applies here: the more money spent on minimizing climate change now would mean less money spent (and lessened human suffering) on mitigating the negative effects.
In reference to the chart below, while the world spends around $1 trillion a year, much more will be needed to keep the global temperature from rising above 1.5° C higher than pre-industrial times, an important threshold that threatens even worse effects if crossed.
Source: Climate Policy Initiative
Why is so little money going into climate finance, considering the urgency of the issue? Governments are reluctant to fully implement emissions-reducing legislation, given the extra costs it would impose on private industries and their constituents. Institutional investors (e.g., pension & sovereign wealth funds), on the other hand, hold a huge amount of money (around $120 trillion) that could be deployed. So why does only around 0.5% of their money go toward climate finance?
A fundamental principle of economics answers this: Incentives matter. The managers of such institutions have a responsibility to those whose money they take care of, and there is a shortage of climate investments that provide suitable returns. However, that is changing as another longstanding principle of basic economics holds true: innovation leads to growth. Newer, more efficient solutions for fighting climate change are drawing investment and driving good double bottom line returns.
What is another area of good returns for climate capital? US electric grid infrastructure. To reach critical net-zero goals, grid infrastructure will likely have to double by 2040. Funds that invested in electricity grids enjoyed double-digit returns in 2023, but there is still a $21.4 trillion of investments needed to support climate goals. The growing demand for electric infrastructure, coupled with federal incentives toward climate solutions, is likely to drive growth in this area. Additionally, anticipated lower interest rates may make other green industries, such as solar or wind, more profitable over the next year and open up even more opportunities for investors looking for that double bottom line.
The Number of Regulated Carbon Markets is Rising
Brazil to launch regulated carbon market
Michael Pooler & Bryan Harris, Financial Times
Global Carbon Markets Get Bigger, Even as Trading Dips
BloombergNEF
As discussed in our first issue of Carbon Market News Roundup, carbon markets are bifurcated into voluntary markets and compliance (or regulated) markets. Participation in voluntary markets is on a voluntary basis, while compliance markets (often in the form of cap-and-trade programs) are regulated by national, regional, or international bodies. While the size of the voluntary market is estimated to be around $2 billion currently (and expected to grow exponentially), compliance markets are much larger, at an estimated $800 billion and still growing.
A number of new national compliance markets are in the works, and existing regimes are set to expand in scope. For example, Brazil, Mexico, and India have all recently announced or implemented carbon regimes. In total, around 20 national compliance regimes are either under consideration or implementation globally, compared to about 30 regimes already operational. The European Union’s Emissions Trading System (EU ETS), which began in 2005, is the world’s leader in such programs in size, as seen by the chart below.
The price of EU allowances (EUAs), which allow a firm permission to emit 1 metric ton of CO2, have risen dramatically since 2021 (over +130%), as seen by the graph below.
Source: ICE
Prices are only expected to rise over the medium term, with BloombergNEF estimating they will reach €149 (~$162) per metric ton by 2030 as the regime is set to expand in scope to include new sectors such as maritime shipping, road transport, and others.
The rise of compliance carbon markets is a herald of even greater regulation and opportunities for investors to get in on the ground floor. The expansion of compliance markets, which may in the future merge with one another and even the voluntary market to some degree, offer a bridge between financial incentives and environmental stewardship.