The One-Way Bet on Carbon Credits has Limits

European emission allowances, one of this year’s hottest commodities, have room to rise further—as long as investors don’t all pile in at once

By guest author Rochelle Toplensky from the Wall Street Journal

European carbon credits are as close as investors can come to a sure thing. Ironically, the chief thing that might trip them up is too much excitement too soon.

All graphics courtesy by the Wall Street Journal

Tradable allowances on the European Union’s emissions trading system (ETS) have been one of the best-performing commodities of 2021, up nearly 36 % so far to more than EUR 44 a metric ton of carbon dioxide. The project’s early stumbles, which left the benchmark carbon price below EUR 10 for much of the mid-2010s, are now a distant memory.

More U.S. buyers are getting involved. Since the start of this year, the number of investors holding the credits on the Intercontinental Exchange in New York has risen by one-third, while KFA Global Carbon ETF, a big U.S. exchange-traded fund focused on carbon credits, has increased assets more than sixfold.

Interest has been boosted by a step change in the EU’s green ambitions. The bloc now aims to cut 2030 emissions by 55 % compared with the 1990 level, up from a prior target of 40 %. A high carbon price—bullish analysts see it exceeding EUR 100 by the end of the decade—may be instrumental in reaching that goal.

In June, officials plan to propose changes to the various EU climate rules to update them for the new 55 % target. Two key changes to the ETS are expected. A new carbon border tax will likely end the practice of giving some emitters free carbon allowances. And new sectors will be added, most likely including maritime shipping and possibly road transport and the heating of buildings. The current project mainly covers the power industry and aviation, though the latter mostly relies on free allowances.

Both proposals will in theory support the ETS market by increasing demand for allowances. Investors need patience, though. After the problems of its early years, European officials are cautious about reforming the ETS and it will take months or even years for national leaders and European legislators to finalize and adopt the changes.

Investors also need to bear in mind a potential roadblock at a carbon price of around EUR 75. That is roughly triple the average price for the past two years—a multiple that, if exceeded for six months, means officials can add a significant new supply of allowances under ETS rules.

Just because they can, doesn’t mean they will. Any such intervention would likely be politically fraught, as the EU’s 27 members face a huge range of decarbonization challenges and the ETS is just one strand in a web of climate-action regulations.

Investors should be aware of two other potential disruptions. British companies might dump their EU emissions credits now that they are no longer part of the bloc’s ETS. But this hasn’t happened yet and seems unlikely given that many are international companies. The allowances are a liquid instrument providing a decent return and there remains a chance the U.K. and EU could eventually link their ETSs.

Longer term, the ETS price also could fall if European emitters clean up much quicker than expected. Given the latest ambitions and technical challenges, though, that really does seem like a long shot.

All this suggests that the rise of EU carbon credits remains a pretty steady one-way bet. Investors just need to see EUR 75, rather than the sky, as the limit for now.

www.wsj.com