Carbon Credit Futures (How Does It Work)

The buying and selling of credits that allow an entity to emit a certain amount of carbon dioxide or other greenhouse gasses is otherwise known as… carbon trading.

The credits are intended to reduce the overall carbon emissions, helping to mitigate climate change.

Carbon trading is based on the concept of cap-and-trade scheme that emerged back in the 1990s. This scheme introduces the market-based incentive to slash pollution.

But instead of mandating certain measures, the policy rewards firms that reduce their carbon footprint while imposing costs on those that cannot.

At that time, the scheme was meant to specifically cut emissions down to just 5% below 1990 levels by 2012. This later became the historic Kyoto Protocol, wherein industrialized nations have to lower the amount of their carbon emissions.

The idea is to incentivize every nation to cut back on their footprint. But as the carbon market continues to grow in size, trading of carbon credits goes beyond just that…

…it produces a market-based financial instrument known as carbon credit futures.

So, if you’re also one of those interested in joining this rapidly growing market, you came to the right place. It pays to know what carbon credit futures are, how to trade them, and what specific instruments are available to bet your money on.

What are Carbon Credit Futures?

Carbon credit futures are an expansion of the carbon market. A carbon credit is a certificate or permit that represents a reduction in carbon emissions, with one credit representing one metric ton of CO2.

Carbon credits are also known in the voluntary market as carbon offsets.

  • By definition, carbon offsetting is a “scheme that allows entities, be it a company or an individual, to invest in environmental projects to balance out their own carbon emissions.”

In other words, if you can’t reduce your carbon footprint directly, then you can pay others to do it somewhere else through those projects. They are the way for the carbon credit mechanism to work by reducing carbon emissions.

Carbon credit futures is a credit instrument where the buyer seeks to slash emissions through carbon offset projects, but without directly investing in any projects at the exact time of investment. Common examples of these projects are reducing or avoiding deforestation, providing fuel efficient household devices, and investing into renewables.

  • Carbon credit futures contract physically delivers carbon credits. Each futures contract is equal to 1,000 carbon credits generated from projects that protect natural ecosystems.

futures contract is a kind of derivative wherein two parties agree to trade an underlying asset at a specific date for a specific price. In such a case, the underlying assets are the carbon credits.

With carbon prices fluctuating, the carbon credit futures can serve as mitigating risk when you add it to your investment portfolio. They’re not just a simple positive socio-environmental asset but they bring real benefits to the investors.

In fact, by introducing carbon credit futures into your portfolio, you can reduce the value at risk of investment. But you should be concerned on how to balance what’s the optimal amount of futures contracts to invest in so as not to take positions that will make your entire portfolio less efficient.

At this point, it’s important to note that futures contracts are a more advanced trading strategy.

And to be brutally honest, carbon credit futures are a more complicated way of investing in the assets that underlie an exchange-traded fund, a.k.a. ETF, as it tracks the performance of the futures.

So, how does trading carbon credit futures work? Is it worth betting?

How Carbon Credit Futures Trading Works?

Carbon emissions continue to rise, leading to humanity’s greatest crisis of all time – climate change. The atmospheric concentration of CO2 jumped 48.0% since the pre-industrial era.

Not only is air quality getting poorer, but the higher temperatures are undeniable. We’ve seen the hottest years since 2005.

So what is the world doing to solve this? The birth of the Paris Agreement – and carbon credits – in 2015.

The Paris accord aims to reduce global warming to pre-industrial levels, meaning the world has to emit 8% less CO2 each year. But that’s no easy task.

This is where carbon credit futures trading fills in the gap… by incentivizing emissions reductions. It’s a new trading horizon.

Governments and companies incentivize carbon reductions, mandatorily and voluntarily. How carbon trading works under each of these carbon markets differ. Here are their major differences:

Carbon credit trading compliance vs voluntary

In the mandatory or compliance reductions world, there’s a more established and government-driven market with ETFs.

In the voluntary reductions world, it remains a free-for-all, for now, and we’ll see how it develops with more market options and regulation.

The main idea with trading carbon credit futures is that you’ll make money if the credits you buy are worth more than their current price. In other words, that’s what a future was contracted for.

But then again, it’s all speculation as nobody knows what the return would be.

Fortunately, recent developments in this space point to a brighter future for carbon credits… carbon prices continue to surge and break records.

For the most direct exposure to the voluntary carbon markets, trading carbon credit futures, such as the EU allowance futures, is a good option as a retail investor.

EU Carbon Credit Futures (What You Need To Know)

The first ETS grew out of the European Union’s need to address the bloc’s pollution. Their target is to slash GHG emissions to at least 55% below the 1990 levels by 2030 – a lofty goal.

The EU ETS, created in 2005, is the largest carbon market in the world. It inspires other countries and regions to establish similar systems such as California and New England.

EU ETS follows the cap-and-trade principles of carbon trading. The bloc sets a “cap” on the amount of emissions that the industrial sector is allowed to emit. Whoever goes above their allowance will be subject to fines.

This makes for an interesting investment market. Why is that so? Because the supply of carbon credits is controlled by the EU ETS.

That means the system influences the price. Too low a carbon price? The ETS will just cut the number of credits in circulation. Problem fixed.

The interesting part?

Anybody can invest in this carbon credit futures market by investing in ETFs that buy the futures contracts, also known as the EU Allowances or EUA.

How about the profit part?

Futures contracts only produce a profit if the price at the time the futures contract matures is more than the futures price when they were bought.

Just recently, the EUA price went beyond 100 euros for the first time.

EU carbon prices for past 6 months

Investors who have futures contracts matured at that time were celebrating for sure. But speculators who entered into a contract need to see higher EUA prices.

But it’s a speculation. No one doesn’t know whether the carbon price will go up or down.

After all, they’re called futures…and these futures contracts are what ETFs trade.

Now let’s introduce to you what instruments are currently available and trading as carbon credit ETF.

What Carbon Credit ETF Instruments Are Available?

There are several instruments available right now for you to assess, but here are some of them that you can start considering.

KRBN: KraneShares Global Carbon ETF

The largest product available, KraneShares Global Carbon ETF a.k.a. KRBN provides exposure to mostly the EU ETS carbon credits or EUA, California’s CCA carbon credits, and the RGGI carbon credits of the northeastern United States. Together, EUA and CCA account for over 80% of its holdings, reflecting the IHS Markit’s Global Carbon Index weights.

This carbon credit futures ETF provides great exposure to the growth of the carbon markets with less risk and volatility than others. That risk is due to the fact that more than half of the fund is invested in the EUA, meaning it’s largely exposed to the euro which has been experiencing some significant depreciation in the past year.

Fortunately, the dollar has been appreciating relative to other currencies. This means you might have some hedge. Some key info to know about KRBN include:

  • created on the 30th July 2020,
  • expense ratio of 0.78%, and
  • total net assets as of 31/10/2022: $766,916,721

KSET: KraneShares Global Carbon Offset ETF 

KraneShares’ latest addition to its suite of carbon market ETFs is the Global Carbon Offset or KSET. For the record, it’s the first in the U.S. to offer exposure to carbon offset futures, which marks a departure from the existing carbon credit funds.

KSET deducted on the NYSE with an expense ratio of 0.79%. It will allow you to track carbon offset futures contracts while also giving you the access to futures that weren’t available through an ETF before. That being said, this ETF offers broader coverage of the VCM, particularly the largest financial derivatives exchange – the CME Group.

Specifically, KSET will trade these carbon offset futures contracts:

  • CBL Nature-Based Global Emissions Offset (N-GEOs)
  • CBL Global Emissions Offset (GEO)

Investors can be confident that credits behind KraneShares KSET are reliable. They’re from emission reduction activities verified by renowned carbon offset registries.

KCCA: KraneShares California Carbon Allowance ETF 

Created in 2021, KCCA or KraneShares California Carbon Allowance ETF provides direct exposure to the California Carbon Allowances (CCA) that trade under California’s cap-and-trade program. It tracks most traded CCA futures contracts, closely following the price performance of California’s carbon credits.

As a part of the KraneShares suite of carbon ETFs, KCCA offers investors a new vehicle for participating in the price of carbon and hedging risk. Just like other ETFs of KraneShares, KCCA supports responsible investing and impact investment goals.

KCCA is one of the largest instruments with an expense ratio of 0.78% and net asset $218,944,249. By pairing it with other KraneShares carbon ETFs, you can customize your portfolio allocation to the global carbon credit market:

KEUA: KraneShares European Carbon Allowance ETF 

The KraneShares European Carbon Allowance ETF is meant to provide direct exposure to a portfolio of carbon credit futures contracts that trade under the world’s largest carbon market, the EU ETS. Hence, KEUA will track EU carbon credits price performance.

KEUA will invest at least 80% of its net assets, which is $18.98 million, in instruments that offer exposure to EUA. Unlike other KraneShares carbon ETFs, KEUA is non-diversified.

CARB: Horizons Carbon Credits ETF

Breaking the KraneShares craze is the Horizon’s Carbon Credits ETF or CARB, which trades on the Toronto Stock Exchange. It is Canada’s first ETF that gives exposure to carbon credits through futures contracts or derivative instruments.

CARB is quite recent, created in February 2022 with a net asset of $7,804,530 to date. Remarkably, it has an expense ratio of a whopping 0.92%.

A passive fund based on the Horizons Carbon Credits Rolling Futures Index, CARB is composed solely of EUA futures, with contracts rolled forward as they expire. But this ETS is flexible with the possibility to expand its exposure to other developed market futures as they mature.

GRN: iPath Series B Carbon ETN

The iPath Series B Carbon ETN tracks the Barclays Global Carbon II TR USD Index, which is almost entirely composed of EU ETS carbon credit futures. It means GRN will closely follow the price performance of EU ETS carbon credits, same as KRBN but with greater risk and volatility.

This instrument’s inception was in 2019, with 0.75% expense ratio and .

GRN has the goal of giving exposure to carbon price as measured by the return of futures contracts on carbon credits from two of the world’s major emissions-related mechanisms. They’re the EU ETS and the Clean Development Mechanism (CDM).

The instrument gives exposure to carbon credit futures contracts that trade on the ICE Futures Europe exchange.

CO2.L: SparkChange Physical Carbon EUA ETC

Making it to the last example of an ETF instrument is the SparkChange Physical Carbon EUA ETC or CO2.L. It was launched in 2021.

Again, just like most of the carbon credit ETFs above, it provides direct exposure to the EUA trading under the EU ETS.

However, unlike most of the other EUA exchange-traded products, CO2.L directly buys and holds EUAs instead of the futures. It means that this ETF tracks the price performance of EUAs even more closely than its peers before it takes expense ratios into account.

You can find some more information about those carbon ETFs with their price performance here.

Carbon Credit Futures Market

If there’s one thing we can say about exploring the carbon credit futures market, it’s exciting. Speculating what the future holds spurs excitement, but also some risks. You can’t really tell what will happen and whether the price will be up or down.

Yet, it is one way to get your feet wet in the carbon markets if you’re an individual investor. Let alone the potential profits you can earn if things go your way.

Data shows that most carbon ETFs have an upward trend in their price performances. That alone is a good point of reference to test the waters of carbon trading.

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