Investment views: ‘Carbon is probably the most impactful investment you can have’

Summing up the carbon market for those who may be unfamiliar with it, Oliver notes it has nothing to do with forests or carbon-capture but is, rather, a price mechanism in place in markets such as the European Union, the UK, California and the northeast of the US – areas covered by KraneShares – as well as the likes of Australia, China and South Korea.

“These markets have a price mechanism where they issue these carbon allowances – which are essentially ‘permits to pollute’ – and any company operating in those economies, if they pollute a million tonnes of CO2 into the atmosphere, they have to go and buy the permits,” Oliver explains.

“So we are not going long carbon as a commodity – we are going long the economic value of producing a tonne of carbon – and that has grown to be a trillion-dollar market that is making its way into more and more portfolios. And people are very interested because the return expectations are high while the correlations with other asset classes are low.”

‘Historic reset’

Investors are now witnessing a “historic reset” in carbon prices, believes Oliver, adding: “Go back two years and we had some of the best-performing markets – both in European carbon and California carbon. Those prices have been reset through the Ukraine invasion and the huge spikes in gas prices that resulted and we have also had political shifts in the US. That all pulled carbon prices back down but now the market is teeing itself up for a return to normalcy – and that return to normalcy will mean returns start to pick up again.”

Transcript of KraneShares ‘Special’ on investing in carbon – Luke Oliver, with Julian Marr

JM: Well, hello and welcome to this special KraneShares focus on investing in the carbon markets. I am Julian Marr, editorial director of Wealthwise Media, and I am very happy to be speaking to Luke Oliver, head of strategy at KraneShares. Hello, Luke – how you doing?

LO: Very well, thank you.

JM: Let’s get into nitty-gritty straightaway: why is now the right time – the opportune moment – to be investing in carbon?

LO: Well, right now, we are in this historic reset in carbon prices. A lot of people don’t know a lot about carbon markets but it is a trillion-dollar asset class – and, while we are seeing family offices and institutions all making allocations into this market, it hasn’t really made it into more mainstream portfolios. Go back two years and we had some of the best-performing markets – both in European carbon and California carbon.

And those prices have been reset through the Ukraine invasion; the huge spikes in gas prices we saw as a result of the Ukraine invasion; and we also had political shifts in the US. These have moved a few things around and have pulled prices of carbon back down – back to the levels of about two years ago – when we saw this great performance. So the market is sort of teeing itself up for a return to normalcy – and that return to normalcy will mean these returns start to pick up again.

Just for those who may not know what the carbon market is, this is nothing to do with forests or carbon-capture or any of these things. Rather, it is the market-price mechanism in place in the European Union, in the UK, the state of California – which itself is the seventh largest economy in the world – and the northeast of the US. These are markets we cover – there is also China, New Zealand, Australia, South Korea and so on and so forth.

So they have a price mechanism where they issue these carbon allowances – which are essentially ‘permits to pollute’ – and any company operating in those economies, if they pollute a million tonnes of CO2 into the atmosphere, they have to go and buy the permits. So we are not going long carbon as a commodity – we are going long the economic value of producing a tonne of carbon – and that, as I say, has grown to be a trillion-dollar market that is making its way into more and more portfolios. And people are very interested because the return expectations are high while the correlations with other asset classes are low.

JM: Is the exposure futures-based or is it physical? And could you explain the pros and cons of either?

LO: That is a great question and we are neither a swap nor physical – which we think is the optimal place to be. So swap-based products will tend to have a swap on the underlying futures and you get some layered costs in there. Physical, on the other hand, might seem like the place to go but, to get the physical exposure, you usually have to buy and trade the futures to get there – and then you are in a less transparent, less liquid vehicle.

So when you buy the futures directly and manage the futures, as we do, we are not layering the costs and we are operating in the most liquid part of the market. The futures are where the price discovery is – and that is where we operate. And what is often overlooked is, people think with futures and futures curves – are they expensive? Are they contango? Well, the futures curve for carbon is much like the currency – there is no steep curve based on the transport or storage of a commodity. It is simply the cost of capital – because futures are levered.

We are not levered in our fund. We buy the futures and we have a cost of capital embedded in that future so we only have to post a small amount of margin. So most of our capital we get to put into ultra-high quality, ultra-short duration fixed income – and we earn back most of that. So there is a very small ‘net carry’ in the futures curve but it is not an expensive approach. So we have got the liquidity and we have a modest price-point to get that access – so we find futures to be the optimal way to access this market.

JM: Thank you for that. How would you suggest carbon generally – and your strategy more specifically – fits into client portfolios? And do you see this as an impact investment or are you thinking of it in a different way when you are talking to clients and to potential investors?

LO: Well, investors talk to us about it in some different ways but the way we think about it is, first and foremost, without doubt, this is a classic alternative investment. You have a Sharpe ratio similar to US equities – so a +0.7 versus around a +0.80 for US equities – with double the return and double the volatility, give or take, but the correlation is only 0.3, which is incredible. So you have this very low correlation but with the same sort of risk profile as US equities – that is, first and foremost, what people find very attractive about this.

Secondly, it is also probably the most impactful investment you can have – but it is not a prerequisite. It is not a case of, You should invest in this because it is good for the planet. You should invest in this because of the risk and return and low correlation – but you are also having an incredible impact.

That is because the way carbon works is, as the price of carbon rises – and the design of this market is to rise in real terms above inflation – that is the catalyst for investment into green technology and into making dirtier fuels less attractive and cleaner fuels more attractive and it encourages corporations and governments to shift their operations into lower carbon-intensity processes.

So it is very impactful – but that is not a prerequisite for investing. This isn’t just for your green, sustainable investments – this is for any portfolio. I think that was the second part of the question – what was the first piece?

JM: When you are talking to clients, where do you see the strategy fitting into their portfolios?

LO: So that alternative allocation makes a lot of sense – that is the classic place people put it. The other place people put it is they just say, Well, this is a replacement for commodities. It is either wanting less of the fossil fuels or the fact that commodities don’t really have a real return – they are a good diversifier, they are a good inflation hedge, but they just really move with inflation. They don’t grow in real terms. Carbon is designed to rise in real terms. So if you replace commodities – and it is a very simple switch – you actually move your official frontier out, for all the reasons we have described.

Another place, of course, is people look at this and say, Well, we know this market is expected to post returns above large-cap equities and we are interested in that story. We have also had people saying, We are pulling back from ESG and SRI and so on but we want to have an overlay on the portfolio – and being ‘long’ carbon provides that overlay without having to drop sectors out of your portfolio. So alternative, first; sustainable, sure; commodity replacement, sure; overlay to hedge climate risk in your portfolio, that works as well.

JM: Last question, just to pick up on something you said there – you mentioned fossil fuels and dirty fuels and there is a lot of discussion at the moment about natural gas versus coal. Is carbon the way to position for this then?

LO: Well, this is a really interesting shift. We know that, especially in the US, there has been a backlash on the issue. We are generally seeing people less focused on that and keeping their ‘risk-return hat’ on more – which, of course, is in play here. But there is no doubt that we are going to burn less coal relative to gas. Of course, India and China, they’re still building coal-fired power generation but it is on the decline – gas is going to be that interim fuel and we’re seeing volumes of oil-trading shifting to natural gas.

So, naturally, a lot of people also want to think, How do we play the transition to natural gas? Natural gas futures are incredibly expensive to hold so we are starting to see people use European carbon as a way to play Europe’s move towards more natural gas and less coal – because it is a cheap way to be long that growth.

There is a relationship – as the price of carbon goes up, you have more switching from coal to gas. So gas goes up – and, if gas goes up, you are going to see some backpedalling with the relationship with coal and that is going to push carbon prices higher. So that positive relationship of gas and carbon makes carbon a really effective way to play that transition. That is an emerging use case for our products.

JM: Luke Oliver, thank you so much.

LO: Thank you so much.

JM: And thank you very much for watching.