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An introduction to carbon pricing and how to navigate it as an investor

Never before have we faced a challenge as daunting as climate change. Global greenhouse gas (GHG) emissions must be reduced to almost zero by 2050 to have any chance of not exceeding an increase in temperature of 2° over pre-industrial levels. The closer we get to that threshold, the greater the risk of catastrophic global scenarios. The time has come to invest in radical change. And to do so, the economic approach is an eminent one.

Figure 1: McKinsey Global Institute. Climate risk and response. Physical hazards and socioeconomic impacts. 2020

Why put a price on carbon

In the end, it’s all about chemistry. Carbon dioxide and all the other organic compounds that are tipping the balance of global warming contain the crucial “C” in their chemical formula. After their combustion, these gases are released into the atmosphere where they absorb a part of the radiation from the sun and send it back to Earth, also known as the Greenhouse Effect. The reason why we talk about carbon when it comes to tracking pollution levels and not about PPM or kg of methane, is that it serves as a form of currency, a benchmark. Since GHGs are made up of multiple compounds, to quantify them and especially to compare different emissions, the ton of CO2 equivalent is used as the unit. Knowing that one ton of methane is about 28 times more harmful to the environment than one ton of CO2, this means that one ton of methane is worth 28 tons of CO2 equivalent.

Enough about chemistry.

Control mechanisms, a glossary of terminology.

Now that we are able to properly account for our emissions, decision makers have several tools to limit and, ultimately, to control pollution levels. Two main classes of instruments are available. On the one hand, there are regulatory mechanisms. On the other, there is the reliance on price signals and market logic to drive behavioural change. The second class is what is being addressed in this article. It consists of the carbon tax and the carbon market.

In the case of the carbon tax, the concept is that the government sets a price per ton of CO2 equivalent emitted. The revenues generated are returned to the taxpayers or are used in green transition programs. In Europe, the carbon price ranges from US$10 to US$140/t. According to simulations and projections, the estimated price in a few years is expected to rise to around $100-150/t. This increase will have a significant impact on energy-intensive projects. This approach gives a concrete idea of the dynamics of emissions and is easily implemented by regulators

The second tool based on market theory is the carbon exchange. In Quebec, it is called the CATS (Cap and Trade System for Emission Rights). GHG emission rights are sold at auction according to the total emissions cap per year. It is then possible for environmentally efficient companies to sell their emission rights to larger polluters. The currency used is the carbon credit. This credit is equivalent to 1 ton of CO2 equivalent. Thanks to its mechanism, the CATS is the only tool that guarantees the reduction of total emissions and, unlike the tax, it is more easily linked to similar systems elsewhere in the world. 

The chart below compares different international carbon pricing initiatives.

Figure 2: McKinsey Global Institute. Comparing carbone pricing across the globe. 2018

Investing in a low-carbon market

Although often compared to the stock market, the CATS is not a suitable system for the retail investor. Fortunately, conventional stock markets provide a concrete opportunity to invest in a low-carbon future.

For many years already, there has been talks of integrating an ESG (Environment – Social – Governance) criteria to asset selection. In fact, this type of investment is growing rapidly. The growth is six times greater for ESG financial products than in traditional products. The Canadian investment firm Brookfield Asset Management Inc. is a leader in this field. The firm has just launched the Brookfield Global Transition Fund, the largest of its kind with a value of $US 7.5 billion.

That said, there is an even more direct way to trade on the price of carbon. It is now possible for an investor to buy or sell carbon credits directly, without going through the CATS. Currently, the European Climate Exchange, NASDAQ OMX Commodities Europe, PowerNext, Commodity Exchange Bratislava and the European Energy Exchange are the five exchange markets trading carbon on prices. Louis Redshaw, the head of environmental markets at Barclays Capital even claimed in an interview with the New York Times that “Carbon will be the world’s biggest commodity market, and it could become the world’s biggest market overall.”

The next decade will be critical, and as policy makers fundamentally rethink economic infrastructures, we must commit collectively to mitigating the risks of climate change. Whether it is through engagement or investment, all approaches are valuable.

References

Kanter, J. (2007, 06 20). Carbon trading: Where greed is green. The New York Times.

Purdon, D. H. (2014). L’économie politique des systèmes de plafonnement et d’échange de droits d’émission de la Californie et du Québec. La Prospérité durable, 33-35.

McKinsey Global Institute. (2020). Climate risk and response Physical hazards and socioeconomic impacts.

United States Environmental Protection Agency. (2020, 09 9). Understanding Global Warming Potentials. Retrieved from EPA.gov: https://www.epa.gov/ghgemissions/understanding-global-warming-potentials