Carbon markets: not for the faint-hearted

Welcome back. Indian commerce minister Piyush Goyal pulled no punches on a visit to Abu Dhabi yesterday, telling the FT that the EU was showing “bias, discrimination and unfairness” with its growing set of green trade restrictions.

In particular, the EU has been worrying trade partners with its decision to introduce tariffs on imports from countries that don’t have a carbon pricing scheme like its own (the tariff system has been having teething problems, as Alice Hancock reported from Brussels yesterday).

But while the EU’s green trade policy has sparked alarm about potential adverse effects for developing nations, it has also been helping to spur the development of regulated carbon markets in major economies around the world. And this could open new opportunities for risk-hungry investors.

That’s the focus of our first item in today’s edition. Also today, we look at World Bank head Ajay Banga’s new plan to galvanise private-sector investment in low-income nations.

Have a great weekend. — Simon Mundy

Carbon markets

Is carbon the next big opportunity for commodity investors?

Of all the ways to align your portfolio with the energy transition, one rather obvious one remains curiously neglected by most investors: regulated carbon markets.

Public discussion of carbon markets has focused heavily on the $2bn unregulated trade in voluntary offsets, issued to fund forest protection or clean cooking stoves.

Far larger, however, is the $800bn market in mandatory emissions permits, which high-emitting companies are required to buy in a growing number of jurisdictions, from the UK to China. Financial investors have so far proved leery of these volatile assets, but this may be a good time to start paying attention.

Analysts at Morgan Stanley told clients this week that they have a “buying opportunity” in EU carbon permits — currently the biggest carbon market open to financial investors — which have fallen to €52 per tonne, down from a peak of just over €100 last February.

The price decline has been driven largely by soft demand from European industrial companies, which have been scaling back production due to high energy prices and wider economic uncertainty.

To help struggling manufacturers and raise revenue for clean energy investment, the EU is moving to issue additional permits. Crucially, however, it will do so by bringing forward the distribution of permits that would otherwise have been issued in the three years from 2027. This means that a supply squeeze is set to hit in a few years, which could send the price surging upwards.

Coupled with rebounding industrial output, Morgan Stanley predicts, the tighter supply of new permits will push up the carbon permit price to €120 in 2027, and €135 in 2030.

Financial investors are not yet warming to this logic, showing their weakest demand for European carbon credits since early 2019, according to Morgan Stanley.

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But readers who see an opportunity in this can get exposure to the market through a range of exchange-traded products that track carbon prices in various jurisdictions.

Then there are hedge funds focused on these markets, like the World Carbon Fund run by London’s Carbon Cap Management with $330mn under management. Unlike the exchange-traded products open to retail investors, this fund has been taking some targeted short positions — enabling it to make money last year even as carbon prices fell in key markets. A particularly lucrative move for the company was a short bet on the UK carbon price, which plummeted as Rishi Sunak’s government expanded the permit supply amid a wider green policy retreat.

“The price of a carbon market is like a scorecard for the existing government on how they’re doing on climate policy in their country,” Carbon Cap Management’s chief executive Mike Azlen told me. “With the UK price trading at a 25 per cent discount to Europe, the market’s saying: ‘Get back to the drawing board, you’re not doing well.’”

Market growth ahead

Azlen predicts that carbon is set to become a major commodity market for financial investors. Of the world’s major economies that don’t already have emissions trading schemes, many are in the process of setting them up: Japan, Brazil, Mexico, Indonesia and Turkey, to name just a few.

The EU has added to the international momentum with its forthcoming “carbon border adjustment mechanism”, which will impose tariffs on imports from countries that don’t have carbon-pricing schemes of their own.

The biggest compliance carbon market — China’s, which covers over 4bn tonnes of emissions, roughly triple the amount covered by the EU scheme — is not currently open to financial investors, but Azlen hopes this will change in the next few years.

But does this sort of investment come with positive impact — or is it just another form of speculation? One argument for it is that buying carbon permits helps to push up their price — making it more expensive to pollute, and putting more pressure on high-emitting companies to decarbonise. (Carbon Cap’s managers also use 20 per cent of their performance fees to buy and cancel carbon permits, taking them off the market permanently.)

Even without the intervention of speculators, government policy gives this market a unique form of long-term support for price levels, notes Per Lekander, managing partner of London-based hedge fund Clean Energy Transition Partners, one of the most active financial investors in this space.

Governments have committed to steady reductions in carbon permit issuance: in the EU, for example, it will fall at an average rate of over 4 per cent per year between now and 2030. “The stock market is much more emotional,” Lekander told me. “This is much more about mathematics.”

In this case, however, the mathematics remain subject to politics. The UK has already blinked with its measures to expand the supply of carbon permits. If carbon prices rise much higher in the EU and other jurisdictions, policymakers will come under pressure to weaken their own green policies by doing the same. To invest in this market, then, is to bet that they will hold their nerve. (Simon Mundy)

Climate finance

The World Bank’s plan to speed up private investment in developing nations

Over the past decade, as developing countries have gained better access to capital markets and private investment, the World Bank’s role as the primary source of capital for development has waned. It has, however, increased its focus on coalescing private funds to address global climate challenges — particularly, under its new president Ajay Banga.

But progress has been slow. 

According to an October IMF report, to achieve net zero emissions by 2050, emerging markets will need $2tn in green energy investments annually by 2030 — a fivefold increase from the current $400bn in annual climate investments forecast over the next seven years. The private sector would need to supply between 80 and 90 per cent of that capital, the IMF says — but it’s currently funding only 40 per cent of green energy investment in developing nations.

Since taking the helm of the World Bank last June, Banga — who was previously chief executive of Mastercard — has doubled down on bringing more private sector investment to emerging markets. In his first month in this role, Banga launched the World Bank’s Private Sector Investment Lab, a working group of 15 chief executives focused on increasing climate-related investment in emerging markets. 

On Wednesday, Banga announced the first outcome of the lab: a structural overhaul of the World Bank’s private sector investment guarantee programmes and a new issuance target.

“We are going to triple guarantee issuance by 2030,” said Banga.

Through the Multilateral Investment Guarantee Agency (MIGA), the World Bank lowers the risks for investors to enter developing markets by insuring their investments against extraneous political risks like terrorism or revolution.

The World Bank now aims to annually issue $20bn in investment guarantees by 2030, a huge jump from the $6.8bn issued last year.

The overhaul is intended to accelerate private investment by streamlining the MIGA application process and moving all of the bank’s other private investment offerings, such as bond issuance support and credit enhancement, under MIGA.

But will it be enough?

While capital markets are starting to thaw amid signs of coming interest rate cuts, many countries are still teetering on the edge of a debt crisis, and continued uncertainty over geopolitics in the Middle East has made investors wary. Foreign direct investment was down 9 per cent across emerging markets last year, according to the UN Conference on Trade and Development.

“Energy infrastructure investments have such high political risk, the private sector cannot manage that on its own,” said former Bank of England governor Mark Carney, who co-chairs the Private Sector Investment Lab. “CEOs were clear that an expansion should be a priority, and there is a need for simplicity and improved access.”

The new guarantees platform is set to launch in July 2024, and Banga said it was just a start.

“$20bn is not a cap imposed by the bank,” he said. “The quicker we do it, the more ambitious we will be.” (Aiden Reiter)

Smart reads

• Global carbon emissions rose to a record high last year despite falling fossil fuel usage in the EU and US, according to the International Energy Agency.

• The recent upheaval involving Swedish digital payments company Klarna and venture capital giant Sequoia Capital highlights “the governance gap that affects many late-stage private companies still waiting to go public,” writes John Thornhill.

Letter in response to this newsletter:

World Bank ‘lab’ fails to address climate challenge / From Inder Sud, Former Director, World Bank (1990-2001), Reston, VA, US