This article first appeared in Wealth, The Edge Malaysia Weekly on December 25, 2023 - January 7, 2024

The race to decarbonise is picking up pace as 2050 — the deadline set by many entities to achieve net zero emissions — inches closer. This has, in turn, elevated investors’ interest in carbon markets, which have been touted as a much-needed strategy to fulfil climate targets.

There are already multiple ways for investors to get exposed to this emerging asset class. Banks are helping clients trade carbon credits, while asset managers are gathering portfolios of carbon credit-generating

projects. Exchange-traded funds (ETFs) that track carbon credit futures also exist in the more mature and liquid markets.

In a nutshell, carbon markets refer to trading systems where carbon credits are sold and purchased. The ultimate purpose of these carbon credits is for entities to offset their greenhouse gas (GHG) emissions and channel funds towards efforts to remove or reduce GHG emissions.

One carbon credit is equal to one tonne of carbon dioxide or the equivalent amount of other GHG reduced, sequestered or avoided. It is no longer tradable if an entity uses it to offset its own emissions.

Despite the fanfare, it is a new market with nascent demand in some countries and regulations that are still being developed. There is also pushback on carbon markets, which is seen as a greenwashing strategy for entities that want to avoid doing the real work of decarbonisation.

These translate into risks for investors, who may have to deal with low liquidity and fluctuating prices as they seek to benefit from the rising interest in carbon markets.

“Most of our clients understand that their own emissions in GHG inventories should not be offset by carbon credits. Therefore, the main demand for carbon credits from our clients is for investment purposes,” says Teppei Yamaga, head of net zero strategy at Nomura Asset Management.

“On the other hand, many companies and clients have set their net zero goals by 2050, so if they will have residual emissions that they can’t reduce by themselves in the long term, they may want to offset their own emissions using carbon credits, which is acceptable.”

Over the past decade, the price of carbon credits has risen significantly in compliance markets around the world. Yamaga expects this to continue rising as the 2050 deadline comes up. “[Because of that] we can expect capital gains from investing in carbon credits.”

But the returns and risks expected will differ depending on the type of carbon market an investor opts for and the kind of carbon credit it is, among other factors.

There are two types of carbon markets: compliance and voluntary. Compliance markets set a price for carbon either via a tax or an emissions trading scheme (ETS), where entities from different industries are given a limit on the total amount of GHG they can emit. This limit can be reduced over time.

The entities — typically companies in carbon-intensive industries — will have to surrender carbon allowances to cover their emissions annually. If they emit less than the limit, they can keep the additional allowances or sell them. Those that emit more will have to buy additional allowances.

The European Union’s (EU) ETS is the world’s first compliance market, established in 2005. The market is big and liquid enough that the “carbon credits”, called EU Allowances (EUA), can be traded in spot, forward and future markets, with primary and secondary markets. ETS can also be found in the UK, California, Washington and China.

“The EU ETS market is the most mature. In addition, the market size of China’s national ETS is large, and this will mature in the medium to long term,” says Yamaga. China’s ETS began operating in 2021.

One reason investors go to the futures market is for hedging. “For example, if they see the [price of] EUA going up in two to five years’ time, they might buy futures in advance. If they’re worried that the [price of] EUA might drop in the coming months, they might hedge against it. Another type of investor goes for speculation,” says Hiro Chai, founder and director of Mitsusho Sdn Bhd. The company provides consulting services on carbon credit development and carbon offsetting for corporates.

The compliance market is attractive to investors because it is regulated and mandatory to comply, he adds. For instance, when the EU adds more industries into the ETS — the shipping industry will be included by January 2024 — or reduces the limits on emissions, more entities will be buying EUA, thus driving up demand and prices.

The voluntary carbon market (VCM), meanwhile, is smaller and allows entities to voluntarily purchase carbon credits generated from projects that avoid, reduce or remove GHG emissions. Examples include a project that reforests degraded land or turns biogas captured from landfills into energy.

Companies purchase these carbon credits to offset their own emissions and meet their climate targets. Brokers and traders, meanwhile, may bundle credits into portfolios and sell them to end buyers. Several exchanges — such as Singapore’s AirCarbon Exchange — exist to allow these transactions to occur more seamlessly. Malaysia’s Bursa Carbon Exchange (BCX) is a VCM.

It is important to note that carbon credits that are certified by recognised organisations such as Verra and Gold Standard tend to be seen as more credible, although investigations by the likes of The Guardian have alleged that over 90% of rainforest carbon credits by Verra — the largest certifier of voluntary credits — are not backed by actual emissions reductions. This has been refuted by Verra but greenwashing concerns in VCMs continue to pose a risk for buyers.

On the other hand, there is a link between the voluntary and compliance markets that can drive up demand for carbon credits from VCMs. Jurisdictions like Singapore allow entities to use a limited number (up to 5%) of credits purchased from VCMs to offset their taxable emissions. This is not allowed in the EU ETS.

As Singapore’s carbon taxes increase, this will drive up interest in carbon credits. The country’s carbon tax will rise to S$25/tCO2e in 2024 and 2025, eventually reaching as high as S$80/tCO2e by 2030.

“Singaporean companies have to estimate that by 2030, when the carbon taxes go up, if they should buy [credits from the VCM] now or later. The demand [for carbon credits] will definitely be greater [going forward],” says Chai.

This demand is not just spurred by 2030 net zero targets and rising carbon taxes. It takes time to build a carbon-credit-generating project and get it certified. “It is widely seen that the demand will definitely outpace the supply,” he adds.

This link is also seen with the International Civil Aviation Organization’s Carbon Offsetting and Reduction Scheme for International Aviation, or Corsia, which will make it mandatory for international flight emissions to be covered by offsets from 2027.

Russia’s invasion of Ukraine, the volatility in commodity prices and the weak economic outlook have dampened carbon markets in the past few years.

According to Morningstar, the price of EUA had tripled to nearly €100 per tonne from 2021 to 2022, but following the Ukraine war, the price of the benchmark contract (yearly futures maturing in December) has fallen to €55 per tonne.

Trading volumes have fallen since 2021 due to this factor, based on data from BloombergNEF in October. Policy uncertainties around carbon market reforms and higher interest rates have also dampened trading activities.

A Morningstar article in June listed 16 ETFs tracking carbon markets, eight of which focus on the European market. Almost all recorded negative one-year total returns.

One of them is the KraneShares Global Carbon Strategy ETF, which tracks the most traded carbon credit futures contracts, covering major European and North American cap-and-trade programmes, or ETS. According to its latest fund fact sheet (as at Nov 30), its cumulative returns were -0.94% (fund net asset value) year to date, but 125.47% since inception (2020).

The showing was worse for voluntary markets. The KraneShares Global Carbon Offset Strategy ETF tracks carbon offset futures contracts by the CME Group. Its cumulative returns were -87.31% (fund net asset value) year to date and -95.16% since inception (2022). Poor confidence in the VCM is a contributing factor, said Morningstar.

“Although the demand is expected to pick up in the coming seven years, geopolitical reasons and the economic environment with high interest rates and slow growth are why carbon market pricing is also a bit lacklustre,” says Chai.

Clearly, other than geopolitical and economic factors, more policy clarity and confidence in carbon markets must be in place for carbon credits to become a more attractive investment asset.

“Let me be clear at the outset that the concept of carbon credits itself is correct and reasonable, and the problem is the process of [producing] carbon credits and how to measure, create, report and verify them,” says Yamaga.

“To navigate the issues of carbon credits and avoid price fluctuations or low trading volume, we have to make carbon credits more transparent by improving the measurement, reporting and verification processes; the methodologies for creating them; and increasing market stability through expanding hedging tools against price fluctuations,” he adds.

At the global level, negotiations continue on issues related to the measurement and reporting of carbon markets, including at the United Nations Conference of the Parties. This is important to establish the legitimacy of carbon credits and stabilise carbon prices.

“Trading carbon credits under common multilateral rules would also improve carbon credit liquidity. This is a transitional period in which the carbon market will expand and improve, and the current price of carbon credits should be recognised on this basis,” says Yamaga.

Greenwashing is another challenge that must be addressed. Reputational risks from buying carbon credits, especially those that have received criticism, are a consideration for buyers.

The value of carbon credits on VCMs depends on the type of project and the additional benefits it brings, among other factors.

For example, a project that improves cookstoves in Rwanda, where households typically use solid fuels such as firewood for cooking, reduces indoor air pollution, improves health among women and children, and requires less wood, which saves families money and prevents deforestation. Children also need to spend less time collecting wood, so they have more time for school activities.

The co-benefits of this project are more than, say, a large-scale wind project in Turkey, which provides more country-level benefits such as access to clean energy and energy independence than community-level benefits.

This example, provided by Gold Standard, highlights how the cookstove project could deliver more value and thus fetch a higher price in the market.

This is also why nature-based credits generated from projects that manage and restore natural ecosystems often fetch a higher premium, thanks to the benefits they could bring to the environment and community.

“A similar trend in which nature-based offsets are traded at a premium is seen in the Japanese credit market. Meanwhile, the downward trend in its prices can be attributed to an imbalance in supply and demand due to an increase in nature-based credits, a cautious view on the quality and an increase in demand for fossil fuels due to geopolitical factors,” says Yamaga.

“However, in the future, if the value of natural capital is re-recognised by natural capital disclosures through the Taskforce on Nature-related Financial Disclosures and other disclosure regulations, nature credits will be traded at a premium.”

According to the 2023 State of the Voluntary Carbon Markets Report by Ecosystem Marketplace, the average price of nature-based credits rose 75% (forestry and land use) and 14% (agriculture) from 2021 to 2022.

The report also highlighted that those credits with at least one co-benefit certification had a 78% price premium compared to those without and newer credits that follow more robust recent methodologies are attracting higher prices.

New ways to get involved in carbon markets continue to emerge, including by investing in projects that generate carbon credits or funds that do so.

Nomura Holdings, for instance, announced in August that it entered into an agreement through a subsidiary to invest in a Southeast Asian forestry fund managed by New Forests Asia (Singapore) Pte Ltd.

New Forests is the second-largest unlisted forestry asset management company in the world and the largest in Asia-Pacific, according to Nomura’s press release. The fund manages forestry and nature-based assets with an emphasis on environmental value and engagement with local communities to provide sustainable timber supply.

Nomura will obtain a share of excess carbon credits generated through the fund’s investments in forestry and carbon projects, as well as gain financial returns. The firm will leverage its platform, including Nomura Asset Management, to market multiple funds managed by New Forests.

Given these options, how should investors approach this asset class? Corporate investors might go for more liquid markets like in the EU and invest in EUA futures, Chai observes, while those who are familiar with the market might be interested in going into projects directly.

“Entering into a project [would mean] that the gestation period is longer. If it is a tech-based project, [it might take] two to three years. A nature-based project could take five to seven years. The gestation period has to take into account the risk and what would happen seven years [down the road],” says Chai.

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