My wealth management firm, Hesperian Wealth, recently completed its research into a new Carbon Solutions investment opportunity. In my portfolio manager role, I am always looking for innovative ways to help impact-oriented clients invest their savings more sustainably while at the same time support the environmental issues they care about. Impact investors can now move beyond socially responsible stock funds and green bond strategies. They now have the ability to directly support the cap-and-trade programs designed to decarbonize the global economy. And investors in such Carbon Solutions can potentially earn an attractive return in the process. Here’s how:
What Are Carbon Solutions?
Several cap-and-trade programs have been established across the globe. Rules and structures differ, but they all require designated polluters to purchase certain carbon allowances to offset their emissions. The programs then use the funds raised to support renewable energy and social initiatives. They may also provide allowances directly to green projects, which can then be sold effectively as carbon offsets.
The ultimate goal, though, of cap-and-trade is to increase the cost of carbon by incrementally constraining allowance supply and eventually capturing the true societal externalities of fossil fuel consumption not fully accounted for by today’s capital markets. But gradually, so that companies and economies have time to adapt. Cap-and-trade programs ingeniously tap market forces to do environmental good. And it is my conviction that higher carbon costs will incentivize the green transition more effectively and efficiently than government subsidies.
There are now investable derivatives-based allowance markets for the programs of the European Union, the United Kingdom, California/Quebec, and the Regional Greenhouse Gas Initiative in the US Northeast. These exchanges have been set up to facilitate trading, invite carbon investors in, and encourage carbon price discovery. More will follow. This is where impact investors come in.
Why Invest in Carbon Solutions?
The Impact Case
By buying carbon allowances and taking them off the market, impact investors can play a small part in shrinking supply even faster. All else equal, this will accelerate the rise in carbon prices necessary to materially alter economic incentives. At the same time, investor-purchasers of carbon allowances are offsetting carbon exposure in their own portfolios and lives.
The Investment Case
There may also be a compelling investment case:
- Professional forecasts of what future carbon price would be consistent with achieving current program and net-zero goals imply high single-digit to low-double-digit annualized returns between now and 2030 (depending on the allowance market assessed and the assumptions used).
- Already since the establishment of these markets, carbon allowances have delivered strong returns to investors (see the performance discussion below).
- Returns to carbon futures have also been lowly correlated to most any other investment class so there may be a diversification benefit in portfolios.
- The regulatory environment remains strongly behind these programs and could lead to further tightening of supply to push the carbon price up faster. The California program recently reduced allowance supply, likely driving the carbon price rally observed for its allowances throughout 2023.
Carbon Solutions Returns, Correlations & Downside Protections
In the chart above, you can see the history of California and EU carbon allowance futures prices, with S&P 500 and US intermediate Treasury bond returns for reference. Carbon allowance futures should be expected to be very volatile, with high downside risk (less for California allowances, but more on that in a minute).
But over the time period shown, returns have also been high: 10.17% annualized for the California market and an eye-raising 29.45% annualized for the EU market. Meanwhile, correlations to stocks and bonds have been low (ranging from -.05 to .32). So in a portfolio context, despite the big price swings, a modest carbon allowance futures allocation (say 10% of equities) would have increased portfolio-wide returns and actually lowered volatility.
The Inner Workings of the California Allowance Program
The California allowance program offers investors some interesting downside protections. First, it sets an auction reserve price. If an auction ever settles under that price, the program would begin to restrict allowance supply further until auctions clear above it. So far, despite inter-auction volatility in the trading market, this mechanism has successfully acted like a magnet on prices and kept auction settlements (the yellow dots in the chart to the left) at or above the reserve level (the black line).
Second, the program raises that auction reserve level each year by 5% plus inflation. So not only does the reserve price provide investors with a reliable idea of their downside, but also some security that carbon prices will indeed be pushed higher in the future.
The Investment Risks
As with any investment, there are risks:
- Carbon allowance markets are relatively young with a limited trading history.
- They are highly volatile, although this can be addressed by limiting position size, funding the position from other highly volatile assets, and diversifying across different regional allowance programs, which is where a knowledgeable wealth manager comes in.
- In a slowdown or recession, I’d expect carbon prices to fall as they are connected somewhat to economic activity. This was borne out during COVID when carbon prices fell precipitously alongside other economically sensitive assets.
- And regulatory support could always flag in the future because of shifting policy priorities, though this seems remote given the present political situation, in California and Europe in particular.
Harnessing Hesperian Wealth's Expertise in Impact Investing
Given how little progress has been made in cutting emissions to meet aggressive net-zero targets, it is no longer enough for impact investors to focus on screening out fossil fuel companies and other polluters from their equity allocation. Those extractive and toxic industries still participate in destructive activities whether you own their stocks or not. Our whole global economy remains inextricably linked and reliant on fossil fuels. Motivated impact investors need to do more and be more proactive. My view is investing in Carbon Solutions, namely supporting cap-and-trade carbon markets, is the next logical step. And fortunately, they may offer attractive returns and diversification potential if the right strategies are chosen and they are sized appropriately.
Impact-oriented clients trust my firm, Hesperian Wealth, to guide them in building portfolios that will meet a dual mandate to (1) deliver the returns they need to meet their financial goals and (2) make a positive impact on the world around them. If you’re interested in a sustainable portfolio that has the potential to truly drive change, I encourage you to reach out and set up a portfolio consultation:
Eric R. Figueroa, CFP®
I am a Folsom, CA, fee-only wealth manager serving the Greater Sacramento area, California Gold Country, and the nation virtually. I offer financial planning and investment management services. I specialize in serving working professionals and clients interested in impact investing and personalized values-based investing.
All content presented in this article is for informational purposes only. Materials presented should not be interpreted as a solicitation or offer to buy or sell a security or the rendering of personalized investment advice, which can only be provided through one-on-one communication with a financial advisor. The content reflects the opinions of Hesperian Wealth LLC (HW), except where cited, which are subject to change at any time without notice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. All information or ideas provided should be discussed in detail with a financial, tax, or legal advisor prior to implementation.
Any reference to a market index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indexes are unmanaged vehicles that do not account for the deduction of fees and expenses generally associated with investable products.
Investing involves substantial risk, including the potential loss of principal. HW makes no guarantee of financial performance nor any promise of any results that may be obtained from relying on the information presented. HW may analyze past performance, but past performance may not be indicative of future performance.
Impact investment strategies may underperform investment strategies without additional non-financial objectives. There is also no assurance that impact strategies will achieve the financial and non-financial outcomes Clients seek to bring about. HW, Clients, and investment managers may have different definitions of “impact” and what the optimal strategies are to achieve it.