Carbon credits are one way that companies are offsetting their emissions with the aim of reducing their global footprint. Now, ETFs are available that allow investors to put their money into this cause. But is it actually going to generate the outcome investors are expecting?

Let’s look deeper into the investment case for carbon credits, i.e. why should we assume that their price will go up over time? And does buying a carbon credit ETF actually contribute positively to emissions reduction?

For context, a few years ago the guidance given by authorities and regulators to companies was to first de-carbonise the business as much as possible, and only then, turn to the carbon credit market if the business falls short of its carbon reducing objectives. That has changed recently, with companies being told to do both at the same time. This is a positive development for carbon credit prices. However, companies are also finding out that the alternative, i.e. offsetting their carbon emissions by planting trees, is expensive. Both of these, and the continued global focus on emissions reduction, point to sustained demand for carbon credits.

One of the potential risks is that regulators could increase the supply of credits, which would depress prices. However, regulators are actually reducing the number of credits allowed every year in order to encourage companies to cut emissions faster. So, the investment thesis is that we continue to see more demand and less supply, which should be supportive of prices over the long term.

The risks are that this is still a very “young” market, which means it’s likely to be volatile and prone to mispricing. While the general trend for prices should be up, prices could go down or sideways for extended periods of time. Currently the only carbon credit ETF available is XCO2, managed by vanEck and another should soon be launched by Global X (formerly ETFS) (GCO2). The XCO2 ETF includes carbon credits from the four main carbon trading schemes (Europe, UK, California and North-Eastern America), but new ones may be added in the future if they become large and liquid enough. The addition of new futures also represents an “unknown” risk to the ETF price.

In terms of whether buying carbon credits contributes positively to the emission reductions, the answer is multi-faceted. Buying carbon credits clearly doesn’t offset any carbon emissions, but it can have an indirect effect on emissions over time: as more investors buy credits, pushing the price up, it will make it more expensive for companies to buy credits and therefore encourage them to reduce actual emission instead. For an ethically minded investor, the XCO2 ETF could be considered as part of the investable universe, maybe as an alternatives allocation.

For more information about how InvestSense invests in socially responsible and climate sensitive investments, please visit our Better World page, or call our team.

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