Does Your Portfolio Need A Carbon Credit ETF?

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There are many hazardous consequences due to the presence of greenhouse gases in the earth’s atmosphere. Some of these are ozone layer depletion, climate change, global warming and a rise in sea levels. This has resulted in many global initiatives taking shape, in order to urge nations to cut down on their carbon emission levels.

Thanks to this, many industry-oriented economies are facing a dilemma, since curbing pollution levels would result in a reduction of industrial activities. This, in turn, would result in a reduction of income and output for the economy in question, thereby hampering economic growth, not exactly a popular stance to take when seeking to get reelected (see Clean Energy ETFs In Focus).

In order to mitigate some of these concerns while still attempting to control emissions, investors have witnessed the birth of the emission trading (ET) industry. With the increasing participation of nations in the guidelines of Kyoto Protocol (:KP) and rising social accountability, the emission trading industry has the potential to emerge as a major global industry, despite non-ratification of the Kyoto Protocol by the U.S.

Overview of the Kyoto Protocol (:KP)

In 1997, the Kyoto Protocol was adopted by a host of participating countries. However, these countries were divided into two broad categories:

1) The developed industry-oriented economies responsible for a majority of GHG (Greenhouse Gas) emission were categorized as Annexure 1 countries (developed European nations, Japan, Australia, New Zealand, etc.) and 2) Developing nations as Non-Annexure 1 nations (China, Brazil, India, etc.)

The basic premise of the KP was to reduce emission of GHGs with specific emission reduction targets being assigned to the countries by the year 2012 (with an average of 5% leeway).

In addition to conventional and scientific methods of reducing emissions, countries also welcomed market-based mechanisms for the compliant Annexure 1 nations in order to meet the specified targets, including:

1) Emission Trading (ET) i.e. countries that have emission units to spare, can sell their units to countries in need for those units.

2) Clean Development Mechanisms (CDMs) which facilitated Annexure 1 countries in setting up “green” projects in Non-Annexure 1 countries. These projects earn tradable Certified Emission Reduction Credits (CERs) issued by the United Nations Framework Convention on Climate Change (:UNFCCC). One CRE equals one ton of carbon dioxide which would be counted towards meeting the targets.

3) Joint Implementation (JIs), which is an initiative by the Annexure 1 and Non-Annexure 1 nations, to set up emission reduction or removal projects in developing nations in order to earn Emission Reduction Units (ERUs) which also would be counted towards the target.

Therefore we see that these ‘instruments’ have been given an economic value having demand and supply, with potential buyers being the industrial firms in the Annexure 1 countries and potential sellers being the firms who obtain carbon certificates by reduction in their emission levels (see more on ETFs at the Zacks ETF Center).

This has given rise to the carbon trading market and these certificates are being categorized as an investable asset class. These certificates have been trading in major exchanges throughout the world and have been categorized as commodities. The major players in the market are manufacturers, spot market intermediaries, arbitragers, commodity financers and investment/fund managers.

Risks involved in investments

Investments in these instruments usually involve supply side risk. The prices of these instruments are influenced by a variety of factors such as the supply of emission credits, energy prices, global-economic growth rates, and most importantly, government policies.

Given the above factors it is prudent to note that supply-demand mismatch can be either natural (i.e. lack of certificates being issued by UNFCC on account of emission not being reduced), or manmade (i.e. big supplying nations holding back supply in order to increase prices artificially). Therefore the prices can be influenced by major players in the market as well.

Products targeting this space are largely influenced by geopolitical issues. Any negative development can result in a significant decrease in prices. Therefore political risk is quite high in this type of product, especially considering the nations involved (see Greek ETF Plunged on Election Results).

However, it is not easy for retail investors seeking exposure in this asset class to enter and exit the market directly. Therefore an ETF approach—or at least for the current market, an ETN technique-- to investing in these complicated segments is really the only way to go for most retail investors at this time.

While the market is sparse, there is currently one choice that is available, thanks to an exchange-traded note from iPath:

iPath Global Carbon ETN (GRN)

Launched in June of 2008, GRN seeks to replicate, before expenses, price and yield performance of Barclays Capital Global Carbon Total Return Index. The index measures the performance of the most highly traded carbon related credit plans and serves as an industry benchmark for carbon investors. The ETN charges investors 75 basis points in fees and expenses and has total assets of $1.12 million (read Hard Times In Soft Commodity ETFs).

Presently the note holds around 90% of its total assets in future contracts of EXC Emission Reduction Units (ERUs) and the remaining 10% in future contracts of EXC Certified Emission Reductions (CERs). The product had faced tough times last year, basically due to a recessionary environment in the Euro zone - the largest buyers of carbon credits.

Moreover, the political turmoil in many parts of the continent also was responsible for such dismal performance, as prices of such products are very much dependent on political decisions and reforms as they relate to the number of credits outstanding in the marketplace.

Beyond this, investors should also be concerned about the volume and tradability of the note. Currently, there is just over $1 million in assets invested in the product while daily average volume is below 1,500 shares (see charts of GRN here).

Given this, and the uncertain outlook for both the euro zone and the carbon credit market, many investors might want to stay away from this product at this time. While carbon investing might sound trendy or profitable, there are arguably too many credits out on the market and demand for these seems likely to sink lower, especially if the euro zone debacle intensifies.

This suggests that for investors concerned about the environment, the best way to play the trend is via energy efficiency ETFs or those that target segments such as wind or solar. The carbon ETN, unfortunately, isn't a very good option, especially during this current market cycle.

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