Compliance carbon allowances are an emerging asset class whose strong performance has recently captured significant attention. Compliance carbon is based on cap-and-trade programs, also known as Emissions Trading Systems (ETS), which regulate emissions for mandated industries in their respective jurisdictions, forming a new type of investable asset class called carbon allowances or carbon credits. Over the past three years, KraneShares has built $800 million across its suite of carbon ETFs¹:

Carbon allocations can provide investors access to robust and uncorrelated performance potential and direct climate impact. As the wave of carbon investment grows, clients want to know how their peers utilize carbon within traditional portfolios.

What our investors say:

We spent time with a select group of institutional investors to discuss why they allocate to KraneShares carbon ETFs and the merits of carbon investing as part of a robust investment portfolio. This exercise identified five primary portfolio applications for carbon allocations. In the following guide, we describe those five objectives and the profiles of the clients who are putting carbon to work in their portfolios today. KraneShares believes these case studies will be helpful to all investors.

Client Description:Leading Multibillion Dollar Foundation
Primary Portfolio Role: Performance
Invested Fund: KRBN, KCCA

Today, the blended carbon price is $50 and is forecasted to rise to $120-160 over the coming years.² This potential move forms the basis of many investors’ interest in global compliance carbon markets. The reason for these expanding forecasts is that carbon markets are structured to rise in price to act as a catalyst to decarbonize the global economy and enable governments to hit their emissions targets. Europe, for example, now tightens by over 4% per year, plus has a market stability reserve that can absorb 24% of excess auction supply. California tightens at approximately 7% per year and is discussing shifting from a 40% to a 48% reduction in emissions below 1990 levels by 2030, which puts more upward pressure on the market.³

A leading multibillion-dollar foundation, that was an early investor in KRBN and KCCA, invests in carbon primarily for its structural growth opportunity but also for diversification as a secondary benefit. The foundation allocates roughly 75% to California carbon and the remainder to the global basket. They have a heavy overweight to the California market because it is still considered in its early stages, and they see a long runway for potential growth, especially with its unique market mechanisms and current market tightening reform expected to be finalized by year-end. That said, the blended basket also holds appeal because each market has its own unique growth story and return potential. The European market, which is the oldest and highest priced, still offers a steady return profile. BloombergNEF expects EUA prices to more than double by the end of the decade, revising their forecast after the EU passed its recent Emissions Trading System (ETS) reform.⁴

Client Description: RIA ($20+ Billion AUM)
Primary Portfolio Role: Inflation Hedge
Invested Fund: KCCA

Compliance carbon allowances are designed to rise with and outperform inflation. Allowances are intrinsically valuable to corporations, who must purchase them for every ton of emissions generated in day-to-day business activity. For this reason, carbon takes on some of the characteristics of real assets as they are an input in the business’ production, similar to energy, copper, real estate, and other resources. However, compliance carbon has the significant benefit that it is designed to rise above inflation as carbon prices must increase in real terms to reduce emissions. This design means carbon can provide an inflation hedge plus real return while also providing similar diversification benefits as traditional alternatives. Many investors also highlight California’s market because it has a Consumer Price Index (CPI) plus a 5% adjustment to its reserve price (floor price), signifying the regulator’s intention for prices to maintain an above-inflation trajectory.

One of the largest US RIAs invests in KCCA for inflation protection. At the firm, every investment on its platform has to fit three objectives: growth, capital preservation, or inflation protection. In their view, California carbon allowances naturally fit into the inflation hedge bucket because of its floor price mechanism. While inflation protection is the leading investment case, the firm also considers carbon a pure play climate investment. In their view, carbon presents a double win for its inflation protection and sustainable impact factor.

Client Description: Wealth Management Advisor ($5 Billion AUM)
Primary Portfolio Role: Inflation Hedge
Invested Fund: KCCA

Another wealth management advisor shared the same objective of hedging inflation with KCCA, adding that they see CCAs as the only true inflation beneficiary. They believe other inflation hedges (i.e., TIPS & REITS^†) are too rate sensitive and, therefore, serve as more of an immediate hedge but can lead to an eventual reversal. Beyond inflation protection, they invest in KCCA because of what they view as an asymmetrical return profile inherent in CCAs.

Client Description: Multifamily Office ($10 Billion AUM)
Primary Portfolio Role: Diversification
Invested Fund: KCCA

Historically, carbon markets have demonstrated low correlations to other asset classes. We believe these correlation benefits will continue as carbon prices increasingly reflect the policy tightening schedule more so than economic factors, meaning a carbon allocation, despite its own volatility, can bring down overall portfolio risk. Since 2014, carbon allowances have maintained a correlation of 0.3 or lower to other major asset classes.⁵ The correlation across the different carbon markets is also notably low because each has unique regulatory structures and regional influences.

A multifamily office invested in KCCA said they take a more capital markets perspective rather than viewing carbon through a sustainability/impact lens. Based on today’s opportunity, carbon credits are a good option to diversify and enhance portfolios through positive risk-adjusted returns.

The firm thinks the California market is desirable for two main reasons: diversification and returns. The market’s embedded mechanisms, with its low correlation to other asset classes, attractive return profile, and increasing floor price, are particularly compelling factors.

This investor also noted that physical CCAs can be hard to access, but futures contracts and ETFs offer an elegant way to get exposure. An investor must set up a Compliance Instrument Tracking System Service (CITSS) account or work with someone with a CITSS account to own physical allowances. Delays have made this a lengthy process, as California’s market is currently backlogged with nearly 250 investor applications to buy physical units.⁶ However, an ETF such as KCCA simplifies market access and, in their view, is the best use of capital for their clients in portfolios.

Client Description: Institutional Consultant to Endowments, Foundations, and Pensions
Primary Portfolio Role: Impact/Climate Benefits
Invested Fund: KRBN

Compliance carbon can offer a pure exposure to climate action and align with impact investment goals. The markets have one purpose: to reduce carbon emissions within the economies in which they operate. By participating in these markets, investors help support price discovery and add liquidity, making the markets more efficient and effective. As carbon prices rise, polluters are incentivized to decarbonize their business operations or incur higher costs to source allowances. These higher prices also drive fuel switching and more capital toward green innovations.

An institutional consultant working with endowments, foundations, and pension funds has included KRBN as a fossil fuel replacement for some mission-oriented clients. This firm still groups carbon as a commodity investment but seeks to replace high emissions commodity allocations with carbon exposure to appeal to clients’ growing preference for sustainability/impact investments.

Client Description: OCIO ($8 Billion AUM)
Primary Portfolio Role: Energy Transition/Exposure Management Tool
Invested Fund: KRBN, KCCA

The rising carbon price and the global energy transition pose risks to some companies and industries. For example, companies that are slow to innovate or struggle to decarbonize will face increasing costs as allowance prices rise. These risks could be viewed as a short position in carbon. It may be appropriate to allocate to carbon at a minimum to hedge this risk or to take a long position to participate in the upside.

The OCIO stressed that climate and ESG are factors that increasingly cannot be ignored in the investment process. They said climate and transition risks should be significant considerations when constructing portfolios. While they are moving away from allocating toward companies with heavy footprints, some limitations will still leave portfolios exposed to these risks. For this reason, they believe it is becoming increasingly critical for investors to have some carbon allowance exposure to help balance their other investments. In their view, adding KRBN and KCCA allocations provides direct climate impact and helps offset the overall portfolio’s carbon exposure to energy transition risk.

Historical Portfolios

We believe the investment characteristics outlined in these case studies offer investors a way to increase diversification with significant upside potential. Allocating to carbon also contributes to global cap-and-trade systems, which many scientists and governments agree is the most potent tool in the fight against climate change. The charts below illustrate that allocating just 10% to carbon can have meaningful portfolio benefits.

Get in Touch

We would love to hear from existing investors if there are additional use cases you have found. Additionally, we would like to hear from prospective investors if they need any support in executing their carbon strategy.

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• S&P 500: Standard & Poor’s Index is a capitalization-weighted index of 500 stocks.
• Bloomberg Barclays US Aggregate Bond Index (” The Agg” ): A broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Inception date: January 1, 1986
• The S&P GSCI: A composite index of commodities that measures the performance of the commodity market. Inception date: May 7, 2007
• MSCI US REIT Index (daily price return USD): A free float-adjusted market capitalization-weighted index that is comprised of equity Real Estate Investment Trusts (REITs). Inception date: June 20, 2005
• MSCI All Country World Index (Gross USD): The MSCI All Country World Index is a market capitalization-weighted index designed to provide a broad measure of equity-market performance throughout the world. Inception date: May 31, 1990
• LBMA Gold Price PM: The global benchmark price for unallocated gold delivered, IBA operates electronic auctions for spot, unallocated loco London gold.
• Oil: S&P GSCI Crude Oil Index: Provides a publicly available benchmark for investment performance in the crude oil market. Inception date: May 1, 1991
• S&P Global Clean Energy Index: Designed to measure the performance of 30 companies from around the world that are involved in clean energy-related businesses. Inception Date: February 22, 2007
• Carbon allowances: Top 4 carbon allowance markets by constituent trade volume. IHS Markit’s Global Carbon Index is used since the index start date July 25, 2019. From 11/30/2016 to prior to the index start date, 60% and 5% were respectively assigned to EUA futures prices (current year and next year December vintages) using Intercontinental Exchange daily published settlement prices, 20% and 5% were respectively assigned to CCA futures (current year and next year December vintages) using IHS Markit OPIS’s daily Carbon Market Report published prices, and 10% was assigned to RGGI (current year December vintage) using IHS Markit OPIS’s daily Carbon Market Report published prices. Prior to 11/30/2016, 60% and 5%, respectively, were assigned to EUA futures prices (current year and next year December vintages) using Intercontinental Exchange daily published settlement prices, and 35% was respectively assigned to CCA futures (current year December vintage) using IHS Markit OPIS’s daily Carbon Market Report published prices. For the two ranges developed prior to the index start date, Intercontinental Exchange and IHS Markit OPIS’s Daily Carbon Market Report publish daily pricing for each contract vintage for all relevant days when the futures trade.
• Market Stability Reserve: The Market Stability Reserve (MSR) holds allowances out of the auction when excess volumes are available on the market and reinjects them when there is low circulation. There is no predetermined price floor or ceiling; however, this mechanism creates stability in the market and improves resilience to future spikes in supply/demand.

*Diversification does not ensure a profit or guarantee against a loss.

†Treasury Inflation-Protected Securities (TIPS): are a type of Treasury security issued by the US government that are indexed to inflation, which provides protection from rising inflation. Real Estate Investment Trusts (REITS): companies that own, operate, or finance income-producing real estate across a range of property sectors.

Citations:

1. Data from Bloomberg as of 9/30/2023.
2. Bloomberg, “REPowerEU Plan Could Push Carbon Prices to €165/t in 2030”, Apr 11, 2021; Bloomberg, “A Tale of Two Carbon Prices to Shape Biden’s Climate Policy”, Feb 19, 2021; IHS Markit, “UN-affiliated Net-Zero Asset Owner Alliance calls for global carbon price”, Jul 7, 2021.
3. California Air Resources Board, 2017.
4. Bloomberg, “REPowerEU Plan Could Push Carbon Prices to €165/t in 2030”, Apr 11, 2021.
5. Data from Bloomberg and IHS Markit as of 3/31/2023. Carbon allowances are weighted by volume. See index definitions section for full definition of each asset class: Equities: S&P 500 ; Bonds: The Agg; Commodities: The S&P GSCI ; Real Estate: MSCI US REIT Index. Index returns are for illustrative purposes only and do not represent actual Fund performance.
6. California Air and Resource Board, as of 9/30/2023.