The global value of carbon markets increased by nearly 20 percent in 2020, marking the 4th consecutive year with growth that has been record-setting. Carbon markets that are compliant (CCMs) where mandatory national regional, international or regional frameworks regulate and trade carbon emissions, are playing a growing prominent part in efforts to cut emissions. Carbon markets that are voluntary (VCMs) which are where businesses and individuals exchange carbon credit on a non-committal basis, are a key factor in generating investment in carbon compensation and neutralization projects that reduce their carbon emissions.

Today, institutional investors take part in these markets to a lesser extent. There are structural barriers that prevail and market dynamics are not clear. But, the landscape is shifting. This joint paper by GIC as well as The Singapore EDB, and McKinsey explores the rapid rise market for carbon as an profitable asset type. They suggest that investors from institutions can play an important role in assisting nations and companies utilize these markets to reach the goals of global climate while satisfying their specific requirements. Although it doesn’t issue an investment advice but it does aim to clarify the development in carbon markets as well as their importance in the context of institutional investors.

1. The carbon markets are quickly reaching critical mass from the perspective of an institutional investor

As we’ve mentioned that the involvement by institutional investors into carbon markets is restricted today. CCMs are more established and more substantial of the two, with a valuation of over $100 billion and a trading turnover of over $250 billion. But, they are still smaller than the $19 trillion worth of assets managed by the top 100 of the world’s institutional investor in the year 2020. CCMs are still in the early stages with a market value of 300 million dollars in 2020. Because of their limited liquidity, inadequate market size, an unstandard method of transaction and the absence of rational or explicable price mechanism, they have not been suitable for institutional investments on a large scale.

However, the overall market picture is changing rapidly. CCMs have been stable and are becoming more accessible institutions to grasp. New emission-trading system (ETS) are currently being created, and the recent market reforms to existing trading systems have led to more stable system.

In the meantime, infrastructure and governance are being designed to facilitate the rapid expansion of VCMs which are as likely to grow in the same way as CCMs. McKinsey’s involvement in conjunction with TSCVM Taskforce on Scaling Voluntary Carbon Markets (TSVCM) illustrates that VCMs are an investment option that is more feasible in the future , if they can meet the requirements of certain requirements, including that of standardizing corporate claim as well as products. Furthermore, VCMs have a significantly more flexible market mechanism with pricing set by demand and supply and, consequently, less prone to regulations and policies.

Carbon markets could be relevant for investors in a range of ways, dependent on the specific investment mandate. In the first instance, they can take action on their own behalf, for instance, purchasing carbon credits through VCMs to offset and offset their own emissions. They could also invest in carbon-removal and carbon-avoidance projects that meet the environmental, social, and governance targets. The second option is to purchase carbon-based products as an investment in the hope of a return on price appreciation. Third, investors could purchase carbon allowances to protect themselves from climate change risks that could influence how other assets perform within their portfolios of investments. Investors may also take a more indirect approach by asking companies their portfolios to pay for their own emissions through buying carbon credits in VCMs or to offset the residual emissions through funding strategies for avoiding and removing emissions.

2. Markets for carbon that are active and liquid will be crucial to help the world reach net-zero emissions

In 2015, the Paris Agreement set the goal of zero emissions by midcentury in the hope of restricting to 1.5degC the increase in temperatures across the globe due to the growth of greenhouse gasses (GHGs) within the air. Five out of the world’s largest 2,000 publicly traded companies have pledged to meet a net-zero emissions goal, as have countries that account for 61 percent of all global GHG emissions. Institutional investors have an vested desire to achieve this goal in the event that it is not met their portfolios could be more vulnerable to climate risk.

Net-zero commitments from national and corporate sources are fueling the growth of carbon markets in two ways. The first is the effort of governments to control emissions via cap-and-trade carbon credits programs have resulted in the growth of CCMs where participants are able to swap carbon allowances. A second, yet to be developed but quickly expanding VCM permits participants to purchase carbon credits which redirect funds to projects to reduce or eliminate carbon which in turn compensates against (or negating) their own carbon emissions. While the primary focus is to cut emission, the carbon credit could aid companies in completing and speeding up their efforts to reduce emissions.

Institutional investors may play an important role in both VCMs and CCMs due to the massive amount of capital they can accumulate, allocate, and use. They can bridge demand and supply and to increase market liquidity and depth. In CCMs, for instance investors can exchange carbon allowances in order to boost liquidity and bridge the gap between demand and supply. In VCMs they are able to promote the global effort to reduce carbon emissions through making investments in the lessening or elimination of carbon credits via third party funds or directly. They also have the ability to exert a significant influence over their portfolio companies to focus on decarbonization and to share the best methods .

3. Carbon allowances under CCM can provide some protection from the downside and increase the risk-adjusted return in scenarios that involve either immediate or delayed climate action

The investment in carbon markets is an uneasy proposition for institutions, however this is likely to change quickly. In light of this, we looked at what investors can achieve through incorporating carbon allowances into their portfolios now. Our research suggests that investors who dedicate just a tiny portion in their portfolios to carbon allowances can have the potential to safeguard themselves from the climate-related risks. While the exact course of carbon prices is still uncertain however, they are dependent on the actions of policymakers; as the result, carbon prices could rise as governments around the world begin to take actions.

Our collaboration in conjunction with Vivid Economics, and the Planetrics platform has resulted in an analysis from the bottom up of the impact of climate risk on different class of assets. With 3 different scenarios for climate, developed through the Network for Greening the Financial System (NGFS) in order to examine a possible transition in line with keeping global warming below 2 degrees Celsius, we analyzed how a portfolio performs which incorporates carbon allowances. The expected performance was calculated over a 10or 30-year time period for a portfolio that has five percent allocation to carbon allowances in comparison to an unspecified portfolio that comprises 60 percent equity with 40 percent of bonds.

We discovered that over the course of the course of 30 years carbon allowances can boost the risk-adjusted returns for an a 60-40 portfolio reference in scenarios involving delayed or immediate climate change by 50-70 basis points, compared to the expected return for a typical 60-40 portfolio, which is around 4 percent. Also, volatility increases by around 10-20 basis points, in comparison to the expected volatility of an average 60-40 portfolio of around 9.8 percent. The only instance in which carbon allowances increased returns below base was one where there were no new climate change policies implemented.

We also discovered that carbon allowances may offer downside protection. They mitigated the anticipated negative effects of climate change risk under two scenarios of delayed or immediate climate action. A carbon allowance allocation of 0.5 up to 1.1 percent provided a sufficient amount of risk diversification during climate change changes.

4. Three steps to aid in developing VCMs Today

Despite the dangers that come with it, private investment in top-quality compensation and neutralization programs is required urgently to achieve net zero. According to one estimate, the world needs to bridge an $4.1 trillion gap in financing by 2050 in order to meet climate change biodiversity, land-restoration, and climate change goals. VCMs are crucial in raising and directing the funding flow.

The institutional investor could assist in the acceleration of the development of VCMs by taking three important steps:

directly and assisting in the expansion of top-quality compensation and neutralization initiatives including natural climate solutions
Supporting high standards of integrity and good governance for carbon credits. The lack of these standards is a major issue in the creation of VCMs
Most importantly, they can guide companies through their journey towards net zero: investors can help companies establish targets for decarbonization, present the progress they make in meeting these targets, and use carbon credits to assist in meeting their commitments to meet them or better yet — increase their climate goals

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