Forest view from below

For producers and users of fossil fuels, carbon credits issued by regulatory organizations are essentially a licence to pollute. For three Canadian ETF providers, they represent opportunity in an emerging alternative asset class.

The investment thesis for these credits — also known as allowances — assumes that governments will not only continue to impose restrictions on carbon emissions, but that restrictions will become more stringent over time.

“That will drive up the price of carbon, which means that the price of these allowances will go up over the long run,” said John Wilson, co-CEO and managing partner with Toronto-based Ninepoint Partners LP.

The Ninepoint Carbon Credit ETF and the Horizons Carbon Credits ETF both launched in February. The newest is the TD Global Carbon Credit Index ETF, launched in August. The low-cost provider by a slim margin is TD, whose management fee of 0.65% is 10 basis points lower than its two rivals.

Asset growth has been slow, with a combined total of a little more than $20 million held in the three funds. Of that total, roughly half is held in the Ninepoint strategy, which is also available as a mutual fund. Horizons has $7.3 million in assets, followed by TD with about $3 million.

Though their strategies aren’t identical, all three funds obtain their exposure to carbon credits through futures contracts: obligations to buy credits at a predetermined price at a future date. Once a year, the carbon futures contracts are closed out, either at a profit or loss, and rolled over into new one-year contracts.

The largest and most liquid market is the European Union Allowances (EUA), which is what the Horizons and TD ETFs are based on. The TD ETF seeks to track the Solactive Global Carbon Credit Total Return CAD Hedged Index; Horizons uses a proprietary index focused on Europe that’s maintained and calculated by Frankfurt-based Solactive AG.

Ninepoint takes a geographically diversified approach with a portfolio of futures contracts equally weighted among four exchanges: the dominant EUA, California/Quebec, the eastern United States and the United Kingdom.

Wilson estimates the combined value of credits traded on these exchanges is close to US$1 trillion, of which the EUA trading system constitutes almost 90%. “We felt overweighting relative to market weight the North American indexes gave greater upside potential for the product over time,” he said.

Both Horizons and TD Asset Management Inc. say they may add exposure to other exchanges in the future as these markets become more developed and actively traded.

“Built into the [Horizons] methodology is a rule that requires a certain amount of liquidity,” said Mark Noble, executive vice-president, ETF strategy, with Toronto-based Horizons ETFs Management (Canada) Inc. “Right now the European credits are the only ones that basically meet that liquidity screen.”

All three sponsors rate their ETFs as high risk. So far, the volatility has been mostly on the downside. Shortly after the two February launches, Russia’s invasion of Ukraine led carbon-credit prices to fall, especially those on the European exchange.

The immediate concern, Wilson said, was a massive recession in Europe that would reduce fossil-fuel emissions and lower the demand for carbon credits. There was also a general flight from European assets, including carbon credits, and fears that energy shortages would prompt governments to back off their emissions-reduction targets.

By early March, the Ninepoint ETF was down by 17% and the Europe-only Horizons ETF had lost one-third of its original value. “While there are some diversification benefits to holding carbon credits, they are highly volatile,” Noble said.

By early December, Horizons had recovered nearly all of its losses since its inception, and both Ninepoint and the newer TD ETF were in positive territory.

“We haven’t based the investment case for this on a short-term time horizon,” Wilson said.

Even with a recession, he added, energy costs will remain elevated, which can push up the price of carbon allowances.

Noble said that if the price of natural gas — a key input for electricity costs in Europe — remains high, there’s likely to be some switching over to coal. “That will probably create more demand for carbon credits because coal obviously has a much higher carbon load.”

Though the price of carbon credits may serve as an incentive for companies to reduce their emissions, the credits aren’t considered to be an ESG investment.

“Their usage allows for the further propagation of carbon fuels,” Noble said. But for investors who are worried about emissions, he added, carbon credits are a more palatable investment than energy producers and companies that use fossil fuels.

“You are getting correlated exposure to commodity usage and carbon fuel usage but you’re also investing directly in something designed to reduce their usage,” Noble said. “So that makes them a very powerful portfolio tool, particularly for investment counsellors or advisors trying to put a little bit more of an environmental bent on their portfolio.”

For investors who aren’t averse to fossil fuels, a fund investing in traditional energy and a carbon credit fund can complement each other in a portfolio, Wilson said. His firm also manages the Ninepoint Energy Fund, which, as of early December, had a year-to-date return of 56%.

“Over the long run, we think carbon credits are a really good investment vehicle,” Wilson said. “So you can have two good investments that, if you want, offset each other from an emissions standpoint.”