KraneShares Carbon Strategy: Riding Higher With Carbon Price, But Has Its Limits (KRBN)

When attending investment events, discussions inevitably gravitate toward sustainable investments, particularly in the context of decarbonization. In recent years, decarbonization has assumed paramount importance in both international discourse and financial agendas, driven by the escalating climate crisis and a more stringent policy environment. The carbon market emerges as a pivotal tool in this landscape, placing a price on corporate emissions and mandating entities to bear the financial consequences.

The carbon market, a product of carbon emissions trading, operates through market transactions in either an authority-controlled or a free and voluntary market. According to data from the

International Carbon Action Partnership (ICAP), the percentage of global greenhouse gas emissions covered by the carbon market has surged from 5% in 2005 to a significant 17% in 2023. The volume of carbon emissions subject to the global carbon market has witnessed substantial growth, and expectations point to a further price increase driven by increasingly ambitious international reduction targets.

Investment thesis

The investment outlook for carbon price-related products, such as KraneShares Global Carbon (NYSEARCA:KRBN), hinges on three factors: the evolution of the carbon market, trends in carbon pricing, and the ETF’s investment strategy.

Carbon trading has proven itself as an effective and increasingly favored mechanism for reducing carbon emissions. Projections indicate a doubling of long-term carbon prices by the end of the decade. The critical question remains whether KRBN’s investment strategy can effectively capture the upside potential and deliver returns to investors. While benefiting from spot price changes, KRBN, benchmarked to the IHS Markit Global Carbon Index, adopts an annual contract rollover approach. Given the prolonged contango situation in the carbon futures market, the roll yield in this scenario is negative.

If KRBN were to focus on the spot carbon credit market with substantial upside potential, a strong buy recommendation would be without doubt. However, being an ETF investing in futures within a contango market, the rating leans toward a buy, with a cautionary note for investors to be mindful of futures price movements and associated volatility.

The case for carbon market

To clarify, when we mention the “carbon market” in this context, we specifically refer to the compulsory “cap and trade” market, distinct from the voluntary carbon offset market. This regulatory framework is established by the government, imposing limits on the overall greenhouse gas (GHG) emissions permitted by companies within the emission trading system. The capped emissions are progressively reduced over time, contributing to an overall decrease in total emissions. Within this system, participants who emit below their allocated cap have the option to sell their surplus allowances in the market to other entities, as illustrated in the graph below.

Due to the escalating international commitment to stringent carbon emission reduction targets, carbon credit trading emerges as an effective mechanism, essentially compelling emitters to curtail their emissions by attaching a price tag. The ICAP ETS world map provides a visual representation of current, evolving, and potential emissions trading systems. KRBN boasts coverage of the world’s most expansive emission trading markets, including prominent systems such as the European Union Emissions Trading System, the California Carbon Allowance, the Regional Greenhouse Gas Initiative, and the UK Emissions Trading Scheme cap and trade regimes. Notably, the two largest markets within its purview are:

The EU Carbon Market

Established in 2005, the EU Emissions Trading System is the world’s earliest-operating carbon market, covering industries such as electricity, manufacturing, and domestic aviation. The market has undergone multiple reforms and can be broadly divided into four phases:

• Trial Period (2005-2007): The initial phase served as a trial run
• Operational Phase (2008-2012): Carbon quotas were primarily allocated through free allocation (over 90%) with a supplementary auction allocation. The allocation method followed a historical approach, imposing relatively minimal constraints on businesses.
• Third Phase (2013-2020): The market transitioned to a total quantity control approach, reducing quotas by an annual average of 1.74%. The allocation method shifted to a baseline approach, increasing the auction allocation to 57%. The introduction of a Market Stability Reserve (MSR) facilitated the price stability of the market
• Fourth Phase (2021-2030): Further reduction of quota totals, initially at a rate of 2.2% annually, later revised to 4.2%. The MSR was employed to withdraw excess quotas from the market

California-Quebec Carbon Market

Also known as the U.S. California Carbon Market and the Canadian Quebec Carbon Market, was established in 2014. The California-Quebec Carbon Market encompasses various sectors, including electricity, industry, construction, and transportation. California’s carbon market covers 75% of emissions in its region, while Quebec’s carbon market covers 77% of emissions in its respective area.

Consequently, KRBN stands to gain from the formidable carbon emission reduction goals set by European nations and California, renowned for its ambitious initiatives. The outlook for the future development and expansion of the carbon market is unequivocal, with anticipated increases in trading volume and liquidity.

Carbon price trend

The market case has been established, prompting the next question: where are carbon prices headed? The answer hinges on the dynamics of supply and demand.

On the supply side, the fundamental purpose of an emissions trading system is to incrementally decrease its cap until total emissions align with the target. Consequently, the supply of carbon credits is destined to diminish. According to basic economic principles, a decrease in supply typically results in an increase in price. However, is it really as straightforward as it seems?

Let’s consider the demand side. Returning to the fundamental goals of the carbon market, its intention is to drive carbon emission prices to levels where businesses find investing in low-emission technologies and operational changes more economically viable, ultimately curbing annual emissions – this means the demand for carbon credits is going to fall in the long-term. Therefore, the ideal scenario of carbon prices escalating to a prohibitive level remains more of an aspirational dream.

Therefore, realistically, the upper limit of carbon prices will align with the costs associated with achieving climate targets-such as adopting renewable energies, implementing new clean technologies, or funding environmental cleanup. For investments to scale and progress at the required pace, carbon prices must experience sustained growth in the long term. The High-Level Commission on Carbon Prices Report estimates a global carbon price of around US$100/tCO2e by 2030 to align with the objectives of the Paris Agreement.

In the short term, carbon prices are susceptible to various factors due to their status as an emerging commodity class, involving speculators and investors. This susceptibility was evident during the Russia-Ukraine war, causing a crash in EU carbon permit prices. However, the positive trajectory of long-term carbon prices remains highly likely.

Investment strategy of KRBN and valuation

KRBN employs futures contracts as its primary method to access the carbon market. This approach is chosen for its liquidity, transparency, efficiency, and exchange-cleared nature, offering a position in compliance carbon markets without compromising impact or price discovery features. However, concerns arise regarding the use of futures.

The primary worry is the contango effect, wherein the ETF may incur losses even when the spot price is rising due to the annual rollover necessity. This occurs when futures contracts with later expiration dates command higher prices than those with earlier dates, resulting in a negative “roll yield” that erodes spot price returns. KraneShares counters this concern by asserting that, given the unique characteristics of the carbon market, both futures-based and physical products provide the same exposure in the end.

KRBN’s investment strategy is poised to capitalize on carbon price trends by focusing on the most liquid, credible, and promising carbon markets. However, it is crucial to remain mindful of the inherent investment risks associated with carbon credits.

Investment risks

Carbon futures markets exhibit remarkable volatility. A carbon futures ETF, classified as a derivative product, targets investors well-versed in the inherent nature and associated risks. These include:

• Rolling Futures Contracts Risk: In a contango-driven carbon futures market, the ETF faces negative roll yield due to the necessity of replacing expiring contracts with longer-term ones
• Single Asset Volatility Risk: Unlike diversified ETFs, a carbon futures ETF is susceptible to the heightened price volatility of a singular asset-carbon emission allowances
• Carbon Price Volatility Risk: Prices of carbon emission allowances are subject to significant fluctuations influenced by global and local supply-demand dynamics, industry inclusion in emission trading, geopolitical events, and investor expectations
• Energy Sector Impact: The energy sector, a major GHG emitter, holds sway over the supply and demand dynamics of carbon emission allowances
• “Cap and Trade” Sensitivity: Under the “cap and trade” principle, if the reduction in emissions cap falls below market expectations, the ETF may face negative impacts as demand for carbon emission allowances decreases

Investment comments: Overweight with undiversifiable risks

In conclusion, my confidence in the future of the carbon market, the potential of carbon prices, and the strategic approach adopted by KRBN remains steadfast. I hold an optimistic outlook regarding the upward trajectory of carbon prices in Europe, the US, and other markets. Nevertheless, it is crucial to bear in mind the distinctive nature of carbon credit prices and the mentioned undiversifiable risks, which have the potential to significantly influence the stock price of KRBN.