The Four-Step Guide to Understanding Carbon Allowances

Climate change policies are becoming more prevalent around the world as governments and companies scramble to meet net-zero by 2050. Carbon allowances have come to the fore as one of the most effective measures to reach this goal. This once obscure asset class is now accessible through ETFs which invest in carbon futures. It may appear to be an abstract investment opportunity but fear not, we’ve stepped out the four key concepts you need to understand about carbon allowances and their growth potential for your portfolio.

1. What Are Carbon Allowances?

Carbon allowances – also called carbon credits – are tradable permits which enable polluters to emit one tonne of carbon dioxide (CO2). Think of carbon allowances like tickets to a football game. You must have a ticket to attend and the more matches you want to see, the more tickets you will need. Typically speaking, heavy CO2 or equivalent greenhouse gas emitters such as airlines, coal fired and gas turbine power stations are the organisations which need to annually purchase carbon allowances – by effect putting a price tag on carbon.

2. How do Emissions Trading Schemes Work?

Emission trading schemes are the issuers of and marketplace for carbon allowances. They were introduced to help address climate change concerns and became more widely known after the Paris Agreement in 2015 when governments from around the world agreed to reach net-zero carbon emissions by 2050 to prevent global warming increasing by more than two degrees Celsius. According to the Organisation for Economic Co-operation and Development (OECD), “broader use of emission trading systems (or of environmental taxation) would be one of the most efficient and effective ways of promoting green growth” – making them a vital tool in accomplishing these targets.1

The most regulated and enforceable type of emission trading scheme is the ‘cap-and-trade’ model. ‘Cap-and-trade’ schemes auction off carbon allowances to put a strict “cap” on the overall amount of emissions which can be pumped into the atmosphere each year and incrementally lower the “cap” to work towards net-zero goals. The largest and most established trading schemes in the world follow this model. Each scheme has its nuances, however the basic principles are similar across the board.

  • Emission trading scheme authorities hold an annual auction where polluters bid to purchase enough carbon allowances to see them through the year.
  • The number of new allowances issued is reduced each year – creating a more competitive market, pushing up the price of CO2 and encouraging the adoption of clean energy.
  • Participating organisations can also auction off their leftover allowances from the previous year.
  • To ensure allowance limits are adhered to, trading scheme authorities conduct audits and enforce hefty fines.

3. Where Are The Biggest Emission Trading Schemes?

The first emission trading scheme was started by the European Union in 2005. Other jurisdictions including the United Kingdom and areas of America have since followed suit and now there are more than 20 carbon markets around the world. The four most robust and regulated schemes are the European Union Emissions Trading Scheme, Regional Greenhouse Gas Initiative, Western Climate Initiative and the UK Emissions Trading Scheme.

  • The European Union Emissions Trading Scheme requires every country in the region to participate, plus Iceland, Liechtenstein and Norway.2
  • The Regional Greenhouse Gas Initiative is comprised of eleven east coast states in the US – including New York – which has established a regional cap on carbon emissions by specifically targeting power plants in each state.3
  • The Western Climate Initiative operates in the US states of California and Washington, as well as the Canadian provinces of Québec and Nova Scotia. Heavy polluters including power plants and refineries were required to participate from 2013, while other emitters like suppliers of transportation fuels had to comply by 2015.4
  • UK Emissions Trading Scheme is governed by the UK, Scottish and Welsh Governments and Northern Ireland Department of Agriculture, Environment and Rural Affairs. The scheme applies to energy intensive industries, the power generation sector and aviation as well as smaller emitters such as hospitals. 5

4. Why Are Carbon Prices Rising?

The investment case for carbon allowances is growing thanks to favourable supply and demand dynamics, political pressures and international investment in decarbonisation. These factors should multiply the growth potential of carbon allowances, particularly if climate change targets become more ambitious than current net-zero goals.

Now that you understand how emission trading schemes work, it is easier to understand how supply and demand could affect the price of carbon over time. With supply shrinking each year, all things being equal, prices should rise. This also works to help cut emissions by making pollution more expensive.6

Political pressures from global entities such as the United Nations – notably policies like the Paris Agreement – are seeing governments and companies alike reduce their carbon footprint. More broadly, climate change awareness from the broader public is also contributing to mounting pressure for polluters to address their environmental impact. This may lead to more jurisdictions around the world implementing emission trading schemes to ensure climate change goals are being met.

Carbon Allowances: Fighting The Good Fight

Carbon allowances and emission trading schemes are becoming a leading method to meet net-zero goals and limit global warming. As existing schemes in the European Union, the United Kingdom and US continue to crack down on emissions and more countries enact similar policies, the overall cost of carbon is set to increase – making carbon allowances a valuable tool in the fight against climate change and a cleaner way to incorporate growth potential into your portfolio.

Related Funds

GCO2: For investors wishing to invest in carbon allowances, the Global X Global Carbon ETF (Synthetic) (GCO2) provides a solution. The fund tracks the ICE Global Carbon Futures Index and invests in carbon markets covering the European Union Emissions Trading Scheme, Regional Greenhouse Gas Initiative, Western Climate Initiative (California cap and trade program) and the UK Emissions Trading Scheme.

Click the fund name above to view the fund’s current holdings. Holdings are subject to change. Current and future holdings are subject to risk.