Investing in carbon: a new asset class

Summary

— Carbon markets are a priority at COP28,^[1] but allowances are not offsets. The EU Emissions Trading System (ETS) requires major companies to hold an EU Allowance (EUA) per tonne of emissions or face steep fines.

— Unlike other commodities, the EUA supply or cap falls every year, to create scarcity and a carbon price that encourages companies to cut emissions. The EU concludes^[2] that the ETS is effective in reducing emissions.

— Policymakers have strengthened market rules: the annual cut in EUAs is now 4.3% (2.2% previously), which is likely to lead to higher prices. Market rules have reduced volatility and improved price forecast accuracy. EUA correlation with other asset classes is low but growing.

— We forecast that carbon allowances could hit EUR 95 by the end of 2024. This could make EUAs one of the strongest performing asset classes in DWS’s Chief Investment Office (CIO) forecasts^[3] from November 2023.

— The declining cap means that EUAs could disappear by 2039 with long-term price implications that will depend on the speed and cost of industrial decarbonization and policy response.

— Financial regulators conclude:^[4] “the market appears to broadly function as expected”. As investor participation grows, market monitoring is important to maintain the ETS’s aim to facilitate the transition.

— DWS’s CROCI® carbon price scenario analysis of European equities finds that the energy, utility, industrial and material sectors could face financial risks. Investing in carbon allowances could be an innovative hedge. However, carbon allowance accounting standards are needed to facilitate company level risk assessment.^[5]

— Net zero portfolio guidance focuses on offsets^[6] rather than allowances. We are more cautious regarding strong claims of real carbon reductions from a buy-and-hold strategy,^[7] particularly as an academic cut his estimate of potential emission reductions.^[8] A price effect is possible, but more analysis is needed.

— Companies regulated by the ETS have an essential role to play in the transition, but many climate equity funds underweight these sectors. Hedging with EUAs can thus complement net zero transition engagement goals by helping address potential financial risks from remaining invested in these sectors.

— Using a Strategic Asset Allocation (SAA) model, Defensive, Balanced, & Dynamic portfolios could receive a small return enhancement (0.11% to 0.23% to 0.34%) with reduced volatility, by adding carbon with an allocation ranging from 2.1% to 4.5% to 6.75% respectively. We also examine other allocation methods.