Invest in Carbon Credits to Diversify Your Portfolio

By Ron Galloway,
Researcher, Finance and Healthcare Expert

One area of investing that has taken off in the last few years is socially aware investing due to the dual influences of the environmental movement and the sustainability movement. Most people don't think of carbon emissions as an investment, but they are. And this is accomplished when you invest in carbon credits.

In this article, we will cover:

What Are Carbon Credits?

A carbon credit is a bit like a stock certificate. It represents a certain amount of carbon emissions, for instance, one metric ton of carbon emissions. A company that emits a lot of carbon during its business process can offset its carbon output by purchasing carbon credits. If the company emits 30 metric tons of carbon, they buy 30 carbon credits to counteract this. This investment in carbon credits has become so common now that carbon credits are routinely traded in major markets worldwide.

Watch Episode #12, Investing in Carbon Credits, to hear our experts discuss investing in carbon credits. The webinar is on Wistia and does not require a log-in.

Why Should I Invest In Carbon Credits?

Let's look at this a little bit more. Carbon credits are a function of the government's "cap and trade" policies. The "cap" refers to the amount of carbon emission (in metric tons) a company can produce as a part of its normal business process. The "trade" refers to the number of carbon credits a company is allowed to buy or sell to bring its carbon emissions under the "cap."

If you decide to invest in carbon credits, remember the market is relatively new. Still, it is a market that represents tens of billions of dollars per year and is growing. Environmental regulations on companies increase every year, and carbon credits have become the default mechanism for adhering to these regulations.

For instance, when Ford Motor Company is building cars, their factories emit a lot of carbon. The government allows Ford a certain amount of carbon pollution. If the carmaker goes over that allotment, it needs to purchase carbon credits to offset its overages.

Investing in carbon credits is attractive because the number of existing credits is relatively fixed; it's not infinite. There is a limited supply, but ­not limited demand.

Therefore, it's not just companies that can profit (by balancing their carbon emissions). There are also many opportunities for investors to benefit from this area. There are a few different ways to do this.

How Can I Invest In Carbon Credits?

One straightforward way is to invest in companies that trade carbon credits as part of their everyday business. Companies that have announced that they're going to become 'carbon negative,' such as Boeing, need to contract a certain amount of carbon offset credits to achieve these goals. Some companies, such as Shell, directly buy and sell carbon credits with other companies as a trading profit center.

Another mechanism is to invest in carbon credits through an exchange-traded fund (ETF). This investment pool tracks the performance of the assets that comprise it. For example, the QQQ exchange-traded fund mirrors the S&P 500's performance. There are existing ETFs benchmarked to different carbon indexes that track the performance of carbon credit-related futures contracts. ETF such as these commonly returned double-digits in 2021.

Probably the most active market for carbon credits exists in the futures market. Much as you can trade corn, gold, or hog bellies in the futures market, you can also trade carbon credits. This market is more complex, but returns can be much higher in the futures markets because you can use leverage. There are lots of risks and lots of potential rewards.

As with any investment, there is risk involved. There is some risk in investing in carbon credits through the aforementioned vehicles. Remember that investing in carbon credits is a very specialized and targeted investment. It does not by any means represent a diversified investment, but what it does represent is an asset class for an overall portfolio.

This particular investment is attractive because it is new and growing at a tremendous rate. Institutions at first did not invest in carbon credits; now, they do.

What Do You Predict For The Carbon Credit Market?

Here's where things get interesting:

Of the world's 20 largest countries that emit the bulk of the carbon, 19 of them have set a "date certain" for when their net emissions will reach 0. Hitting that goal means subsidizing lower emission activities, taxing higher emissions, or simply banning some activities. Essentially carbon credits are a "tax" on higher emission activities. Offsetting emissions with cash is the path most countries and companies will use to hit their emission targets.

Worldwide accounting standards will soon have standardized metrics for measuring carbon emissions. The new metrics will create explicit standardized targets that companies and countries must follow. It's the same principle that currently has oil trading settled in dollars. It's a standard. And the accounting of carbon credits will soon be standardized.

As more and more companies deal with the reality of reducing their carbon footprint, the easiest way for them to accomplish this reduction is to trade carbon credits. After all, it's much easier to pay a tax than shut down a factory or retool a factory to produce fewer emissions. Carbon credits are taxes in the form of a tradable asset.

The emerging asset invites speculation into the market as hedge funds and other portfolio managers invest in carbon credits. Since the number of carbon credits is limited, higher demand will create higher prices. Suppose a portfolio manager looks at a company and realizes that it has not set aside enough money to pay for its carbon credit targets. In that case, that portfolio manager can go for "long" carbon credits.

Or, more deviously, they could "short" carbon credits. A short squeeze would occur if companies went into the market and realized there weren't enough carbon credits to buy at their intended price. The companies would have to buy at any cost. In this scenario, the price of carbon credits could go parabolic. A short squeeze on carbon credits is inevitable at some point.

In 2021 we witnessed short squeezes in several stocks that caused prices to go straight up. There's no reason this cannot happen in the carbon credits market because:

Carbon credits act just like stocks.

There's more potential for upside in carbon credits than in many other investments because governmental and institutional pressure drives the need for these carbon credits. It's artificial, but that doesn't mean that demand doesn't exist. It does exist and provides much of the momentum for rising carbon credit prices.

Key Takeaways

The opportunity to invest in carbon credits is relatively new and not very well understood. Hopefully, the discussion we had in this article gives you some actionable advice.

In this article, we:

The market is not well known and relatively new.

Still, credit carbon investments will be part of any portfolio that follows the "prudent man" rule sooner rather than later. Being early will be much better than being late in this particular investment.

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