California Carbon Allowances: A New Asset Class?

February 8, 2021 by Simon Choules

Although California Carbon Allowances (CCAs) have been around since 2013, they are still often perceived to be a risky asset. However, a new consensus is emerging that CCAs perform admirably on all the key metrics used by investors to judge an asset: tradable volumes, liquidity, expected return on investment (ROI), and correlation with other asset classes. In this article we investigate these claims. 

Past performance

The past performance of CCAs, shown in figure 1, indicates a stable, if unspectacular asset. Regulation mandates a reserve price that increases by 5% + inflation every year, which guarantees a reasonable return. For instance, since 2013 the annualised real Return on Investment (ROI) for CCAs has been 5%, which compares favourably to gold (6%) and real estate (3%). However, in comparison to the major U.S. indices, which have performed strongly over the last half-decade (between 10% and 30% annualised real ROI), these results are not eye-catching.

Future outlook

However, we expect to see a far greater ROI over the next decade. Our recently designed CarbonOutlookTM model enables us to make predictions on emissions and carbon prices in different scenarios with 200+ variables. In our report we detail three scenarios, the Likely scenario, the Slow-Economy scenario (where COVID-19 leads to slow economic growth and deprioritised climate action), and the Heroic Climate Action scenario (where the economy bounces back quickly and state policy makers accelerate their climate goals).

Our forecast shows the expected price path up to 2030 for these three scenarios. Our forecast predicts steep rises to above $60 in each of the scenarios, albeit with staggered timing throughout the decade ahead. These price rises set in when the market has a cumulative deficit of CCAs, i.e., when all the CCAs accumulated during the years of surplus have been used up. The timing and gradient of these price increases will be dependent on how and when financial players and compliance entities internalise the upcoming market shortage, and so plan for it by buying up carbon assets ahead of compliance needs. We are already seeing this process taking place in the futures market, where managed money entities make up a growing proportion of long positions. There’s a comparison across the Atlantic here, in the emergence of financial players in the EU Emissions Trading System, which has already contributed to promising price rises.

So in sum and based on our model, forecasted ROI over the next ten years could be in the region of 250-450%.

Correlation of carbon as an asset class

Modern Portfolio Theory advocates the construction of portfolios with non-correlated assets to minimise exposure to risk. As a result, we analysed whether CCAs were correlated with other key asset classes. We found that CCAs were strongly correlated with the Dow Jones, the S&P 500 and the NASDAQ, and only moderately correlated with gold and real estate. However, we also found that CCAs were significantly negatively correlated with the key fossil fuel futures markets: Brent Oil, Crude Oil, and Natural Gas. This suggests that, for fossil fuel investors, CCAs could be a useful asset to limit exposure to future declines in fossil fuel assets.

The final metrics discussed are tradable volumes and liquidity. The CFTC futures market for CCAs demonstrates that the market has matured quickly, and has a fully liquid secondary market where trades are taking place at high volumes. At the end of 2020, positions taken represented 606,675,000 CCAs, where each CCA represents one tonne of Carbon Dioxide or Carbon Dioxide Equivalent. This was a 627% increase since 2013.

We know that CCAs represent a strong investment opportunity. To find out more about investment companies within the market, the keys opportunities and risks, as well as more detail on everything discussed within this article, please watch our webinar recorded here, or look ahead for our upcoming report on our InSights Page.

Webinar recording

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