Inflation Protection and Upside from California’s Carbon Ambitions
In Europe, the European Union has its own carbon trading market – the EU Emissions Trading System ( EU ETS ) - for which there are several European listed ETFs, eg from Wisdom Tree (CARB), HANetf and KraneShares.
In the US, states set their own policy and sometimes club together to form regional groupings. But until this month there was not a European listed product for the largest US carbon market, California. WisdomTree’s launch of WisdomTree California Carbon (WCCA) changes that.
California’s Cap and Trade Program state policy targets a 48% reduction in 1990 emission levels by 2030 and an 85% reduction by 2045. This is pretty close to the Paris Agreement adopted by over 100 countries, which targets a 45% reduction by 2030 and net zero by 2050.
What makes California’s carbon market special is the way the contracts are structured. There is a structural price floor of 5% above the California inflation rate, which in itself is an extraordinary return, well above inflation linked government debt in developed countries.
Then the carbon reduction targets effectively reduce the supply of allowances over time, which is expected to increase their price. Since 2014 the price has roughly tripled to about USD 30 per metric tonne, which is well below the EU price of around EUR 85 (more than USD 90) per tonne. While it is not currently possible to arbitrage this part of the carbon market through buying the California allowances and selling into the European system, California allowances are arguably good value: they could triple again just to match the European price.
CCA allowances are not only interesting in their own right, but also offer diversification benefits even for investors who may already have exposure to European carbon emissions. The correlation between the two has averaged only 0.23, according to Wisdomtree.
The management Expense Ratio (MER) of 0.49% seems reasonably competitive for a relatively exotic market, though it does not currently publish a Total Expense Ratio (TER). The product is structured using a swap with an index (Solactive California Carbon Rolling Futures Total Return Index (SOLCCATR)) based on the futures listed on the Intercontinental Exchange (ICE). The daily swap rate fee listed on the factsheet is 0.001233%, which would work out at 0.45% over 365 days, taking expenses to 0.94%.
By way of comparison, the US listed Krane Shares California Carbon Allowance ETF (KCCA) has total expense ratio (TER) of 0.78%.
Going forward, investors seeking more diversification in carbon exposures may want to keep an eye on China’s carbon market, which is several times bigger than the next three largest - EU, South Korea and California - put together. While various carbon transition and carbon neutral Chinese equity ETFs exist, we have not yet noticed a product tracking Chinese carbon emissions trading. It is probably only a matter of time before some of the more creative ETF houses find a way to wrap this market into an ETF in some shape or form.
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