This joint paper from GIC, the EDB and McKinsey discusses how carbon markets are rapidly emerging as a viable asset class. It suggests that institutional investors could play a critical role in helping corporations and nations use these markets to achieve global climate goals whilst also fulfilling their own mandates.

While the paper does not issue an investment recommendation, it aims to shed light on the evolution of market mechanisms and their relevance to investors.

As the drive to curb global warming gathers pace, carbon markets are becoming increasingly fundamental to the task of achieving net zero greenhouse gas (GHG) emissions.

  • Compliance carbon markets (CCMs), in which carbon allowances are traded and regulated by mandatory national, regional or international regimes, are a vital part of emission reduction efforts in a growing number of countries.
  • Voluntary carbon markets (VCMs), in which carbon credits are traded by companies and individuals on a voluntary basis, play an important role in driving investment in carbon compensation (avoidance and reduction) and neutralisation (removal) projects.

The total value of global carbon markets grew by more than 20% in 2020, a fourth consecutive year of record growth.

Today, institutional investors’ participation in carbon markets is limited as a result of structural obstacles as well as a lack of visibility on underlying market dynamics and future trends. CCMs are the larger and more mature of the two markets, with a market value of over $100 billion and an annual trading turnover of over $250 billion, but they are small in relation to the $19 trillion of total assets under management by the world’s top 100 institutional investors in 2020.

In comparison, VCMs are tiny with a value of $300 million in 2020, and have not been viable for institutional investment due to limited liquidity, insufficient market size, a non-standardised transaction process and a lack of explainable price mechanisms.

However, the market landscape is changing rapidly. CCMs have stabilised and are becoming easier for institutional investors to understand. Meanwhile, governance and infrastructure are being developed to support the rapid growth in VCMs. We believe that investors should support the development of robust, liquid carbon markets for three reasons.

First, carbon markets are rapidly approaching critical mass from an investment perspective. New emissions trading systems (ETS) are being established and recent market reforms in existing trading systems have created a more predictable framework for institutional investors. VCMs have as much potential to scale as CCMs, with estimates of their expected size in 2030 ranging from between $ 5 billion and 180 billion. McKinsey’s work with the Taskforce on Scaling Voluntary Carbon Markets (TSVCM) shows how these markets could become a more viable investment option in the future if certain important milestones (such as the standardisation of corporate claims and products) are met.

Second, functioning carbon markets are essential to reach the globally agreed target of keeping global warming to 1.5 C. As stated in the public statement on the High Ambition Path to Net Zero, companies do not only have the obligation of decarbonising their own operations and value chains. They should also compensate and neutralise their own emissions “on the path to net zero” through high-quality carbon credits. Institutional investors also have an interest in this goal, since if it is missed, their portfolios will be exposed to increasing physical climate risks.

Third, carbon markets offer an important opportunity for institutional investors to manage risk-adjusted returns. Our analysis shows that if investors allocated even a small part of their portfolios to carbon allowances, they could improve the resilience of their portfolios against climate transition risks. This is because, while the precise course of carbon prices remains uncertain, they hinge on policy action, which means that as governments around the world start to take real action, carbon prices could rise.

Working with Vivid Economics, McKinsey’s strategic economics consultancy, and its climate analytics suite, Planetrics, we conducted bottom-up modelling of the relative impact of climate risks across individual asset classes. Our goal was to assess the performance of a portfolio that includes carbon allowances, based on three different climate scenarios as outlined by the Network for Greening the Financial System (NGFS).

Based on their widespread adoption, technical criteria, relevance and comparability, we adopted “below 2°C” NGFS REMIND scenarios that reflect the Paris Agreement’s goal to keep warming well below 2°C; a more ambitious scenario to keep warming below 1.5°C would have more pronounced impacts on transition risks and investments. Across these three scenarios, we modelled the performance of a portfolio with an allocation to carbon allowances against a reference portfolio made up of 60% equities and 40% bonds, over a 10- and 30-year horizon.

We found that carbon allowances could provide downside protection and enhance risk-adjusted returns in scenarios involving immediate or delayed climate actions. On average, a carbon allowance allocation of approximately 0.5 to 1% could mitigate the negative impact on the returns of a 60/40 reference portfolio. In scenarios involving immediate or delayed climate action, a hypothetical 5% carbon allowance inclusion in the 60/40 reference portfolio could enhance annual return by 50 to 70 basis points (versus the expected return for a regular reference portfolio of approximately 4%) over 30 years while volatility would improve by 30 to 50 basis points (versus the expected volatility for a regular reference portfolio of approximately 9.8%). In a scenario where no new climate policies are introduced, by contrast, the inclusion of carbon allowances in the portfolio led to diminished returns. This is just one action investors can take to hedge against climate transition risk.

Other actions include:

  • Selecting securities (picking specific companies within the overall asset-class allocations that have more climate-resilient business models);
  • Moving the portfolio away from the sectors most exposed to the transition, such as fossil fuels;
  • Increasing exposure to potential transition winners, such as “green” mineral producers (copper, cobalt, lithium, zinc and nickel);
  • Selecting asset class allocations that have more climate-resilient business models; and
  • Actively engaging portfolio companies to encourage them to take action to improve their own climate resilience.

Investors will likely adopt a mix of all these actions.

While the reasons for institutional investors to consider active participation in carbon markets are compelling, they also need to be mindful of the inherent risks. In CCMs, there are execution risks given the small market size in relation to the scale of institutional assets — for example, there may be potential difficulties in exiting investments in allowances given the relative illiquidity of these markets.

Reputational risks are also present given the political sensitivity of ETS. While a healthy amount of trading promotes market growth and liquidity, such activity could also attract criticism if investors appear to be profiting from volatile price movements. Heightened regulatory scrutiny could be invited in the event of sharp price movements or suspicions that carbon allowances are being used for purely speculative purposes.

Institutional investors should thus take care to balance their quest for financial returns with due consideration of the markets’ fundamental objective, which is to reduce emissions by driving down carbon allowances year on year. Although liquidity in all markets depends on trades made in expectation of a financial return, companies should use CCMs to achieve real decarbonisation, not for profit through pure speculation.

VCMs also harbour many types of risks for institutional investors. There is the risk that the demand for carbon credits will not scale up as projected – for example, if credible standards for the use of credits by companies and investors as part of their climate strategies cannot be established, or if demand from the aviation and shipping industries fails to materialise.

Other risks include being seen to invest in low-quality credits as a result of the absence of fixed standards; liquidity risks; execution risks arising from the long time horizon of credits; and more generally, the reputational risk that stems from criticism of compensation and neutralisation projects as an alibi for genuine emissions reduction or ‘greenwashing’.

With all that said, private funding for quality compensation and neutralisation projects is urgently needed to achieve net zero. By one estimate, the world needs to close a $4.1 trillion financing gap by 2050 if it is to meet its climate change, biodiversity and land restoration targets. VCMs are critical to raising and channelling this flow of funding.

We believe that institutional investors can help accelerate the development of VCMs in three key ways:

  • By investing directly and helping to scale up the supply of high-quality compensation and neutralisation projects such as Natural Climate Solutions (NCS);
  • By supporting the establishment of high-integrity standards and governance for carbon credits, the absence of which is a critical hurdle in the development of VCMs; and
  • Most importantly, by guiding portfolio companies on their journey to net zero. Investors can help companies set decarbonisation targets; report annual progress against those targets; and use credits to help meet their unavoidable commitments, or – better – to set higher climate ambitions.

In setting out these actions, this paper highlights the critical role that institutional investors can and should play to help create viable carbon markets in support of decarbonisation.

One in five of the world’s 2,000 largest publicly listed companies have now committed to a net zero emissions target, along with countries responsible for 61% of global GHG emissions.These targets will not be achieved without robust and investable carbon markets, and such markets will not come into being unless institutional investors become actively involved.

This is the Executive Summary of the report ‘Putting carbon markets to work on the path to net zero: How investors can help decarbonise the economy and manage risk-adjusted returns’.

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