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’.