Interviewer Sean Aylmer: Welcome to The Point podcast from Pendal. Today I’m talking to Stuart Eliot, senior portfolio manager at Pendal Group. Stuart, tell me what are carbon credits and carbon futures?
Pendal Senior Portfolio Manager Stuart Eliot: I’ll start by talking about what our carbon credits.
There are two types of carbon credits. There are regulated ones and voluntary ones.
With the voluntary credits, imagine you’re a farmer who decides to plant some trees, then you can go and claim some credit for the carbon that you’re going to sequester.
Then on the other side of that, let’s say you’re someone who wants to offset the emissions of taking a flight somewhere.
You can actually go and purchase the carbon credits to offset the carbon of your flight. This is a bilateral transaction.
The voluntary credits have a mixture of value and credibility and quality, and they’re quite inefficient to transact.
There are some moves in place to try to put these on the blockchain to make them more efficient, but it’s still early days.
With regulated credits, which is the main carbon market in the world at the moment, you might have an example such as the European Union’s cap-and-trade system.
That covers about half of all of the EU total greenhouse emissions, which is currently around 10,000 installations in airlines and things like that.
The important thing from the futures perspective is that these emissions are standardised so that leads to a large and incredibly liquid futures market.
The way their cap-and-trade system works is by regulating an increasing number of industries into scope while simultaneously reducing the number of allowances that are available each year.
So you have more and more companies that are emitting in the system and they’re all competing for fewer and fewer allowances.
Interviewer Sean Aylmer: Okay. So they’re becoming more prominent, purely on the back of necessity now. People understand that they need to achieve carbon neutrality or most people understand that. And so this is actually a way for them to do that. Hence this market has been created.
Pendal Senior Portfolio Manager Stuart Eliot: Yes, exactly. And it’s governments also driving or creating incentives for the right sort of behaviour by companies.
So when we talk about carbon credits, it’s really a shorthand. These things actually cover carbon dioxide, nitrous oxide and nasty gases from things like producing aluminium.
The way the carbon credits are allocated each year is that the regulator will allocate about 40 per cent of them to, say, hard-to-abate industries. And then the other 60% are auctioned off.
So there’s this competitive environment where companies are trying to estimate what their emissions will be this year and try to buy the permits to offset the cost of that.
At the end of the year, each mandatory participant must report what their emissions were in that year and then surrender the number of permits for their emissions on that year.
If they don’t have enough permits, they’ll actually have to go out into the market and buy the remaining permits at whatever the price is, in order to cover their emissions.
If they’ve been good corporate citizens and have a lower emissions, then they can actually monetise that difference by selling their remaining permits.
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Interviewer Sean Aylmer: Is this an investible market? I understand what you’re saying from a company’s viewpoint, but is it something that investors can get exposure to?
Pendal’s Stuart Eliot: Yep, absolutely. The easiest way to access it is through the futures market.
In the futures market the way the contract is designed is that one contract covers 1000 tons of carbon allowances.
Why would you do that? Well, it’s a way of increasing the portfolio returns while at the same time having positive externalities, which is a good thing in two ways.
Interviewer Sean Aylmer: Just explain that.
Pendal’s Stuart Eliot: Let’s say that I have an investment thesis, which is the price of carbon emissions will go up. Then I can buy the futures in my portfolio. And if I’m right and the price goes up, then my investors will profit from that.
But at the same time, because I’m buying some of the limited quantity of carbon credits, then at the margin that drives up the price of emissions, which is where you get the positive externalities side of things.
Interviewer Sean Aylmer: So what other reason might an investor have for being interested in carbon credits?
Pendal’s Stuart Eliot: An investor might have a buy-and-hold exposure in their portfolio to hedge the impact of rising carbon prices on emission-exposed portfolio holdings.
Let’s say if you have an aluminum smelter in your portfolio, then you might hold the carbon credits to hedge the risk of that.
Interviewer Sean Aylmer: So how and why does Pendal use them in your diversified fund?
Pendal’s Stuart Eliot: Precisely for those reasons. We are trying to increase returns for investors.
Also we try to do that in a way that’s efficient in terms of not adding too much risk to the portfolio while you’re generating returns.
You achieve that by diversifying over a whole range of different types of assets.
Because of the nature of the carbon market – part of it is the supply and demand related to economic activity but you’ve also got this government intervention, which is deliberately trying to force up the price – then that is less correlated to other assets in the portfolio.
That leads to a sort of a more efficient outcome. So essentially you’re getting higher returns in a smoother journey, which is what we’re all about.
Interviewer Sean Aylmer: Stuart, thank you for talking to The Point. That was Stuart Eliot, senior portfolio manager at Pendal Group. I’m Sean Aylmer.
Sean Aylmer is an economist, a former editor-in-chief of The Sydney Morning Herald and host of leading Australian business podcast, Fear and Greed.
Stuart Eliot is a senior portfolio manager with Pendal’s Multi-Asset team. Stuart has day-to-day responsibility for the monitoring and management of all portfolios within the Multi-Asset team.
Stuart’s expertise includes portfolio construction, risk analysis, development and implementation of systematic investment strategies.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Led by Michael Blayney, the team manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.
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