Investing in Carbon Neutrality
The total amount of carbon dioxide (CO2) emitted each year by human activities is approximately 50 billion tons. The graph below shows the evolution of atmospheric CO2 concentration from 1984 to 2019. The red line indicates the level that must not be exceeded by 2100 in order to respect the limit decreed by the Paris Agreements. The graph clearly shows that at such a pace, our trajectory is leading us to an atmospheric CO2 concentration higher than this limit. Although the planet has a certain capacity to absorb and store CO2, it is still insufficient to neutralize all anthropogenic emissions.
On a global scale, land and ocean carbon reservoirs absorb respectively 13 Gt CO2/year and 9 Gt CO2/year, i.e. a total of 55% of our greenhouse gas (GHG) emissions each year. This imbalance between emissions and natural absorption leads us to today's issues: how companies are trying to neutralize their carbon footprint, how they are integrating it into their reporting, and how investors can expose their portfolios to the mechanisms that put a price on carbon, as well as their underlying technologies.
Carbon Allowances and Carbon Offset Credits
A carbon allowance is a document allowing the emission of 1 ton of CO2 or its equivalent for any other GHG (tCO2eq). Allowances are part of a mandatory carbon market, of which there are various forms around the world. These markets, such as the European Emissions Trading Scheme, operate on a "cap-and-trade" basis. The annual supply of allowances (in tCO2eq) from regulators is progressively reduced, thereby encouraging projects with the best GHG/cost efficiency. Nevertheless, some companies do not manage to emit less CO2 than their allocation allows for. These same companies therefore turn to the allowance secondary market to meet their need by buying allowances from surplus companies. Thus, the supply and demand for allowances, given the cap, sets their price. Carbon allowances are a necessary tool for reducing GHG emissions and play a significant role in achieving the Net Zero goal.
As an investor, it is interesting to look at ETFs that reflect the average price of a carbon allowance across the world's trading systems, to contribute to and benefit from the growth of these markets. Among the most popular, the Chinese management company Krane Funds Advisors has an ETF that replicates the price of 1 tCO2eq on the Californian and European allowance markets, as well as an ETF that includes the 3 largest allowance markets in the world. The latter, KraneShares Global Carbon Strategy ETF (KRBN), is based on the IHS Markit Global Carbon Index, which itself tracks carbon allowance futures contracts.
A carbon offset credit, often confused with a carbon allowance, is a document certifying that a company has financed projects that avoid or capture 1 tCO2eq. These credits are traded on the voluntary carbon credit market, which can be found at different scales around the world. The size of the global voluntary market per year is estimated at $0.4 billion in 2020, $10-$25 billion in 2030, $40-$115 billion in 2040 and $90-$480 billion in 2050. Unlike its mandatory counterparts which offers prices up to $87 on the European market, the voluntary market offers carbon credits for only $2 to $8 per tCO2eq. Providing a source of revenue for carbon offset companies, the underlying projects can take many forms, the most common of which are renewable energy, energy efficiency improvements, CO2 and methane capture and storage, as well as reforestation, afforestation or other land uses. As an investor, this promising market decorrelates portfolios from market cyclicality, and exposes them to significant long-term growth. NETZ.NEO, a fund managed by Carbon Streaming Corporation, based its business model on investing in and selling carbon-credit-generating projects.
Compliance & CSR Reporting
Compliance with ever-tightening regulations poses real challenges for companies. Indeed, they must first measure their emissions covering scopes 1 to 3, then implement strategies to reduce them accordingly. Each year, companies must choose between buying increasingly expensive allowances, or launching long-term emission reduction projects to reduce their allowance purchase. Regular reporting from companies on their corporate social responsibility (CSR) is mandatory in Europe as part of the Extra-Financial Performance Declaration (EFPD), imposed by the NFRD on large companies. For other companies, it is not always mandatory, and the details of its content are often voluntary. It is therefore in the interest of companies to purchase carbon offsets to meet their resolutions to be carbon neutral by 2050, for which there is a growing demand from consumers and investors.
While the data provided on the carbon footprint of companies is heterogeneous, the inclusion of carbon credits in its calculation is even more so. For instance, in the US, only 20% of listed companies include their emissions in their CSR report. Among them, Apple does not specify the proportion of carbon credits in its net zero strategy. Others, such as BlackRock, JPMorgan and Disney, have used the Nature Conservancy, the world's largest environmental group, to sell carbon offsets based on the protection of forests that were actually already well preserved. Since the purchase of these credits did not improve forest conservation, these companies falsely claimed to be offsetting their carbon footprint this way. The bottom line is carbon credits still face credibility issues, and their standardization is crucial to their integration into an impactful Net Zero strategy.
In the US, a proposal by the SEC, the financial regulator, would make the inclusion of GHG emissions in financial reports mandatory, along with other climate-related metrics and corporate governance. This proposal, intended to be published in December 2022, is aligned with globally accepted climate reporting principles. The calculation of emissions should therefore exclude any carbon offset credits, i.e. their reporting relies on voluntary disclosure. We could eventually expect the emergence of a scope 4 dedicated to carbon offset credits, facilitating the transparency of companies regarding their net emissions.
Carbon credits are still a recent tool, used by companies and for investors. They finance projects to reduce future emissions or to capture and store carbon. This second type of project will be discussed in the following section.
Investing in carbon capture and storage technology
There are a multitude of technologies available to capture and store carbon dioxide. DAC, or direct capture of CO2 from the air, is a promising technology, provided we achieve sufficient economies of scale. Global Thermostat, for example, uses this technology, and Climeworks operates the largest facility of its kind. But this technology is still far too expensive: up to $600 per tCO2eq. As natural carbon “sinks”, the oceans are also an opportunity for direct ocean capture (DOC) techniques. These methods employ various technologies to deacidify the oceans, capturing their CO2 and by extension, reducing the concentration of atmospheric CO2.
Nevertheless, carbon capture and storage (CCS) technologies are by far the most widespread due to their profitability. We will therefore focus on these. In general, CCS technologies can capture about 80% of the carbon dioxide from fossil fuel extraction plants before it is released into the atmosphere. This CO2 is then stored in liquid or solid form. Specifically, CO2 can be captured in the pre-combustion phase, but the most common capture method today takes place during the post-combustion phase. Variations of CCS technology include CCUS, adding a U to the acronym for "usage," which encompasses all technologies that find a use for the extracted CO2, rather than simply storing it underground. BECCS, another variant, combines bioenergy to the CCS process. Biomass is converted to energy, and the CO2 emitted in the process is captured and stored.
Although necessary to achieve Net Zero, CCS and related technologies cannot replace emission reductions, partly due to their cost. According to various sources, capturing 1 tCO2eq would cost between $75 and $145. Carbon capture facilities require high upfront costs, which is a second barrier to the development of CCS technologies. Cost-effectiveness can be achieved by selling carbon credits for the tCO2eq generated, or through alternative methods, such as using the CO2 to make stronger, less polluting cement. Unfortunately, the most widespread usage remains injection into the ground to increase pressure, also known as enhanced oil recovery (EOR), and thus extract more fossil energy. It is therefore difficult to talk about carbon neutrality or even carbon compensation in this case.
Nevertheless, projections indicate a future full of opportunities with accelerating growth. Global CCS market are expected to quadruple by 2025 and reach $50 billion, according to a Rystad Energy study. In addition to the 56 facilities and stations already operating around the world, 84 new private projects are expected to be launched by then. These initiatives are expected to increase industrial storage capacity from the current 41 million tCO2eq to 150 million tCO2eq. Europe and North America are home to 63 of these 84 initiatives. Namely, Norway plans to open Longship, the largest climate project in its industrial history. Private companies using these technologies include, for example, Quest and NET Power. They are attracting the attention of large investors, such as Carbfix which benefits from Bill Gates’ investment. Among public companies, Aker Carbon Capture, whose operations are focused on CCS, is expanding across Northern Europe and considering emerging opportunities in the US.
The urgent need to address climate change, combined with the growing demand for energy and increasingly strengthening regulations, make the use of CCS technologies inevitable. Numerous innovations continue to emerge to capture, store and reuse CO2, the carbon capture market and, by extension, the carbon offset market, a promising future. As a source of opportunity and diversification, this industry deserves its share in our investment portfolios.