Futures: The Most Effective Way to Get Exposure to Carbon Markets
By Luke Oliver, Head of Strategy, Head of Climate
KraneShares carbon funds manage $900 million of global carbon compliance allowances.1 This is equivalent to 18 million tons of carbon, or roughly the same as the annual greenhouse gas emissions of 4 million gasoline-powered passenger vehicles, 3.5 million homes' electricity use, or 4.8 coal-fired power plants.2 As a leader in carbon investing,3 we are continuously on the road speaking with investors and educating them on this exciting new asset class. Through this process, we inevitably receive some frequently asked questions. One of which is surrounding our use of futures contracts to gain exposure.
Futures contracts are the most liquid, transparent, efficient, and exchange-cleared way to take a position in compliance carbon markets without giving up any of the impact or price discovery features. Below we will examine tracking, performance, and how futures are ultimately backed by physical allowances.
Do futures provide the same experience as the underlying allowances?
Futures contracts are fundamentally intertwined with their underlying markets and, in many cases, ARE the market in the underlying commodity or asset. This is even more true when the futures contract is physically settled, as is the case for carbon contracts. A physical settlement means that when the futures contract matures, the physical carbon allowances are transferred from sellers to buyers, ensuring that the futures contract price always converges with the price of the physical carbon allowance.
As a result of this mechanism, there is constant arbitrage, the trading of futures versus their underliers, to ensure efficient pricing between the futures contract, the carbon allowance auctions, and the secondary market in physical allowances. This means that the performance and volatility are consistent, and market mechanisms keep them aligned. As such, we strongly favor futures exposure for their liquidity and cost.
Let’s prove this concept using the largest carbon market, the European Union Allowance (EUA) market. The EUA futures market traded $628.9 billion in volume in 2022 compared to a primary auction cap of approximately €136.1 billion ($149.1 billion) and a total number of allowances in circulation of €102.1 billion ($111.9 billion).4 Clearly, based on its substantially larger size, the futures market is the most robust source of liquidity and price discovery.
The European auctions happen several times per week, settling at a single price per day (US carbon markets have only four auctions per year), whereas the European carbon futures trade intraday each business day. Of course, this means the futures settlement price and auction price are not the same; however, due to the constant arbitrage/efficiency, the relationship holds tight day after day.
To further show the relationship in price, we charted the difference in daily returns between futures and physical contracts and calculated the 90-day rolling average. As shown in Figure 1, the average price difference is less than one basis point. In other words, the daily change in prices between futures and physical can differ on any given day but ultimately normalize to perfectly track over time.
Another method of determining if future and physical price action is truly intertwined is by calculating correlation using historical pricing data. In Figure 2 below, you will see that the futures and physical markets are highly correlated, resulting in a positive correlation of 97%, meaning the price moves are almost exactly the same.
Some investors assume that futures markets are more volatile than physical markets; however, this is not true. We observe essentially identical volatility of 45% using daily data and virtually the same using monthly data, with futures at 37% and physical auctions at 35%.
We can even demonstrate that the much-discussed "cost of carry" or "contango", the shape of the futures curve that implies the cost of holding a position using a futures contract over time, does not create material drag on an unlevered investment in carbon futures. Figure 4 shows the price difference between auctions ("spot") and the forward price ("futures"). This demonstrates that the 90-day average "premium" that futures trade relative to auctions is less than both the 3-month and 1-year Treasury rates that we earn on the futures collateral. This means that the combined performance of the futures plus the collateral return creates an experience equivalent to holding the physical allowances, except with the liquidity of the exchange-traded vehicle.
Now that we have established that the futures and physical markets move in lockstep, we can illustrate why. It is intuitive because they are not two different markets but simply two elements of the same market. They are entirely interconnected as part of one liquidity ecosystem. The aggregate futures position is backed by a part of the physical "bank," and the price of auctions is as much a signal to futures markets as the futures prices are a signal for auction prices. The futures are where the continuous market pricing is achieved, with auctions being periodic. We illustrate the interconnectivity of the carbon ecosystem below in Figure 5.
To further hone in on their interconnectivity, we discuss how each futures position is backed by physical allowances in the market. It cannot be any other way. There are three scenarios of how our futures positions are backed, and all lead to the same outcome.
- We buy a future in the market, and a bank takes the other side. They are now short, and their only possible hedge is to buy physical allowances. Their business model is to sell futures slightly higher than the cost of hedging. If they decide to hedge with another future with somebody else, that “somebody” will have to cover with physicals. It doesn’t matter how long the daisy chain is. In the end, the position can only be hedged with physical. So, our long position is making the market net longer and therefore creating a long position in physical allowances at the market level.
- We buy a future in the market, and a natural hedger takes the other side. That is, an entity such as a power station or bank that is long physical allowances and wants to hedge its risk of a price decline. In this scenario, we have essentially assumed their physical position. They will hold the physical position against their short future that matches our long position. If they decide to use or sell their allowances, they will need to buy back their short futures, which will result in forcing someone else (like in example 1) to take on the long physical position.
- We buy the future in the market, and a naked short seller is on the other side. A naked short seller in this scenario is someone without a physical position or long exposure selling futures to bet on prices moving lower. In this example, which is less common, it might feel like no one is holding a physical allowance. However, the physics of financial markets ensures they are. Had we not been a long only buyer, the buyer would likely have been a bank or market maker who would then hedge by reducing their physical position. As such, our purchase of futures removed the need for physical allowances to be sold and therefore continue to back our long position.
It doesn’t matter which combinations of the three examples above are applied: our long positions all lead to an aggregated longer position in the actual underlying market. The same is also true of swaps, options, notes, ETFs, and any other derivative. Our KraneShares suite of carbon ETFs, for example, make the carbon allowance market longer an additional $900 million of carbon allowances.
Positive Impact of Investing in Carbon Futures
Now that we have covered how both physical and futures-based exposures have the same effect on the market, we can discuss how these long positions have a positive impact. Through both positions, investors help support price discovery and make markets increasingly tighter, making polluting more expensive and incentivizing the decarbonization of various economies, which is the very purpose of the cap-and-trade programs. This impact is powerful and at the heart of our thesis that we can create strong returns while also having a positive impact on our global environment and economy.
Some suggest that holding a long position in carbon leads to the European program canceling additional allowances that permanently stop pollution. However, this is very much overplayed if not entirely incorrect. Holding a position does tighten markets, but it does not cancel them. The EUA cap and trade program does have a cancellation policy in place designed to reduce the number of allowances stored in the Market Stability Reserve (MSR) if the Total Number of Allowances in Circulation (TNAC) is too high. The MSR, for context, is a reserve that has been withdrawing huge numbers of allowances to tighten the market supply. It also has the potential to release those reserves in certain scenarios. The TNAC is simply the sum of allowances auctioned minus those retired. Why is this claim inaccurate? First, the allowances that can be canceled are in the MSR and have already been taken out of circulation and, therefore, not available to polluters. The permanent cancellation versus being locked in the MSR is only a marginal improvement.
Secondly, an investor buying or selling allowances, in any form, does not change the TNAC. For example, if an investor sold their long position in allowances, it wouldn’t increase or reduce the TNAC. It would simply move them from one holder to another, albeit possibly at a lower price. It is the TNAC that determines whether allowances are canceled, so stating that holding physicals over futures has a greater impact is erroneous.
All of this said, there is no doubt that holding a long strategic position in allowances (again, physical or futures based) means that there are fewer allowances readily available to polluters, forcing these polluters to pay potentially higher prices to source allowances and further encouraging them to reduce their emissions even faster than the program designed.
We've shown that futures and physical are two parts of the same market and create the same price discovery and impact. We take great pride in offering the largest, most liquid ETFs5 to millions of global investors to participate in one of the most effective tools we have against climate change while also providing the potential to generate strong returns.
Investors can gain access to carbon futures through our suite of carbon ETFs. Our flagship fund, the KraneShares Global Carbon Allowance Strategy ETF (Ticker: KRBN), provides a blended basket of the largest, most liquid carbon markets, including the European Union, California, United Kingdom, and the Northeast Regional Greenhouse Gas Initiative (RGGI). Beyond our global fund, we also have market-specific funds covering the EU emission trading system through the KraneShares European Union Allowance Strategy ETF (Ticker: KEUA) and a pureplay on the California program with the KraneShares California Allowance Strategy ETF (Ticker: KCCA).
You can read more about the latest drivers of all these markets in our summer climate report here. We are also available to discuss physicals, futures, and global carbon markets in detail. Please email [email protected] to schedule a meeting with a member of the KraneShares climate team.
For KRBN standard performance, risks, and other fund information, please click here.
For KEUA standard performance, risks, and other fund information, please click here.
For KCCA standard performance, risks, and other fund information, please click here.
- Data from Bloomberg as of 6/30/2023
- Data from EPA.gov, Greenhouse Gas Equivalencies Calculator, retrieved 7/31/2023
- Leader in carbon investing based on managing the largest US-listed carbon allowance ETF
- Data from IHS Markit and Bloomberg as of 6/30/2023
- Data from Bloomberg as of 8/17/2023