Over the last 15 years, California has laid out climate goals that reduce their carbon emissions substantially. These goals have created an investment opportunity viacarbon allowances created by their Cap-and-Trade program. The underlying market dynamics of this program can offer both an inflation hedge and capital appreciation.

Let’s dive into what California’s carbon program looks like and how investors can gain access to it via the
KraneShares California Carbon Allowance Strategy ETF (Ticker: KCCA).

Understanding California's Carbon Program

California's Cap-and-Trade Program was implemented by the California Air Resources Board (CARB) in 2012. It covers approximately 80% of the state's greenhouse gas emissions. It is a comprehensive system that sets limits on total emissions while simultaneously allowing companies to trade carbon allowances. This program was novel because it used a market-based approach instead of the more common regulatory approach of issuing fines and outright banning.

The program plans to reduce carbon levels to 40% of 1990 levels by 2030. This leads further to full carbon neutrality by 2045. The total cap reduces emissions by 4% per year to achieve this goal. Comparatively, this represents one of the most aggressive decarbonization timelines in North America. Recent legislative updates have actually accelerated the 2030 target from a 40% reduction to 48% reduction below 1990 levels. This shows just how committed the California government is to achieving carbon neutrality.

KCCA provides investors with exposure to this market through California Carbon Allowance futures contracts. These contracts are the closet to a pure-play investment investors can get in this regulated carbon market without the added complexity of direct allowance ownership.

Structural Price Floor Provides Downside Hedge

One of KCCA's most attractive features is its built-in inflation hedge mechanism. The current auction reserve price is set at $25.87 per allowance for 2025, originally established at $10.00 in 2012, and increases annually by 5% plus inflation as measured by the Consumer Price Index.

This price floor ensures that carbon allowance prices cannot fall below their inflation-adjusted target level. This provides a potential hedge against inflation since it is pegged to inflation rates. For investors seeking an inflation hedge in their portfolios, this mechanism offers a unique hedge that automatically adjusts over time with economic conditions.

The price floor has demonstrated its effectiveness over the program's history. Across a variety of market conditions and economic cycles, CCA’s have consistently traded at or above this floor, providing a reliable downside hedge for long-term investors.

Market Hasn't Priced in Aggressive Supply Reduction

While the price floor provides a downside hedge there is a real opportunity in the market's underappreciation of the dramatic supply constraints coming through 2030. Based on current market, the cumulative surplus is anticipated to be fully depleted by around 2030-2031, creating a structural shift from surplus to scarcity.

If we assume the cap reducing 4% annually and economic growth driving emissions, the supply-demand imbalance becomes more and more pronounced. Once the credit reserves are depleted, prices could rise to hit the price ceiling projected to be over $134 in 2030, aligning with CARB's scenarios that predict prices following the price ceiling through at least 2035.

Strategic Opportunity at Current Levels

Recent market dynamics have created what appears to be an attractive entry point. CCAs experienced a pullback in 2024, moving from $42 to $36. This was driven by uncertainty over the timing and scope of potential upcoming market reforms. This temporary weakness occurred despite strong underlying fundamentals.

Most of the investors that exited were short-term speculators and current price positioning ahead of new reform policies creates a prime opportunity for long-term investors to consider allocations toward the California carbon market.

KCCA offers investors exposure to an asset class with some unique characteristics. It has embedded structural price appreciation driven by supply scarcity, an inflation hedge via the price floor mechanism, and low correlation to traditional asset classes. This recipe makes for a very compelling addition to a diversified portfolio.

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For KCCA standard performance, top 10 holdings, risks, and other fund information, please click
here.