What is the difference between carbon allowances/ credits and carbon offsets?
- Carbon allowance, or sometimes referred to as carbon credit, represents the legal right to emit one metric ton of carbon dioxide or equivalent greenhouse gas. These allowances are issued to companies and organizations participating in a mandatory national or international carbon market (i.e., EU, CA of RGGI). Depending on the specific market or trading scheme, carbon allowances are either purchased by regulated emitters, often by auction or allocated for free based on forecast carbon emissions.
- Carbon Offset: An offset is generally outside of an emission trading scheme (ETS) or can be imported into an ETS. It also represents one ton of carbon dioxide or equivalent greenhouse gas (GHG). However, it is generated by a reduction in emissions made by a voluntary project designed specifically for that purpose. Typical carbon offset projects include building wind turbines or a solar farm, supporting methane reduction projects, planting a tree, or preserving forests.
How does a cap and trade system work?
Also known as an emissions trading system (ETS), cap and trade is a system designed to reduce pollution in our atmosphere by putting a price on emissions as well as a limit. The regulatory authority in the regional jurisdiction sets a cap on greenhouse gas emissions across a given industry or the entire economy. The total amount of the cap is split into allowances, each permitting a company to emit one ton of carbon dioxide or carbon dioxide equivalent. Regulators then auctions the allowances to companies. The cap gets stricter over time, decreasing the overall greenhouse gas emissions for the region and mitigating climate change.
The trade part is a market for companies to buy and sell allowances that let them emit only a certain amount of carbon dioxide and has supply and demand set the price. Companies that cut their pollution faster can sell allowances to companies that pollute more, or they can hold them for future use. This market system, informally called a carbon market1, gives companies flexibility. It increases the pool of available capital to make further emission reductions, encourages companies to cut pollution faster and rewards innovation.2
Who are the entities that participate in the cap-and-trade system?
1. Emission trading schemes (ETS), i.e. European Union ETS, California Cap and Trade, Regional Greenhouse Gas Initiative, China National ETS*, and United Kingdom ETS*
2. Emitters, i.e. power plants, industrial plants, refineries, transportation, and agricultural businesses
3. Capital market participants that create markets, provide liquidity and offer risk transfer (speculation)
Sector coverage continues to expand as these exchanges mature
What is the investment objective of the KRBN ETF?
The KraneShares Global Carbon ETF (the “Fund”) seeks to provide a total return that, before fees and expenses, exceeds that of the IHS Markit Global Carbon Index (the ‘‘Index’’) over a complete market cycle. KRBN is benchmarked to IHS Markit’s Global Carbon Index, which offers broad coverage of cap-and-trade carbon allowances by tracking the most traded carbon credit futures contracts. The index introduces a new measure for hedging risk and going long the price of carbon while supporting responsible investing.3
What is the process in constructing the portfolio for KRBN?
KRBN tracks the IHS Markit Global Carbon Index which was developed in partnership with Climate Finance Partners (CLIFI), the funds sub-advisor. The Index Provider (IHS Markit) determines the components and the relative weightings of the components in the Index.
The Index is designed to track the liquid, investable segments of the global carbon allowances market using relevant futures contracts. The Index includes only carbon credit futures maturing in December of the next one to two years and that have a minimum average monthly trading volume over the previous six months of at least $10 million. The Index weights eligible carbon credit futures based on their average monthly trading volume during the relevant six-month period. No single carbon credit future (determined by expiration date) will receive an allocation between 5%-60% at each Index rebalancing/reconstitution. The minimum weight per KRBN ETF is 10% and the regional cap is 65%. The fund plans to add value versus the index through enhanced cash management as the index uses basic overnight rates for cash return.
The Index is rebalanced and reconstituted annually on the last business day of November.
As the global carbon credit market grows, additional carbon credit futures may enter the Index, and the Fund may invest in such additional carbon credit futures, if they have a minimum average monthly trading volume over the previous six months of at least $10 million.
Which cap and trade systems make up the IHS Global Carbon Index, and how are the different regions weighted?
KRBN tracks the IHS Global Carbon Index, which is comprised of the European Union Emissions Trading System (EU ETS), the California Cap and Trade (CCA), the Regional Greenhouse Gas Initiative (RGGI) and the United Kingdom Emissions Trading System (UK ETS). The base weights that are rebalanced annually are as follows:
- EU ETS: 65%
- CCA: 25%
- RGGI: 5%.
- UKA: 5%
Why does KRBN utilize futures and not the underlying carbon credits?
The futures included in the IHS Markit Global Carbon Index are liquid, offer transparent pricing and are exchange traded allowing the fund to take efficient exposures in the relevant market. These futures traded $260bn in 2020 and ensure daily liquidity and pricing efficiency for KRBN. As of December 31, 2020, the three largest global carbon futures markets, tracked by IHS Markit’s Global Carbon Index, had a market size of $260.79 billion.
Explanation of futures and the futures market.
Futures contacts are financial derivatives that oblige the buyer to purchase some underlying asset (or the seller to sell that asset) at a predetermined future price and date.
A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument, either long or short, using leverage.
Futures are also often used to hedge the price movement of the underlying asset to help prevent potential losses from unfavorable price changes.
Why does the fund maintain a position in collateral and currency management?
Futures positions are maintained with margin. This means that the fund is only required to post a certain amount of capital when taking a position. This is then increased or decreased daily with the performance of the future position. As a result, the fund maintains the remainder of the cash and invests in short dated, high quality instruments. Further, the fund also manages to the index by ensuring that the currency exposure is in line with the markets it is invested in.
How does an investor gain access to the KRBN ETF?
KRBN is an US exchange traded fund that is listed on the New York Stock Exchange. Individual shares of KRBN can be bought and sold throughout the trading day like other publicly traded securities through a broker-dealer on the Exchange.
The minimum size is one share. The price of an individual Fund share is based on market prices, which may be different from its NAV. As a result, the Fund’s shares may trade at a price greater than the NAV (at a premium) or less than the NAV (at a discount). Most investors will incur customary brokerage commissions and charges when buying or selling shares of the Fund through a broker-dealer. You can find daily performance data here.
Does KRBN provide a K1 for tax purposes?
No. KRBN will be reported on your 1099.
*These markets are currently not investment options for KRBN.
- United Nations Climate Change, https://unfccc.int/process-and-meetings/the-convention/glossary-of-climate-change-acronyms-and-terms#c
- EDF, “How cap and trade works”, https://www.edf.org/climate/how-cap-and-trade-works
- A Global Price For Carbon Emissions, IHS Markit, April 2020