Please, somebody create an ETF that buys EU CO2 emission allowances! I'd like the gamble to earn money by fighting climate change.

05 Feb 2020

I really would like to buy now EU CO2 allowances and keep them for 5-20 years before selling them back. This transaction is likely to reduce total EU CO2 emissions and I would even have the chance to make some money out of it.

That one can actually reduce emission (rather than only postpone them) just by holding allowances for some years seems strange but can happen due to the rules of the new EU Market Stability Reserve.

In this post I want to give some background, explain the main mechanism and discuss possible risks. In 2005 the EU set up a ‘cap and trade’ system for CO2 emissions covering power plants, industrial plants and intra-european flights. For each emitted tonne CO2 (or equivalent) the covered companies have to surrender an emission allowance to the EU until April 30th the next year to avoid a heavy fine. Allowances can be freely traded and new allowances are supplied to the market in two main ways: the largest share (goal 57%) is auctioned off each year by the member states, the remaining allowances are given for free to sectors that are deemed under carbon leakage risk. In addition, allowances are supplied for innovative emission reduction technologies by the NER300 programe and by international credits for certain verified emission reductions outside the EU.

Starting from 2008 participants can bank allowances for future years (currently without time limit). E.g. a firm can buy an allowance today, keep it and surrender it in 5 years.

The following plot shows the emission, new allowances and an estimate of the banked amount between 2008 and 2013 using data extracted from the EU emissions trading viewer and made available in converted form in a corresponding Github repository of this blog post.

dat = read.csv("wide_eua.csv")

d = dat %>%
  filter(year >= 2008, year < 2014) %>%
  mutate(banking_estimate = cumsum(eua_allocated-emissions))

ggplot(d,aes(x=year)) + 
  geom_line(aes(y=eua_allocated), color="blue") + 
  geom_line(aes(y=emissions), color="brown") +
  geom_area(aes(y=banking_estimate), fill="red", alpha=0.5) +
  annotate("text",label="Banked Allowances (Underestimated)",x=2011,y=1000) +
  annotate("text",label="New allowances",x=2012,y=2400, color="blue") +
  annotate("text",label="Emissions",x=2012,y=1700, color="brown") +
  ylim(0,2500) + ylab("Million allowances")

We see that starting from 2009 the number of newly allocated allowances was always larger than the actual emissions. This increased over time the number of banked allowances. Note, however, that the number of banked allowances is underestimated since the data ignores additional supply from international credits. Indeed, the EU states here that in 2013 the total number of allowances in circulation (TNAC) was 2.1 Billions, i.e. more than twice the amount shown above. (Another reason for this larger number by the EU could be that the EU counts the TNAC on December 31st. Possibly many firms have not yet surrendered their current year’s emission allowances at that date, since they can wait until April 31st next year.)

At the same time as the number of banked allowances rose, the price of emission allowances collapsed. I could not find auction prices reaching back until 2008, but here is a time series of Future prices which can be found on Quandl.

eua_prices = readr::read_csv("eua-price.csv",)
ggplot(eua_prices, aes(x=Date, y=Price)) +
  geom_line() + ggtitle("EU Emission Allowance Price") +

Of course, such low allowance prices provide very little incentives to reduce carbon emissions. Was the initial oversupply and the large quantity of banked of allowances the culprit for inefficiently low allowance prices? The answer is not completely obvious. In classic economic models with little distortions and rational forward looking market participants, allowing banking and front-loading allowances (i.e. initially sell more allowances than are likely to be emitted) is actually necessary in order to obtain a dynamically efficient abatement path. However, these models cannot describe well all observed price dynamics (see e.g. here). Hence, even though not clear cut from a theoretic point of view, it seems to me quite sensible to try to stabilize the price by reducing the amount of allowances in circulation.

Market stability reserve

In the years 2014-2016 the EU indeed reduced the number of auctioned allowances in total by 900 million with the announcement that those allowances shall be put in a market stability reserve (back-loading). In January 2019 the new Market Stability Reserve (MSR) began operating, which the EU calls a long-term solution.

Now for every year the EU counts the total number of allowances that are in circulation (TNAC) on 31st of December using this formula:

TNAC = Supply – Demand - allowances in the MSR

The supply contains all allocated allowances since 2008-01-01. The demand contains all surrendered or voluntarily cancelled allowances also since 2008-01-01. The allowances already in the MSR are also subtracted. For 2018 the TNAC is computed by the EU as 1.6 billion allowances (see here).

If the TNAC exceeds 833 million in a year then 12% of the TNAC will be transferred to the MSR (in the years 2019-2023 even 24%). This transfer to the reserve is implemented by reducing the number of next year’s auctioned allowances by that amount.

Should the TNAC fall below 400 million in a year, then 100 million allowances will be transferred back from the reserve to the market by increasing the auction volume.

Cancellation of excess allowances in the MSR

The EU announced that starting from 2023 allowances can be ultimately cancelled from the reserve. More precisely, the following is planned: The MSR can never contain more allowances than have been auctioned off in the previous year. Any excess number of allowances in the MSR will be permanently cancelled.

In 2018 a total of 921 million allowances have been auctioned off. This was around 54% of the totally allocated allowances in 2018. The number of totally allocated allowances is reduced linearly by 1.71% currently and by 2.2% from 2021 onward. The number of auctioned allowances will likely drop at similar rates, given that the EU aims to increase the share auctioned allowances only slightly to 57%.

Given these numbers and reasonable projections, most studies predict that at least some certificates from the MSR will be permanently cancelled.

An example calculation of the effect of a buy-hold-and-sell fund.

OK, we now know the essential institutional background. Assume there is a larger group of investors, who want to fight climate change but also like the chance to make a bit of money. They buy via a fund today 100 million allowances and hold them for several years before starting to slowly sell them back.

What happens? I would guess that this additional demand increases today’s allowance price. The higher price should lead to some emission reduction by firms. But it is unlikely that firms reduce emissions by the full allowance amount bought by the fund. Probably, firms and other market participants will also reduce their banked allowance reserves to some extend.

The net increase of the TNAC is given by the 100 million allowances bought by the fund minus the reduction of other participants’ banked allowances. This value is hard to predict, but let’s just say that half the fund’s volume is offset by the reserve reduction of other market participants, i.e. the TNAC would then increase by 50 million allowances due to the fund.

Allowances will be transferred from the TNAC to the MSR as long as the TNAC remains above 833 million. Hard to say until when that will be the case. The EU projection in Figure 3 here suggests that will be the case until 2023, but also until 2028 does seem reasonable, in particular if the fund substantially increases the initial amount of TNAC. Let us say that it is the case until 2025.

Then a share of

1- (1-0.24)^4 * (1-0.12)^2 = ca. 75%

of the 50 million initial TNAC increase will be moved to the reserve, i.e. roughly 37.5 million. (The term (1-0.24)^4 comes from the years 2020-2023 in which 24% of TNAC are moved to the MSR and the term (1-0.12)^2 from the years 2024-2025 where only 12% are moved to the MSR.)

Not all allowances in the MSR will be cancelled but only those that are above the number of auctioned allowances in the previous year. But once that threshold is reached, all additional allowances put into the MSR will be cancelled. Since most analysts suspect that this threshold will be reached (even without a fund), we assume that all 37.5 million additional allowances put into the MSR by our fund will be cancelled.

This means even though the investors keep all 100 million allowances bought by the fund, according to our back of the envelope calculation the fund triggers cancellation of 37.5 million allowances. Hence, we essentially have the same effect as if there were no MSR but only 62.5 million of the fund were sold back and the rest would be manually cancelled. Thus the fund should lead to a reduction of total overall emissions.

Given that allowances are reduced, it is also perceivable that the fund investors manage to sell their allowances back at a higher price than at which they initially bought the allowances. But that is not clear since asset price formation is subtle and if everybody would rationally expect that such a fund causes extra cancellations, it should already drive up today’s prices.

Discussion about risks, impact and political reactions

The example calculation above already pointed to a number of uncertainties: By how much will a fund that buys and holds allowances actually increase the TNAC? How much of that increase will end up in the MSR and finally be cancelled? What will be the price dynamic?

While I personally see a good chance to reduce EU carbon emissions with such a fund, the impact size is not clear. Neither is it clear whether investors will make or lose money from such an investment.

Could such a fund also have extreme unintended consequences? What if a gigantic amount of money flows into such a fund that buys and holds allowances, such the allowance price increases to an extreme level like 1000€/tCO2? Electricity prices soar, electricity intensive firms massively lay off workers EU, and people may start rioting on the streets…

That scenario can currently not happen. There is an implicit price cap on allowances defined by the fine firms have to pay for emitting CO2 without surrendering an allowance. According to the ETS trading handbook this fine was set to 100 €/tCO2 in 2013 and is henceforth adjusted for inflation.

Obviously, EU legislators can adapt the regulation and thus substantially influence future price paths, e.g. by changing the supply of allowances, adapting the fine for emitting withour surrendering a certificate, or by changing the rules of banking. How should this political uncertainty affect the investors of our fund?

My personal theory is that there is an interval of allowance prices that the EU deems reasonable. As long as prices are in that interval, the EU may not substantially change their current regulatory path. Yet, if prices are too high or too low, a change of regulation becomes more likely.

This means, personally, I would buy and hold allowances only as long as I consider the allowance price sufficiently low. What are sensible reference levels to assess whether allowance prices are too high or too low?

Natural candidates are estimates of social costs of CO2. These estimates vary largely, however. Personally, I find the higher estimates that explicitly account for tipping points and the possibility of catastrophic events more plausible, see e.g. here. But the EU’s assessment may differ.

Another benchmark are carbon prices outside the EU trading mechanisms, e.g. on the carbon content of gasoline. Sweden has currently the highest carbon taxes in the world with approximately 114 €/tCO2 in 2018. While most other countries don’t have high explicit carbon taxes, the OECD computes here implicit carbon prices from other taxes in the road transportation sector, which are in some countries much higher than then energy taxes in other sectors. E.g. for Germany the OECD finds implicit taxes of 216€/tCO2 (road transportation) vs 6.6€/tCO2 (other sectors, excluding costs for allowances).

Current EU allowance prices (January 31st 2020) are 23.80 €/tCO2. In my view, the price references stated above, suggest that currently there is still scope for allowance price increases that are politically deemed reasonable.

How to buy EU emission allowances as a private investor?

Unfortunately, I have not yet found a cheap, trustworthy, simple method to buy and sell EU emission allowances as a private investor. I would just like to log-in in my online banking account and buy some allowances directly or buy a trustworthy fund that physically invests in allowances (and has reasonable fees). I found an ETF that allows to participate in the movement of future prices of allowances, but that ETF does not seem to be physically buying allowances. It is thus not clear whether investing in such an ETF would cause allowances to be cancelled via the MSR.

I really have no idea how hard it is to open a fund that directly buys emission allowances, but I could imagine that there might be quite some demand from green investors for such a fund. So if you work in a company that can create investment funds, perhaps you could pitch the idea to your colleagues. I imagine that such a fund might be a profitable endeavor that at the same time can help fighting climate change.

There have been organisations (like the compensators) that took donations, bought allowances and then directly cancelled them. Due to the introduction of the MSR, they currently stopped their activities, but they may soon start again with a buy-hold-cancel scheme as e.g. proposed here. This looks like a great way to donate money in order to reduce emissions. Yet, I could imagine that a fund that leads to some cancellation via the MSR while not cancelling the investors’ allowances may attract much higher amounts of money.

If you already know of such a fund or another simple, trustworthy and cheap method to directly buy emission allowances as a private investor, please let me know.

And of course the disclaimer: This blog post only contains my personal thoughts on the topic and should in no way be considered as official investment advice. There are definitely risks involved and I also may very well have made some mistake in my description and assessment above. Always think for yourself how you want to invest.

Published on 05 Feb 2020