The voluntary carbon market has rapidly increased in size over the past few years. And with unstable and unpredictable markets, investors seek non-traditional assets to invest in. Can voluntary carbon offsets have diversification benefits as a new asset class?
Climate change is one of the biggest problems of our generation. Human activities have caused rapidly rising greenhouse gases in the atmosphere. These activities continue to hurt the climate and pose a threat to people’s wellbeing, as well as damaging critical infrastructure, causing sea level rises, and many other natural disasters. Such instability also hurts economies likewise.
Recently, the voluntary carbon or non-compliance market took off. The demand for carbon offsets could grow by more than 15-fold by 2030. And, the market for carbon credits could overall be worth upwards of $50 billion in 2030.
Moreover, the COVID-19 pandemic proved the economy is fragile, urging investors to diversify their portfolios to cope with these risks. As an alternative asset class, some investors have been investing in carbon compliance assets, as these credits have shown diversification benefits in some research.
The Clean Development Mechanism is a mechanism where developed countries can invest in the infrastructure and technology of less-developed countries. In exchange for these investments, they receive certified emission reduction credits. One credit is equivalent to a tonne of carbon dioxide (C02) reduced or removed. This mechanism stimulated the carbon credit trade, which helped developed countries reach their greenhouse gas goals, and also created a new market where carbon credits became tradable commodities.
After the Clean Development Mechanism was established, not only the volume of carbon markets but also the number of different marketplaces increased. The biggest international market is the European Emission Trading Scheme. It covers around 11.000 companies and sets an absolute limit on the number of greenhouse gases that can be emitted each year by these operations. Over time, decreasing this maximum cap of free allowances encourages companies to limit their emissions. If companies exceed their limits, they must purchase additional carbon credits through market trade or organized carbon auctions. Companies with excess allowances can trade these on the market. Because of the volume and price increase, carbon markets have become interesting for investors.
Besides the Clean Development Mechanism, there are other voluntary carbon markets. The American Carbon Registry was the first private voluntary greenhouse gas registry in the world. It was founded to register verified emission removal or reduction credits and record the purchase, sale banking, and retirement of these offsets. This allowed private companies to voluntarily invest in projects for certified emission reduction credits. Soon after, the Verified Carbon Standard and the Voluntary Carbon Market were launched. These organizations verify and certify voluntary carbon credits. Private companies, non-profit organizations, governments, and individuals can create projects and get them accredited by these organizations. These projects in reducing or removing tonnes of C02 consist of initiatives such as waste management, cleaner agriculture, reforesting, and other renewable energies.
As it currently stands, many certified emission reduction credits have different prices. This is reflected in the quality perceived by buyers and the cost of production. Because the market of voluntary carbon offsets is so big, and large variations in prices and quality exist, it is hard to get a good representation of the complete market.
The question remains whether an investment in voluntary carbon credits as a new asset class is beneficial for portfolio diversification. With other voluntary carbon assets and a bigger selection of traditional assets, diversification could be better studied.
It would be interesting to see if investors will make use of carbon credits as a new asset class to diversify their portfolios while creating more impact simultaneously.