Carbon fund increases returns by decreasing supply of permits

Europe’s emissions trading system could be a catalyst for the energy transition, but only if prices rise

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Take-off: SparkChange's commodity fund holds carbon credits allocated to industries such as airlines

BP is one of Europe’s largest contributors to climate change. It is also the place where a trader came up with the idea for a fund that allows investors big and small to increase the cost of the permits that oil companies, airlines and other major polluters must buy to keep emitting carbon.

Dan Barry traded BP’s carbon allowances with other companies that belonged to the European Union’s Emissions Trading System. Barry wanted to allow outside investors to buy and sell the permits too. The move would have reduced the supply of allowances, which are finite, increasing their price and hastening – in theory – the transition to a low-carbon economy. “I might as well have been from Mars,” says Barry. “The answer was ‘Computer says no.’”

BP’s loss became Barry’s gain. He left the oil major in 2018 to found SparkChange, an exchange-traded commodity issuer that is unique because it invests in carbon allowances rather than futures contracts based on those allowances. The SparkChange Physical Carbon EUA ETC launched at the end of last year and has amassed €200 million ($211 million).

The ETC – European rules prevent exchange-traded funds from holding a single security or type of derivative – buys EU carbon allowances (EUAs). Each EUA is a permit allowing an energy-intensive company to emit one tonne of carbon dioxide. The European Commission automatically issues fewer EUAs each year. If it succeeds the SparkChange fund will ratchet up the carbon price in Europe. Most economists say that putting a price on carbon is necessary to stop unconstrained climate change.

Europe’s carbon pricing system could make a difference to global warming, yet it lacks transparency because allowances only trade in the over-the-counter market, frustrating attempts to value them. The EU publishes the number of spot transactions with a three-year delay. The commission claims it has decreased emissions from power and energy companies by 42% in the last 16 years.

However, alternative research shows that the Emissions Trading System had a surplus of carbon credits at the end of 2021. The number of EUAs had fallen by just nine million since 2019, according to estimates based on EU data and reported by Sandbag, a carbon policy think-tank. If the trading system is tightened in line with the bloc’s 2030 climate targets, emissions will exceed the caps in future years by up to 40%, the report says.

Every report that comes out, the wording gets stronger and stronger and the gaps are getting wider
Dan Barry, SparkChange

Each time an investor buys one contract of the SparkChange fund, they help shrink the surplus. The idea is to let the public crank up carbon credit prices to levels extortionate enough to steer polluters towards greener pastures. And governments need help, says Barry. Despite all net zero pledges, the world is far from delivering the decrease in carbon emissions that scientists demand.

“Every report that comes out, the wording gets stronger and stronger and the gaps are getting wider,” he says. The SparkChange product offers investors a way to play their part, and make a profit in the long term.

The biggest risk for investors is that regulators cool on their commitment to carbon pricing. “You will always have regulatory risk in a market that only exists because of the regulation,” says Stefan Feuchtinger, an independent emissions markets analyst who also trades in the carbon allowance market. “Rule changes could potentially have a big impact.”

Feuchtinger doubts that Europe would ditch its Paris alignment targets or decide that the carbon market it built isn’t fit for purpose, but the outside chance is a risk for investors.

Regulators are instead focused on carbon futures. The EU’s markets watchdog said on March 28 that it would consider position limits on these derivatives. It also means to increase transparency in futures markets.

Dan Barry
Dan Barry

Though futures and physically backed carbon allowances trade in different spaces, Esma noted the volatility of the carbon price, which almost tripled in 2021, from €33 to above €90. Feuchtinger predicts the carbon price will continue to rise. “The carbon market is only going one way and that’s up.”

SparkChange has no direct competition. It’s confident this will continue. Anthony Gordon, head of trading operations at SparkChange, says the complexity of creating a structure to house physical carbon allowances inside a security will deter would-be rivals. The software must be secure enough to protect investor cash while also connecting to the fund’s two market-makers, Flow Traders and Jane Street. The EU Registry which issues carbon permits for the Emissions Trading System is operated by an independent administrator in Jersey. End investors get quotes from the two market-makers.

SparkChange’s €200 million is too small an amount to single-handedly increase the price of carbon allowances or make it tougher for emitters to buy permits at all. Barry hopes that as the fund grows, this will change.

Russia’s invasion of Ukraine prompted the price of carbon to fall 38% from last year’s highs to €56 but the SparkChange CO2 fund’s total redemptions were only 1.25%.

Editing by Will Hadfield

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