Many investors are indirectly exposed to carbon credits through their investments in companies that purchase them. However, these credits can also be actively incorporated into portfolios, write Sarita Gosrani and Kathryn Saklatvala
Recent conflicts within the high-profile Science Based Targets Initiative (SBTi) have served to highlight the tensions surrounding the use of carbon credits.
The often-voiced fear is that credits may be used as a reporting-friendly sticking plaster to mask a lack of real change. Yet the evolution of a large and robust carbon credit market can facilitate global progress on combatting climate change.
Most investors are already exposed indirectly to carbon credits, in that they hold stocks or bonds from companies that purchase them. Yet credits can also feature in portfolios directly: the scheme and/or their asset managers can purchase credits, or indeed generate them. Natural capital strategies, for example, can produce credits, giving investors the prospect of either having their cake (portfolio decarbonisation) or eating it (selling it for a return). At the margins, we even find some pension funds engaging in speculation-oriented carbon trading strategies.
Pension fund investment officers and trustees may now be evaluating the potential relevance of carbon credits for their portfolios, or indeed re-evaluating the question following a period of rapid market development and the emergence of newer strategies. During these assessments, three questions may be particularly helpful to consider.
1. How do investment strategies generate carbon credits?
This market has evolved dramatically during the past two years. As of late-2023, there were more than 30 commingled funds targeting an allocation to projects that can generate or will generate voluntary carbon credits. Most are natural capital strategies that invest in ‘natural climate solutions’ projects: these protect, restore and better manage ‘nature’ in order to reduce GHG emissions and sequester carbon.
Strategies vary widely, as do their projected returns. At one end of the spectrum, we find strategies generating real asset-type commercial return streams, with an additional potential uplift from carbon credit sales. At the other end, we find a small minority of funds with return forecasts entirely predicated on carbon credit sales (typically offering low or no yields, with returns projected to begin materialising no earlier than the three-year mark). Others lie in-between.
The future trajectory of carbon pricing remains an uncertain and challenging subject. Currently, carbon compliance markets are as volatile as other major commodity markets. Supply and demand factors, potential changes in government policy, a lack of global consensus on the use of credits and even changing energy prices all contribute high volatility and high uncertainty.
2. Does carbon credit ‘quality’ matter?
The short answer: definitely. Not all credits are created equal. Lower-quality credits may under-deliver on the carbon removal or the avoidance of future emissions: this can reduce financial value and create reputational risks for all those involved.
Investment in natural climate solutions does not itself guarantee that the carbon credits generated will be of high quality. Recent asset manager research indicates broad dispersion in the approaches being undertaken: investors must handle the subject with care.
A pension fund that is involved in carbon credit generation must carry out thorough due diligence on how the asset manager will ensure quality. This should include examination of additionality (emissions reductions and removals exceed ‘business as usual’, with leakage considered), permanence and community benefits. The asset manager’s strategy – including the holding period, the strategy for exit and the way in which risks are managed relating to physical climate events (e.g. wildfires), pests and diseases – are all extremely relevant to permanence.
3. Keeping credits or selling them to the market?
Direct exposure is of particular relevance to the large and growing cohort of pension schemes that have now made explicit commitments on portfolio carbon emissions. Yet there are arguments for and against investors using carbon credits themselves to help deliver on their own portfolio objectives, versus selling them into the market to allow other entities to purchase them.
Fund managers in this sector differ in terms of how much optionality they’re willing to give their investors. Among the 30-plus noted above, some give investors discretion (to ‘retire’ credits against their own ‘net zero’ goals or obtain additional returns via sale), while others are clear that credits are only intended for sale and bake this into the overall return target.
The real world remains on a trajectory of temperature rise. According to Griscom et al (Natural Climate Solutions, 2017), natural climate solutions could provide more than a third of the total ‘mitigation’ required by 2030. Acknowledging the lack of supply of better quality ‘removals’ credits, pension funds should carefully consider the role of the credits they generate via their investments: is it more beneficial to sell them into the market and thereby support more credible real-world decarbonisation rather than simply achieving a portfolio objective?
Time to act?
With more pension funds now considering involvement in the carbon credit market, it is crucial that investment officials, trustees and stakeholders ask the right questions and consider the full breadth of what’s available now. Natural capital strategies that generate carbon credits hold particular appeal at present, but it is important to develop a proper understanding of the market and define appropriate objectives.
