A Guide to Understanding the California Carbon Market

Advisors and investors seeking opportunities in commodities often overlook carbon allowances and the diversification benefits they offer portfolios. Within the U.S., the California carbon market benefits from strong regulatory support and is worth consideration.

Eron Bloomgarden, founder and partner at Climate Finance Partners, and Oktay Kurbanov, partner at CLIFI, wrote a paper recently reviewing global carbon market performance in 2022.

A California Carbon Market Overview

California remains a trendsetter within the U.S. when it comes to environmental policy. The joint California and Quebec carbon market has outlined aggressive emissions reductions beyond federal mandates. Aggressive tightening in California’s market in the next two decades creates a strong investment case looking ahead.

Graph of the California carbon market from 2013 to 2022. Includes actual emissions reductions, rising CCA prices, and decreasing emissions cap

Image source: KraneShares

One carbon allowance equates to one ton of carbon dioxide or equivalent greenhouse gases. Currently, the cap-and-trade program regulates about 85% of greenhouse gas emissions in California. That equates to roughly 450 different compliance participants from a range of industries, including fuel distribution and electricity distribution.

“The objective of the California Cap-and-Trade program is to provide a market-based price signal that drives the energy transition with innovation,” the authors wrote. At the same time, it’s balanced “with a mechanism that minimizes the risk of entities leaving the system.”

Market Mechanics and Liquidity

California’s carbon allowances market employs a price floor which ensures that allowances cannot be sold for less at auctions. This price floor also increases by 5% plus inflation each year, creating positive price momentum over time.

Carbon allowance reserves set aside annually also work to reduce price volatility. These are held in the Allowance Price Containment Reserves and released into auction if prices at auctions exceed 60% above the reserve trigger price. “The APCR is designed to contain prices should the demand for carbon allowances exceed auction supply,” explained the authors.

The California cap-and-trade market also tightens every year, reducing its cap by 4%. This cap should tighten further this year when the market aligns with new 48% emissions reductions goals by 2030. Previous targets were 40% reductions by 2030 compared to 1990 levels.

Graph of rising, choppy CCA futures prices from Dec 2018 to March 23

Image source: KraneShares

Liquidity grew substantially in the last few years: the California Carbon Allowances (CCS) futures market experienced trading volume around 44.5 billion last year. “Market makers and hedge funds have moved into the market, signaling an increasing interest in carbon as an asset class,” the authors wrote.

Invest in California’s Carbon Market With KCCA

The KraneShares California Carbon Allowance ETF (KCCA) offers targeted exposure to the joint California and Quebec carbon allowance markets. It will benefit from California’s aggressive push to reduce emissions alongside the increasing demand for allowances within the market.

This market is one of the fastest-growing carbon allowance programs worldwide. Its benchmark is the IHS Markit Carbon CCA Index and includes up to 15% of the carbon credits from Quebec’s market.

The index measures a portfolio of futures contracts on carbon credits issued by the CCA. The index only includes futures with a maturity in December in the next year or two. The fund also uses a wholly owned subsidiary in the Cayman Islands, which makes a K-1 unnecessary for taxes.

KCCA carries an expense ratio of 0.78%.

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