Carbon Credits and the Russian Invasion with John Wilson

April 2022

Russia’s invasion of Ukraine has taken the carbon credit markets on a wild ride. But for Ninepoint’s John Wilson, the investment thesis is only getting stronger.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

Michael Hainsworth:
The global carbon credit market is projected to climb to more than US$700M by 2027 — a compound annual growth rate of almost 12% between now and then. But it’s been a rollercoaster ride for investors following the Russian invasion of Ukraine more than a month and a half ago. For Ninepoint’s co-CEO and managing partner John Wilson, it’s a function of the industry’s youth. And while a reduction in economic activity due to the invasion is a risk, Wilson believes the world is facing energy supply crisis already in progress, and the conflict has exaggerated and made it worse. After Russia launched its attack, we saw the most liquid carbon credit market in the world, the European Union Carbon Allowance, tumble. Then, the California Carbon Allowance followed suit. Both bounced back. What does that tell Wilson?

John Wilson:
Well, I think maybe a more accurate way to think about that is we were already on a supply crisis, and all that has happened with Russia and Ukraine exaggerated it and made it worse.

Michael Hainsworth:
With that in mind, after Russia launched its attack, we saw the most liquid carbon credit market in the world, the European Union Carbon Allowance, lose more than a third of its value. Then, the California Carbon Allowance posted a 14% loss. What did this reaction tell you at the time?

John Wilson:
It's like most traded financial markets in times of stress, there are a lot of factors at play and some of them can actually tell you something useful and others are just a result of people panicking or not knowing what to do in an environment where, at one point, people were worried that this could be the start of World War 3. I think let's work backwards through those.

First of all, the largest publicly traded carbon market in the world is the European market, both in terms of the amount of credits out there and the value of the credits. It would be on the order of seven or eight times larger than the California-Quebec market, and so when it declined, which we'll get to a minute as to why we would argue or why we would speculate why that happened.

When the largest market goes down 30%, the other markets are going to track it somewhat, and people are just going to say, "Well, wait a minute, the price of carbon's moving in the biggest market, maybe I should be readjusting my price here." Ultimately, we're going to get into this when we think about the longer term prospects for carbon markets, but this is obviously a global problem. Theoretically, we all need to making adjustments so there should be some similarity in the price of carbon globally. Doesn't mean it's going to be the same everywhere, but it should be in a similar ballpark.

Why did Europe react the way it did? Actually, when the price of oil and gas goes up, normally you would expect the price of carbon credits to go up, and that's because gas in particular is used for power generation in Western Europe and if it goes and becomes much more expensive, then they tend to flip back to coal generating, and coal generating obviously has much higher emissions so those plants need to buy credits to offset those emissions.

The normal relationship would be natural gas prices go up, more coral generation happens because it's cheaper, and actually the price of carbon goes up. That's obviously not what we saw in this situation, and again, it's very unusual. It's not every day that Russia decides to invade its neighbor, the largest land country in Europe. When that happened, there's other dynamics that come into play. First of all, people start shedding European assets. Europe's going to be at war, maybe I want to de-risk my portfolio, I'm an international investor, I don't want to own things with European exposure. When those sorts of things happen, there's not a lot of discrimination that goes on as people just dump things.

That's one. Clearly, there was also some speculation that Russia had owned significant amounts of those credits and was dumping them to raise cash as sanctions took hold, so that's another potential cause. To us, the carbon markets are always going to be volatile at this size because they're relatively new, not everyone's involved, it's an evolving marketplace, and over time we expect not only will those markets get much, much, much larger, both because there'll be more industries under these this sort of regulation, but also the price of carbon per ton was going to go up over time.

All of that are going to make them larger markets, which will make them less volatile, but you do need to think of them on a longer term perspective. In the short term, there's going to be these types of ups and downs and you just have to hold through it. One parallel we've used, which might seem a little strange when I introduce the idea, is from a timing perspective. You have to think of this asset class similar to what you may have thought about crypto seven or eight years ago.

Crypto seven or eight years ago, the price of Bitcoin was probably pretty much the only crypto people would've heard of. There were other cryptos evolving at that point, but most people had only heard of Bitcoin. It was under a thousand dollars for Bitcoin per coin, and it was seen as this weird thing, gambling. People who didn't know what they were doing were doing this stupid crypto stuff, it didn't mean anything, but there are plenty of people, sophisticated investors, who looked at it and said, "Everything in our world is digitizing, money's going to be the same. This is new technology, this is the way you would do it if you were going to do it."

There's some immediate uses people could think of beyond just doing transacting over the internet. Things like store of value, so if traditionally you held gold, what's the difference between Bitcoin and gold? Gold, you can't really do anything with other than keep it in a safe and assume that other people want to buy it from you.

People with a longer term perspective said, "Yeah it's really volatile, but the dynamics of this over the long run are really, really good, and I know I'm early, but if I buy some now, one, I'm there, I'm learning about it, and two, over time, I should do really well," and that has absolutely worked out for people in crypto.

I would look at carbon markets the same, only with one very important difference. Similar to crypto, you're very early. Most people don't really understand what's happening with carbon markets, generally. It's amazing how much education we're doing right now with people, but generally people can understand that, "Yeah, hey, this whole climate thing, I think this argument over..." Remember when you used to go to a party, Michael?

Michael Hainsworth:
In the olden days?

John Wilson:
In the old days. Pre-COVID, for sure, but you go to a party and there'd be some climate deniers in the room. There'd be people, you'd be engaged in a conversation, some people say, "Ah, I don't really believe it, it's just the natural way the planet goes." You don't really have that anymore. That horse has left the barn, and everyone understands that the kind of economic costs that are being placed on our economies from environmental damage are significant and getting worse, and that we need to stop this and the way to do it is reduce greenhouse gases.

Everyone understands a long term use case. The big difference between this, at this point in time, with carbon versus crypto is there is an immediate need for these credits. There's a use for them. People don't just own them and hold them and say, "Woohoo, I've got a credit." Industries need them. These are called a credit and these are carbon allowances, so if you're a carbon-emitting industry, you need these allowances to offset the emissions you're making to hit the targets that are being set by your government and your jurisdiction. Those targets keep getting more difficult every year, which means you're going to need to improve your emissions or own more credits, so there's a real marketplace for these credits and these allowances and you own something of value, which important.

Michael Hainsworth:
We did see that both the EUA and the CCA bounced back in early March, but let's think on a short term basis, early spring, isn't it typically week for the carbon credit market because it's weak for the energy markets broadly?

John Wilson:
Yes. It depends on the jurisdiction you're in, but again, if we think of Europe, traditionally in Europe, they have to hit their targets by a certain point of the year and that is actually early spring. That's when they have to meet their emissions target and own the right number of allowances, so following that period there's some weakness because they got a whole other year to figure out how to make their emission target.

So yes, there has been that cycle. I also expect that to become more muted over time, one, because emission targets continue to get more difficult each year. There are going to be more industries put under this type of regime, so there'll be more people that are involved in the marketplace, and people are learning how to use the carbon credit market more efficiently. Rather than just something that, "Oh my gosh, I haven't come near the end of my measurement year, I need to do something," they'll put in programs that take place more steady state throughout the year. Yeah, there has been some seasonality, but again, it's a small market, it's a rapidly growing market. The size of this market has been growing a little over 30 to 40% a year, and anytime you're in a market that's changing that quickly, there's always going to be volatility.

Michael Hainsworth:
What though of the Russian invasion? How significant is the expected reduction in economic activity because of it, and what does that mean for the carbon credit markets?

John Wilson:
That's an excellent point that I neglected to mention when we were talking about the decline of the European carbon value/ The obvious one is if the European economy goes into a steep recession, there'll be less economic activity, which means less emissions, which means less demand for carbon. That's always true over long periods of time. We obviously experience economic growth, at least in most developed economies other than really Japan, and the emissions from carbon tend to track that, so they climb as economic growth climbs.

Yes, if economic growth was to go down, there would be less demand for carbon allowances. However, don't forget that each year we're also allowing fewer carbon emissions. Imagine I had growth of a hundred this year, and now I go into recession and I'm actually going to shrink next year, I'm going to shrink, say, to 95. Whatever my emissions were, they might be dropping by more than that, so the demand for carbon credits could still go up even in a downward moving economy, depending on how-

Michael Hainsworth:
Because the market's getting that much bigger.

John Wilson:
The market's getting bigger, but also the target that you have to reach gets that much harder. As an example, Canada two, three days ago announced their emissions reduction plan that they're going to update now every two years, and part of that plan, among other things... They mention all the programs they're going to do to to help enable emissions reductions across the country, but a key part of that plan is putting a price on carbon. Most jurisdictions in Canada, the federal government has chosen a different way at coming at carbon pricing. Rather than having a cap and trade market like Europe does or California or even Quebec does, the rest of the provinces in Canada and the federal government have chosen a carbon tax.

Under the cap trade system the government in that jurisdiction will say, "Okay, your emissions are X, we need them to be 95% of X next year," and then 90% and then 80 and so on, and the market will figure out what the right price of carbon is to make that make sense for everybody. In Canada, we've done the opposite, which I'm glad we're doing something because we need to do something on this problem. I would prefer the cap and trade system, but the way our government has chosen to do it is to just put a dollar value on the price of carbon emissions and make that cost force people to adjust their emissions. To me it's backwards, but that's the way they've chosen to do it.

In their plan, the price of carbon in Canada has been rising at $10 a ton. It was initially $20 a ton in 2019 when it was initially put in place, and now it's going to be $50 this year. Starting this year, they're actually going to start raising it by $15 a year, so actually the rate at which it's going to go up is going to increase and that's going to continue until 2030 when it will reach $170 a ton.

You can see over that 12 year period from 2019 to the end 2030, the price of carbon's going to go from $20 a tonne to $170 a tonne, which means you're going to have to materially reduce your emissions along the way or it's going to cost you a whackload more money. If you think of that in a cap and market, it's the other way around. They're taking emissions much lower and the price of carbon's going to go up, probably in a similar amount to what the Canadian government's doing.

Michael Hainsworth:
It sounds like this is the basis for why you're bullish long-term on carbon credits. Sure, maybe we see a weak spring for the carbon credit markets because of the energy consumption, maybe we see reduced economic activity because of Russia's invasion, but is this the basis for your long-term bullish view, that the price is just going to continue to climb, or do we also copy and paste from Eric Nutall's playbook, which talks about peak supply and the fact that demand is going to continue to rise?

John Wilson:
I think you can use both. Regardless of what was happening with oil and gas supply, if you were just looking at the dynamics of climate change and what needs to get done to incentivize industry, to reduce their emissions, and/or invest in technologies and capital investments that are going to remove carbon from our, whether that's capture and storage or renewables or whatever else, all of those are going to require a significant increase in the price of carbon to make those types of things happen, obviously.

People react to economic incentives, so if I can keep doing what I'm doing with the capital I've already invested, and it costs me a little bit more because I have to pay this carbon tax, well, I'm probably not going to change. If I know that carbon tax is going to keep going up, that it's going to get more and more expensive every year, I'm going to start to think about, "How do we get off of this?" because I don't want to keep paying this higher tax every year.

So yes, from a long term perspective, and I do think you need to think of this asset class in a long term perspective, I'm not just bullish. I'm incredibly bullish. We're talking $20 a ton in north America, and the Canadian government itself is targeting in eight years from now to be $170 a ton, and I'll tell you one thing about markets, they tend to overshoot. 170 from 20 is an eight bagger, from 50 we are right now, that's over a triple, and I think we can go much further than that. On the one hand, yes, there's an enormous opportunity here to see the value of a carbon allowance go up a lot. As I mentioned earlier, I think there's going to be a lot more industries, so the size of the market's going to get a lot bigger and a lot more liquid.

Another key benefit and the reason we like it is it has very low correlation to other assets in your portfolio, whether that be bonds or equities or almost anything else you own. That's a really nice diversifier in a portfolio, to have something that has great long-term growth dynamics but it's not adding to the risk of other things you own that you like, so that's also really powerful.

All of those things, we just think, yes, it's early, but it's amazing how many people I meet at a party that said, "Oh, I wish I bought Amazon in 2002," or, "I wish I bought crypto in 2019." Everybody on the one hand says, "Well, it's new, not many people are talking about it," but if you really sit back and think about, "Do you believe five years from now that we'll be less concerned about climate change or more concerned?" I think almost everybody in a room would answer more concerned, and if we're going to be more concerned, are we going to want industries producing less carbon or more carbon? Everyone's going to say less carbon, and are we accurately reflecting the cost of pollution today? If you think of a ton of carbon as pollution and the economic costs, whether those be floods in BC or wildfires in California or hurricanes, all the huge economic costs that have happened over the last decade and that are being attributed to climate change, I think everyone would say, "Well, actually we're not accurately capturing that. The price of carbon has to be higher."

Michael Hainsworth:
How's the Ninepoint Carbon Credit ETF position to benefit from your bullishness?

John Wilson:
We looked at the opportunity as one that people wanted to access. They wanted to do it simply, know what they owned, so we didn't want to get too, too fancy so it's a passive vehicle, meaning you own the underlying value of carbon allowances in the major markets, so Europe, California, Quebec. There's one called RGGI, which is, I think, 11 states in the Northeast United States, and just this month on our rebalance, we've introduced the U.K., which is, of course, no longer in the EU so is now its own separate market. We equal weight those. We don't get too fancy, it's just equal.

In this case right now, it would be 25% in each of those markets. We like that for a number of reasons. One, it gives you diversification. As we just talked about at the start of this podcast, if you were just in the biggest market or you were weighted to the biggest market, you would be about 80% EU, and EU went down 30% when Russia invaded. That's just a lot of risk in one investment product, so by diversifying to all the jurisdictions, we lower risk to any one jurisdiction, which we think is important.

Secondly, by doing that, we get much greater weight on North America, which is, for most of our clients, where they live and where they want to be investing in, and third, the North American markets have been pricing at a substantially lower price of carbon than Europe, and that's simply because we got started on this behind the Europeans. Europeans have always been ahead of us on the environment and environment regulation, and we just follow them, so we're just slowly catching up. If you look at it that way, we think having a larger exposure to the North American relative to their market weight gives you better exposure to undervalued markets, which have more room still to go. All of those reasons, we felt it was a good way to do it. It's simple, it's passive, it's diversified, and it gives you great exposure to North America.

Michael Hainsworth:
If there was one thing you'd like the listener to take away from this conversation, what would it be?

John Wilson:
This is going to take a long time. One thing I want people to take out of this podcast, we absolutely have to do this transition, but it is going to take us 20, 30, 40 years. It's going to take us a long time.

Canada's emissions reduction plan target to get net zero is not 2025, it's 2050. That's almost 30 years from now, so it's going to take a long time, and if it's going to take a long time, there are two things. If you really want to invest with morality, the two things we need to do are find a pragmatic way to get us there, and the pragmatic way is to keep producing the energy we need to run our economy so that we can keep jobs and cash flow and investments, all that stuff, so that we can reinvest in the technologies and infrastructure that's going to be necessary to achieve our target. The way you incentivize that reinvestment is carbon credits.

If you're an existing industry that's got a lot of capital tied up in using carbon-based energy, then you're going to have to pay a higher and higher price each year for the allowances that allow you to use that capital, and that's going to incent you, over time, to find ways to not use carbon because that's too expensive, and/or it may even incent you to invest in technologies and capital that don't require carbon energy.

The thing to take away is this going to take 30 years, we're going to need traditional energy, and the way to incent people off of that energy over time is with this cap and trade system. You can benefit as an investor by owning these carbon credits. First of all, traditional energy's been an incredible investment class over the last two years and probably going to stay that way, to our point about the energy shortage and Eric Nuttall's comments. You may have that in your portfolio, but if you think about it, you own carbon allowances also in your portfolio and that offsets the carbon footprint of your energy investments.

I think it's a more pragmatic way to think about where we want to get to. You're helping the price of carbon go higher by owning these allowances, it helps offset any other carbon footprint you might have in your portfolio, and it makes more sense to me than trying to wish that we're not going to use any carbon today because that's just not going to happen.

Michael Hainsworth:
John, great conversation. Thank you so much for your time and insight.

John Wilson:
Yeah. Thank you, Michael.

 

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

 

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