Putting carbon markets to work on the path to net zero

| Report

The total value of global carbon markets grew by over 20 percent in 2020—the fourth consecutive year of record growth. Compliance carbon markets (CCMs), where mandatory national, regional, or international regimes trade and regulate carbon allowances, play an increasingly visible role in efforts to reduce emissions. Voluntary carbon markets (VCMs), where companies and individuals trade carbon credits on a voluntary basis, play an important role in driving investment in carbon-compensation and -neutralization projects to offset their emissions.

Today, institutional investors participate in these markets only to a limited extent. Structural obstacles prevail, and the market dynamics are relatively unclear. Yet, the picture is changing. This joint paper from GIC, the Singapore EDB, and McKinsey discusses the rapid emergence of carbon markets as a viable asset class. It suggests that institutional investors could play a critical role in helping corporations and nations use these markets to achieve global climate goals while also fulfilling institutional investors’ own mandates. While it does not issue an investment recommendation, it aims to shed light on the evolution of carbon market mechanisms and their relevance to institutional investors.

1. Carbon markets are rapidly approaching critical mass from an institutional investor’s perspective

As we have noted, the participation of institutional investors in carbon markets remains limited today. CCMs are the more mature and larger of the two markets, with a value of more than $100 billion and an annual trading turnover of more than $250 billion. Nonetheless, CCMs are small compared with the $19 trillion of total assets under management by the world’s top 100 institutional investors in 2020. VCMs are currently nascent, with a value of only $300 million in 2020. As a result of limited liquidity, insufficient market size, a nonstandard transaction process, and a lack of rational or explainable price mechanisms, they have not been viable for institutional investment at scale.

However, the market picture is rapidly changing. CCMs have stabilized and are becoming easier for institutional investors to understand. New emissions-trading systems (ETS) are now being established, and recent market reforms in existing trading systems have created a more predictable framework.

Meanwhile, governance and infrastructure are being developed to support the rapid growth of VCMs, which have as much potential to scale as CCMs do. McKinsey’s work with the Taskforce on Scaling Voluntary Carbon Markets (TSVCM) shows how VCMs could become a more viable investment option in the future if they meet certain important milestones, such as the standardization of corporate claims and products (Exhibit 1). In addition, VCMs have a significantly more fluid market mechanism, with the pricing determined by voluntary supply and demand and, therefore, considerably less susceptible to regulatory mandates and policy.

Institutional investors have a crucial and central role to play in carbon markets, primarily by creating market liquidity and providing project financing.

Carbon markets are potentially relevant to investors in a variety of ways, depending on the investor’s specific mandate. First, they could act on their own behalf—for example, by buying carbon credits in VCMs to compensate for and neutralize their own emissions. Or they could fund carbon-avoidance and -removal projects to fulfil environmental, social, and governance objectives. Second, investors could buy carbon products as an investment, seeking a return from price appreciation. Third, investors could buy carbon allowances to hedge against climate transition risks that might affect the performance of other asset classes in their investment portfolios. Investors can also act indirectly by asking the companies in which they invest to compensate for their own emissions by purchasing carbon credits in VCMs or to mitigate residual emissions by funding avoidance and removal schemes.

2. Active and liquid carbon markets will be critical in helping the world attain net-zero emissions

The 2015 Paris Agreement set the goal of net-zero emissions by midcentury, with the aim of limiting to 1.5°C, the rise in global temperatures caused by the accumulation of greenhouse gases (GHGs) in the atmosphere. One in five of the world’s 2,000 largest publicly listed companies have now committed themselves to a net-zero emissions target, along with countries responsible for 61 percent of global GHG emissions. Institutional investors have a vested interest in this goal, for if missed, their portfolios will be exposed to increasing levels of climate risk.

Corporate and national net-zero commitments are driving increased carbon market activity in two forms. First, the efforts of governments to regulate emissions through cap-and-trade schemes have created growing CCMs, in which participants can trade carbon allowances. Second, a nascent but rapidly expanding VCM makes it possible for participants to buy carbon credits that channel funds into projects to reduce or remove carbon, thus compensating for (or neutralizing) their own emissions. While the biggest priority is reducing emissions, carbon credits can assist companies in complementing and accelerating their efforts to do so.

Institutional investors could play a critical role in both CCMs and VCMs as a result of the sheer volume of capital these investors can collect, allocate, and deploy. They can connect supply and demand and help build liquidity and market depth. In CCMs, for example, investors can trade carbon allowances to increase liquidity and bridge gaps in supply and demand. In VCMs, they can promote global decarbonization efforts by investing in the reduction or removal of carbon credits, either directly or through third-party funds. They can also exert a significant influence on their portfolio companies to prioritize decarbonization and share best practices (Exhibit 2).

Demand for credits in voluntary carbon markets could grow by 100 times by 2050.

3. CCM carbon allowances could provide downside protection and enhance risk-adjusted returns in scenarios involving immediate or delayed climate actions

Investing in carbon markets remains a difficult proposition for institutions, but this could change rapidly. Recognizing that possibility, we explored what investors could achieve by including carbon allowances in their portfolios today. Our analysis shows that investors that allocate a small part of their portfolios to carbon allowances could potentially protect themselves against climate transition risks. Although the precise course of carbon prices remains uncertain, they hinge on policy action; as a result, carbon prices could potentially rise as governments around the world start to take action.

Our work with Vivid Economics and its Planetrics platform has enabled a bottom-up model of the relative impact of climate risks across individual asset classes. Using three different climate scenarios prepared by the Network for Greening the Financial System (NGFS), to explore a transition consistent with limiting global warming to below 2°C, we examined the performance of a portfolio that includes carbon allowances. Expected performance was modeled over a ten- and 30-year horizon for a portfolio with a 5 percent allocation to carbon allowances against a reference portfolio comprising 60 percent equities and 40 percent bonds.

We found that over 30 years, carbon allowances could improve the risk-adjusted returns of a 60–40 reference portfolio in scenarios involving immediate or delayed climate action by 50 to 70 basis points versus the expected return for a regular 60–40 portfolio of approximately 4 percent. Volatility also improves by approximately 10 to 20 basis points, versus the expected volatility for a regular 60–40 portfolio of approximately 9.8 percent. The only scenario in which including carbon allowances pushed returns below the base was one in which no new climate-change policies were introduced.

We also found that carbon allowances can provide downside protection. They mitigated the expected negative impact of climate transition risks under the two scenarios of immediate or delayed climate action. On average, a carbon-allowance allocation of approximately 0.5 to 1.1 percent was a sufficient level of portfolio risk diversification under climate transitions (Exhibit 3).

About 1 percent of carbon-allowance allocation would be sufficient to neutralize a potential drop in returns caused by climate risks.

Investing in the development of carbon markets is just one action investors can take to hedge against climate transition risks. Others include selecting companies within asset-class allocations that have more climate-resilient business models, weighting the portfolio away from the sectors most exposed to the transition, increasing exposure to expected transition winners (such as green mineral producers), and actively encouraging portfolio companies to improve their own climate resilience. Investors can adopt a mix of these actions.

Although the reasons for institutional investors to consider active participation in carbon markets are relatively compelling and clear, investors also need to be mindful of the inherent risks (see sidebar, “Understanding the risks”). Investors should also ensure that their objectives are aligned with the fundamental goal of carbon markets: to reduce emissions.

4. Three moves to help develop VCMs today

Despite the risks, private funding for high-quality compensation and neutralization projects is urgently needed to achieve net zero. By one estimate, the world must close a $4.1 trillion financing gap by 2050 to meet climate-change, biodiversity, and land-restoration targets. VCMs are critical to raising and channeling this flow of funding.

We believe that institutional investors can help accelerate the development of VCMs in three key moves:

  • investing directly and helping to scale up the supply of high-quality compensation and neutralization projects, such as natural climate solutions (Exhibit 4)
  • supporting high standards of integrity and governance for carbon credits; the absence of such standards is a critical problem for the development of VCMs
  • most importantly, guiding portfolio companies on their journey to net zero: investors can assist companies to set decarbonization targets, report annual progress in achieving them, and leverage carbon credits to help meet their unavoidable commitments or—better yet—to set higher climate ambitions
Nature-based solutions could account for 65 to 85 percent of total supply potential by 2030.

These proposed actions highlight the critical role that institutional investors can and should play to help create viable carbon markets with the primary objective to support decarbonization. As we have shown, increasing numbers of companies and countries have committed themselves to reaching net-zero emissions by 2050. These targets will not be achieved without robust and investable carbon markets, which will not come into being without institutional investors becoming actively involved.

Investors must plan the pathway to incorporate carbon markets as an asset class into their portfolios. Carbon Markets will help investors not only manage risk-adjusted returns as the climate transition gathers pace but will also provide portfolio companies additional opportunities to manage their transition to net zero. Given the physical climate risks that uncontrolled climate change poses for their portfolios, investors should have every interest in making this a reality.

Likewise, the ultimate objective of both voluntary and compliance carbon markets is to help the world set a path to net-zero emissions in line with the Paris Agreement, and to be an effective mechanism for managing risks and returns. As investors set out to develop and invest in carbon markets, they should never lose sight of this goal.

This is an edited extract from Putting carbon markets to work on the path to net zero: How investors can help decarbonize the economy and manage risk-adjusted returns, a report jointly developed by McKinsey, GIC, and the Singapore Economic Development Board.

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