Fund managers and other private investors are jumping into cap-and-trade markets, attracted by the promise of large returns as prices for carbon emission allowances continue to climb on both sides of the Atlantic.

The growing demand from the private sector is pushing up carbon credit prices while strengthening the overall performance of compliance markets created to reduce greenhouse gas emissions, said analysts and other experts following the trend.

At the end of 2021, speculative investors held 46% of allowances in the U.S. mid-Atlantic and Northeastern market known as the Regional Greenhouse Gas Initiative, up 9% from the beginning of the year, according to the program's annual market monitor report.

In California, private-sector investors bid on and won around 20% of allowances in 2021 auctions, data from the California Air Resources Board shows. Such investors have increased over time, but California imposes a holding limit that prevents any company from amassing credits, David Clegern, a spokesman for the state agency, said in an email.

And in the European Union's cap-and-trade market, the world's longest-running emissions trading program, private investment firms with allowance holdings jumped from about 100 in early 2018 to 350 by the end of 2021, according to the London-based market analysis firm CRU. A driver for the investor interest is likely growing confidence in EU climate policies and the expectation of higher carbon prices in the future, CRU said.

"Investors coming in increases liquidity, and the higher prices will force dirtier plants to retire, which is the whole idea, right?" said Paul Tesoriero, a director at Evolution Markets, a brokerage and advisory firm for environmental markets. "The more money that comes into the market on the demand side, the more prices will go up."

Asset managers like Pacific Investment Management Co. LLC and Krane Funds Advisors LLC have been adding carbon market offerings to their portfolios, arguing that investors should get into those markets early, as prices will only go up from here.

"With supply shrinking faster than demand and the price of emission allowances below where we believe technology can be deployed to reduce emissions, we view emission allowances as an attractive investment opportunity across cap-and-trade programs," Pimco said in a December 2021 market assessment.

Krane Funds Advisors has had an allowance fund trading on the New York Stock Exchange since 2020 with investments in the EU, RGGI and California cap-and-trade markets. The KraneShares Global Carbon Strategy ETF has thus far accumulated $1.2 billion.

A market with a climate purpose

Unlike voluntary carbon markets, where companies buy and sell credits to offset their greenhouse gas emissions, compliance markets are mandatory regimes created to bring down climate-warming pollution from covered industries or economic sectors.

In the U.S., compliance markets are created by states that form a regional market, as is the case with the RGGI and the Western Climate Initiative. The RGGI encompasses Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont and Virginia. California and the Canadian provinces of Quebec and Nova Scotia make up the Western Climate Initiative and will be joined by Washington in 2023.

Since it began operating in 2009, the RGGI has issued carbon credits for power producers equal to each ton of carbon dioxide they release. The companies must hold such credits, or allowances, and can sell any excess credits if their emissions drop. Over time, the "cap" of allowances is tightened, making it increasingly expensive to pollute and incentivizing companies to invest in cleaner fuels.

RGGI allowances are sold at quarterly auctions and traded on a secondary market where actual allowances, along with futures and options contracts, can be traded at any time, giving investors flexibility.

The RGGI saw an influx of private investors after prices began to rise steeply in September 2021. Allowance auction clearing prices jumped from $7.60 in March 2021 to $13 in December. Secondary market prices were generally consistent with the auction prices, the May 13 market report said.

Rising allowance prices, acrimony

The price of carbon allowances has been a flashpoint in the acrimonious debate in Pennsylvania after its decision to join the market in 2022. Opponents of the measure say RGGI will force up electricity prices for residential customers and businesses already struggling with inflation. Pennsylvania's participation in the carbon market has been delayed until the fall after Republican opponents in the state sued Democratic Gov. Tom Wolf over his administration's RGGI rulemaking.

Meanwhile, Virginia's new Republican governor has pledged to pull his state out of the regional carbon compact. Gov. Glenn Youngkin recently appointed four new members to the state's Air Pollution Control Board as part of that plan, although legal scholars say only the state legislature has the power to nullify RGGI participation.

Virginia in 2021 received $228 million in revenue from RGGI allowance auctions, money that is going to coastal restoration, energy efficiency and other climate change-related programs. Like RGGI opponents in Pennsylvania, Youngkin has focused his argument on rising RGGI allowance costs and how they may affect energy prices.

But for carbon markets to work as intended, the price for a ton of carbon must reach a certain level to effectively reduce emissions from the companies covered by the program. Participation from private-sector players allows the market to determine a price on carbon while at the same time supporting a robust secondary market, which can also be accessed by companies obligated to buy allowances.

"Higher prices are a stronger price signal to invest in mitigation and to cut your emissions now, because prices are going higher," said Katelyn Roedner Sutter, a senior manager at the Environmental Defense Fund and expert on the California cap-and-trade market. "Instead of saying, 'I'll invest in this new technology in 10 years,' they'll do it now. It means we can get those reductions sooner, which will help decrease the cumulative pollution in the atmosphere."

But the upheaval in states like Pennsylvania and Virginia over the market regulations also presents uncertainty for investors.

"These investors are not in it for a quick turnaround; they're looking at a long-term strategic play," Tesoriero said. "But the risk of a regulated market is that [politicians] just change the rule."

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