Wednesday, February 18, 2009

Investing in Carbon Credits: A Poor Decision?

Turns out there is an ETF of European Carbon futures as part of CO2 cap and trade.

This is an example of a product that is simply designed to make the ETF provider money without much hope of outperforming European industrial stocks in the long run.

CO2 futures will be more expensive when more carbon is being produced and less expensive when less carbon is being produced. As far as I can intuit, carbon production from a company should fluctuate in the same direction as companies cut back production during down markets.

Because "supply" is set by the government at a fairly fixed level while demand fluctuates, the price of carbon should exhibit large fluctuations (the same way most commodities do). Based on this, beta should be higher than 1 relative to the European stock market (beta is a crude volatility measure - what the security moves if the comparison index moves up 1).

Demand for carbon should hopefully slowly decrease as companies install more efficient technology. Perhaps more pressingly, the expenses of owning this ETF should be larger than the expenses of owning an index of European industrial stocks because futures require a) more effort on the part of the manager and b) more money to keep turning over the futures. Therefore, the alpha (expected return) should be less than that of a set of diversified European Industrials.

The alpha and beta are also affected by political risk - in different markets, the Eurozone comes under different pressures to increase or decrease allowable carbon. This could intuitively be correlated with economic activity positively (if Eurozone listens to corporate requests for greater carbon allowance) or negatively (if it listens to environmental groups as carbon demand goes up). This creates a risk that's not easily summed up in Beta or Alpha, but certainly exists.

So, the question is... why not just invest in European Industrials? Better alpha, an adjustably similar beta, and less political risk. The lag should be minimal; both carbon futures and industrial stocks are priced based on future performance. Even as a market timing mechanism it makes no sense; you can almost certainly piece together some European industrials with a similar beta and a higher alpha if you think that the market has hit bottom.

Can anyone think of a good reason to invest in this? Maybe carbon futures are more short term, so you can get visibility into upturns in carbon futures based on recent European Industrials performance (which would move first)... does this happen? Not enough of a history to backtest it so the answer has to be theoretical. Cookies to whoever can give me a good answer.

Additionally, I don't sell short because of the margin requirement, but couldn't you theoretically use this for some seriously nice arbitrage? Bet long on a portfolio of Euro Industrials with a similar Beta to the Carbon Credits ETF, bet short on Euro Carbon Credits, and enjoy a high expected value return relative to risk?

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