Description

Recommendation:

We are recommending an investment in the Krane Shares California Carbon Allowance Strategy ETF (KCCA.)

We believe the dynamics for California Carbon Allowances (“CCA”) fit the playbook for successful supply/demand-driven upside:

• Demand for allowances is growing, driven by carbon emission restrictions in the state of California that become more stringent annually between now and 2030.
• Supply of allowance is shrinking, driven by a supply bank and auction schedule that shrinks annually.
• There are no substitutes, polluters who can not produce less carbon must buy CCAs to avoid massive non-compliance fines.
• Price insensitivity, the price of CCAs is small in the grand scheme to the emitters and can often be passed on to customers.

In our experience, when each of the above boxes is checked, it often results in upside for the commodity in question. We have seen this play out many times in uranium, coal, potatoes, specialty chemicals, aggregates, etc. In the case of CCAs, we believe they could appreciate from today’s price in the high $30s to prices over $100 over the next 3 years.

While it is the potential return of this investment that excites us, we also believe there are a few other attractive elements of CCAs:

• Downside protection, as CCAs have a current floor price of $22.21 – a level which grows by CPI +5% annually.
• Uncorrelated returns, as CCAs exhibit relatively low volatility (ex-COVID) and little linkage with other asset class returns.
• Measurable social impact (if that’s your thing), as CCA proceeds go to fund earth-friendly projects in the state of California (high speed rail, parks, trees, bicycles, etc.)

A Brief History of CCAs

California Carbon Allowances trace their roots to Assembly Bill No. 32 in 2006 and its extension Senate Bill No. 32 in 2016 which set formal limits for carbon emissions by 2030. While there were a number of programs in these bills aimed at climate impact, by far the most important was the establishment of a cap-and-trade program (“CTP”) for carbon emissions, which is administered by the California Air Resources Board (“CARB” which incidentally was created by Ronald Reagan in the 1970s.)

The legislatively prescribed goal of the CARB’s CTP program is to reduce greenhouse commissions to 40% below 1990 levels by 2030. To achieve this goal, any player emitting more than 25,000 metric tons of carbon a year in the following sectors are subject to regulation and given a schedule of how much their carbon emissions must be reduced each year.

• Large industrial facilities (including cement, glass, hydrogen, iron and steel, lead, lime manufacturing, nitric acid, petroleum and natural gas systems, petroleum refining, and pulp and paper manufacturing, including cogeneration facilities co-owned/operated at any of these facilities); electricity generation; electricity imports; other stationary combustion; CO2 suppliers;  suppliers of natural gas, suppliers of reformulated blendstock for oxygenate blending (i.e., gasoline blendstock) and distillate fuel oil (i.e., diesel fuel), suppliers of liquid petroleum gas in California, and suppliers of liquefied natural gas are covered by the program.

In total, the program covers about 400 facilities. The program started 10 years ago and as you might imagine, easy changes such as closing coal-fired plants have already been made.

For many of the largest carbon emitters in the state (refiners, large manufacturing facilities, electricity generation with fossil fuels), reducing their carbon output to the legislated level in the coming years is literally impossible or ridiculously expensive. So how does an emitter who cannot meet their mandate get into compliance? By purchasing California Carbon Allowances, issued by the state of California.

It is important to note that a California emitter cannot get into compliance by buying generic carbon credit. Chevron can not buy a carbon credit from a tree nursery in Georgia and apply it to their Sacramento refinery. They must buy an official CCA, which is sold by the state of California at quarterly auction.

CCA Pricing

CCAs do not expire, so some emitters (and some investors) have been buying more than they need at auction over the last decade, creating what CARB calls an “allowance bank.” CCAs have steadily risen along with the auction reserve price but inflected positively in 2021, not coincidentally when the reserve bank peaked and began to decline. We model an actual shortage of CCAs later in this decade (the chart below is from a few months ago and the current CCA price is a bit dated.)

But What About California Regulatory Risk?

There are two things that could blow this idea up. The first is the appearance of affordable, widely adaptable carbon abatement technology in the next 3 to 5 years. I’ll take my chances on that. The second is the politicians in California screwing something up. This one caused me to pass (laughingly) on this idea the first time I heard it. Some things that made me change my mind:

-          This program has wide bipartisan support amongst California politicians.

-          Liberals like that it fines carbon emitters.

-          Conservatives like that it is a free market mechanism.

-          Proceeds from CCA auctions have come to represent about 3% of California state revenues.

-          Federal courts dismissed the Trump administration's attempt to challenge the program in 2020 (by an HW Bush-appointed judge.)

-          The prevailing concern in California seems to be that the program is not moving fast enough to remove greenhouse gases from the environment. As a result, the state is considering moving the goalposts from a 40% reduction of 1990 levels by 2030 to a 55% reduction. The market mechanism for doing this would be removing allowances from future auctions, thus further tightening the supply/demand equation going forward. Chatter around this topic is what has moved the futures market for CCAs in the last few weeks. https://climatemarketnow.com/2023/11/03/ccas-continue-moving-higher-on-carb-announcement/

How To Trade?

CCAs can be purchased two ways. Covered emitters and a limited number of commercial participants buy CCAs at quarterly auction. This requires proper licensing and permitting from the state of California to hold “physical” CCAs in a Compliance Instrument Tracking System Service account. This would be the preferred method for a buy and hold strategy for CCAs, but is unavailable to the vast majority of us.

The other and much simpler way to buy CCAs is via the futures market. These are quite liquid, trade on ICE and are available out thru December 2026. KCCA simply holds near-term futures and rolls them forward at expiry. It is important to note that because they are not an actual market participant, they can never settle them physically. You can see their holdings here: https://kraneshares.com/resources/factsheet/2023_10_31_kcca_factsheet.pdf

Am I Helping The Environment?

Sure. If impact is important to you, as an individual or as a professional who needs to check the box on the topic, this is one you can feel good about. CARB puts out a dense annual report on how they are using all the money from CCAs to save the earth. We view this as an ancillary benefit and recognize that it may drive interest from certain corners of the investing world.

Further Reading

We’ve presented a thumbnail sketch of the topic here. Resources if you’d like to learn more:

https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program

https://icapcarbonaction.com/en/ets/usa-california-cap-and-trade-program

https://www.c2es.org/content/california-cap-and-trade/

https://engage.kraneshares.com/s/ef18942d?ks_product=kcca&utm_source=krbn-search&page=1

Timing

We like this trade over the next 3 to 5 years. It is worth noting that, in the near-term, there is a CARB open hearing tomorrow (November 16) evening, where it is expected they will unveil the tightening model for 2030 standards. Unclear whether or how much this is priced into the futures market already.

Catalyst

CARB meeting 11/16.

Passage of time.