Carbon ETF Market Has Room to Grow

Apr. 8.09 | About: iPath Global (GRN)

When President Barack Obama included a carbon cap-and-trade provision in his budget proposal, analysts and investors struggled with what to think and what to trade. Currently, two exchange-traded products are available to carbon investors: the iPath Global Carbon ETN (NYSEARCA:GRN) and the AirShares EU Carbon Allowances Fund (ASO). While GRN and ASO offer different approaches and vehicles for carbon investors, they are likely just the beginning of a carbon-ETF trend. The development of GRN and ASO is a good example of how the ETF market seizes upon new trends, such as green energy or scarce commodities, and launches products and indices quickly. The launch of the new S&P 500 Carbon Efficient Index represents another opportunity for carbon exchange-traded products to be created, as well as a greater desire to differentiate between the carbon-efficient funds available.

Carbon-efficient ETFs have gained more attention as the new administration sets forth its plan for carbon cap-and-trade, which is a system of emissions allowances (credits) allocated to companies that produce emissions during the course of business. Because different companies pollute at different rates, the number of carbon credits varies from company to company. Assuming that the allocation is imperfect and that companies will change their needs over time, a cap-and-trade system will allow businesses to reallocate their carbon needs. Companies that pollute less can sell their credits to companies that need them more, and additional credits can be earned by companies taking initiatives to reduce pollution.

Barclays became the first to introduce a carbon-efficiency-themed product, in early 2008. GRN, which we first reported on in August, comprises exchange-traded notes that represent carbon emissions allowances. What complicates GRN, and every exchange-traded note, is that “issuer risk” accompanies the notes. The price of GRN could be affected by the credit rating of the issuing bank, Barclays—a concern that has become more acute in the last year as previously “impervious” banks slashed their value. ETNs have had some difficulty gaining traction in a dismal credit market, and GRN has proved to be little exception thus far. The three-month average daily trading volume for GRN is currently fewer than 2,000 shares per day.

Launched in mid-December, X-Shares added ASO, which is a pool of commodities that track a basket of exchange-traded futures contracts. Because these contracts are not physically deliverable and ASO tracks the pool of contracts, rather than notes, ASO cannot be considered a “true” ETF. ASO has a 0.85% management fee and is just shy of $4 million in assets. With only 200,000 shares outstanding and an extremely light trading volume, ASO could be an opportunity for investors to watch and wait—to track price movements in the market without actually getting involved yet.

The promise of more carbon cap-and-trade products arrived with the advent of the S&P U.S. Carbon Efficient Index in March. The new index, which promises to be the first of a series, is set to measure the performance of large U.S. companies with relatively low carbon emissions output. The index is rebalanced quarterly when index components are compared to their carbon emissions. The 100 equities with the highest scores, and whose aggregate exclusion does not reduce any individual sector weight of the S&P 500 by more than 50%, are removed from the index.

While the latest carbon cap-and-trade headlines are educating a new wave of investors, global economic forces may cause the cap-and-trade market to contract in the short term. The current economic slowdown has forced emissions producers to focus on the near-term crisis. Global production slowdown could drop the value of the carbon market by 32%, according to a recent report by Point Carbon. So while investor interest in trading carbon may be increasing, the declining value of the market could cause a short-term bubble.

By some estimates, the global carbon market is worth more than $50 billion per year, and the new exchange-traded products are attempts by issuers to grab a slice of the pie. Not all similarly themed products are created equal, and some become more popular than others. Examples of similar products with vastly different trading volumes include Pharmaceutical HOLDRS (NYSEARCA:PPH) versus the iShares Dow Jones Pharmaceuticals (NYSEARCA:IHE) or PowerShares FTSE RAFI Japan (PJO) versus the iShares MSCI Japan Index (NYSEARCA:EWJ). While many factors impact the different trading interest in similarly themed funds, it is important for investors to remember simply that there is, indeed, a difference. While one methodology might seem preferable to another, factors such as volume and liquidity are important for investors when it actually comes down to the trading process.

As with any investment, prospective carbon investors should stay alert and attentive to the volume and development in the carbon ETF market. While GRN and ASO have yet to gain traction among the investing public, new, more viable ETFs could spring up from the advent of the S&P 500 Global Carbon Index. As with any narrowly themed exchange-traded products, however, investors should be wary of an influx of new funds to the market. If individual investors don’t know where to start, they should look to the trading volume of current ETFs. More market participants in the carbon market will lead to tighter spreads, and the trading community is often quick to decide what works.