Inside the Carbon Markets: Where Climate Incentives Actually Work | Open Interest | Ep.18
Summary
Voluntary vs. Compliance Carbon Markets: The podcast highlights the differences between voluntary carbon markets, which are plagued by issues like moral hazard and lack of regulation, and compliance markets, which are highly regulated and more effective in reducing emissions.
Market Size and Liquidity: Compliance carbon markets are significantly larger and more liquid, trading nearly $1 trillion annually, compared to the voluntary market's $1 billion, offering better transparency and a capped supply of permits.
Investment Opportunities: The compliance carbon markets present rich alpha potential due to their built-in scarcity and the expectation of rising prices, driven by the need for companies to reduce emissions cost-effectively.
Carbon Pricing and Policy: Effective carbon pricing mechanisms, such as cap-and-trade systems, are preferred over carbon taxes due to their ability to harness the profit motive for least-cost abatement and their political feasibility.
Global Market Integration: There is a trend toward linking regional carbon markets, which could eventually lead to a unified global carbon price, enhancing market efficiency and liquidity.
Trading Strategies: The fund employs a mix of long-biased core strategies to capture risk premiums and alpha-driven strategies, including arbitrage and relative value trades, to generate uncorrelated returns.
Impact Investing: Carbon Cap uses 20% of its performance fees to purchase and retire carbon allowances, directly reducing emissions and aligning financial performance with environmental impact.
Future Outlook: The podcast underscores the importance of carbon dioxide removal technologies and the growing role of compliance markets in addressing climate change, suggesting a positive long-term investment outlook.
Transcript
[Music] I think at a systems level very logically you can make a very strong argument that the voluntary carbon market in its current format is actually exacerbating climate change. I think the key word in the voluntary market is the key words moral hazard. Moral hazard looms large. There have been project after project. There have been scandal after scandal and a lot of legal things. And and our advice very strongly to clients is to avoid any involvement in the voluntary market until it becomes under proper financial regulation. Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world. So you can take your manager due diligence or investment career to the next level. Before we begin today's conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran hedge fund manager Neil's Kra Larson. Welcome to another episode in the open interest series on Top Traders Unplucked hosted by Moret Seabbert. In life as well as in trading, maintaining a spirit of curiosity and open-mindedness is key. And this is precisely what the open interest series is all about. Join Moritz as he engages in candid conversations with seasoned professionals from around the globe to uncover their insights, successes, and failures, offering you a unique perspective on the investment landscape. So with no further ado, please enjoy the conversation. Hello and welcome. I'm Murett Sebert and this is episode number 18 of the open interest series. My guest today is Mike Alen, the founder of Carbon Cap and manager of the world world's largest carbon focused hedge fund. Carbon Cap is based in London where Mike started the firm in 2018. They launched the World Carbon Fund in 2020 and the objective of that fund is to generate absolute returns from active management in the global compliance carbon markets. In this episode, Mike and I will speak about which markets they trade in, how these markets function, the differences between carbon allowances and carb credits, why these markets offer rich alpha potential, and how their trading has direct and positive impact on climate change. But before we start, let me give you some background and tell you that Mike has been involved in the trading and investment management space since many years, including the roles of founder and CEO of Asset Alliance International and Frontier Investment Management, a firm which he sold in 2017. Mike holds a Sloan Mast's degree in leadership and strategy from the London Business School. He is a chartered alternative investment analyst and has completed the economics and governance of climate change course at the London School of Economics. Let's stop there. Mike, let's get started. I'm really looking forward to that. It's great to have you here. Thanks for joining me today. >> Real pleasure to be here, Morates. >> So, this is going to be fun. This is going to be a different topic. We'll be focused on carbon. We'll be speaking about carbon markets, compliance, carbon markets, carbon credits. You run the world's largest carbon fund, which is super interesting. and we'd like to learn how these markets work, how you trade in these markets, um what the inefficiencies are and all the rest of it. But I was thinking that we should broadly segment our conversation into two parts. We start with, you know, what are these markets, how do they function, how large are they, where are they, how can you access them, and then in the second part, we'll speak about how to trade them, you know, what the alpha opportunities are, where you think these markets will be going, and much more. So, um, maybe to start, what are these markets? I mean, how many compliance carbon markets are there? What's the difference between compliance carbon and carbon credits? The floor is yours. >> Thanks. Uh, thanks, Mor. So, there's a lot of things to unpack there. Um, the the compliance carbon markets originated, um, after the US introduced a very successful cap and trade program for sulfur dioxide emissions in the 1990s. And off the back of that success, Europe launched the world's first compliance carbon market in 2005. And since it was launched in 2005, it's been very very successful as a climate policy mechanism. Emissions in Europe have declined by approximately 1.1 gigatons, that's billion tons per year on an annual run rate basis. And about 75% of that decline has come from the big emitters who are the compliance entities inside the European carbon market. So it's been a very very successful mechanism. Um now there are many markets around the world and very exciting. There's many countries who are at some stage of preparing to launch their own compliance carbon market. So um we trade five markets. Um Europe of course the longest standing market also the most liquid. Number two is the UK. Number three um is the California carbon market. Number four is the Reggie carbon market which is 10 states together on the east coast of the United States. And market number five is New Zealand. It's a small carbon market but one that we think in particular is very interesting. Provides diversification and alpha opportunities. Um so those are the the five markets and um in a nutshell these markets they are designed as a as a compliance tool um to manage emissions. So the government sets the supply of permits each year and that supply declines by a fixed amount. Typically it's between 3 and 5% per year. So there's built-in scarcity in this asset class. And um that scarcity over time what what all participants are hoping except for the companies of course is for the price to rise. Um so every CEO of a big emitter in Europe they look at two carbon prices. They are audited by the government every year. So at the end of the year if you emit 3 million tons you must within three or four months then you must give the European government 3 million permits. Now you can buy the permits at auctions. There's a daily auction in Europe. Government sells the permits and of course there's a very liquid secondary market. The secondary market um in Europe now trades about 2 billion US dollars per day. So it's very very liquid mainly in the futures market like many commodities. Carbon liquidity is concentrated in exchange listed futures. So that that um that company that CEO knows that today the European carbon price is €70 for every ton and they will they will ask their head of engineering to calculate what is our internal cost to cut our emissions and if the internal cost is 60 well then obviously um as a as a profit seeking CEO they will choose to invest the money to cut their emissions at a cost of 60 per ton. instead of giving the money to the government and buying the permits at 70. And and here in lies the huge power of this mechanism because if you think about what I just said, it means that the invisible hand of the profit motive, the strongest driver of of corporate decisionm profit seeking results in the three magic words. What are they? least cost abatement. We want to decarbonize. We must decarbonize, but we want to do it at the lowest cost possible. And so, how does a carbon market, it doesn't just cut emissions at any price? Because all 7,000 CEOs in Europe, they all do the calculation, external price, internal price. And those with the lowest internal price to cut their emissions, we call that the abatement cost, they self- select. They self- select themselves to cut their emissions. And therefore when the supply is reduced every year, we know that someone within the ecosystem has to cut. But we allow the invisible hand and the profit motive to guide self- selection among the constituents. And those companies indeed who have the lowest cost of cutting, they cut. And the reason they cut, they're not green morates. They're not ESG focused. They may be, but the primary reason they choose to cut their emissions, they're profit- seeeking. They just want to make more profit. So, you harness the profit motive to achieve the magic of least cost abatement. So, we reduce emissions every year and we do it at the lowest possible cost. And and so that's how the mechanism effectively functions. And I think this is probably one of the reasons why it works and why it works better than a carbon tax, which could be an alternative solution, right? You could just tax pollution, but then that takes the profit motive away because a tax is kind of like just there. You have to pay it. It's it's very very interesting. At LSE, we studied all of the main climate policy mechanisms that governments had attempted to bend the curve of emissions downwards. almost nothing has worked. The two things that have worked probably not surprisingly in a market-based economy have been carbon pricing. Carbon pricing can take the form as you said can be a tax or you can have a cap and trade market. Um theoretically in in economics terms if the price carbon price in a carbon market is 70 and the carbon tax is 70 you achieve the same level of abatement theoretically. But I would be with you Morates. I think there are a number of psychological and legislative reasons why a carbon market is is preferable. Um number one, no one likes the word tax. Politicians don't like the word tax. People don't like the word tax. So you have this psychological barrier to introducing whereas a carbon market, oh it's a market, it's a it's a free market solution. It's a market-based solution. Um the second uh interesting thing about a carbon tax versus a carbon market is normally in most western liberal democracies to implement a tax like on carbon you require a twothirds majority whereas to launch a carbon market often this can only be um a a straight majority you know in your in your house or your senate or in your biccameal legislative system. So there's some uh interesting things. The the the other point is of course um politicians love revenue and and a carbon market the the generates revenue through the auctioning of the permits. In most carbon markets when they auction the permits to the polluters. So it's a polluter pay principle. That revenue is segregated and 100% in the case of the EU and California of that revenue is reinvested into energy efficiency and lowcarbon initiatives. So you have a you know a primary benefit of the it caps emissions and lowers them. Secondary benefit it it does the lowering at the least cost because of the invisible hand. Third benefit, all the auction revenue is recycled into energy efficiency. And the fourth benefit, which there's been a little bit of research on this, if you're trying to commercialize lowcarbon intellectual property, if you have a carbon market, it's much easier to get venture capital backing for that IP because you have a pathway to monetize. If you're trying to commercialize some lowcarbon intellectual property and there's no carbon price, the venture capitalist says, "Well, who's going to buy? Where where's your pathway to monetize?" So, this is the fourth key benefit and we certainly need, you know, all hands to the pump. I mean, the you know, the overarching issue amongst above everything we're speaking about, of course, Moritz is the the terrible situation that exists with regard to the concentration of CO2 in our atmosphere. We just hit a new all-time record over 430 parts per million. Temperatures are out of control. Wildfires are out of control. Um, you know, annual damages, economic damages and human migration due to extreme weather. I mean, these are these are becoming very serious issues. So, you know, that's the macro tailwind behind why we're we're dealing with climate change. Now the very interesting thing is that there's no singular price for a carbon molecule in the same way that currently at least there's no singular price for a gas molecule like TTF trades at a different level than Henry Hop natural gas and maybe there's going to be an integrated LGbased market at some point that's global but in the carbon markets it's even more extreme like you know European the EUAs they trade at what do you say around €7 per ton California carbon allowances trade at 28 $28. So that's €25 per ton. So let's just say it's it's about a third. And then New Zealand is different and um the UK is different. And there's a bunch of other markets that are I think are starting to develop in Brazil uh and China uh or China I think is already active and everything is driven in kind of like a unique way by local policies and local rules and regulations which is why there is no one price for carbon in the world. A absolutely correct and and just to be clear about this the intention of uh purveyors of carbon markets is for carbon markets to link. So Switzerland had its own separate carbon market for years and then around four five years ago Switzerland linked with the European market and we had price converge and um I think what we will see because you're right China launched four years ago. South Korea launched uh six seven years ago. Japan's launching next year. Um Brazil and India are both moving plans through to launch. And there's probably another six seven countries around the world that are launching. um the the we will probably see regional linkages. So you know maybe North American linkages and then South America and then over time perhaps it takes 10 or 15 years we'll have eventually the markets will link and we'll have one global carbon price but until then and certainly uh based on our um our academic work and our quantitative work the pair-wise correlation between the five markets that we trade is effectively zero. And of course that you know that has a very important implications around portfolio construction. If you have five assets that have zero pairwise by combining those you really crush portfolio volatility without necessarily crushing return. So you're out of sample sharp is uh it can be very attractive. >> Yeah it's already happened a bit right with the western carbon western carbon initiative where we have the CCAs in Quebec I think linked >> correct. Yeah. So California has linked with Quebec. Um, now the state of Washington launched their carbon market about two years ago and the state of Washington is currently in negotiations to link with the California Quebec market and as you say the name of that initiative is the western climate initiative. And interesting uh New York State has announced that they will use the WCI uh framework for a a cross economy carbon market they intend to launch in California. I'm sorry in in New York. We should speak, Mike, a little bit about the difference between credits or offsets and compliance markets because I think a lot of listeners might be familiar with offsets or they may have come across them because that's the stuff that you can buy on top of your airfare if you want to offset your carbon footprint for a flight from A to B or when you go to the gas station and you, you know, fill up your car. Some of these gas stations offer you offsets, but these markets are different. They are certainly less transparent. There is not a futures market or any central market where these things trade. Why don't you run us through the differences and also the complexities that go along with offsets. >> Yeah, I always encourage people having having done a very deep dive on the voluntary carbon market, I've tried to um dilute it down to five key points. So if we um look at the voluntary carbon market and you're quite right when you say carbon to most people that they say oh yeah I heard about a project where they plant some trees and of course as the trees grow they it sequesters carbon dioxide which is true. Um and then somebody uh calculates how much has been sequestered and they issue these uh these credits. But unfortunately um the the the five key points that people should perhaps write down if you're listening to this and you want to explore it is number one regulation. Uh those carbon credits trade um and they are a financial asset but there is no financial regulation. And I think just a combination of a financial asset and no regulation already you can see trouble potentially brewing. The market is very very small. I'll come back to that in a moment. It's illquid. This is a private equity asset. As you explained, it's very complex and opaque to understand the calculation methodology. There's so many different methods of how they calculate these credits. And number five, unlimited supply. There is virtually an unlimited supply. And of course, when you have an unlimited supply of a commodity, that tends to mean a low price. And very important to always remember that abatement decision. So if I'm gonna do I abate do I cut my emissions or oh I could buy a credit for $2. My internal cost is 10 to cut my emissions but then someone brings me a $2 credit. I'll just buy that. But if the $2 credit isn't equivalent to a ton of actual emissions, by buying the credit and not cutting my emissions, which was my other option, now we've just exacerbated climate change. And I'm afraid that at a systems level, if one steps back, I think at a systems level, very logically, you can make a very strong argument that the voluntary carbon market in its current format is actually exacerbating climate change. Now let's take the the compliance markets, the regulated markets, and go through the same five points. Number one, they're highly regulated, run by the governments. Number two, they're very large. So let's just go to this size point. So last year, the global compliance markets traded just under 1 trillion US and the voluntary market did a little less than 1 billion. So this isn't 10 times or 100 times. This is a thousand times difference in size. Number three, liquidity. The regulated markets are very liquid. They're trading 60 billion US per month. Number four, transparent. The government publishes all the rules. It's completely transparent on how it works. But most important, number five, the supply of permits is capped. And every year the supply goes down. It's not unlimited supply. And that induces higher price. And what does a high price induce? Abatement. Abatement. And that is what we need. We need dramatic abatement. And and so these these two markets are really there's huge clear blue water. And unfortunately that lack of regulation. I think the key word in the voluntary market is the key words moral hazard. Moral hazard looms large. There have been project after project. There have been scandal after scandal and a lot of legal things. And and our advice very strongly to clients is to avoid any involvement in the voluntary market until it becomes under proper financial regulation. >> It would be great if they're cleaning this up. Um because I do agree with you. I mean the there are some if listeners don't know that there are some registration agencies not going to be naming names but it's kind of like what price you pay for an offset of a tree that would not have otherwise been planted in a country in Asia. That's kind of like it's it's a big question mark and the price can be anything they say it is. Um so you're completely left in the dark and that is something that I just found um well that that's just not how markets should be working. It it cannot work that way. It just gives rise to what you've said is the moral hazard on third party lining their pockets um in the process as a middleman. Speaking to that, just quickly related came to my my head is um carbon capture. What's your view on this which you know is massively expensive to suck carbon dioxide out of the atmosphere and store it. Um do you think that should be playing a larger role or no role? Is it just um too complex and too costly? So within the voluntary carbon market, less than 1% of of the projects are involved in what I would call novel carbon dioxide removal, CDR, carbon dioxide removal. And um one of the methods of removing carbon dioxide is direct air capture um which you you mentioned. And that's where you can um you can extract air and uh carbon dioxide is present in the atmosphere. It's very dilute, but you can um extract it, liquefy it under pressure, transport it, and inject that liqufied CO2 deep underground and cap it off and store it permanently. That is actually removing a ton that I would pay for. But as you as you point out, to do it properly is very very expensive. This can be $500 per ton. But there are other um novel CDR methods. And the key metric here, Morates, is permanence and durability. In other words, when the carbon is removed, like when we plant a bunch of trees, they grow over over 30 years and they remove carbon. Then either one of two things happen. They get old and die and the trees then release the carbon back into the atmosphere. Maybe that happens slowly, correct? but they do release it back or they're burned down or there's pests or there's a storm that knocks them down and in either case it's released. So you you can you can say okay if I had multiple of these projects I can estimate the the average um life of the permanence of the CDR and there's now a growing uh wish among some buyers like Microsoft they want longer duration permanence of the removal and they want less these are the key words risk of reversal. So once you remove it, what's the risk it reverses? And with forestry, we're getting hotter, we're getting drier. The risk of the forest burning and releasing all the carbon back into the atmosphere is becoming, in my view, very, very high now. So that's not a safe place where we would sit around and say, let's store a whole bunch of carbon in the forest because it's simply not a safe place. So my view is take a step back. We've breached all of the levels in terms of our emissions and we're still going to emit, you know, another, I don't know, 40 billion tons this year. So, we're way behind. And therefore, the IPCC has come out and said over the next 75 years, we will have to overshoot and then remove billions and billions of tons of CO2 from the atmosphere. So, this will be an extremely big industry. So, we should support carbon dioxide removal. It's the one area within the voluntary market where I've got some time. As long as I understand the method and I can if I can see, feel, and touch the carbon that's been removed and I know it's long-term storage, then I'm saying I I really like this. So, CDR is growing. It's growing very very fast. Um, but it's starting from a very small base. Um, other methods are biochar, soil, car carbon burial, organic biomass burial. There's other methods of novel CDR and I I really would like to see that industry expand and grow. [Music] Great. I think we can uh slowly move toward the um the trading side of our conversation. And I think from what you've described in our conversation about the compliance markets and the way these um you know you've called it the invisible hand and the profit motive probably also one of the reasons why you started your fund is because you think these markets over the long run will go higher over the next 5 to 10 years. Um in our precall you said that you believe that there is a risk premium included in the compliance carbon markets. Can you explain why that is? So why that risk premium exists? >> Yeah. So um from a classic uh academic uh perspective of course a risk premium is present in an asset class that produces a cash flow. So equities produce a dividend stream and fixed income have uh coupons. And so classically academically speaking these asset classes have a formal risk premium. Carbon does not have any cash flow. So there's not a formal risk premium. But when you understand that um the carbon market can only achieve the objective of the politicians and all the people behind it if the price rises because every time the price rises, another set of constituents choose to cut their emissions instead of buying the permit. Again, they're driven by profit. Then the price price rises again and another set of constituents cut their cut their emissions. So the the market will only achieve its objective if the price rises. And the question is what level of the price does it have to rise to to let's say be in line with the 1.5 or twoderee um levels of the Paris agreement. Now what we've simply done in our academic paper is we've taken four really wellrespected estimates and they've calculated the bank of England, the IEA and we took the average and they have said that we need a carbon price globally of about $120 per ton by the year 2030 in order to stimulate enough reductions to be in line with between the one and a half and two degree threshold. So in our mind at at carbon cap we have this kind of price level of $120 a ton across all the markets and and then you simply look at where is the price today. So if you create a cap weighted index of the five markets um they finished last year at around 60 $60 a ton. So the risk premium is simply the trajectory if you bought today as a passive investment at 60 and if we reach 120 by the year 2030 this works out to about a 13% annualized return for a passive buy and hold and you're quite right mor is being cut every year in this market. So as an investor you you want to sit with the regulator. You want to be long but the you know carbon markets have have don't go up every single year as as you know the last three years after a very powerful bull market in carbon in 2021. Markets fell in 22 fell in 23 and fell again last year and they're actually down a bit this year. Um and and we believe as they've fallen that prospective risk premium of course has been increasing because we we do believe we will achieve that level. So we think that big picture this is a very attractive entry point with someone with a medium-term horizon even even as a passive investment. Of course, we we aim to add significant alpha, but you know, just speaking about the asset class, it's it's uncorrelated, it's liquid, and it has this very attractive forward-looking policy risk premium. >> I think we should be touching at that point on the differences between spot or physical permits and the futures markets, and I know that you're also trading options, OTC, or maybe you then clear them on the exchange. I think for a longer or medium to longer term buy and hold position where you just want to have a long exposure, you probably pre uh prefer to be in the physical markets, right? And participate in the auctions and just pay cash for the position and then hold it in the registry. >> Yeah, I mean it it really depends on um a whole bunch of factors. Um certainly the futures mark price trades at a premium to the physical carbon price um and that is called contango in commodity markets. And in in most carbon markets, that contango is roughly equivalent to the cost of carry, the short-term funding rate. However, in a market like California, um it trades at a significant additional contango. So, if risk-free rates are 4 a.5%, the contango in California is more like 7%. So, you know, for us, because we principally trade futures, we have lots of free cash in the fund. We deploy some of that cash by buying the physical in California, shorting the futures contract, and of course those converge on the expiry date and we harvest a a 7% effective, you know, synthetic T bill return on that cash. So you're quite right. Certainly in the case of California, you really would like to just hold the physical and avoid that negative roll yield by by roll buying the futures and and holding them >> cash and carry trading. >> Yeah. The the problem of course in California is you can't get an account to hold the physical. These accounts in California are um administered by the government. Uh in California, there's now more than a a year to a year and a half waiting list. It took us one year to get our physical account with the state of California. Um and I've heard anecdotally that that waiting list is now year to year and a half long. Is it easy to get a physical account for the EUAS and the UKAS or do you have to be kind of like within the realm of compliance and be an emitter to get there? No. Um, I think there's a there's a a real recognition among uh the regulators in these carbon markets that they want a full ecosystem of participants in the market to bring liquidity and price discovery. Very important. You know, in the EU market, the biggest traders are the big power companies. Um, they burn coal and gas to make electricity. They sell their electricity up to 3 years forward to buyers like BMW and Volkswagen who want to lock in their electricity prices. And having sold their their power forward, they buy their coal and their gas and their carbon forward and therefore they lock in that forward margin. And and so they're very sophisticated in how they trade the carbon. And uh certainly the regulators recognize they want a nice blend between compliance entities who trade the carbon and financial actors, speculators who bring liquidity and price discovery and allow that hedging activity to take place. Why do you think is the funding premium or the excess funding spread in the California carbon allowances so large like 4.5 short-term rate where kind of like a table rate or a sofa rate and and I think you mentioned seven. Why is there X's there? >> So, so interestingly, if you track this, let's call it the unexplained contango over time, and we we've done that extensively in all of the markets and you try to answer the answer your question like what's the driver, it's it's there's nothing we have found to indicate, you know, what drove this unexplained additional contango or for instance, in the Reggie market, there's almost a negative contango. In other words, you put the cash and carry on in Reggie, you get less than you get in bills. like well what's behind that? So it's very interesting this this contango phenomenon in the different carbon markets probably if I were to guess in the state of California it's the difficulty of holding the physical. You you you know many people would like the physical they can't get an account so they buy the futures and they and it keeps it at a premium. Got it. So it's a political or legislative bottleneck so to say not enough people can get access to the physical market and therefore the market isn't exactly arbitrage free. Correct. >> Now with respect to your trading, you run the world's largest carbon fund, carbon hedge fund. You have some I think you call it core strategies where you have exposure on the long side. Call that a beta exposure if you will in these five markets. You've mentioned that you're holding physical as well as futures. Uh maybe you also implement some of your delta with with options uh for additional convexity. Um but then you also have several alphadriven strategies. So I think some of them are systematic, some of them use qualitative inputs or fundamental research. Could you run us through these? >> Yeah. So um there there there are two substrategies. Um we begin with a um a perspectus limiting VAR budget. So we we decided to set a hard VAR limit on the fund at 2.2 VAR. So around a 15 annual volatility. That was just a decision we made which I think has been very very wise given the last five and a half years of of of all in these markets. So we're we're capped out on our volatility. Um we then divide that risk budget into these two strategies. The core and the second strategy we call alpha. And you're quite right the the core has two objectives really. First the core is long bias. We do want to capture that long run risk premium. But secondly, we want to add significant tactical alpha by going long, flat or short in these carbon markets based on a whole range of fundamental and technical factors and the drivers of that. I'm happy to talk a little bit more about those, but they are 75% quantitatively driven and 25% qualitatively driven. And our bias as a firm is definitely on the quantitative uh side of things. Um repeatable um investment performance and alpha generation out of sample we think comes from a disciplined more systematic uh approach. So so that's the core. It has these two goals. Get the risk premium number one and then add tactical alpha. And if we if we say the risk premium is 5% a year instead of that number I quoted earlier of 13 and we want to generate 5% tactical alpha we have a a return expectation for the core of about 10% per year. The second strategy is called alpha and as you say this is effectively like a short-term CTA packaged in inside the fund. We currently have approximately 20 completely systematic strategies here ranging from hourly intraday strategies to daily to strategies that might last for two or three weeks. Um and those are 20 systematic strategies. They have an entry signal, an exit, a stop-loss and a profit take. So it's all completely systematic. And our goal there 5% per year of completely idiosyncratic and uncorrelated alpha. the two strategies are just completely uncorrelated to each other. So if you put those building blocks together, you get this 15% kind of total return expectation >> in the short-term CTA bucket. Um I guess that encapsulates mean reversion, trend following, some other things. Now you've mentioned relatively short-term hold periods there like from intraday, daily, you know, a few weeks. Um, so in the EUA market and the UK market where you have kind of like on-screen liquidity in the futures contracts, you can probably execute these relatively easily, but would you also be able to run that on the CCAs and the New Zealand markets? Um, because these are still markets that are much more OTC and then you kind of like do a block trade and um, clear it at the close of business on the exchange. Yeah, the I would say that 90% of our alpha strategies and of the volume that we trade in alpha is in the single market of EUAS. It's all in so >> because that is the most liquid one. >> Yeah, we've got the daily auction, we have four auction arbitrage strategy. So we have four buckets within alpha. We have arbitrage, relative value, short-term directional, and then the carry. And the carry we have in in on in multiple markets. And as you know that's effectively a synthetic T bill you know kind of strategy. So the other three buckets are arbitrage relative value and short-term directional. And the bulk of those strategies are implemented in the EUA market simply because narrow bid offer high liquidity low slippage and market impact. We do have a number of strategies in the UK. We do have a couple strategies in CCA and Reggie but the bulk of it is in the EUA market. So relative value could be like a spread of U uh UKAS to EUAs or EUAS to CCAs or whatever like stuff like that. It it is exactly that. It's it's like the core strategy but on a much shorter term time frame and driven driven more by shorter term factors technicals I would say technicals volatility and volume factors to create that long short exposure in the within alpha in the relative value bucket >> and and arbitrage uh maybe conceptually the most interesting uh part of this I mean it's this because these markets you know they have these actors they have these um firms that need to comply And it is it is therefore driven by different dynamics as far as supply and demand is concerned. So do you see these kind of like these patterns where there's just liquidity coming into the auction or missing from the auction and you can kind of like find arbitrage opportunities between say settlement prices on futures contracts and auction participation. Is it that these type of things you do? >> The the bulk of the arbitrage strategies um are governed around uh the EUA auction. It's a it's a daily auction. The UK auction is every two weeks, so it's less less frequent. We we have strategies we deploy there in the arbitrage bucket as well. Um and they're not, of course, they're not pure arbitrage in the sense of, you know, immediate um taking a spread out, but they're, you know, high probability transactions that are um for very short periods of time that that harvest a you know, a nice alpha at a high probability rate. We're very numbers driven when we when we back test in sample, out of sample, and we look at all of the metrics, win loss ratio, size of average win versus average loss, all those kind of classic trade statistics that you would expect. We built all our own code there. Um, so that the strategy development process is now quite speedy. Um, I would also say that these alpha strategies, they decay, they decay sometimes quite quickly. So, you know, these these auction arbitrage strategies, we're on the the fifth iteration of these strategies from where we started. So, they you know, they they work, they work, they work, then you start losing money, you shut them off, you go back to the drawing board, testing, testing, and then you reimplement. >> Of course, I mean, these markets, especially the EUAs, they have become larger, and hedge funds and CTAs are trading on them. You are you're not the only one. One thing I'd like to touch on at the very end or as we kind of like um finish this conversation which by the way I think was really interesting or is still remains interesting is is is actual impact and positive impact and we did speak a little bit about the offsets and planting trees and these type of things but you've decided to go a different route. Um from what I remember I think you are taking 20% of your performance fee income and you're using that money to cancel allowances. So you're essentially buying allowances and you burn them up. Poof, there they go. They're gone. Which means that nobody else can use them to emit carbon. Is that that's the way you're going about this, right? Which is which which does have impact. I would say that's direct and positive impact and that's one of the reasons why you are an article 9 fund. >> Yeah. So very very good summary you I think you did there. um after having done that very deep dive on the voluntary market and determining that it simply isn't a place you can have confidence of um you know buying these credits or offsets and having any impact at all. We we then said where can we go? We we want to try and create some alignment um quite unusual for a hedge fund with you know performance and impact and it was my partner's idea. He said, "Well, you know, we want to perform. That's that's the first primary objective. We must perform and generate absolute returns, but why don't we then link the impact side to the performance?" And that's where the idea came to take 20% of our annual performance fee when it's crystallized. If we're fortunate to crystallize a positive year, we take 20% and we use that to purchase regulated permits. Now remember, if Voluntary is trading at $2 a ton, $8 a ton, $10, we're buying at $50, 60, $70, $80. So you're paying much more, but as we said earlier, you're really getting what you pay for. And we believe this is the highest impact spend that you can make, especially in a carbon market where the supply is quite tight. Um, by taking those permits out, you're really preventing those tons of emissions from ever hitting the atmosphere. And the best ton Morates is the ton that never is released, right? That's the that's the best ton of CO2. So since since launch, we've crystallized we've had five positive years. Um, and so we've had crystallized five times and approximately$1.3 million US has gone towards that. Now the fund's much bigger. um those numbers could start really escalating and therefore we've decided to to take a portion of the funds and look at other um highly impactful activities and one of those is we've sponsored a piece of research at the uh London LSE Grandanthm Climate Institute to update the seinal academic paper um that proves the effectiveness of the European emission trading system because we think it's very important for new governments around the world to be able to point to high quality academic research arch and say look this mechanism they did in Europe it's very successful so the the seminal paper there by Frank Venman's and and uh colleagues we've um we've sponsored the update of that paper and that should be released in the next couple of months and the preliminary results really are are very positive. So we're we're going to expand our impact activities as that pool of money grows and it's something we're all very passionate about at Carbon Cap. Not speaking about performance but given that we've mentioned that the current compliance markets are relatively uncorrelated to one another maybe with the exception of UKAS and EUAS where you do have relatively persistent positive correlation but then also the combination of your alpha strategies and the beta exposure that I guess makes your overall return stream very much uncorrelated to anything like including CTAs or the hedge funds just you know directional exposure. So a great portfolio addition. >> Yeah. So certainly as I said before, I mean I think you can you can make a very strong argument for a passive long only exposure to carbon and there are there are some ETFs that are available out there because the the asset class is very interesting properties. It's liquid. It's completely uncorrelated and it has this forward-looking risk premium. Um we are not even correlated to the asset class. Um and it's not not correlated. So you know investors and and uh we now have nine big institutions you know they've done their their deep homework on our on our 5 and a half year track record and you know there is no correlation you're absolutely right. So it's a it's a liquid strategy but with low correlation and as you say it it has this this impact element if if that's something that is u that is interesting for the investor. >> Excellent. Mike I think this makes for a very good time to wrap it up. We've been going for a long time. It's been super interesting. And for our listeners, uh, where would you like to send people if they would like to find out more about you or Carbon Cap? >> Yeah, certainly. Uh, please, uh, go to our website. We have a lot of, um, video content. It's all educational content because that's part of our mission to educate on emission trading systems, how they work. So, it's um, uh, carbon-cap.com is our website. Um, and uh, if you have any questions, just hit click on the info and uh, send us information and uh, someone from the uh, team will come back to you. >> Great, Mike. Thanks once again for coming on to the open inter series today. It's been great speaking with you and I think this episode especially includes some really interesting and valuable takeaways for our listeners as we've been speaking about a new topic. We didn't cover that on this show before and I don't think it's widely covered in other podcasts either. So, it's been great. As ever, we'll include the most important points of today's discussion in our show notes. And should you have any questions or comments, please send us an email to info@toptradersunpluck.com where we'll pick it up and respond. Thanks again for listening and until next time, thank you very much. >> Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you. And to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged. [Music]
Inside the Carbon Markets: Where Climate Incentives Actually Work | Open Interest | Ep.18
Summary
Transcript
[Music] I think at a systems level very logically you can make a very strong argument that the voluntary carbon market in its current format is actually exacerbating climate change. I think the key word in the voluntary market is the key words moral hazard. Moral hazard looms large. There have been project after project. There have been scandal after scandal and a lot of legal things. And and our advice very strongly to clients is to avoid any involvement in the voluntary market until it becomes under proper financial regulation. Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world. So you can take your manager due diligence or investment career to the next level. Before we begin today's conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran hedge fund manager Neil's Kra Larson. Welcome to another episode in the open interest series on Top Traders Unplucked hosted by Moret Seabbert. In life as well as in trading, maintaining a spirit of curiosity and open-mindedness is key. And this is precisely what the open interest series is all about. Join Moritz as he engages in candid conversations with seasoned professionals from around the globe to uncover their insights, successes, and failures, offering you a unique perspective on the investment landscape. So with no further ado, please enjoy the conversation. Hello and welcome. I'm Murett Sebert and this is episode number 18 of the open interest series. My guest today is Mike Alen, the founder of Carbon Cap and manager of the world world's largest carbon focused hedge fund. Carbon Cap is based in London where Mike started the firm in 2018. They launched the World Carbon Fund in 2020 and the objective of that fund is to generate absolute returns from active management in the global compliance carbon markets. In this episode, Mike and I will speak about which markets they trade in, how these markets function, the differences between carbon allowances and carb credits, why these markets offer rich alpha potential, and how their trading has direct and positive impact on climate change. But before we start, let me give you some background and tell you that Mike has been involved in the trading and investment management space since many years, including the roles of founder and CEO of Asset Alliance International and Frontier Investment Management, a firm which he sold in 2017. Mike holds a Sloan Mast's degree in leadership and strategy from the London Business School. He is a chartered alternative investment analyst and has completed the economics and governance of climate change course at the London School of Economics. Let's stop there. Mike, let's get started. I'm really looking forward to that. It's great to have you here. Thanks for joining me today. >> Real pleasure to be here, Morates. >> So, this is going to be fun. This is going to be a different topic. We'll be focused on carbon. We'll be speaking about carbon markets, compliance, carbon markets, carbon credits. You run the world's largest carbon fund, which is super interesting. and we'd like to learn how these markets work, how you trade in these markets, um what the inefficiencies are and all the rest of it. But I was thinking that we should broadly segment our conversation into two parts. We start with, you know, what are these markets, how do they function, how large are they, where are they, how can you access them, and then in the second part, we'll speak about how to trade them, you know, what the alpha opportunities are, where you think these markets will be going, and much more. So, um, maybe to start, what are these markets? I mean, how many compliance carbon markets are there? What's the difference between compliance carbon and carbon credits? The floor is yours. >> Thanks. Uh, thanks, Mor. So, there's a lot of things to unpack there. Um, the the compliance carbon markets originated, um, after the US introduced a very successful cap and trade program for sulfur dioxide emissions in the 1990s. And off the back of that success, Europe launched the world's first compliance carbon market in 2005. And since it was launched in 2005, it's been very very successful as a climate policy mechanism. Emissions in Europe have declined by approximately 1.1 gigatons, that's billion tons per year on an annual run rate basis. And about 75% of that decline has come from the big emitters who are the compliance entities inside the European carbon market. So it's been a very very successful mechanism. Um now there are many markets around the world and very exciting. There's many countries who are at some stage of preparing to launch their own compliance carbon market. So um we trade five markets. Um Europe of course the longest standing market also the most liquid. Number two is the UK. Number three um is the California carbon market. Number four is the Reggie carbon market which is 10 states together on the east coast of the United States. And market number five is New Zealand. It's a small carbon market but one that we think in particular is very interesting. Provides diversification and alpha opportunities. Um so those are the the five markets and um in a nutshell these markets they are designed as a as a compliance tool um to manage emissions. So the government sets the supply of permits each year and that supply declines by a fixed amount. Typically it's between 3 and 5% per year. So there's built-in scarcity in this asset class. And um that scarcity over time what what all participants are hoping except for the companies of course is for the price to rise. Um so every CEO of a big emitter in Europe they look at two carbon prices. They are audited by the government every year. So at the end of the year if you emit 3 million tons you must within three or four months then you must give the European government 3 million permits. Now you can buy the permits at auctions. There's a daily auction in Europe. Government sells the permits and of course there's a very liquid secondary market. The secondary market um in Europe now trades about 2 billion US dollars per day. So it's very very liquid mainly in the futures market like many commodities. Carbon liquidity is concentrated in exchange listed futures. So that that um that company that CEO knows that today the European carbon price is €70 for every ton and they will they will ask their head of engineering to calculate what is our internal cost to cut our emissions and if the internal cost is 60 well then obviously um as a as a profit seeking CEO they will choose to invest the money to cut their emissions at a cost of 60 per ton. instead of giving the money to the government and buying the permits at 70. And and here in lies the huge power of this mechanism because if you think about what I just said, it means that the invisible hand of the profit motive, the strongest driver of of corporate decisionm profit seeking results in the three magic words. What are they? least cost abatement. We want to decarbonize. We must decarbonize, but we want to do it at the lowest cost possible. And so, how does a carbon market, it doesn't just cut emissions at any price? Because all 7,000 CEOs in Europe, they all do the calculation, external price, internal price. And those with the lowest internal price to cut their emissions, we call that the abatement cost, they self- select. They self- select themselves to cut their emissions. And therefore when the supply is reduced every year, we know that someone within the ecosystem has to cut. But we allow the invisible hand and the profit motive to guide self- selection among the constituents. And those companies indeed who have the lowest cost of cutting, they cut. And the reason they cut, they're not green morates. They're not ESG focused. They may be, but the primary reason they choose to cut their emissions, they're profit- seeeking. They just want to make more profit. So, you harness the profit motive to achieve the magic of least cost abatement. So, we reduce emissions every year and we do it at the lowest possible cost. And and so that's how the mechanism effectively functions. And I think this is probably one of the reasons why it works and why it works better than a carbon tax, which could be an alternative solution, right? You could just tax pollution, but then that takes the profit motive away because a tax is kind of like just there. You have to pay it. It's it's very very interesting. At LSE, we studied all of the main climate policy mechanisms that governments had attempted to bend the curve of emissions downwards. almost nothing has worked. The two things that have worked probably not surprisingly in a market-based economy have been carbon pricing. Carbon pricing can take the form as you said can be a tax or you can have a cap and trade market. Um theoretically in in economics terms if the price carbon price in a carbon market is 70 and the carbon tax is 70 you achieve the same level of abatement theoretically. But I would be with you Morates. I think there are a number of psychological and legislative reasons why a carbon market is is preferable. Um number one, no one likes the word tax. Politicians don't like the word tax. People don't like the word tax. So you have this psychological barrier to introducing whereas a carbon market, oh it's a market, it's a it's a free market solution. It's a market-based solution. Um the second uh interesting thing about a carbon tax versus a carbon market is normally in most western liberal democracies to implement a tax like on carbon you require a twothirds majority whereas to launch a carbon market often this can only be um a a straight majority you know in your in your house or your senate or in your biccameal legislative system. So there's some uh interesting things. The the the other point is of course um politicians love revenue and and a carbon market the the generates revenue through the auctioning of the permits. In most carbon markets when they auction the permits to the polluters. So it's a polluter pay principle. That revenue is segregated and 100% in the case of the EU and California of that revenue is reinvested into energy efficiency and lowcarbon initiatives. So you have a you know a primary benefit of the it caps emissions and lowers them. Secondary benefit it it does the lowering at the least cost because of the invisible hand. Third benefit, all the auction revenue is recycled into energy efficiency. And the fourth benefit, which there's been a little bit of research on this, if you're trying to commercialize lowcarbon intellectual property, if you have a carbon market, it's much easier to get venture capital backing for that IP because you have a pathway to monetize. If you're trying to commercialize some lowcarbon intellectual property and there's no carbon price, the venture capitalist says, "Well, who's going to buy? Where where's your pathway to monetize?" So, this is the fourth key benefit and we certainly need, you know, all hands to the pump. I mean, the you know, the overarching issue amongst above everything we're speaking about, of course, Moritz is the the terrible situation that exists with regard to the concentration of CO2 in our atmosphere. We just hit a new all-time record over 430 parts per million. Temperatures are out of control. Wildfires are out of control. Um, you know, annual damages, economic damages and human migration due to extreme weather. I mean, these are these are becoming very serious issues. So, you know, that's the macro tailwind behind why we're we're dealing with climate change. Now the very interesting thing is that there's no singular price for a carbon molecule in the same way that currently at least there's no singular price for a gas molecule like TTF trades at a different level than Henry Hop natural gas and maybe there's going to be an integrated LGbased market at some point that's global but in the carbon markets it's even more extreme like you know European the EUAs they trade at what do you say around €7 per ton California carbon allowances trade at 28 $28. So that's €25 per ton. So let's just say it's it's about a third. And then New Zealand is different and um the UK is different. And there's a bunch of other markets that are I think are starting to develop in Brazil uh and China uh or China I think is already active and everything is driven in kind of like a unique way by local policies and local rules and regulations which is why there is no one price for carbon in the world. A absolutely correct and and just to be clear about this the intention of uh purveyors of carbon markets is for carbon markets to link. So Switzerland had its own separate carbon market for years and then around four five years ago Switzerland linked with the European market and we had price converge and um I think what we will see because you're right China launched four years ago. South Korea launched uh six seven years ago. Japan's launching next year. Um Brazil and India are both moving plans through to launch. And there's probably another six seven countries around the world that are launching. um the the we will probably see regional linkages. So you know maybe North American linkages and then South America and then over time perhaps it takes 10 or 15 years we'll have eventually the markets will link and we'll have one global carbon price but until then and certainly uh based on our um our academic work and our quantitative work the pair-wise correlation between the five markets that we trade is effectively zero. And of course that you know that has a very important implications around portfolio construction. If you have five assets that have zero pairwise by combining those you really crush portfolio volatility without necessarily crushing return. So you're out of sample sharp is uh it can be very attractive. >> Yeah it's already happened a bit right with the western carbon western carbon initiative where we have the CCAs in Quebec I think linked >> correct. Yeah. So California has linked with Quebec. Um, now the state of Washington launched their carbon market about two years ago and the state of Washington is currently in negotiations to link with the California Quebec market and as you say the name of that initiative is the western climate initiative. And interesting uh New York State has announced that they will use the WCI uh framework for a a cross economy carbon market they intend to launch in California. I'm sorry in in New York. We should speak, Mike, a little bit about the difference between credits or offsets and compliance markets because I think a lot of listeners might be familiar with offsets or they may have come across them because that's the stuff that you can buy on top of your airfare if you want to offset your carbon footprint for a flight from A to B or when you go to the gas station and you, you know, fill up your car. Some of these gas stations offer you offsets, but these markets are different. They are certainly less transparent. There is not a futures market or any central market where these things trade. Why don't you run us through the differences and also the complexities that go along with offsets. >> Yeah, I always encourage people having having done a very deep dive on the voluntary carbon market, I've tried to um dilute it down to five key points. So if we um look at the voluntary carbon market and you're quite right when you say carbon to most people that they say oh yeah I heard about a project where they plant some trees and of course as the trees grow they it sequesters carbon dioxide which is true. Um and then somebody uh calculates how much has been sequestered and they issue these uh these credits. But unfortunately um the the the five key points that people should perhaps write down if you're listening to this and you want to explore it is number one regulation. Uh those carbon credits trade um and they are a financial asset but there is no financial regulation. And I think just a combination of a financial asset and no regulation already you can see trouble potentially brewing. The market is very very small. I'll come back to that in a moment. It's illquid. This is a private equity asset. As you explained, it's very complex and opaque to understand the calculation methodology. There's so many different methods of how they calculate these credits. And number five, unlimited supply. There is virtually an unlimited supply. And of course, when you have an unlimited supply of a commodity, that tends to mean a low price. And very important to always remember that abatement decision. So if I'm gonna do I abate do I cut my emissions or oh I could buy a credit for $2. My internal cost is 10 to cut my emissions but then someone brings me a $2 credit. I'll just buy that. But if the $2 credit isn't equivalent to a ton of actual emissions, by buying the credit and not cutting my emissions, which was my other option, now we've just exacerbated climate change. And I'm afraid that at a systems level, if one steps back, I think at a systems level, very logically, you can make a very strong argument that the voluntary carbon market in its current format is actually exacerbating climate change. Now let's take the the compliance markets, the regulated markets, and go through the same five points. Number one, they're highly regulated, run by the governments. Number two, they're very large. So let's just go to this size point. So last year, the global compliance markets traded just under 1 trillion US and the voluntary market did a little less than 1 billion. So this isn't 10 times or 100 times. This is a thousand times difference in size. Number three, liquidity. The regulated markets are very liquid. They're trading 60 billion US per month. Number four, transparent. The government publishes all the rules. It's completely transparent on how it works. But most important, number five, the supply of permits is capped. And every year the supply goes down. It's not unlimited supply. And that induces higher price. And what does a high price induce? Abatement. Abatement. And that is what we need. We need dramatic abatement. And and so these these two markets are really there's huge clear blue water. And unfortunately that lack of regulation. I think the key word in the voluntary market is the key words moral hazard. Moral hazard looms large. There have been project after project. There have been scandal after scandal and a lot of legal things. And and our advice very strongly to clients is to avoid any involvement in the voluntary market until it becomes under proper financial regulation. >> It would be great if they're cleaning this up. Um because I do agree with you. I mean the there are some if listeners don't know that there are some registration agencies not going to be naming names but it's kind of like what price you pay for an offset of a tree that would not have otherwise been planted in a country in Asia. That's kind of like it's it's a big question mark and the price can be anything they say it is. Um so you're completely left in the dark and that is something that I just found um well that that's just not how markets should be working. It it cannot work that way. It just gives rise to what you've said is the moral hazard on third party lining their pockets um in the process as a middleman. Speaking to that, just quickly related came to my my head is um carbon capture. What's your view on this which you know is massively expensive to suck carbon dioxide out of the atmosphere and store it. Um do you think that should be playing a larger role or no role? Is it just um too complex and too costly? So within the voluntary carbon market, less than 1% of of the projects are involved in what I would call novel carbon dioxide removal, CDR, carbon dioxide removal. And um one of the methods of removing carbon dioxide is direct air capture um which you you mentioned. And that's where you can um you can extract air and uh carbon dioxide is present in the atmosphere. It's very dilute, but you can um extract it, liquefy it under pressure, transport it, and inject that liqufied CO2 deep underground and cap it off and store it permanently. That is actually removing a ton that I would pay for. But as you as you point out, to do it properly is very very expensive. This can be $500 per ton. But there are other um novel CDR methods. And the key metric here, Morates, is permanence and durability. In other words, when the carbon is removed, like when we plant a bunch of trees, they grow over over 30 years and they remove carbon. Then either one of two things happen. They get old and die and the trees then release the carbon back into the atmosphere. Maybe that happens slowly, correct? but they do release it back or they're burned down or there's pests or there's a storm that knocks them down and in either case it's released. So you you can you can say okay if I had multiple of these projects I can estimate the the average um life of the permanence of the CDR and there's now a growing uh wish among some buyers like Microsoft they want longer duration permanence of the removal and they want less these are the key words risk of reversal. So once you remove it, what's the risk it reverses? And with forestry, we're getting hotter, we're getting drier. The risk of the forest burning and releasing all the carbon back into the atmosphere is becoming, in my view, very, very high now. So that's not a safe place where we would sit around and say, let's store a whole bunch of carbon in the forest because it's simply not a safe place. So my view is take a step back. We've breached all of the levels in terms of our emissions and we're still going to emit, you know, another, I don't know, 40 billion tons this year. So, we're way behind. And therefore, the IPCC has come out and said over the next 75 years, we will have to overshoot and then remove billions and billions of tons of CO2 from the atmosphere. So, this will be an extremely big industry. So, we should support carbon dioxide removal. It's the one area within the voluntary market where I've got some time. As long as I understand the method and I can if I can see, feel, and touch the carbon that's been removed and I know it's long-term storage, then I'm saying I I really like this. So, CDR is growing. It's growing very very fast. Um, but it's starting from a very small base. Um, other methods are biochar, soil, car carbon burial, organic biomass burial. There's other methods of novel CDR and I I really would like to see that industry expand and grow. [Music] Great. I think we can uh slowly move toward the um the trading side of our conversation. And I think from what you've described in our conversation about the compliance markets and the way these um you know you've called it the invisible hand and the profit motive probably also one of the reasons why you started your fund is because you think these markets over the long run will go higher over the next 5 to 10 years. Um in our precall you said that you believe that there is a risk premium included in the compliance carbon markets. Can you explain why that is? So why that risk premium exists? >> Yeah. So um from a classic uh academic uh perspective of course a risk premium is present in an asset class that produces a cash flow. So equities produce a dividend stream and fixed income have uh coupons. And so classically academically speaking these asset classes have a formal risk premium. Carbon does not have any cash flow. So there's not a formal risk premium. But when you understand that um the carbon market can only achieve the objective of the politicians and all the people behind it if the price rises because every time the price rises, another set of constituents choose to cut their emissions instead of buying the permit. Again, they're driven by profit. Then the price price rises again and another set of constituents cut their cut their emissions. So the the market will only achieve its objective if the price rises. And the question is what level of the price does it have to rise to to let's say be in line with the 1.5 or twoderee um levels of the Paris agreement. Now what we've simply done in our academic paper is we've taken four really wellrespected estimates and they've calculated the bank of England, the IEA and we took the average and they have said that we need a carbon price globally of about $120 per ton by the year 2030 in order to stimulate enough reductions to be in line with between the one and a half and two degree threshold. So in our mind at at carbon cap we have this kind of price level of $120 a ton across all the markets and and then you simply look at where is the price today. So if you create a cap weighted index of the five markets um they finished last year at around 60 $60 a ton. So the risk premium is simply the trajectory if you bought today as a passive investment at 60 and if we reach 120 by the year 2030 this works out to about a 13% annualized return for a passive buy and hold and you're quite right mor is being cut every year in this market. So as an investor you you want to sit with the regulator. You want to be long but the you know carbon markets have have don't go up every single year as as you know the last three years after a very powerful bull market in carbon in 2021. Markets fell in 22 fell in 23 and fell again last year and they're actually down a bit this year. Um and and we believe as they've fallen that prospective risk premium of course has been increasing because we we do believe we will achieve that level. So we think that big picture this is a very attractive entry point with someone with a medium-term horizon even even as a passive investment. Of course, we we aim to add significant alpha, but you know, just speaking about the asset class, it's it's uncorrelated, it's liquid, and it has this very attractive forward-looking policy risk premium. >> I think we should be touching at that point on the differences between spot or physical permits and the futures markets, and I know that you're also trading options, OTC, or maybe you then clear them on the exchange. I think for a longer or medium to longer term buy and hold position where you just want to have a long exposure, you probably pre uh prefer to be in the physical markets, right? And participate in the auctions and just pay cash for the position and then hold it in the registry. >> Yeah, I mean it it really depends on um a whole bunch of factors. Um certainly the futures mark price trades at a premium to the physical carbon price um and that is called contango in commodity markets. And in in most carbon markets, that contango is roughly equivalent to the cost of carry, the short-term funding rate. However, in a market like California, um it trades at a significant additional contango. So, if risk-free rates are 4 a.5%, the contango in California is more like 7%. So, you know, for us, because we principally trade futures, we have lots of free cash in the fund. We deploy some of that cash by buying the physical in California, shorting the futures contract, and of course those converge on the expiry date and we harvest a a 7% effective, you know, synthetic T bill return on that cash. So you're quite right. Certainly in the case of California, you really would like to just hold the physical and avoid that negative roll yield by by roll buying the futures and and holding them >> cash and carry trading. >> Yeah. The the problem of course in California is you can't get an account to hold the physical. These accounts in California are um administered by the government. Uh in California, there's now more than a a year to a year and a half waiting list. It took us one year to get our physical account with the state of California. Um and I've heard anecdotally that that waiting list is now year to year and a half long. Is it easy to get a physical account for the EUAS and the UKAS or do you have to be kind of like within the realm of compliance and be an emitter to get there? No. Um, I think there's a there's a a real recognition among uh the regulators in these carbon markets that they want a full ecosystem of participants in the market to bring liquidity and price discovery. Very important. You know, in the EU market, the biggest traders are the big power companies. Um, they burn coal and gas to make electricity. They sell their electricity up to 3 years forward to buyers like BMW and Volkswagen who want to lock in their electricity prices. And having sold their their power forward, they buy their coal and their gas and their carbon forward and therefore they lock in that forward margin. And and so they're very sophisticated in how they trade the carbon. And uh certainly the regulators recognize they want a nice blend between compliance entities who trade the carbon and financial actors, speculators who bring liquidity and price discovery and allow that hedging activity to take place. Why do you think is the funding premium or the excess funding spread in the California carbon allowances so large like 4.5 short-term rate where kind of like a table rate or a sofa rate and and I think you mentioned seven. Why is there X's there? >> So, so interestingly, if you track this, let's call it the unexplained contango over time, and we we've done that extensively in all of the markets and you try to answer the answer your question like what's the driver, it's it's there's nothing we have found to indicate, you know, what drove this unexplained additional contango or for instance, in the Reggie market, there's almost a negative contango. In other words, you put the cash and carry on in Reggie, you get less than you get in bills. like well what's behind that? So it's very interesting this this contango phenomenon in the different carbon markets probably if I were to guess in the state of California it's the difficulty of holding the physical. You you you know many people would like the physical they can't get an account so they buy the futures and they and it keeps it at a premium. Got it. So it's a political or legislative bottleneck so to say not enough people can get access to the physical market and therefore the market isn't exactly arbitrage free. Correct. >> Now with respect to your trading, you run the world's largest carbon fund, carbon hedge fund. You have some I think you call it core strategies where you have exposure on the long side. Call that a beta exposure if you will in these five markets. You've mentioned that you're holding physical as well as futures. Uh maybe you also implement some of your delta with with options uh for additional convexity. Um but then you also have several alphadriven strategies. So I think some of them are systematic, some of them use qualitative inputs or fundamental research. Could you run us through these? >> Yeah. So um there there there are two substrategies. Um we begin with a um a perspectus limiting VAR budget. So we we decided to set a hard VAR limit on the fund at 2.2 VAR. So around a 15 annual volatility. That was just a decision we made which I think has been very very wise given the last five and a half years of of of all in these markets. So we're we're capped out on our volatility. Um we then divide that risk budget into these two strategies. The core and the second strategy we call alpha. And you're quite right the the core has two objectives really. First the core is long bias. We do want to capture that long run risk premium. But secondly, we want to add significant tactical alpha by going long, flat or short in these carbon markets based on a whole range of fundamental and technical factors and the drivers of that. I'm happy to talk a little bit more about those, but they are 75% quantitatively driven and 25% qualitatively driven. And our bias as a firm is definitely on the quantitative uh side of things. Um repeatable um investment performance and alpha generation out of sample we think comes from a disciplined more systematic uh approach. So so that's the core. It has these two goals. Get the risk premium number one and then add tactical alpha. And if we if we say the risk premium is 5% a year instead of that number I quoted earlier of 13 and we want to generate 5% tactical alpha we have a a return expectation for the core of about 10% per year. The second strategy is called alpha and as you say this is effectively like a short-term CTA packaged in inside the fund. We currently have approximately 20 completely systematic strategies here ranging from hourly intraday strategies to daily to strategies that might last for two or three weeks. Um and those are 20 systematic strategies. They have an entry signal, an exit, a stop-loss and a profit take. So it's all completely systematic. And our goal there 5% per year of completely idiosyncratic and uncorrelated alpha. the two strategies are just completely uncorrelated to each other. So if you put those building blocks together, you get this 15% kind of total return expectation >> in the short-term CTA bucket. Um I guess that encapsulates mean reversion, trend following, some other things. Now you've mentioned relatively short-term hold periods there like from intraday, daily, you know, a few weeks. Um, so in the EUA market and the UK market where you have kind of like on-screen liquidity in the futures contracts, you can probably execute these relatively easily, but would you also be able to run that on the CCAs and the New Zealand markets? Um, because these are still markets that are much more OTC and then you kind of like do a block trade and um, clear it at the close of business on the exchange. Yeah, the I would say that 90% of our alpha strategies and of the volume that we trade in alpha is in the single market of EUAS. It's all in so >> because that is the most liquid one. >> Yeah, we've got the daily auction, we have four auction arbitrage strategy. So we have four buckets within alpha. We have arbitrage, relative value, short-term directional, and then the carry. And the carry we have in in on in multiple markets. And as you know that's effectively a synthetic T bill you know kind of strategy. So the other three buckets are arbitrage relative value and short-term directional. And the bulk of those strategies are implemented in the EUA market simply because narrow bid offer high liquidity low slippage and market impact. We do have a number of strategies in the UK. We do have a couple strategies in CCA and Reggie but the bulk of it is in the EUA market. So relative value could be like a spread of U uh UKAS to EUAs or EUAS to CCAs or whatever like stuff like that. It it is exactly that. It's it's like the core strategy but on a much shorter term time frame and driven driven more by shorter term factors technicals I would say technicals volatility and volume factors to create that long short exposure in the within alpha in the relative value bucket >> and and arbitrage uh maybe conceptually the most interesting uh part of this I mean it's this because these markets you know they have these actors they have these um firms that need to comply And it is it is therefore driven by different dynamics as far as supply and demand is concerned. So do you see these kind of like these patterns where there's just liquidity coming into the auction or missing from the auction and you can kind of like find arbitrage opportunities between say settlement prices on futures contracts and auction participation. Is it that these type of things you do? >> The the bulk of the arbitrage strategies um are governed around uh the EUA auction. It's a it's a daily auction. The UK auction is every two weeks, so it's less less frequent. We we have strategies we deploy there in the arbitrage bucket as well. Um and they're not, of course, they're not pure arbitrage in the sense of, you know, immediate um taking a spread out, but they're, you know, high probability transactions that are um for very short periods of time that that harvest a you know, a nice alpha at a high probability rate. We're very numbers driven when we when we back test in sample, out of sample, and we look at all of the metrics, win loss ratio, size of average win versus average loss, all those kind of classic trade statistics that you would expect. We built all our own code there. Um, so that the strategy development process is now quite speedy. Um, I would also say that these alpha strategies, they decay, they decay sometimes quite quickly. So, you know, these these auction arbitrage strategies, we're on the the fifth iteration of these strategies from where we started. So, they you know, they they work, they work, they work, then you start losing money, you shut them off, you go back to the drawing board, testing, testing, and then you reimplement. >> Of course, I mean, these markets, especially the EUAs, they have become larger, and hedge funds and CTAs are trading on them. You are you're not the only one. One thing I'd like to touch on at the very end or as we kind of like um finish this conversation which by the way I think was really interesting or is still remains interesting is is is actual impact and positive impact and we did speak a little bit about the offsets and planting trees and these type of things but you've decided to go a different route. Um from what I remember I think you are taking 20% of your performance fee income and you're using that money to cancel allowances. So you're essentially buying allowances and you burn them up. Poof, there they go. They're gone. Which means that nobody else can use them to emit carbon. Is that that's the way you're going about this, right? Which is which which does have impact. I would say that's direct and positive impact and that's one of the reasons why you are an article 9 fund. >> Yeah. So very very good summary you I think you did there. um after having done that very deep dive on the voluntary market and determining that it simply isn't a place you can have confidence of um you know buying these credits or offsets and having any impact at all. We we then said where can we go? We we want to try and create some alignment um quite unusual for a hedge fund with you know performance and impact and it was my partner's idea. He said, "Well, you know, we want to perform. That's that's the first primary objective. We must perform and generate absolute returns, but why don't we then link the impact side to the performance?" And that's where the idea came to take 20% of our annual performance fee when it's crystallized. If we're fortunate to crystallize a positive year, we take 20% and we use that to purchase regulated permits. Now remember, if Voluntary is trading at $2 a ton, $8 a ton, $10, we're buying at $50, 60, $70, $80. So you're paying much more, but as we said earlier, you're really getting what you pay for. And we believe this is the highest impact spend that you can make, especially in a carbon market where the supply is quite tight. Um, by taking those permits out, you're really preventing those tons of emissions from ever hitting the atmosphere. And the best ton Morates is the ton that never is released, right? That's the that's the best ton of CO2. So since since launch, we've crystallized we've had five positive years. Um, and so we've had crystallized five times and approximately$1.3 million US has gone towards that. Now the fund's much bigger. um those numbers could start really escalating and therefore we've decided to to take a portion of the funds and look at other um highly impactful activities and one of those is we've sponsored a piece of research at the uh London LSE Grandanthm Climate Institute to update the seinal academic paper um that proves the effectiveness of the European emission trading system because we think it's very important for new governments around the world to be able to point to high quality academic research arch and say look this mechanism they did in Europe it's very successful so the the seminal paper there by Frank Venman's and and uh colleagues we've um we've sponsored the update of that paper and that should be released in the next couple of months and the preliminary results really are are very positive. So we're we're going to expand our impact activities as that pool of money grows and it's something we're all very passionate about at Carbon Cap. Not speaking about performance but given that we've mentioned that the current compliance markets are relatively uncorrelated to one another maybe with the exception of UKAS and EUAS where you do have relatively persistent positive correlation but then also the combination of your alpha strategies and the beta exposure that I guess makes your overall return stream very much uncorrelated to anything like including CTAs or the hedge funds just you know directional exposure. So a great portfolio addition. >> Yeah. So certainly as I said before, I mean I think you can you can make a very strong argument for a passive long only exposure to carbon and there are there are some ETFs that are available out there because the the asset class is very interesting properties. It's liquid. It's completely uncorrelated and it has this forward-looking risk premium. Um we are not even correlated to the asset class. Um and it's not not correlated. So you know investors and and uh we now have nine big institutions you know they've done their their deep homework on our on our 5 and a half year track record and you know there is no correlation you're absolutely right. So it's a it's a liquid strategy but with low correlation and as you say it it has this this impact element if if that's something that is u that is interesting for the investor. >> Excellent. Mike I think this makes for a very good time to wrap it up. We've been going for a long time. It's been super interesting. And for our listeners, uh, where would you like to send people if they would like to find out more about you or Carbon Cap? >> Yeah, certainly. Uh, please, uh, go to our website. We have a lot of, um, video content. It's all educational content because that's part of our mission to educate on emission trading systems, how they work. So, it's um, uh, carbon-cap.com is our website. Um, and uh, if you have any questions, just hit click on the info and uh, send us information and uh, someone from the uh, team will come back to you. >> Great, Mike. Thanks once again for coming on to the open inter series today. It's been great speaking with you and I think this episode especially includes some really interesting and valuable takeaways for our listeners as we've been speaking about a new topic. We didn't cover that on this show before and I don't think it's widely covered in other podcasts either. So, it's been great. As ever, we'll include the most important points of today's discussion in our show notes. And should you have any questions or comments, please send us an email to info@toptradersunpluck.com where we'll pick it up and respond. Thanks again for listening and until next time, thank you very much. >> Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you. And to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged. [Music]