GIC, the Singapore Economic Development Board (EDB), and McKinsey & Company on Friday (Oct 29) published a joint report, ‘Putting carbon markets to work on the path to net zero: How investors can help decarbonise the economy and manage risk-adjusted returns’. The research outlines how institutional investors can play a critical role in helping to develop viable carbon markets in their pursuit of global climate goals, whilst also fulfilling their own mandates.
According to the analysis, carbon markets are rapidly approaching critical mass from an institutional investment perspective.
Compliance carbon markets (CCMs)1 have matured over time, with a global market value of over US$100 billion, and are becoming easier for investors to understand. Voluntary carbon markets (VCMs), on the other hand, are much smaller at US$300 million in value, making them largely unviable for institutional investment today.
With more standardised and transparent pricing, and more established governance mechanisms, however, VCMs could outpace CCMs to bring them to a similar total global market value as soon as 2030.
One in five of the world’s 2,000 largest publicly listed companies have now committed to a net zero emissions target, along with countries responsible for 61 percent of global GHG emissions. To achieve these targets, companies must work towards decarbonising their own operations and value chains, while compensating for and neutralising their existing and residual emissions through high-quality carbon credits.
Institutional investors also have an interest in driving decarbonisation efforts, since their portfolios are being exposed to increasing levels of climate risks.
Working with Vivid Economics, McKinsey’s strategic economics consultancy, and its climate analytics suite, Planetrics, the researchers conducted bottom-up modelling of the relative impact of climate risks across individual asset classes. They found that, in scenarios assuming immediate or even delayed climate action, carbon allowances could improve the risk-adjusted returns of a 60/40 reference portfolio2. On average, an allocation of approximately 0.5 to 1 percent was sufficient for portfolio risk diversification under climate transition scenarios. The only scenario in which carbon allowances led to decreased returns was one where no new climate change policies were introduced.
While the reasons for institutional investors to consider active participation in carbon markets are compelling, they also need to be mindful of their role in providing useful services such as liquidity, price discovery and matching supply and demand, and to refrain from speculative trading.
The authors believe that institutional investors can help accelerate the development of VCMs in three key ways:
Ultimately, investors should keep in mind that carbon markets are one of several solutions that could help accelerate the low carbon transition. Equity and bond markets serve broader social objectives such as economic growth, prosperity and value creation, and can generate returns for investors as a by-product. Likewise, the ultimate objective of VCMs and CCMs is to help the world set a path to net zero emissions in line with the Paris Agreement.
Read more about the study and download the full report here.
To learn more about the contribution of Planetrics to the study, contact Ethan McCormac. Ethan is a Senior Associate at Planetrics, and supports clients across a range of activities, including stress testing, and climate risk and opportunity assessment. Email Ethan at Ethan.McCormac@planetrics.com.
1 Compliance carbon markets (CCMs) are traded and regulated by mandatory national, regional or international regimes, while voluntary carbon markets (VCMs) are traded by companies and individuals on a voluntary basis to achieve carbon compensation and neutralisation.
2 A 60/40 reference portfolio refers to 60 percent equities and 40 percent bonds, where iShares MSCI ACWI ETF is used as the proxy for the equity part of the portfolio and J.P. Morgan Global Government Bonds Index for the bond part of the portfolio.
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