KCCA: This California-Focused Carbon ETF Is Seeing Momentum

KCCA: This California-Focused Carbon ETF Is Seeing Momentum

A number of factors point to a growing carbon market.

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Reviewed by: Lisa Barr
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Edited by: Daria Solovieva

Launched in October 2021, the KraneShares California Carbon Allowance Strategy ETF (KCCA) offers investors the only pure-play exposure to rising prices in the California carbon market.  

This cap-and-trade system, initiated in 2013, was ambitiously designed to reduce greenhouse gas emissions by 40%—based on 1990 levels—by 2030, and now covers about 82% of carbon emissions in the state.  

Last year, Russia’s war in Ukraine precipitated an energy security crisis that had a punishing effect on carbon pricing globally, including the North American market. But 2023 is proving to be a very different year, one defined by resilience and genuine possibility.  

The idea of carbon pricing remains enshrined in the 2015 Paris Agreement, and despite the hiccup of 2022, we are seeing a deepening commitment to decarbonization across the developed world—from the European Union’s “Fit for 55” agenda to a host of developments in the U.S.  

In February, the state of Washington debuted its own cap-and-trade system. New York is also moving forward with a program. And California itself greenlighted a new raft of climate initiatives that should turbocharge its carbon pricing into the next decade.  

How KCCA Is Structured 

KCCA does not invest in stocks, bonds or commodities. Instead, it focuses on carbon credit allowances, an arguably distinct asset class. Ten years of data suggests that these permits have a minimal correlation to equities or fixed income.  

As a passive ETF, KCCA is benchmarked to the IHS Markit Carbon CCA Index, which tracks the future contracts of the state’s carbon emissions permits. Each permit, or CCA, allows a covered emitter—typically a utility, refiner or big industrial firm—to legally release one ton of GHG into the atmosphere. The state government holds quarterly auctions for these CCAs, at which emitters can buy and sell allowances.  

The asymmetric opportunity for investors is that in order to achieve the California Air Resources Board’s original mandate, emissions must drop 4.1% a year, requiring the allowance cap issued per year to tighten that decreases the credits in circulation each year.  

The auction reserve price, which is essentially the lowest price that CCAs can sell for at auction, now increases annually by 5.0% + CPI. This ladders up prices structurally, thus incentivizing emitters to reduce pollution.  

From Abundance to Scarcity 

Since the program's launch in 2013, the secondary market pricing for CCAs generally mirrored the annual auction reserve price because the program was kept oversupplied (probably to initially foster corporate acceptance) and the ARP was low.  

That is changing, however, as many indicators point to a new era of undersupply.  

A lot of state-level climate initiatives got the green light over the past year, from the California governor’s executive order requiring all new passenger vehicles to be zero-emission by 2035 .  

Most importantly, in December, CARB officially approved the 2022 Climate Change Scoping Plan, a sector-by-sector roadmap that cuts GHG emissions by 85% and achieves carbon neutrality for the state by 2045.  

The agency’s plan accelerates the pace of carbon reductions. This shifts to a 48% reduction of greenhouse gas emissions, from the prior 40%, below 1990 levels by the end of this decade. By 2045, the plan takes fossil fuel consumption to less than one-tenth of present use—a 94% reduction in demand.  

CARB is now expected to lower its allowance caps by 2025 and extend the cap-and-trade program beyond 2030. Any oversupply in the market will be addressed by an additional supply adjustment mechanism and a tightening of requirements for any offsets.  

The Future of CCA Prices 

Speaking at the KraneShares Climate Summit in New York earlier this month, Bloomberg’s Lead Carbon Analyst Bo Qin discussed many policy developments in the California market, and sees the CCA market moving to a consistent state of undersupply in 2024.  

She projected CCA prices rising to $42 per metric ton by early 2024 and essentially doubling to $63 by 2030, despite some interim weakness around 2025-2026. KraneShares’ own modeling also shows a deepening supply deficit of allowances as we proceed through the decade. 

 

KraneShares_Supply_Demand

 

KCCA has risen sharply over the past month and is now up 10.46% for the year. The next CCA auction occurs on Aug. 16 and should see strength. The stricter emissions regulations expected over the next two years and the tightening supply of allowances should pressure prices going forward.  

One important technical aspect that is worth keeping in mind: KCCA is still 18% below its all-time high of $31.39 set 19 months ago on Nov. 15, 2021. The invasion of Ukraine, which triggered a massive sell-off in the European carbon market, pulled down the carbon prices in North America tangentially as ETFs holding both EU and California permits sold off.  

KCCA’s drop was collateral damage. It fell to $20.22 on March 7, 2022, during the darkest days of the invasion, and essentially “double bottomed” in late September when Europe’s energy security crisis over winter heating was arguably at its most dire.  

 

KCCA Technical Chart June 24 2023

 

Since the Scopes Plan was revealed in November, KCCA has shown strength. And in early March, shares arguably broke out when CARB Chair Liane Randolph publicly said to the state legislature that the cap-and-trade system will become more aggressive and that both cap-and-trade and the state’s Low Carbon Fuel Standard program will be recalibrated for the new 48% reduction target.  

At present, about 20% of all carbon emissions worldwide are now covered in some form of cap-and-trade program. The WCI is now the largest carbon market in North America. It’s also the first to be implemented at the subnational level in two different nations, a fascinating indication of how climate policy in North America will unfold in the future.  

For long-term investors, looking for mitigated downside risk and the uncorrelated returns of a new asset class, KCCA is worth keeping an eye on. 

Sean Daly writes on ETFs, biotech and wealth management. He was educated at Columbia University and has taught international finance, computing and financial risk management at Pace, Tulane and Princeton. Follow him on Twitter (X) via @Sean_Daly_.