Market Insights: Putting a Price on Emissions

Macroeconomic and Market Developments:

• North American markets were lower this week. In Canada, the S&P/TSX Composite Index was down by 0.94%. In the U.S., the Dow Jones Industrial Average was down 2.15% and the S&P 500 Index declined 1.68%.
• The Canadian dollar was also down this week, closing at 78.87 cents vs 79.81 cents last Friday.
• Oil prices were slightly higher this week. US West Texas crude closed at $69.58 vs $69.26 last week, and the Western Canadian Select price closed at $57.90 vs $57.25 last week.
• Gold prices were down, closing at $1,788 vs $1,828 last Friday.
• Enbridge (ENB) announced that it has entered into a agreement with EnCap Flatrock Midstream to acquire Moda Midstream Operating, for US$3.0 billion in cash. A key component in the transaction, Enbridge will acquire a 100% operating interest in the Ingleside Energy Center (to be renamed the Enbridge Ingleside Energy Center), located near Corpus Christi, Texas - North America's largest crude export terminal, which loaded 25% of all U.S. Gulf Coast crude exports in 2020. This terminal, built in 2018, comprises 15.6M barrels of storage and 1.5M barrels per day of export capacity.
• The Bank of Canada met this week and has agreed to hold its target for the overnight interest rate at the effective lower bound of 0.25%, with the Bank Rate at 0.50% and the deposit rate at 0.25%. The central bank’s quantitative easing (QE) program is being maintained at a target pace of $2 billion per week. Bank of Canada Governor Tiff Macklem said decisions around QE and interest rates are distinct and that when the central bank does tighten, its first move will likely be a rate hike.
• Freehold Royalties (FRU) announced that it has entered an agreement to acquire U.S. royalty assets in Eagle Ford oil basin for US$180 million. The concentrated royalty land in the core of Eagle Ford oil basin in Texas covers ~92,000 gross drilling unit acres with an average royalty rate ~1.8%. In conjunction with the deal, Freehold announced a C$150 million share offering at $9.05/share.
• Lululemon (LULU) reported blowout earnings after the market closed on Wednesday. Earnings per share came in at $1.65 vs $1.19 expected and revenue at $1.45 billion vs $1.34 billion expected. The stock, which trades on the NASDAQ market in the U.S., closed up 9.6% on the week.
• Canadian jobs numbers were released by Statistics Canada on Friday and saw employment rise by 90,200 jobs in August, the third consecutive monthly increase and above market expectations of a 55,000 gain. The unemployment rate fell 0.4 percentage points to 7.1%. Job gains were in both full-time (+68.5K) and part-time (+21.7K) jobs. Regionally, Ontario (+53.0K) accounted for the majority of the job creation while Quebec (-11.0K) led the laggards.
• Here is a link to a short video from Canaccord’s chief U.S. Strategist Tony Dwyer entitled Indigestion Continues: DWYER VLOG

Weekly Diversion:

Check out this video of a pilot setting a world record for flying through the longest tunnel.

Charts of the Week:

We are taking a bit of a detour this week to highlight some real assets as part of the reflationary theme we have discussed in our quarterly wrap-up comments. One being physical Uranium, and the other Carbon Credit Futures. On the former, we examined this topic in one of our weekly commentaries, specifically our June 4th post titled Uranium Rally to Power Ahead. We backed that up by committing capital to both this past July as part of an overall move to increase our weighting to real assets in general across most of our Milestone mandates. Since our initial investment in physical Uranium, our position is up close to 50% in less than two months; so far so good.

Here is a look at the price of Uranium (U3O8) in just the past month:

Source: Insider Inc.

We wrote about Uranium in June, so we thought we would now introduce carbon credits and why we believe there could be long-term upside potential there. We would venture to say that, along with physical Uranium, carbon credits and their prices, are not a well-known investment idea in general so we first wanted to lay some groundwork.

Earlier this month, there was a rather dire report from leading scientists that if certain actions are not taken over the next decade to curb emissions and rising planet temperatures, there could be very serious consequences. This claim is clearly not a surprise to anyone, whether one believes in climate change or even its causes. However, what we do know is that there is significant action taking place in the developed world based on the core emissions guidelines set by the 2015 Paris Agreement, and most corporations are making decisions based on this. As portfolio managers, we are always looking for investment ideas where there could be a long-term argument for sustained price increases, and this is an area that may fit that bill. When corporations, which drive earnings growth, and thus the direction of the stock market, make long-term decisions, they don’t normally or easily change course, and therefore we don’t think this low emissions theme is going anywhere anytime soon.

What are carbon credits? A carbon credit is a tradable financial product allowing entities that emit carbon over their permitted thresholds to purchase credits to effectively reduce (offset) their emissions back down to target. Carbon credits are the latest in the growing space of ‘sustainability commodities’, and in turn, a part of the growing Environment, Social and Corporate Governance (ESG) investment theme. The main function of carbon credits is to attempt to influence corporate entities towards low or zero carbon operations through a cost deterrent (rising credit prices) and commercial incentive through the potential to generate and sell carbon credits. Corporations can gain carbon credits or offsets through their own emissions-reducing projects and claiming the resulting carbon credits or by buying them through a secondary market to offset their emissions. Here is an image below that helps depict how the process works in Australia.

Source: Australian Clean Energy Regulator

The intent of our comments here this week is not to go into too much detail on carbon credits, but more to shed some light on the investment theme (carbon credit prices) and why we believe it has potential from that aspect. In Canada/US, the system works more as a “cap-and-trade” program, where corporations are set a tonnage limit on their carbon emissions. If they exceed that cap, they are financially penalized, either through fines or even the inability to access a lower cost of capital. However, they can offset this by buying credits on the secondary market, and therefore are motivated to lower emissions below the cap. Here is image below from the Government of Nova Scotia on the cap-and-trade process. The cost of capital issue is another growth area called ‘Green Bonds’ and could also potentially motivate corporations to comply with emissions guidelines in order to borrow capital at lower costs.

Source: Government of Nova Scotia

There is concern as to whether an incentive for polluters to purchase offsets is actually addressing the issue of emissions or just masking the problem. However, what is occurring right now is still in the early stages, and likely is a positive step in the right direction. What we do know is that this market is definitely growing at a rapid rate, with an added tailwind from governmental pressures to meet the 2015 Paris Agreement emissions targets, and the mechanisms underneath the hood seem to suggest to us that the prices of carbon credits (futures markets) could potentially continue to increase. We will finish off today’s comments with a chart below from Trove that shows the rapid rise in cumulative retired credits over the last 10 years. In other words, those credits which have been used by companies to offset their emissions.

You are probably wondering how does this all affect the ‘price’ of carbon credits? That is a complex question that probably doesn’t have a direct answer. There is currently no uniform pricing system in the world to determine the value of carbon credits, or more specifically, the price of a tonne of carbon. According to the World Bank, there are 74 regional, national and sub-national pricing schemes across the globe. That being said, from an investment perspective, Milestone’s view is that as ESG pressures on companies continue to rise, so should likely the demand for offset credits in the secondary market and thus the price of carbon. On the supply side, it seems that demand could grow faster than supply, which by nature is more difficult to come by as it requires carbon reducing projects to be delivered, or for businesses to become more environmentally friendly, both of which may not keep up with demand. As such, we know that high demand and low supply creates the economics of rising prices, and therefore we view this as an opportunity. We are able to invest in this market through an ETF called the KraneShares Global Carbon ETF, which tracks the IHS Markit Global Carbon Index, and offers broad coverage of cap-and-trade carbon allowances by tracking the most traded carbon credit futures contracts.

Source: Trove Intelligence

 

Sources: CNBC.com, Globe and Mail, Financial Post, BNN Bloomberg, Tony Dwyer, Canaccord Genuity, First Trust, World Bank, Insider Inc, Australian Clean Energy Regulator, Government of Nova Scotia, Trove Intelligence