By Régis Bégué, Manager, Equities Management, Lazard Frères Gestion
A ton of CO2 has never been so expensive on the European carbon market. The challenge of sustainable development is now taking on a very concrete financial dimension for companies. For investors, it is high time they adapted to it.
The carbon market is a strange animal. Created in 2005, it remains little-known by both the average person and professionals. It is not a “classic” securities (equities, bonds) market, nor a commodities (gold, oil) market, but a market of “CO2 emissions allowances”.
Origins in political will
Bearing the official name of the Emissions Trading System, the carbon market works like any other financial market. It trades in one asset: tons of CO2. The market participants are companies that can buy or sell emissions allowances.
Covering 11,000 European companies from sectors known for their production of greenhouse gases (industry, energy, aviation), this market is based on simple rules. Every year, emissions allowances are allocated free of charge by the European Union to the companies concerned. When they emit less carbon dioxide than their quota, they can sell the balance on the market. Conversely, they must buy allowances. Clearly, the aim is to encourage companies to reduce their carbon footprint.
In European countries where electricity is generated by coal-fired power plants, the price of a ton of CO2 also influences the cost per kilowatt-hour. When the carbon market is stretched, certain companies then prefer to turn to cleaner forms of energy. But beyond a certain level, they may pass on this extra cost, at the risk of losing some of their customers.
A truly unlimited surge in prices
At 47 euros, a ton of CO2 is today at an all-time high. It has gone beyond its 2008 peak of 31 euros, which gave way to a plunge in prices to 2.7 euros per ton in 2013. At that time, the European Union reacted by deciding to withdraw excess quotas beginning in 2019, creating a rally in prices to 30 euros per ton. The adoption in December 2020 of the European Green Deal, targeting a 55% reduction in EU greenhouse gas emissions by 2030, was another shock. Anticipating a drastic drop in available quotas, the market is now beginning to overreact.
In theory, carbon prices have no limit. A market on which supply is dwindling can see prices surge to irrational levels. All the more so because the carbon market is now attracting hedge funds that see in CO2 a new asset with huge upside potential. This is a dangerous situation for companies that need to purchase these allowances! If prices rise above 50 euros per ton, the cement and steel sectors could begin to seriously suffer. Conversely, the “greenest” among the 11,000 companies concerned would have a powerful competitive advantage.
The runaway prices have a safeguard: European determination. Let’s not forget that the carbon market is a political tool, seeking to influence companies’ behavior. It is not supposed to have a negative impact on European competitiveness. However, in a world in which sustainable development has taken on considerable importance, the EU could use a firm hand with the “bad boys”. We cannot therefore rule out a sharp rise in prices.
Investing “responsibly” is becoming a necessity
One thing is certain: the issue illustrates to what extent sustainable development is becoming, and will remain, both an ethical and financial challenge for companies. Major carbon emitters are faced with new risks, ranging from having a poor image to being the targeted by government policies. “Greenwashing” will no longer be enough to save companies that do not make real efforts to evolve. And the axe could fall sooner than anyone thinks.
It is now crucial for investors to take this issue into account. The environmental strategy guiding companies is now one of the main criteria to be analyzed in order to anticipate risks and build resilient portfolios. This approach enables investors to identify the most advanced companies in this regard, as well as those making the most tangible progress to set themselves apart from the competition.
Selectivity very much remains the watchword. Over the last year, numerous “green” companies have reached excessive valuation levels. Fads will remain investors’ worst enemy: sustainable development is no exception to this rule, and must be approached in an informed manner to separate the wheat from the chaff.
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Article written on 26 April 2021. The information provided is not intended to constitute investment advice and is intended for information purposes only. The data used in this document is used in good faith, but no guarantee can be given as to its accuracy. All data contained in this document, unless otherwise indicated, comes from Lazard.
Sources: Bloomberg and Lazard Frères Gestion
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