Expert: John Caulfield – Van Eck – ETF

Bryce: [00:00:13] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing. Whether you're an absolute beginner or approaching Warren Buffett status, our aim is to break down your barriers from beginning to dividend. My name is Bryce and as always, I'm joined by my equity buddy, Ren. How are you going? 

Alec: [00:00:30] I'm very good. Bryce is very excited for this episode. We are talking about an asset class that I believe you've even had some interest in before. Yes, but it's becoming more and more accessible for retail investors. So excited to get into it. 

Bryce: [00:00:45] Yes, it is. Carbon credits Ren. And we've got an expert in the studio, so we would love to welcome John Caulfield. John, welcome. 

John: [00:00:51] Thanks very much. Good to be back. 

Bryce: [00:00:53] So John is director of institutions and intermediaries at ETF provider Vaneck Australia. And before we get into it, just a reminder that we are licenced. However, we are not aware of your personal circumstances. All information on this show is for education and entertainment purposes. Any advice is general advice only. But John, as Ren said at the top, is an asset class that is getting more accessible. Which is carbon credits and VanEck has just launched Australia's first carbon credits ETF. The ASX ticker is CO2. So let me explain it like I'm five. Yeah. What is a carbon credit? 

John: [00:01:33] Yeah. Well, I mean, think of the carbon credits as basically a permission slip to emit. So essentially, you know, there are emissions that, you know, come out of industry, aviation, obviously just general power generation. The aim, as we know with sort of climate awareness, climate change, ESG, is to try and limit global warming and reducing emissions is the way to go. So, you know, this is a structure that's been put in place to basically, you know, monitor those emissions. And, you know, certain industries will have a limit of what they can emit over a certain year. And we can get into the sort of mechanics of how these things come into existence and get used. But it's essentially saying to, you know, an energy generator, you now have permission to emit one tonne of CO2. 

Alec: [00:02:23] And so I take it if I invest in your ETF, I'll have permission to emit more carbon. 

John: [00:02:27] I mean, the ETF itself is basically an exposure to call it an asset class or a commodity, which is the price of carbon dioxide. We can sort of talk about how the ETF and what we hold, you know, translates through to the actual credits. But, you know, think of it as you are helping that price discovery process. 

Alec: [00:02:47] Yeah. Well, before we do, let's just talk about carbon credits in general and then we'll get into the investing side of it. So it's a permission slip to I mean, how does a carbon credit scheme or an emissions trading scheme actually reduce the total amount of. 

John: [00:03:02] Emissions in terms of changing behaviour? And that's what this is all about. You know, we're trying to change the behaviour of people, but industry as well to reduce carbon emissions. And economists generally agree that the best way to do that is to put a price on carbon. And so, you know, carbon credits essentially evolve or involve the regulated markets. So where there's sort of mandatory caps on emissions and those credits get issued or you need to be bought and sold, traded, you know, reasonably similar to carbon offsets and the term gets used interchangeably a little bit, but the offsets are I guess, more relevant to the voluntary market. So, you know, you don't necessarily have to go and do something. But when you book your Qantas ticket and they say, do you want to offset something and you tick the box, you're not mandated to do that. So that's just the offset. Someone's going to go and plant a tree. But the credits themselves, like I say, it's, you know, legislated. 

Alec: [00:04:01] And a lot of the companies that are saying they're going to be net zero by a certain date, they're buying offsets, the government telling them they have to be net zero, but they're doing it. 

John: [00:04:10] Well. Again in Australia, you know, we have this voluntary market where, you know, people are offsetting their actions and that's best endeavours. It's not the government sort of holding them to account, whereas in other markets which are more developed and I mean we'll talk a bit more about Europe, which, you know, certainly are the leader in this space. You know, it's written in law and that's where the credits come into it. And, you know, those will get issued. And they need to be used, as you say, by companies to, you know, they hit their targets or pay up. If they don't. 

Bryce: [00:04:44] Let's move to how they are investable as an asset class, because that's kind of why we're here today. You've just explained how they work for companies, allowing them to sort of offset their carbon emissions, but how are they actually an investable asset class? 

John: [00:05:01] Yeah. So I mean, these credits are issued by governments and regulators. Some of them are given away to companies to help with that transition. Those are auctioned by governments. And so, again, companies need to go in, bid up and pay. And then you do get obviously industries who, you know, you may have a rainforest or a carbon capture firm. You essentially get those credits that you can put into the market and sell to those that need them. So, you know, there are these exchanges where you can sort of buy and sell. It's not that easy for retail investors to go and buy credits, but it's certainly possible. And it's, you know, obviously more an industry led activity where people are buying and selling these things for genuine, like I say, legislated reasons. 

Alec: [00:05:50] Like conceptually an emissions trading scheme will make sense to people when it's companies and governments and it's, you know, the government sets like looks at how many emissions in the market in 2022 and says, you guys will all be given credits or permission slips 10% less than your emissions from this year. And then you guys need to trade amongst yourselves. But we're capping the amount of emissions. Yeah. And then we're trading like that makes sense. And then all of a sudden you put investors in the mix and they also have the ability to buy credits. And it becomes a little bit more confusing, I guess, in terms of what role the investor plays and how that changes the market. So how do they change the market? Does it push the price out to push the price down? Net positive. Net negative. I'd be surprised if you said net negative given you've got an ETF. But yeah, yeah, you throw an investor into that picture. How does it change what comes out? 

John: [00:06:42] I mean, look, you're adding liquidity and with anything, the more liquidity you have, the better your price discovery is. I think it's also important to say that, you know, the European scheme was designed with investors slash speculators in mind. It wasn't set up, you know, hoping that people would never participate in that role. So they basically saying, look, we know people are going to do this. And I mean, even the investor speculator side of it could be firms that actually do need these credits for legitimate reasons. But they are saying, okay, well, we're going to hold these credits on our balance sheet because we may need them next year or the year after. And we know that the price of carbon is going to go up. So we want to participate in that. And that's a natural hedge to things that may be going on elsewhere in our business as well. So I think the entire ecosystem is important and it's like I say, you know, the more players you have, the more transparency there is, the more liquidity, the better the price discovery. And again, ultimately, you know, we need people to change behaviour and they are only going to do that when the price of carbon is such that they are forced. 

Bryce: [00:07:51] To with most asset classes within that there are good quality assets and then not so good quality ones. Yeah. Does that apply to carbon credits? Are there credits that, you know, some investors are really gunning for and others that you don't want to get your hands on as much? 

John: [00:08:07] Yeah, look, there is a difference. But I think, you know, broadly speaking, the distinction could probably be split along the mandatory and the voluntary side of things. So like I said, where there's a volunteer and you sort of say, well, look, I'm going to go out and plant a few trees. If you take the Qantas bucket having line of sight to, you know, how big are your trees, how many of you planted is difficult and those are sort of I guess project specific, whereas you know, something like the credits, what you're really doing is saying, well for those credits to be put into the system as tradable sort of securities, for want of a better word, you know, they do need to essentially be stamped by some sort of oversight regulator. So you have that degree of certainty that what you're buying or selling is legitimate. And then, you know, the price of carbon is ultimately what you buy or sell there. You're not necessarily saying I just own a patch of grass which has a few trees on it and that's my offset. So it's very hard to quantify when it's project specific, not impossible. And you know, certainly there are some very good legitimate operators there. But like I say, it's just a bit more opaque. Yeah, yeah. 

Alec: [00:09:20] So there are 25 emissions trading schemes around the world and this ETF has exposure to four of them. Yeah, I guess maybe introduce us to the four emissions trading schemes and then we'll get into why those four and not the other 21. But to start with, what are the four emissions trading schemes that are in the ETF? 

John: [00:09:39] Yeah. So the four are Europe UK, which used to be a part of Europe, but obviously spun out with Brexit a couple of years ago. And then we've got an East Coast and a West Coast bus. So, you know, there's the California system on the West and then East Coast is the regional greenhouse emissions. RGGI reduced that court. So those are the four. I mean, essentially the index that we track, as with all of these indices have eligibility criteria. You know, it needs to be, you know, a mandatory system. It needs to. Be large enough, you need to have foreign participation and there needs to be a futures market behind it providing again, that liquidity and price discovery. So those are the four at the moment because they are the largest and most developed. I think as we move forward, like you say, there are others that will become eligible and we'll see. You know, more of those ETFs are included in the index at some point. 

Bryce: [00:10:33] I didn't realise that the US was split California specific. And then was it the North East USA? 

John: [00:10:41] Yeah. Interesting. Yeah. So again, I mean, it's I think 12 states on the East Coast and then California actually includes Quebec as well, so. Oh, really? Yeah. Obviously, Europe is very much, you know, a government led federal, if you like, from a US perspective, whereas on the US side it's all sort of state led as well. So you know, all of these systems, you know, will be set up differently, have different kinds of aims, different caps, different targets and will evolve. 

Alec: [00:11:11] We were going to talk about potential risks a little bit later, but I think this one becomes quite relevant now. So we have a system where the states in the U.S. are taking action on their own. California, notably well out in front with carbon trading, also electric vehicles and stuff like that. Yeah. And there's always an open question of regulatory change when it comes to an asset class like this where it's so driven by government policy. Yeah. Let's say, you know, based on the midterms we saw last week, it doesn't look quite likely, but let's say 2020 for the Democrats, you know, sweep the House, they get more than 60 senators and they win the presidency. And the new Democratic president decides we're going to have a national carbon trading scheme. Yeah. How is there a regulatory risk for these state based schemes? How does that change, you know, the asset class or the assets that you've invested in? 

John: [00:12:05] Yeah, like I said, I think these things will all evolve. They've all been around for a while as well. You know, the East Coast system has been up and running since about 2009. California, 2012, I think. So we've already sort of seen, you know, them exist, whether it's Democrats, whether it's Republicans, again, I mean, you will see different states added to some of those systems. Potentially maybe the two of them get together at some point and say we're going to, you know, call ourselves something else. And everyone who is part of ours becomes one. Again, you know, you wouldn't sort of put anything off the table, but ultimately, you know, the industries that are involved, the emissions targets, the caps, how that's sort of worked out, I think, you know, could be sort of standardised, normalised, whether it's state, whether it's federal exchange, regardless of government. 

Bryce: [00:12:55] So with the mechanics of the ETF, John, is it invested in carbon credits or is it the futures approach? Because I'm in one that's listed over in the States, which I think is the future approach as well. What's the mechanics of it?

John: [00:13:08] It is the futures approach. So like I said, it's certainly possible to get hold of credits directly, but they, you know, don't trade as regularly or as, you know, in enough volume, shall we say, for something like an ETF to hold. So, you know, you need daily liquidity. The futures are the way to go in terms of an investment sort of product. And, you know, correlation wise, you know, it's .0999 in terms of futures versus spot, if you like. So the futures market in carbon or the price of carbon actually tracks the spot price closer than we see in something like oil, for example. 

Alec: [00:13:48] We mentioned there are 25 emissions trading schemes. This ETF really looks at four of them, but there are some other ones around the world. New Zealand is one that's pretty close to home. Yeah. Is that going to be included in the index in the future, do you think? 

John: [00:14:01] Oh, look, it's certainly on the radar. That question has come up quite a bit in our conversations with clients. I say it is a mandatory system. It's just not quite large enough at the moment and doesn't have the futures market. So I think in terms of market size, you know, we understand it's about half the size of California. 

Alec: [00:14:18] Yeah, well maybe if Australia got their act together and we had an oceanic. 

John: [00:14:22] Absolutely it's there we go. So I mean nothing's outside of the realms of possibility. We've obviously got our voluntary market here. And again, I mean, that's a question that comes up a lot, as is China. China has a mandatory system. It has been around for a while. It is quite an aggressive sort of target in terms of their caps, but there's no foreign participation at the moment. So again, they fall a little bit short in terms of that index eligibility. 

Bryce: [00:14:48] So my thesis when I got into this was that there weren't enough credits to meet. Supply sort of has played out. There's been a few ups and downs over the last year or so. I think it's also had exposure primarily to Europe and whatnot. Is there a point that might tip in the opposite direction? We're seeing COP 27 at the moment and a lot going on in. Space. So what does the future hold for this? If someone is kind of sitting at home thinking that the future of carbon credits is just going to get cheaper and cheaper? 

John: [00:15:18] Yeah, you're right. I mean, look, these systems have been around for a while. There've been some ups and downs. As with all of these initial designs, we do expect them to evolve and they have evolved. And the supply demand dynamic is certainly something that's been tweaked. And I mean, I'll talk to sort of the European experience given it makes up around half of the index or the ETF and like I say, is the most developed both in terms of trading volume supply. We also think it is going to be the biggest driver of the asset class and I think it was 2019 or so. You know, they brought in a mechanism to say, okay, well, how many credits are outstanding, you know, on balance sheets or, you know, in circulation? And if that number exceeds a certain number and again, I'm not going to sort of go into the weeds of what the tons are, but 833 is the magic number, and we've got about 1500 in circulation at the moment. So they say, well, because we're above that 33, all of those new credits we were going to issue via auction next year, we're going to reduce that by 25% and if we're still above the 833 next, the year after that, we're going to reduce by another 25%. So there's this mechanism in place for them to really keep supply under control and obviously that is beneficial for the price of carbon because ideally, you know, they have targets, like I said, it's written in blood, you know, whether it's fit for 55, whatever sort of other European legislation is in place, you know, these governments and industries and therefore companies are mandated to hit these targets. And if they don't have the credits, not only do they have to stump up any shortfall of credits that they missed this year in next year's allocation. So it's not like you just wipe the slate clean. You've got to actually pay up for any sort of deficit that you've had in a sort of existing year. But you also get penalised to the tune of around €111 per tonne for a credit that you haven't submitted if you like. So, you know, these guys, you know, have to go out and source these things if there are too many in circulation. Like I said, there's this mechanism to reduce new issuance. And don't forget that governments are starting to earn, you know, serious revenue from these credits as well. Now, they do need to reinvest some of that money into sort of clean energy and those sort of projects, not all of it. So some of it, you know, they can obviously just put in the back pocket, but a lot of it's got to be reinvested. And this is going to be a very strong, regular sort of revenue source for governments. So they have no incentive to see the carbon price lower, whether it's from a revenue perspective or whether it's from an emissions change of behaviour perspective. So they're going to keep that supply demand dynamic finely balanced in their favour.

Bryce: [00:18:10] With a lot of commodity based ETFs. The way that you know, they're used in portfolios is often not that sort of cold, you know, buy and hold for 25 years. It's to kind of just get exposure to the price when it's right in the sort of cyclical sort of process. Yeah. How are you advising clients to think about this in a portfolio? Is it a long term growth play or is this something that you do kind of think coming in and out of as the market dynamics change? 

John: [00:18:40] It is interesting. I mean, understanding how people see this from the initial discussion. And then, you know, once you've had the discussion, how they see it maybe being used as has certainly evolved first cab off the rank you know people go well if I'm environmentally or ESG conscious, you know, this is for me. And then you sort of think, okay, well, it firmly sits in the alternatives bucket. Like you say, it is a commodity. It is not correlated very highly to much 0.3 to global equities and sort of single digits teens to Aussie equities and bonds. So as a genuine portfolio diversifier it can add value. So you don't need to care about global warming, the price of carbon, you just want something that's going to behave differently. And given the year we've had when everything's down and everything's kind of correlated to one, you know, carbon credits have been up. And like I say, that diversifier effect has been valuable. Yeah. You've also then got people who may not care about global warming or the price of carbon and they just think, you know, carbon today is X by 2035. I see it going up to, you know, two x, three x, whatever it may be. I'm just going to play that asset price, hopefully, you know, rise. And then you've got clients that maybe are ESG aware and they don't own oil and gas anywhere in their portfolio for those reasons, whereas something like this is correlated to oil and gas. So you kind of own something that will help your portfolio keep up. You know, like I say, over the course of this year with, you know, people who've been underweight energy have been hurt. This is a way of sort of negating that risk. And then again, you've got others who say, okay, well, look, I just own equities. Some of those equities going forward are going to really be hurt by an increasing price of carbon. And whether that's utilities, whether that's industrials, you know, whether that's transport companies or all the way down the food chain, supply chain. You know, this is a way for me to hedge that risk of an increasing price in carbon. So I think the way it can be used and the duration of its sort of use in a portfolio can honestly be, you know, quite variable. 

Alec: [00:20:45] You mentioned there that governments have an incentive to make sure that the supply of credits isn't so high that the price falls. And we saw in Europe in the mid 20 tens, I think the European system crashed in like 2013 and the price was pretty low for a while and it's come back since. But there is an argument that governments also have an incentive to not keep the price too high because they don't want to cripple industries. They want to create enough incentive to transition without handicapping them against other countries that maybe aren't charging as much or don't have a system at all. Yeah. So really it should trade within a range. You would expect that. Is that a fair assessment? 

John: [00:21:22] Yeah, look, I think so. Again, you know, there's no single price on carbon, which again also complicates things. And again, to go back to the European example, I mean, I spoke about that 833 number where you start seeing supply reduced. There's a flow, if you like, of 400. So if the credits in circulation drop below that, they will issue an extra 100 odd tonnes of credits into the market the next year. So you're right, in terms of that supply, there will be a band in terms of the price of carbon and the index we track in the ETF. You know, you've obviously got Europe as half of the weight. So the influence is large. You know what happens in the UK, you know the price of carbon and California's $13, the price of carbon in Europe's €88. So again, you've got a disparity there. And like you say, if New Zealand comes in, what's the price? How much does the price go up? So again, you sort of buy the price of carbon, but it's not a singular price. And even if Europe is possibly close to an equilibrium, then some of the others, as more become eligible for index inclusion or ETF inclusion, they may then have this kind of runway to kind of replicate what the European market has done over the last couple of years. And I mean, even with Europe, you read a lot of analyst forecasts and even sort of Bank of England, Bloomberg UN, all targets are somewhere around the 125, $150 mark. So even Europe potentially has a reasonable amount of upside there. 

Bryce: [00:22:57] Ten bucks for California. 

John: [00:22:59] For California, exactly. 

Alec: [00:23:00] And I guess that makes sense because there would be a group of companies that are €88 can wear the costs. And so there is an incentive to keep ratcheting that up slowly and slowly and slowly to get more companies to feel that pinch, I guess. Yeah, that makes sense. 

John: [00:23:15] Yeah. I mean, you're right. Politically, they can't let it escape too much because things will just grind to a halt. But I mean, even on the 88 number, like I said, if you can't source enough credits this year and you then get penalised to the tune of 111, you know your opportunity costs. It's cheaper for you to go and pay 200 than to actually still have to buy the credit and pay the fine. 

Alec: [00:23:39] Also the and €11 fine is on top of having to go and subsequently. Yeah. 

John: [00:23:45] Yeah yeah. If you miss your targets for this year, I think it's an April kind of calendar.

Alec: [00:23:49] The Europeans don't mess. 

John: [00:23:50] Around. Instead I and so yeah, I mean they not only say you still owe us the credits, but you pay the penalty as well. 

Alec: [00:23:57] It feels like there's like I don't know who would have the money to do this. I don't know what the total market cap of European carbon credits is, but it feels like there's an opportunity for a company like a company like BlackRock or someone to just cornered the market and just put them on their balance sheet and just make companies come hat in hand to that. 

John: [00:24:13] Yeah, I mean, look, I said I think, you know, regulators hopefully will adjust supply and demand based on that. But, you know, I think industry, those that can see the risk of a higher carbon price on their own business and it's obviously not necessarily on the investment side or asset management. But you know, like I said, they are buying these things and they are putting them on their balance sheets so they could be cornering the market themselves. So, you know, it doesn't need sort of outside, like I say, investment folk to be thinking like that. You know, they may just say, look, we're going to need these things in future and, you know, we're going to buy them whilst they're cheap because we kind of can see this supply deficit coming or we can see the price going up for various reasons as well. Is there a. 

Alec: [00:24:57] World where like because some of the world's major oil companies are in Europe, like Total in France and BP and, you know, like to they just hop on a plane and move across to the states.

John: [00:25:08] I mean, look, there's again, the. Risk of sort of offshoring some of these emissions. But again, the talk within Europe, you know, you almost going to have tariffs, if you like, to say, okay, well, your supply chain is based, you know, some way offshore. You're a really bad emitter. You're now importing these goods. You know, your carbon footprint on those goods is X. You're going to have to pay a tariff because you're importing emissions to Europe. 

Alec: [00:25:33] Yeah, that's the carbon border adjustment talk. 

John: [00:25:35] Absolutely. Yeah, yeah. Yeah. So, you know, it might work for a little while. Maybe you'll have these go up in New Haven somewhere around the world. 

Alec: [00:25:43] But it feels like Australia has that at the moment. Yeah. 

John: [00:25:47] Exactly. So I mean, you know, people will try and get cute and work around it, but ultimately the man on the street is demanding change. You know, politicians are being held to account. You know, people, you know, have legislation they need to to meet monetary penalties. You know, you can't run forever. Yeah, yeah, yeah. 

Bryce: [00:26:07] It is fascinating. So, John, we are running out of time. So just wanted to, I guess close out with you know, you've mentioned that growing industry as more and more markets mature, there's going to be more opportunity for into invest in this asset class from the mechanics of the ATF as an investor is this rebalance like when how do we get more markets into this ETF? 

John: [00:26:29] Yeah. 

Bryce: [00:26:30] Is that the plan? 

John: [00:26:31] It is. Look, index eligibility, like I said, is an ongoing review process as and when markets, you know, hit those criteria, they will become eligible. And, you know, we obviously don't have sort of timelines on that and the index providers separate from us. But, you know, I'm sure it will happen in terms of the mechanics of the actual ETF. You know, we just hold one year futures. And so we've been rolling forward to the December 23 contracts at the moment because December's where the liquidity is for whatever reason. But I mean, the liquidity in these futures markets is huge. And I think, you know, Europe again, traded about €650 billion last year alone. That's obviously much larger than some of the others. But again, I mean, they're a great little case study to sort of see, you know, the design of the system, what could other regions do. And again, just to sort of look at the UK, I mean, that almost replicates what's being done in Europe because they were part of that. So when they spin out, you know, it's kind of okay, well let's take our learnings and recommendations and we set that up for the UK and off we go. So again I think we'll see a lot more systems in place will potentially see, you know, voluntary turn to sort of mandatory as well. You know, where there is demand, there will be futures markets and those markets will become eligible to the index and the ETF and I'm sure we'll see some growth there. 

Bryce: [00:27:51] Which one does bring us to the end of the episode. The ETF ticker for those listening along that are interested in getting exposure to carbon credits. Is X CO2 listed on the ASX Australia's first? 

John: [00:28:05] Absolutely, yes. 

Bryce: [00:28:06] So check it out. A reminder though that we are not aware of your personal circumstances and all of this information is for education and entertainment purposes. Any advice is general advice only, certainly an asset class that is interesting, certainly playing a role in society. So yeah. Thank you for educating us today, John, and all the best with the future prospects of CO2. 

John: [00:28:31] Thanks very much for having me. It's been great. 

Bryce: [00:28:32] Thanks John.