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While looking at the performance of one of my small portfolio diversification tools, the Kingray Global Carbon ETF (KRBN), I noticed that the Kingray California Carbon ETF (NYSE: KCCA), a subcomponent of KRBN, The performance is much better than KRBN (Figure 1).
Figure 1 – KCCA outperforms KBRN (Seeking Alpha)
Since my article on KRBN, KCCA has outperformed KRBN’s flat performance by almost 20%. Why is KCCA doing well? Should I consider adding KCCA to my portfolio?
Fund Overview
Jinrui California Carbon ETF provides targeted investment in the California Carbon Allowance (“CCA”) cap-and-trade carbon allowance program.
California is a global leader in climate policy, with the CCA cap-and-trade program launched in 2012 and administered by the California Air Resources Board (“CARB”). The CCA covers approximately 80 percent of California’s greenhouse gas emissions.undercurrent Under the regulations, California plans to reduce carbon levels to 60 percent of 1990 levels by 2030 and achieve carbon neutrality by 2045. To achieve this goal, California’s emissions cap is lowered by 4% per year.
The KCCA ETF has $262 million in net assets and an expense ratio of 0.81%.
Carbon credits as portfolio diversification
Before delving into KCCA’s performance, let me walk the reader through why carbon credits might be an attractive investment.
First, carbon credits are a novel and rapidly growing market. Market research firm IHS Markit estimates that the four major global carbon futures markets (EUA, CCA, RGGI and UKA) will trade over $700 billion by 2022, making carbon credits one of the largest alternative investment asset classes (Figure 1 ).
Figure 1 – Carbon credits are a fast-growing asset class (Kraneshares investor presentation)
However, trading in carbon credits is usually reserved for emitters and other regulated entities, so Jinrui’s ETF is one of the few ways retail investors can access that market.
A second reason why carbon credits may be attractive is that historically, carbon credits have had a low correlation with other asset classes such as stocks and bonds (Figure 2).
Figure 2 – Carbon credits can be used as a portfolio diversification tool (Kraneshares investor presentation)
Therefore, the allocation of carbon credits can enhance overall portfolio returns through diversification.
Finally, investing in carbon credits can serve as a portfolio hedge for investors in companies that have been negatively impacted by the tightening of carbon credit schemes (i.e. heavy industry companies).
Portfolio Holdings
Figure 3 shows the current holdings of the KCCA ETF. The KCCA ETF is purely a CCA future, so 100% of its holdings are invested in 2023 CCA futures, with excess cash invested in treasury bonds.
Figure 3 – KCCA Holdings (kraneshares.com)
return the goods
The KCCA ETF was only launched in late 2021, and KCCA’s returns have been erratic since its inception. 2022 has been a down year for KCCA, while 2023 returns have been strong so far. Overall, this rate of return gives KCCA an average annual return of 9.0% from inception through July 31, 2023 (Exhibit 4).
Figure 4 – KCCA Historical Returns (morningstar.com)
Figure 5 shows the returns of the KRBN ETF for comparison. KRBN was launched in 2020 and launched strongly in 2021 with a return of 108.8%. However, returns are weak in 2022, with KRBN underperforming KCCA through July 31, 2023 (Figure 5).
Figure 5 – KRBN historical returns (morningstar.com)
Why has KCCA outperformed KRBN over the past few months?
Getting back to the point of this article, how to explain KCCA’s recent outperformance relative to KRBN? Should investors consider adding KCCA as a supplement to their KRBN holdings?
First, we need to understand that the KBRN ETF invests in all four major carbon futures markets, namely EUA, CCA, RGGI and UKA (see chart below). In KRBN, EUA futures have the largest weight at 57%, compared to 24% for CCA.
Figure 5 – Allocation of KRBN in various carbon markets (Kraneshares investor presentation)
Renewable energy surge and European economic weakness lead to weak EUA
European EUA futures have underperformed so far in 2023, largely due to lower electricity-related emissions in the EU. According to energy think tank EMBER, EU electricity emissions fell by 17% in the first half of 2023 compared to the same period in 2022, thanks to increased electricity generation from renewable sources such as hydro, wind and solar in Europe. In particular, hydropower rebounds in 2022 as the region recovers from a severe drought in 2022. By 2023, combined wind and solar power generation exceeds fossil fuel power generation for the first time (Figure 6). Declining fossil fuel generation will reduce demand for EUA credits/futures.
Figure 6 – Wind and solar displacing fossil fuels (ember-climate.org)
Additionally, European industrial demand continues to slow due to high energy prices and disruptions from the Russia/Ukraine war, resulting in reduced demand for carbon credits.
California wants to tighten climate rules
California CCA futures, on the other hand, benefit from regulatory developments as CARB is considering reducing excess allowances in circulation (approximately 5% of circulating allowances) and implementing a scoping study with the goal of reducing emissions by 48% so that It is below the 1990 level by 2030, an increase from the current 40% target (Figure 7).
Figure 7 – CARB wants to tighten emissions to 48% below 1990 levels (CARB)
The draft proposal is expected to be finalized by the end of this year, with the changes set to take effect in 2025, so some compliant entities may already have purchased CCA credits/futures in anticipation of future deficits and/or price increases.
The combination of a weak EUA market and a strong CCA market has resulted in KCCA significantly outperforming KRBN over the past few months.
European economic weakness could weigh on EUA futures
Looking ahead, the European economy remains weak, with the latest manufacturing PMI showing a contractionary 43.7 (Figure 8). This suggests that heavy industry demand for EUA credits may continue to be weak in the coming quarters.
Figure 8 – European economies remain weak, weighing on EUA demand (tradingeconomics.com)
Therefore, it may make sense for investors currently holding KRBN ETFs to reduce their KRBN holdings and deploy capital to KCCA to address potential weakness in EUA futures and take advantage of possible tightening of climate policy in California .
Personally, I would like to reduce my KRBN holdings by 25%, which would bring my EUA exposure down to 43% (0.75 x 57%). I would reallocate 25% to KCCA, which would bring my CCA exposure to 43% (25% + 0.75 x 24%).
in conclusion
The KraneShares California Carbon ETF provides directed exposure to California CCA futures. CCA futures are expected to outperform EUA futures in the coming quarters as the European economy continues to weaken, negatively impacting EUA credit demand. CCA, on the other hand, could benefit as California looks to further tighten its emissions standards towards the end of the year, potentially increasing demand/price for CCA credits.
I rate the KCCA ETF an a purchase I’m personally looking to add the KCCA ETF to my portfolio to supplement my existing KRBN exposure.
