Institutional Investment in the EU ETS

This general review paper explores the role of institutional investment in EU ETS. We do so by addressing seven questions sequentially, namely: (1) How does the EU ETS work? (2) What drives the value of carbon? (3) What potential diversification benefits arise from investing in carbon? (4) How does investing in carbon sit with investors’ fiduciary responsibilities? (5) How can institutional investors gain exposure to carbon? (6) What unconventional risks does investing in carbon entail? (7) What will happen to the carbon markets post-2012, once the Kyoto protocol expires? From this discussion, it is evident that carbon markets generally and EU ETS specifically are, from an institutional investing perspective, a paradox.

Recent years have seen increased market sophistication (trading efficiency) and it is evident that there are potential diversification benefits from investment in carbon and that investing in carbon can be consistent with fiduciary duties. Despite this, there is little institutional involvement in EU ETS due to the unconventional risks that come with investing in carbon allowances, derivates, and funds. In terms of these unconventional risks, the VAT carousel fraud and the theft of allowances in 2011 are relatively minor issues when placed against the absence of a clear post-Kyoto agreement.

We conclude that if robust growth in climate change–related investing is to continue beyond 2012, more needs to be achieved in order to adequately address the climate investment gap. Legislation incorporating a fiduciary obligation for institutional investors to take into account the social costs of investment as well as private returns would begin to pave the way.

Diaz-Rainey, I., A. Finegan, G. Ibikunle, and DJ Tulloch