KCCA: A buy on possible tightening of California emissions regulations (NYSEARCA:KCCA)

While analyzing the performance of one of my smaller portfolio diversifiers, the KraneShares Global Carbon ETF (KRBN), I noticed that the KraneShares California Carbon Allowance ETF (NYSERCA: KCCA), a subcomponent of KRBN, had been performing much better than KRBN (Figure 1).

Since my article on the KRBN, the KCCA has outperformed the flat performance of the KRBN by almost 20%. Why has KCCA been an outperformer? Should I consider adding KCCA to my portfolio?

Fund Overview

The KraneShares California Carbon Allowance ETF provides targeted exposure to the California Carbon Allowances (“CCA”) carbon allowance program.

California is a world leader in climate policy and the CEC’s cap and trade program began in 2012 and is implemented by the California Air Resources Board (“CARB”). The CEC covers approximately 80% of California’s greenhouse gas emissions. under current Under the regulations, California plans to reduce carbon levels to 60% of 1990 levels by 2030 and achieve carbon neutrality by 2045. To achieve this goal, California’s emissions cap is reduced by 4% per year.

The KCCA ETF has $262 million in net assets and charges an expense ratio of 0.81%.

Carbon credits as a portfolio diversifier

Before I delve into KCCA’s performance, let me brief readers on why carbon credits can be an attractive investment.

First, carbon credits are a new and rapidly growing market. IHS Markit, a market research firm, estimates that the world’s four largest carbon futures markets (USA, CCA, RGGI and UKA) traded more than $700 billion in 2022, making carbon credits one of the largest alternative investment asset classes (Figure 1).

However, carbon credit transactions are typically reserved for issuers and other regulated entities, so KraneShares ETFs are one of the few ways for retail investors to gain access to this market.

A second reason that carbon credits may be attractive is because they have historically shown low correlations with other asset classes such as stocks and bonds (Figure 2).

Therefore, an allocation to carbon credits can enhance overall portfolio returns through diversification.

Finally, for investors who have exposure to companies negatively affected by the tightening of carbon credit programs (ie heavy industrial companies), investing in carbon credits can act as a portfolio hedge.

Portfolio holdings

Figure 3 shows current holdings of the KCCA ETF. The KCCA ETF is a pure play on CCA futures, so your holdings are 100% invested in 2023 CCA futures with excess cash invested in Treasuries.

Returns

The KCCA ETF did not launch until late 2021, and since its inception, KCCA returns have been volatile. 2022 was a down year for KCCA, while returns so far in 2023 have been strong. Overall, this performance profile gives KCCA an average annual return of 9.0% from inception to July 31, 2023 (Figure 4).

Figure 5 shows the returns of the KRBN ETF for comparison. KRBN launched in 2020 and skyrocketed in 2021 with a 108.8% return. However, 2022 returns were weak and to date, through July 31, 2023, KRBN has underperformed KCCA (Figure 5).

What explains KCCA’s outperformance versus KRBN in recent months?

Getting back to the main point of this article, what explains 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 the four major carbon futures markets, namely the EUA, CCA, RGGI, and UKA (see chart below). Within the KRBN, EUA futures have the largest weight at 57%, while CCA has 24%.

The UEA is soft on the increase in renewable energy and the weakness of the European economy

US European futures have underperformed so far in 2023, mainly due to lower energy-related emissions in the European Union. According to the EMBER group of energy experts, EU energy emissions were 17% lower in the first half of 2023 compared to the same period in 2022, as Europe saw an increase in energy generation from from renewable sources such as hydro, wind and solar. In particular, hydropower rebounded in 2022 as the region recovered from a severe drought in 2022. For the first time, combined wind and solar power produced more EU electricity than fossil fuels in 2023 (Figure 6). Less power generation from fossil fuels will reduce demand for US credits/futures.

In addition, in Europe, the slowdown in industrial demand continued due to high energy prices and the disruptions caused by the war between Russia and Ukraine, which led to lower demand for carbon credits.

California seeks to toughen weather regulations

On the other hand, California CEC futures benefited from regulatory developments, as CARB is considering potentially reducing excess allowances outstanding (which account for around 5% of allowances outstanding), as well as implement a scoping study that targets 48% reductions in emissions below 1990 levels. By 2030, an increase from the current target of 40% (Figure 7).

Draft proposals are expected to be finalized by the end of this year, with changes to take effect in 2025, so some compliance entities may have been purchasing CCA credits/futures in anticipation of future shortfalls and/or or price increases.

The combination of weaker US markets coupled with a strong CCA market has led to KCCA significantly outperforming KRBN in recent months.

Weak European economy may weigh on EUA futures

Looking ahead, the European economy remains weak: the latest manufacturing PMI registered a contractionary level of 43.7 (Chart 8). This suggests that the strong industrial demand for US credits may remain weak in the coming quarters.

Therefore, for an investor who currently owns the KRBN ETF, it may make sense to reduce their stake in KRBN and allocate capital to the KCCA, to address possible weakness in US futures and take advantage of possible tightening of US climate policies. California.

Personally, I am looking to reduce my KRBN holdings by 25%, which will reduce my US exposure to 43% (0.75 x 57%). I will reallocate 25% to KCCA, which will bring my exposure to CCA up to 43% (25% + 0.75 x 24%).

Conclusion

The KraneShares California Carbon Allowance ETF provides targeted exposure to California CCA futures. CCA futures are expected to outperform US futures in the coming quarters as the European economy remains weak, negatively affecting US credit demand. On the other hand, the CEC stands to benefit as California looks to further tighten its emissions standards at the end of the year, which could increase the demand/price for CEC credits.

I rate the KCCA ETF as buy and I am personally looking to add the KCCA ETF to my portfolio to complement my current exposure to KRBN.