The path to net zero: Investing in carbon markets

In this episode of the Future of Asia Podcast, senior partners and leaders Oliver Tonby and Badrinath Ramanathan join Adeline Aw, vice president of Environmental Sustainability at Singapore’s Economic Development Board (EDB), and Thongchie Shang, managing director of Enterprise Strategy at GIC, to discuss some of the insights in the recent joint report by GIC, EDB, and McKinsey, Putting carbon markets to work on the path to net zero. An edited version of their conversation follows. For more conversations on the Future of Asia, subscribe to our podcast.

Oliver Tonby: Hello, I am Oliver Tonby. Welcome to the Future of Asia Podcast series. The Asian century has begun. Asia is the world’s largest regional economy. It’s at the center of the technology revolution. It’s at the center of consumption growth and consumers of the future. It’s at the center of climate risk and what we need to do to mitigate it. As our economies evolve further, Asia has the potential to fuel and shape the next normal. In each episode, we are going to feature conversations with leaders from across the region to discuss what Asia’s rise means for businesses everywhere.

Today’s topic is investing in carbon markets, and I am joined by three distinguished panelists: Adeline Aw is the vice president of environmental sustainability at the EDB, Thongchie Shang is the managing director of enterprise strategy at GIC, and Badri Ramanathan is a senior partner at McKinsey.

All three of our panelists today are authors of a newly released report called Putting carbon markets to work on the path to net zero. Let’s just understand a little bit about who you are before we get into the content. Let me ask each of you: we’ve now been through one and a half, maybe two years, of COVID-19. What are some of the learnings, personal or professional, that you’ve had during that period?

Thongchie Shang: On the personal side, I’ve learned that my daughters are delightful when they are playing well with each other. I have a seven-year-old and a five-year-old. And during COVID-19 and the work-from-home and home-based learning, I’ve had much more exposure to that, but they are terrible when they’re fighting with each other and I’m on a Zoom call with my boss and the management committee.

On the professional side, I think I’ve really learned about the importance of overcommunicating to my team, to my stakeholders, with the people I work with. Because they can’t really pick up on some of the subtle cues that we are all used to in meetings. And you can’t really stand up and whiteboard a solution anymore. So it’s really about being a lot more prepared and a lot more deliberate in communicating the points.

Oliver Tonby: Excellent. Thank you, Thongchie. Adeline?

Adeline Aw: Thanks, Oliver. Through the last couple of years, I really learned how adaptive, how innovative, and how resilient we can all be in the middle of a real-life crisis. And that really came through both professionally and personally for me. Professionally, we had to do many things at the EDB that we were not used to doing, including helping the industry tide over a period of crisis, dealing with the situation, both in their companies themselves and with their employees at the EDB.

On the personal side, I think it’s about finding new ways of interacting with family and friends in the “new normal,” as everyone likes to call it. It’s something that took some getting used to. But I think we’re now in that new groove, and people are kind of getting used to it. So that’s really something that I learned through this entire experience.

Oliver Tonby: Indeed, indeed. Very hectic times. Badri, last but not least, what are your reflections on the last year or two?

Badrinath Ramanathan: Sure, Oliver. It’s of course been quite a difficult time, but to focus on the positive, I think what was brought home to me is, sometimes a constraint can really open up opportunities, right? We kept talking about how digitalization might take a while to make progress, and customers may not adopt certain things. And suddenly, when they had no choice, things [started] growing by leaps and bounds. So sometimes constraints can lead to progress. And I just look at the positive and what can we do to make the world a better place.

Oliver Tonby: Superb. Thank you all. Let’s dig into some of the content now. All three of you are core authors of this report that you have just released on carbon markets and how they can help us on the path to net zero. Let’s start with the basics first. Adeline, let me ask you, what are carbon markets?

Adeline Aw: We’re really in the middle of a low-carbon transition right now. And what’s really important is to help finance and bring to life projects that can help us to remove and to avoid carbon emissions. And that’s what carbon markets are for.

In the compliance space, carbon markets are where you have an instrument called a carbon allowance, or an offset, that’s used to meet regulatory requirements to decarbonize. And they are important because they place a price on carbon, which can then influence business actions to decarbonize.

In the voluntary-market space, on the other hand, that’s where carbon credits are used on a voluntary basis, and they are not for meeting regulatory requirements. They allow corporates to meet their corporate-finance commitments and drive investment in carbon-avoidance and -removal projects toward their goal.

Oliver Tonby: Exactly. And we’re going to come back to this, the difference between voluntary and compliance markets, in a second. But I want to go to Thongchie first. Why is this important, Thongchie, to have carbon markets? A carbon market doesn’t remove more CO₂. So why is this important?

Thongchie Shang: Thanks, Oliver. I think it’s super important and very interesting for us because it really puts a price on what economists call an externality. Like Adeline said, it puts a price on carbon. Before the advent of carbon markets, you had carbon being an unpriced byproduct of industrial processes. People didn’t even think about how much carbon was spewing into the atmosphere from their corporate and personal activities. And because we are working in a market society and a capitalist system, that kind of byproduct was not factored into the decisions of companies or regulators or individuals.

But with carbon markets, for the first time you have a price, an explicit cost, that decision makers in companies and individuals will have to take into account, because they are compelled to pay for this price in the compliance markets. And there is a willingness to pay for them in the voluntary space.

So for the first time, you can actually do things like think about the economics of conservation and the preservation of forests, as an example. Historically, it’s been very hard to get good economics and, to put it bluntly, a profitable business model from preserving forests or mangrove swamps or planting trees. It’s a public good. It requires taxpayers’ money to be pumped into it. It’s historically been the province of governments and public policy. But with a carbon price and a carbon market, you can have a mechanism where the companies and foundations and entities that are doing preservation activity and planting trees are being able to monetize the benefits of storing carbon and of capturing carbon. And that gets traded in the market and incentivizes private investors and private companies to allocate capital to what is an activity that will be beneficial for climate change.

So it’s really exciting because it harnesses the power of market prices and market signals for the good of the planet and for the fight against climate change.

Oliver Tonby: How is that price set? Thongchie, let’s stay with you for a second here. How does the price setting happen?

Thongchie Shang: It happens slightly differently in the compliance markets and in the voluntary market. Take the compliance markets, which I think is the most straightforward example. Here, the regulator gets involved. The first step is that the government or the regulator sets a cap on the total amount of carbon emissions that companies can emit. And this has been happening in real life—in the European Union for about 20 years now. So companies that emit more carbon than the regulatory cap have to buy additional carbon allowances—otherwise they’re in violation of the law and they get penalized. And companies that emit less than the cap can sell [the allowances].

So now you have these two sets of companies, those that emit more and those that emit less, having to trade with each other through intermediaries to be able to balance out their carbon emissions so that they meet the regulatory cap. And companies that want to buy the allowances have to pay an explicit price to the companies that sell them.

And what is that price that the companies will have to pay? Well, that depends on the opportunity-cost rate, the next best alternative, which is to reduce output; and therefore, the carbon price is equivalent to the foregone output and value to that company. Or they have to invest in carbon-abatement technologies, like carbon capture and storage or some other low-carbon industrial processes. And that price therefore gets set according to the marginal cost of reducing carbon.

So, economically, it’s pretty efficient. It’s almost a textbook case of how you would price an externality to get companies to internalize the cost of carbon in their corporate decision making.

Oliver Tonby: Perfect. Thank you, Thongchie. I’m now going to you, Badri. We’ve now heard the terms compliance carbon markets and voluntary carbon markets a few times. What’s the difference between the two? And is there any difference in the growth and the popularity of these two different mechanisms?

Badrinath Ramanathan: Sure, Oliver. So, as Thongchie said, compliance covered markets [CCMs] are driven almost entirely by regulatory actions. This has been happening for over 20 years. Now, they’re not yet huge, but they are sizable already. So we are talking about a market value of about $100 billion worldwide, with the sort of trading turnover of about $250 billion. So these markets are becoming sizable, and they are driven entirely by regulatory actions. This is not one market; there are more than 20 such markets around the world, and we expect 20 more to come online soon, including recently China brought one of the emissions trading schemes online.

So this space will develop. Now, just to contrast this with the voluntary carbon markets, these are still nascent and small. The total value of these markets is about $300 million today—a fraction of the size of the CCMs, if you will. But they’ve been growing rapidly—at least 20 percent a year for the last two years. And we do expect that voluntary carbon markets will continue to grow and will become as important as CCMs. And this is a good thing because it gives more avenues for folks to participate in the global carbon market and to mitigate the emissions that are not abatable immediately.

Oliver Tonby: You say there are more than 20 markets in place already. What are some of the leading ones, and what are the learnings that we have from there?

Badrinath Ramanathan: There are two large ones in the US: one in California and another on the East Coast. The European Union is actually one of the earliest ones in operation, and [there are] a few smaller ones in New Zealand. And, like I said, China.

I don’t want to give the impression that this is one smooth market, operating sort of in a connected way; these are all quite different, and the prices can be quite different across [them]. But, of course, the regulators do compare notes, and they do look at each other and try to chart a way forward, which might end up synchronizing these. The mechanisms are also quite different. Some are an open-auction kind of mechanism. Others simply are allocated a certain amount of credits, and then you go and trade them.

So what I’m trying to paint is a picture of variety, but then I think this is actually a good thing, because through this, we will actually discover the most efficient mode of this market. As the years go by, we’ll settle on something, which can scale much more.

Thongchie Shang: Just to add to that, Badri—I think [the individual markets] are not just diverse across the different compliance carbon markets but also evolving over time. Just to take the largest single one today, in the European Union, that is also one of the oldest—like I mentioned earlier, it’s been in existence for about 20 years. The European Emissions Trading System [ETS] today is quite different from the one ten years ago or 20 years ago. I mean, it’s the same, but the details of the regulations and the market mechanisms have evolved as policy makers and market participants have learned over time.

To give you a specific example: two or three years ago, the European Union introduced a Market Stability Reserve [MSR] to be able to more directly control the amount of excess supply or short supply in the market. And that’s allowed them a more direct lever to influence the trajectory of carbon prices in the market for a long time, until about four or five years ago. If you look at the historical price charts, the price of carbon in the European ETS has been pretty low, and that has been widely seen to be not as effective in inducing corporate actions to fight climate change and to abate carbon emissions.

But recently, with the MSR mechanism, the regulators have been able to put the EU on a path of increasingly lower carbon emissions more directly, and that’s resulted in an increasing price. The price of emissions is increasing from about 30 euros 12 months ago to over 60 euros now. So that’s one mechanism, just the most visible one on price.

The other dimension is around the coverage. I think regulators are learning that it’s not just about the headline price, the coverage of how many sectors. What percentage of the economy’s total emissions is covered by the emissions trading regime is also important. Here, I think regulators are quite rightly trying to expand them over time. You see the EU doing that, you see China starting small, with only the power-generation sector, but with explicit plans to expand it to chemicals and steel and so on.

Oliver Tonby: Thank you. I want to go to you, Adeline. This sounds fascinating. From a government point of view, why and how do governments around the world think about these carbon markets? And I know that Singapore is at the forefront on many, many dimensions. How do governments think about this?

Adeline Aw: Well, in Singapore, we don’t really have an emissions trading system. What we have is a simple carbon tax regime. And when we were starting out with our climate measures, where we were coming from was to look for a simple and effective system that could provide a clear price signal to businesses to decarbonize and [start] small. But we did say we were going to review the system as the years go by and, in fact, we are right now reviewing the trajectory as well as the level of the carbon price.

But from a government perspective, there are many factors to take into account. One, of course, is the incentive for businesses to decarbonize. Thongchie and Badri have spoken about [this], but the other, of course, is the effect on other important dimensions, including economic competitiveness and affordability of electricity, for example. [Affordability of electricity would affect] consumers from such measures applied to the power sector. So there are many different aspects. The question is how do we put in place the right policies and the measures that can encourage that transition to a low-carbon future while managing a lot of these other complex dimensions in the equation?

But going back to Asia, and Southeast Asia in particular, we see many countries in the region also stepping up action over recent years. And, in fact, some of the other Southeast Asian countries have announced that they are considering an emissions trading scheme. So I think that the transition is gaining momentum and that carbon markets will play an important role.

This is really on the compliance front, but on the voluntary space, we also see more corporates committing to climate action, and that’s great. It also means that they will need to look for avenues to address different types of emissions, including some of their residual, hard-to-abate emissions. And that’s where carbon markets and carbon credits have a big role to play, to offer a cost-effective and complementary way for corporates to decarbonize such emissions, in addition to other important abatement measures that they’re taking in the value chain. So there are strong drivers that I think will help to encourage the growth of these markets.

Oliver Tonby: Badri, I want to turn to you. You work with many institutional investors—you work with banks and the like around the region. How do they think about carbon markets?

Badrinath Ramanathan: For institutional investors, this is an increasingly important topic, and there are many facets to this. First of all, we make it clear—and I think most institutional investors would agree—that net zero should be the ultimate goal. And abatement is incredibly important. Within that context, there are several elements that are important.

First of all, global warming poses a risk to [institutional investors’] portfolios and to businesses. So the first step is to quantify that risk, to put a number on it, try to create scenarios, and so on. And there, carbon markets can actually play a significant role in helping to address the impact arising out of global warming. So if you just look at a normal 60-40 reference portfolio, which is globally diversified, allocating about half a percent to 1 percent of carbon allowances in such a portfolio can help mitigate the risk. And if you’ve done nothing, you perhaps would’ve lost 20 to 40 basis points of returns over a 30-year period.

Oliver Tonby: Sorry, Badri—just to understand what you’re saying. You’re saying that there’s risk from the energy transition, there’s risk for the returns of a portfolio. And that is an order of magnitude of 20 to 40 basis points. So that’s what you’re saying?

Badrinath Ramanathan: Yes.

Oliver Tonby: OK. And then you said that carbon markets can actually help mitigate some of that.

Badrinath Ramanathan: Exactly. Even a small allocation would help. Half a percent to 1 percent allocated to this asset class can help mitigate this risk. So that’s the first way of thinking about it, as a sort of potential hedge to climate risks.

The second way we look at it is, it’s an emerging-asset class in its own right, because the characteristics of returns, the sort of volatility patterns that are exhibited, are quite different from current asset classes. If you took the same 60-40 reference portfolio, which is expected to return, let’s say, 4 percent annually over the next 30 years, adding 5 percent carbon to the portfolio could generate returns of about 50 basis points annually. So this is actually quite meaningful improvement in the returns.

But I want to go back to the theme of abatement first and the goal really being net zero, because the idea is to use these markets to support abatement objectives and not use them as a way to profit; that cannot be the primary motive. Investors should make sure that they’re taking other actions, like direct investment in projects, supporting carbon-capture projects, working with the investee companies, helping them set decarbonization goals, and helping them focus along those. And only when all those actions have been taken, they could certainly look at carbon as an asset class and then look at the kind of effect it has as a part of hedging strategies.

Oliver Tonby: Thank you. I’m going to go back to Adeline for a second because I know, Adeline, you’ve also been looking at what are some of the sectors that are more affected and less affected by climate risks. Would you care to elaborate a little bit on that, and what are some of the sectors that should be even more interested in these markets?

Adeline Aw: If you look at the risks that climate change poses to business value, there are the different dimensions to think about. But one way is to think about where business value and business strategies are greatest and are most at risk, and, frankly, that’s really in the resource-intensive and the energy-intensive sectors. And so, in a way, we see that many of the leading companies in these sectors are taking action to think about how they can incorporate carbon-mitigation, carbon-abatement, measures into their business strategies. The international oil companies are thinking about how they can transform their businesses to adapt to a lower-carbon future. We see that as a growing trend, especially in recent years.

So I really think it’s important that investors also consider how they can play a role in enabling this transition in these sectors. And, in fact, maybe just to go back to the voluntary carbon markets, beyond investing in the secondary market, right now what we urgently need is to allot investment to build up the necessary expertise and infrastructure to scale the supply of high-quality compensation and neutralization projects.

Investors can play a more active role to capitalize on this development and facilitate that transition. This would include committing and purchasing carbon credits of high integrity to meet their own ESG [environmental, social, and governance] goals, investing directly in projects to help scale up the supply of high-quality credits, supporting the establishment of high-integrity standards in the voluntary carbon markets, and then guiding portfolio companies in their transition, in their journey, to net zero so that they make choices that are aligned with reinforcing the trust and the integrity of these global markets that’s necessary to ensure that we see a stable, successful, and continuous progress and transition in this journey.

Oliver Tonby: Got it. I want to shift to you, Thongchie. GIC is one of the largest institutional investors globally. We heard Badri saying the risk here from the energy transition is 20 to 40 basis points—carbon markets can help mitigate a significant part of that. How do you think about this? The opportunities here, but also, what are some of the risks involved?

Thongchie Shang: Indeed, Oliver. We look at carbon markets as a pretty exciting development because it’s one of the key mechanisms that help investors “do good” as well as “do well” at the same time. If you cast your mind back to ten or 15 years ago, when sustainable investing and ESG investing really started entering into investors’ consideration set, I think the initial reaction a decade ago was that, intuitively, there must be a trade-off between returns and impact, right? Because Finance 101 says that the efficient frontier for investors—if it’s as unconstrained as possible, if your investment universe is as wide as possible—then truly you can gain from diversification, which is the only free lunch, right?

That’s what Finance 101 that everyone studies in college tells you. But with carbon markets, it’s really a game changer in the sense that, as we said earlier, it prices an externality. It changes the economic calculus of firms to behave a certain way. And if you look at how carbon markets are evolving, they are essentially driven by government policy in the case of compliance markets or by corporate commitments to fight climate change in the case of voluntary markets. And as Badri pointed out, these things tend to have low correlation or even negative correlation with a standard portfolio: 60 percent stocks and 40 percent bonds.

Actually, carbon markets help us diversify even more risks that have been unpriced before. So in a way, it helps us expand our option set from an investment point of view. And from an impact point of view, it has a very positive outcome. I think we spoke about how it helps to facilitate the flow of capital into nature-based solutions or reforestation projects that would otherwise not be economical. So it’s really a mechanism to help us pursue both those objectives at the same time.

But, of course, I just want to highlight that investors really should not think about trading speculatively in carbon markets. When we look at the development of carbon markets, what strikes us are the parallels it has with the evolution of other commodity markets, whether it’s soybeans or pork bellies or natural gas. And in commodities markets like that, investors and financial institutions really have an important role in providing liquidity, aiding price discovery, matching supply and demand over time, being market makers. And these are typical functions that we see. Similar to commodity markets, we think carbon markets will evolve in pretty much the same way. So it’s about providing these value-added services rather than trading speculatively.

Oliver Tonby: And I guess for an investor like yourselves, you also would like the markets to have some depth, and that isn’t there just yet. Is that correct?

Thongchie Shang: Exactly, Oliver. We find it interesting, but, frankly, the markets are still at a very early stage of development, [especially] on the voluntary side. As Adeline pointed out, the quality issue is something that a lot of market participants all have to get together to try to solve collectively, even in compliance markets, which today are more developed and more liquid and more deep. There is still a lot to be done in terms of the coverage of the specific regulatory mechanisms. For example, China established its national one in July [last] year, and it’s early days yet. So we see more development and more growth ahead.

Adeline Aw: Yeah, I think Thongchie pointed it out earlier—that there’s a lot to do in supporting the development of the carbon markets, especially in the voluntary space. And we know Singapore is making efforts to scale a well-functioning carbon market and working with like-minded partners in this journey. For example, we are actively participating in negotiations on Article 6 in the lead-up to and at COP26,¹The COP26 Climate Change Conference was held in Glasgow, Scotland, between October 31 and November 13, 2021. and this will help to set rules, we hope, on market and nonmarket cooperation between countries under the Paris Agreement.

We are also working with the World Bank and IETA, the International Emissions Trading Association, to progress the climate warehouse initiative. And that seeks to connect disparate systems, different registries, to enhance the transparency and credibility of the carbon market and address double counting.

We’re also participating in globally leading initiatives. Here, there is space for investors as well to help shape some of this, especially in private sector–led initiatives, to provide guidance to the market on the use of high-quality carbon credits.

And finally, we are also supporting efforts to build the necessary market infrastructure for a high-quality, efficient, and transparent carbon market. We recently had a public–private partnership to develop Climate Impact X, which is a platform for the voluntary trading of high-quality carbon credits. And that’s to be launched soon.

So I think through all these efforts, we see that it’s important for both public, private, as well as nongovernmental, nonprofit, stakeholders to come together to ensure that we can grow and scale the carbon markets in a way that still continues to support and is aligned with our efforts to make a successful transition.

Oliver Tonby: Adeline, I loved hearing what you just said about what you’re doing. Some of the things that you are doing and that Singapore is doing—can you talk about what is happening a little bit more broadly in Asia, and the relevance of this for Asia?

Adeline Aw: Asia and Southeast Asia can play a key role to enable global sustainability, because we are a middle of a region that has a great source of natural assets and resources that can help us with decarbonization. Southeast Asia can be a source of credible and high-quality carbon credits because of our potential here as a carbon sink. We have almost 15 percent of the world’s tropical forests and we contain the world’s highest concentration of blue carbon stocks. We also hold the highest potential for added key biodiversity co-benefits, particularly in countries like Malaysia, Thailand, Cambodia, and others in the region.

So there is a real potential for decarbonization that can be unlocked with the right investments and the right emphasis on quality. There is also a great opportunity to build out greater corporate capacity to navigate climate change. If investors can think about how they can work with their portfolio companies in the region to build up that capacity and build up the ability to make a successful transition, that will also help to contribute to global decarbonization. So for all these reasons, Asia is where I see great potential and great opportunities for partnership and solutions.

Oliver Tonby: Wonderful. Listen, we’re going to round out now. I’m not going to try to summarize everything I’ve heard. It has been a fascinating conversation. I just want a couple of snippets. Number one, I heard Adeline say we are Asia, we’re in the right region. I heard Thongchie say there’s an opportunity here to both do good and do well at the same time. We heard Badri say the risk returns here mitigate 20 to 40 basis points. So, very rich conversations, clearly a very interesting opportunity for many companies, many individuals.

I want to end by asking each of you the same question. If you put yourself in the shoes of the senior executives who are listening to this podcast, what advice would you have for them as they think about carbon markets? Let’s start with you, Badri.

Badrinath Ramanathan: If I were in the shoes of a senior executive, I would be very excited because now there’s an additional tool. There’s an emerging-asset class, which is very interesting in its characteristics and how it plays an important role in a traditional portfolio, and this now allows me to do more with my portfolio.

But I think the most important thing to keep in mind is environmental integrity. I think the objective has to be net zero and to move the world forward on this dimension, and therefore this becomes a way to play a role in furthering this objective, not just for myself but also for my investee companies. So I would be very excited because of that.

Oliver Tonby: Thank you. Adeline, what advice would you have?

Adeline Aw: I would say start building the expertise and the understanding now of carbon markets. It’s a really technical space and it’s not one that I think many outside of the space understand. So it’s important to start thinking about what corporate capabilities you would need internally to shape your agenda and have an effective strategy to address both the risks as well as the opportunities.

Oliver Tonby: Well said. Thongchie?

Thongchie Shang: I would say that the climate imperative is real. We all have to think of ways to make our businesses and our portfolios more climate resilient. And carbon markets are not the only solution, but they will be an increasingly important part of the tool kit.

Oliver Tonby: Thank you. Listen, you have been three wonderful panelists. Thank you so much. And to all the listeners, thanks for tuning in, and you have heard a very interesting conversation about how we can use carbon markets on the path to net zero. Have a wonderful rest of the day, everyone. And again, thank you to our three panelists. Take care.

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