We’re taking a trip across the pond to London in this episode and diving into the carbon markets and emissions trading with Michael Azlen, CEO and founder of Carbon Cap Fund and Management. Whether you care about making money off trending carbon emission prices, or saving the planet,  or both… Mike has become a leading voice for educating and explaining the role carbon emission credits and the emerging carbon futures markets play.

In this episode, Mike breaks down the complex carbon concepts and answers some critical questions, like how do you trade carbon credits? What is an emissions trading system? Why is Europe the big player in this game? And he even gives us his hottest take in the market right now — we’ll give you a slight hint, it involves climate change.

Highlights from this week’s episode include:

• The evolution of the U.S. and European Carbon Market
• Identifying and clarifying the difference between the voluntary carbon market and the compliance or regulated carbon markets (where Carbon Cap invests)
• How to think about a market that is structurally designed to increase in price
• Understanding how this market functions as a policy tool
• A closer look into Europe’s carbon border adjustment mechanism
• And, how a hedge fund can make money and save the planet simultaneously — you’ll want to tune in for these details and more!

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Find the full episode links for The Derivative below:

Apple
Spotify

 

Additional resources discussed in this podcast:

• Purchase Breaking Boundaries: The Science Behind Our Planet by Johan Rockstrom here
• View Climate Change Analysis in the Investment Process here
• View World Carbon Fund — Generating Absolute Returns From Global Carbon Markets here
• Visit Carbon Cap Management’s Website here
• Read Mike Azlen’s bio here and follow him on Twitter here

 

Check out the complete Transcript from this weeks podcast below:

 

Emissions Trading and Carbon Allowance Futures with Michael Azlen

Jeff Malec  00:06

Happy early MLK weekend everyone. Hope you get next Monday off and go get outside. This episode’s brought to you by RCM X execution algorithm specialists. We’ll be talking carbon markets here in a minute. And what do you do when you have 1000 Carbon contracts execute, or corn or crude or cotton, and there’s only a few 100 offer, you either spike prices higher and get a bad fill, or use advanced execution algorithms like they built at our cm x, which is anti gaming logic and historical volume profiles to place trades more intelligently based on what and when the market can handle. It’s also just way cooler to buy with an algo called Prowler than buying with a limit order Come on. To learn more, visit www dot RCM dash x.com That’s RC M dash x.com. Okay, onto today’s episode and the engaging Michael Aslin. Michael has been a lecturer at the London Business School for more than 15 years. And you’ll see why in a second here with him able to break down these complex concepts rather simply for yours truly, like we’re sitting there in a London classroom. Michael’s the founder and CEO portfolio manager of the carbon cap fund and carbon cap management, which did quite well last year past performance not necessarily indicative of future results. But just how exactly do you trade carbon credits? What is an emissions trading system? Why is Europe the big player in this game? We get into all that in more send it Welcome to the derivative by our Sam alternatives, where we dive into what makes alternative investments go analyze the strategies of unique hedge fund managers and chat with interesting guests from across the investment world. Okay, we’re here with Mike Aslin, founder and CEO of carbon camp. Joining us today from the UK. Welcome, Mike. Where are you at? Exactly.

 

Mike Azlen  02:01

I’m in London in the United Kingdom. Alright.

 

Jeff Malec  02:05

Whereabouts in London. Proper.

 

Mike Azlen  02:08

Yeah, in in central London, there’s a neighborhood called delish. And that’s where we are. It’s a green spot in South London. And thank you very much for the invitation to come on the show today.

 

Jeff Malec  02:21

I appreciate it. Thanks for joining us, I haven’t been back to London since the pandemic, but hopefully we can get through this thing and come visit. Great. Um, so we’re here to talk carbon markets and emissions trading, you’ve become one of the premier voices out there educating and explaining how all this works. So I’d like to start if you can and just sort of start at the top and lay out the basics for what Emissions Trading is and what we’re going to do.

 

Mike Azlen  02:47

Great. So I guess the first place to start is the big picture on climate change. And in 2018, after selling my previous company, I had a bit of a sabbatical. And one of the things I wanted to investigate what was the science of climate change, I enrolled in a very high level program at the London School of Economics. And in that program, one of the things we studied was all of the different solutions that governments have tried to try and bend the curve of emissions downwards. And when you do look at that almost nothing actually has worked to lower carbon emissions. But the one thing that has had effectiveness has been when you put a price on emitting carbon dioxide and, and really the history of this goes back to the sulfur dioxide program in the United States. Under the Bush administration, they had a cap and trade program on sulfur dioxide, it was extremely successful, both at lowering the emissions dramatically. But secondly, it did it at extremely low cost in terms of the infrastructure and the administration around that program. And that success really set the stage for the carbon market being launched in Europe in 2005.

 

Jeff Malec  04:02

And the sulfur dioxide we’re talking like acid rain and that kind of stuff.

 

Mike Azlen  04:07

That’s correct. It was acid rain that they were trying to, to you know eliminate. And the the cap and trade program on sulfur dioxide emissions. It was applied across around 3200 coal burning electric utility outposts across the United States. And it was really, really successful.

 

Jeff Malec  04:26

And so I was gonna ask this later, but we’re touching on it now. So it feels like the US sort of fell off a bit after that. And Europe took the baton. Why? Why is that?

 

Mike Azlen  04:35

Yeah, there are many, many reasons for that. Jeff, it’s really unfortunate because a carbon market is really a market based solution to address climate change. And of course, the US really pioneered it so it’s a shame that there isn’t a national carbon market but in the US you probably know there is a very successful carbon market in the state of California and on the east coast of the US there are 11 states together that have formed the Reggie carbon market. That markets been expanding with New Jersey. Recently rejoining Pennsylvania scheduled to join next month. So the markets are growing nicely.

 

Jeff Malec  05:16

And that Reggie’s that are JGI that I read about. That’s correct. Yeah. Much easier to pronounce Reggie. Thank you. Um, so back up one step, and what exactly is being traded? Who’s doing the trading? And like the polluters versus the non polluters? How does that how does all those machinations work?

 

Mike Azlen  05:37

Great. I mean, it might be helpful for me to share my screen is that without any help. So the first thing is I wanted to identify and clarify the difference between the voluntary carbon market and the compliance or regulated carbon markets where, which is where we invest, the voluntary market is for many people, it’s the market they’re most familiar with. That’s where on a website, you can buy some carbon credits or carbon offsets, you might be able to click and offset emissions for a flight. And that voluntary market is as they say, it’s voluntary. So it’s run as a for profit activity by companies who pick a project. And the most common project is to plant trees, trees grow, and they suck in carbon dioxide, and they emit oxygen, which is wonderful. And indeed, our force on the planet, our carbon, massive carbon sink, as well as the ocean. So the voluntary carbon market is project related. But it’s still really in its infancy. And it really needs additional sort of upgrades in terms of the quality of how those projects are monitored, verified, and reported in terms of what carbon is actually sequestered in those projects. I always like to

 

Jeff Malec  06:54

say, and someone in like Saskatchewan, or something’s like, Hey, pay me some money, and I’ll plant these trees. So it’s for profit for them. Right? The people purchasing voluntary, it’s, it’s an expense. It’s not a profit. Yeah.

 

Mike Azlen  07:06

Correct. Yes, but But the ecosystem behind it is a for profit activity. There’s nothing wrong with that. Yeah, it does introduce that element of moral hazard. So, you know, I like there are five key characteristics about the voluntary market. And it’s just where the market is today. The first thing is to say it’s broadly unregulated, so that that is just an issue to be aware of. The second is its illiquid. Thirdly, it’s, it’s quite small in size, the total market last year was $300 million in carbon credits, or offsets. Now, if you compare that to the regulated carbon market last year, that was 300 billion. So there’s a 1000 times difference in size between these two carbon markets. The fourth point is it’s very opaque on the pricing in the voluntary market. And the final point is that the supply of these credits at offsets is virtually unlimited. So they just bring more projects. Now, if we switch the lens over to the regulated carbon markets, and we apply those same five key points. First of all, they’re run by government. So the markets are highly regulated. Secondly, they’re very liquid. So these markets are trading between three and $5 billion daily, there’s exchange listed futures, exchange listed options, the size of the market, I mentioned 300 billion. So it’s very big, it’s very transparent. And the fifth and key point is the supply of carbon in these regulated markets is kept. And every year that supply is reduced. And so very important that the listeners understand that these are two very, very different carbon markets.

 

Jeff Malec  08:52

And just real quick on that the and then I want to get to a little graphic like so you to one of my favorite bands UK group there for you. So they’re doing their tour, they’re saying we’re purchasing carbon credits. That’s voluntary, but you’re saying who who knows how much and if they’re really doing that correctly? And it’s sort of very opaque, like, what would that cost them? Yes, dollars, hundreds of 1000s of dollars.

 

Mike Azlen  09:16

So the the price of carbon credits at offsets in the vault voluntary market can range from as low as 25 cents per tonne to as high as $600 per ton for a very high quality Carbon Project. And there’s everything in between, but probably a, you know, an average price today is seven to $10 per tonne for most projects. And, you know, I think the key thing for me is when you understand, take a step back and say, you know, where are we on climate change? We’re currently the, you know, you look at the concentration of co2 in the atmosphere at 415 parts per million, which is increased by 50%. Really in the last 50 years. During the Industrial Revolution, we’ve warmed the planet already by about 1.1 degrees. From pre industrial times, of course, the Paris Agreement has set an aspirational temperature threshold at 1.5 degrees, or two. So globally, we’re emitting now 40 billion tonnes a year about 150 million tons every day, and that those emissions are impacting continue to impact temperature. So at our current run rate, we have eight years of run rate emissions before we will breach the 1.5 threshold. And of course, when we as we raise the temperature, the planet itself begins to turn from a net sequestering of carbon to a net emitter of carbon. I won’t go into that now, but but certainly that is why those 1.5 and two degree thresholds are, are very, very important indeed. So you know, my issue on the voluntary market is, if you burn coal, oil or gas and you emit carbon dioxide, it’s in the atmosphere for about 1000 years. So it has a very long Half Life 1000 about a 1000 year. So if you then plant a forest and the forest sucks in carbon, of course, as long as the trees don’t burn down, or if the trees aren’t blown down in a in a windstorm, or, indeed, if someone doesn’t just come along 10 or 20 years later and cut them down. Right. As long as that doesn’t happen, those trees will sequester carbon. But eventually, at 90 years, the trees will die. When they die, they fall over the decompose and the carbon is is released. So let’s say, you know, optimistically, 150 year cycle with a forest or trees, so you emit carbon for 1000 years, you buy a tree based carbon offset, and you claim Net Zero. Yeah, that’s the issue. This is not net zero. And I think we really need to, to really think carefully about this. And corporate claims of net zero and how they will achieve them are very, very important. I think this was

 

Jeff Malec  12:08

more like, net 10%. Net 1/10, right? Yes. Bristlecone pines, we used to belong to a golf course named Bristlecone pines. Those live up were about 1000 years I think. So back to the your graphic here and who’s who’s doing this and how it actually works versus the excess units first, the need those who need to purchase units. Yeah.

 

Mike Azlen  12:38

So when you when you understand how this market functions as a policy tool, it’s really fascinating. And I think it’s a it’s an amazing, amazing policy tool to address climate change at scale, and it’s market based. So there’s two ways to put price on carbon, you can put a carbon tax, which I don’t like. Or you could have a cap and trade system where we control the quantity of emissions and we let the market we let the market sort out the price. So here’s how it works. So I’ll use Europe as an example. But California is in Reggio the carbon markets in the United States are exactly the same. It’s a regulated system run by governments. And it’s mandatory inclusion. So so any, any factory that emits more than 25,000 metric tons. So this is a big amount of emissions. Any big emitter is included in the program by law. So it’s mandatory. Once you’re in the program, you are audited by the government every year, and you must give the government allowance permits that match your emission. So if last year your factory admitted a million tonnes, that means by April of this year, you must give the government 1 million certificates. How do you get them? Mainly the the the permits are sold at auctions. So in California, we have four big auctions every year. In Europe, we have an auction every single day. And each one of those permits that is sold allows you to emit one time

 

Jeff Malec  14:06

did I read? Sorry, real quick. I think I read in some of your materials one time is about equivalent to driving a car from LA to New York.

 

Mike Azlen  14:14

Yeah, I think that’s probably quite quite

 

Jeff Malec  14:18

some one a kind of visual or mental model of what these tonnes mean.

 

Mike Azlen  14:23

Yeah. So that that threshold of 25,000 tonnes, you can see that’s quite a large amount for one installation are one factory to omit. I mean, it’s

 

Jeff Malec  14:33

there per year, per year, per year or per year.

 

Mike Azlen  14:36

So that’s where they they set the threshold. And so they’re trying to capture the big emitters, which mainly are electric utilities, steel companies, cement companies and chemical companies. These are the four big, big emitters. Now that total supply that the government sells every year is kept. And every year they lower that supply, the amount that they sell each year is lowered in Europe by about 2.2% in your in California by about three and a half percent. So the way to visualize this because it’s hard for people to get this in their head is that in year one of the program, we sell, let’s say in California 300 million certificates. At the end of the year, we audit those companies. And if their emissions are 300 million tonnes, the companies must give back to the government those permits. Now they have complied, the government tears up the permits and destroys them, we then start year two of the program and the government then sells 270 million, and then the third year 252 40. So we bring the cap down, we’re playing musical chairs, and we’re pulling out a chair. So what we know with certainty, we know emissions are going down, because there’s less permits, they have to go down. What we don’t know is out of all those 1000s of companies, which company indeed will choose to lower their emissions. And that’s where the market the invisible hand of the market, and the price signal answers that question. And that’s how we get what we call least cost abatement. Because the carbon market has two goals. The first goal is to cap emissions and lower them. But the second goal of a carbon market is to achieve that first goal at the lowest cost to our society. And that second objective is very, very important. And that’s where liquidity and price discovery in a liquid carbon market plays such an important role in achieving that second objective,

 

Jeff Malec  16:36

and talk a bit about abatement. So we’re talking about, hey, we know you have to keep making plastics and concrete and steel. But this is we want to incent you to basically transition your equipment transition your stuff to be less emitting. That’s what we mean by abatement. And there’s those that have already done that are progressing. And those that haven’t. So explain that dynamic a little bit.

 

Mike Azlen  16:58

Yeah, so probably the most famous environmental economics graphic is this graphic here, which is the marginal abatement cost curve. And this is a stylistic example of in any industrial economy, we’ve got the price of carbon dioxide per tonne, the price per tonne on the y axis, and on the left axis, each box here represents a different industrial process. So making steel making cement making chemicals. Now, of course, some industrial processes when the carbon price hits $10 a tonne, the management team and the engineers in that business, they run their calculations, they say, Hey, at $10 a tonne, we can switch and make more money adopting this low carbon technology. So indeed, they switch once

 

Jeff Malec  17:45

by selling their certificates. Yeah, so So

 

Mike Azlen  17:47

either they don’t have to buy the certificates in the auction anymore. So they have that savings. Or if they’re in a position where they’re receiving an allocation from the government and some vulnerable businesses do get a free allocation, which falls every year, they would be able to sell those permits to fund that low carbon technology. But the key point here, Jeff, is that we climb this marginal abatement cost curve. So once we unlock the lowest hanging fruit, these this industry abates, we then move to the next hanging fruit and the next and the next. And this is crucial, because we’re lowering our emissions in California. But we have the confidence that we’re doing it at the lowest cost every time it comes down. It’s the low cost guy who abates. Now, you can only make that claim of least cost of Bateman, if you have two things, liquidity and price discovery in that carbon market itself. And that’s why that ecosystem having all these traders trading carbon, just indeed like in wheat, or in corn or an oil, we want to have a liquid market for this price discovery. I just I just wanted to mention two other advantages of a carbon market. Obviously capping and lowering emissions and and ensuring least cost abatement is one. But the other really interesting ones are the fact that a liquid carbon market provides companies the ability to hedge, a carbon permit does not expire. So you can buy today and use it in three or four years to meet your obligation with the government for your emissions four years from now. So you can you can use these permits to hedge your forward carbon obligation. It also provides a an ability for a piece of low carbon intellectual property and someone invents a better scrubber to scrub out co2. When they bring it to a venture capitalist. The VC will back that technology because they know there’s a pathway to monetization. There’s a pathway to attacks doesn’t do that, but a liquid carbon market provides it that’s very interesting. And and I think the final point is these auction revenue So in California, this is raising billions for the California treasury. In most carbon markets, the revenues from selling the permits are segregated. And they’re used to invest in energy efficiency and low carbon initiatives. So it really is kind of a virtuous program to address climate change. And I guess the proof is in the pudding in, you can see the numbers here. So by no means does a carbon market restrict GDP growth in any way. It’s a market based mechanism. So it really utilizes the power of the market, allocating those resources to both give you GDP growth and lowering emissions. And certainly in Europe, which is the longest running market emissions are down 1 billion metric tons per year since the program was started in 2005. So we’re in a world of 40 billion tonnes, 1 billion is moving the needle.

 

Jeff Malec  20:57

Yeah. And helped me understand if I’m, so if I’m a big polluter, why don’t I just okay, I’ve got to pay this cause it gets more expensive every year, because the spy, I just pass on those prices, right, concrete becomes more expensive, steel becomes more expensive. I pass those on to my customers, who cares? Um, what’s the answer to that? So

 

Mike Azlen  21:20

so the there’s a couple different answers, answers to that. The first is obviously we live in a global competitive marketplace. So you know, one of the things that now Europe is bringing in is a carbon border adjustment mechanism. So for instance, the Ukraine, exports from the Ukraine, a lot of steel and cement into Europe. But in the Ukraine, you don’t have to pay a carbon tax. So one of the things that the companies scream about in Europe, they say, Hey, we’re paying this carbon price, but but they don’t. So what they’re bringing in now in Europe, and the US is talking about the same thing is is basically a border tariff. If you’re trying to export from your country with no carbon price into Europe, you will get hit with a carbon tax at the border to export to import your goods. And what was really interesting when when Europe announced this, within a few weeks, the Ukraine announced they’re going to launch their own carbon market, because they want access unhindered access to the European market. And we’re what we’re seeing is an explosion of countries now launching carbon markets off the success in Europe. So today, we’re invested in five carbon markets. Europe, of course, the UK has its own carbon market because of Brexit. There’s two carbon markets in the US, as you know, California, which is linked with Quebec and Canada. I’m a Canadian, Oregon and Washington State are both moving legislation through to join the California market. So that’s interesting. So as New Mexico is making some rumblings on the East Coast, of course, you have the regional greenhouse gas carbon market, that’s 11 US states, New Jersey joined last year, Virginia joined this year, and Pennsylvania is scheduled to join next year, and North Carolina is now making some noises about joining. So really interesting to see these markets growing. And what

 

Jeff Malec  23:15

why is it become such a getting diving off topic a little bit? It’s, it seems like it’s kind of like a red versus blue thing in the US, right? Those are mainly all blue states. Like we could ever get Texas on board, would you ever right. So it seems like a free market solution that Republicans would kind of like? And yeah, indeed, the history is that it was kind of a it was

 

Mike Azlen  23:37

Republican completely. Yeah, it

 

Jeff Malec  23:39

was really political. Yeah, there’s,

 

Mike Azlen  23:42

there’s such a big divide that I think that the chances of, you know, not the chances, I think the timing on a national carbon market in the United States is probably still some time off. I mean, if you look at the the makeup of the Senate in particular, you know, it’s going to be very difficult, isn’t it? So, but it’s nice to see the individual states that are, you know, taking this, but I take your point, it’s difficult to predict, Jeff, what will happen, you know, in the red versus blue states, but but they are growing when you get

 

Jeff Malec  24:12

concrete move from Pennsylvania to Ohio, and then just ship it across the border from Ohio. So you don’t have you have like that similar Ukraine dynamic inside the US with each state,

 

Mike Azlen  24:21

you may you may start to see that what all of the research so far on that, that that what you just described is called carbon leakage. Where the you know, the the actual emissions move to a different jurisdiction. So far, that’s been almost unheard of, because to move a big factory, obviously, it’s hugely expensive. So, you know, there would have to be a major, major price difference to make that you know, economically viable. But but you’re you’re quite right, just globally. Just to touch on what’s happening, though. Is is the amazing development of carbon markets. China has launched their carbon market in the summer covering 5 billion tonnes of emissions. So that is really big news for climate change. Korea has been running their carbon markets since 2015. We’re invested in the New Zealand market, we really like the New Zealand market. Mexico has a big carbon market. They’re in their pilot phase, Brazil, even with balsa narrow in Brazil, they’re now moving legislation through both houses in Brazil to launch a national carbon market. And five weeks ago, Malaysia, the country of Malaysia announced they’re launching a national carbon market. There’s another dozen countries that are looking at this. So we’re probably in the first or second inning on carbon. When I began to look at it three years ago, we were trading about half a billion per day. Now we’re trading three or 4 billion per day. And I think very soon we’ll be trading in excess of 10 billion per day, and many are saying we will overtake crude oil in the next 10 or 20 years

 

Jeff Malec  25:56

room. And and so this kind of neuters that argument of like, hey, it’s not worth it trying to reduce our carbon emissions, because China’s just gonna pollute and do whatever they want, right? What are your thoughts on that the more global becomes the less valid that argument becomes?

 

Mike Azlen  26:13

Yeah, I mean, what we all hope for is we hope that we have eventually these markets linked, so Switzerland had its own separate carbon market, but then last year it linked with with the European carbon market. And what we’d like to see is we want one global carbon price, where all the markets eventually link, because again, it comes back to the efficiency of least cost abatement. You know, it’s it’s probably cheaper to abate emissions in Africa or in some Asian countries than it is in highly developed Western economies. So linking these markets makes sense. But obviously, there’s a lot of political issues. So I think we’re probably a decade away from linking all the carbon markets. But you’re right. I mean, if China lowers their emissions on their carbon market by 2% per year, that’s 100 million tons per year, which is, that’s the entire emissions of the United Kingdom being taken out every year. So this is one of the few policies that has the ability to move the needle for the Paris Agreement, I believe.

 

Jeff Malec  27:13

And so you’re talking about this, the trading and the increase in the trading talk to me a second about who are the like, how does it clear? Is there counterparty risk? Like that seems a big deal to me if I’m buying this certificate from someone else, and they can’t pay me.

 

Mike Azlen  27:29

So So yeah, so carbon. Most of the carbon trading that is done today is done through exchange listed futures and options. So on the Intercontinental Exchange, which owns the New York Stock Exchange, of course, they have listed futures and options if you buy the futures contract and hold it to expiry. You get delivered delivered the physical permits, just like if you hold oil or you hold wheat,

 

Jeff Malec  27:53

so our listeners know it as ice. Yes. Savvy guys is but go ahead. Yeah.

 

Mike Azlen  27:59

Okay. Yeah. So So yeah, for people that are savvy, it’s ICE Futures, Europe and ICE Futures in the US. So that’s where the contracts trade as well as the options market. One interesting thing is that a carbon permit in California, you can’t bring it to Europe and give it to the regulator in France to meet so there’s no cross fungibility or direct arbitrage capability. So the markets are priced quite differently in terms of the price per tonne, even though it’s the same one tonne of co2, same commodity, but it means there’s also very low cross correlation. And in fact, that’s one of the things we leverage on in our global carbon fund. by diversifying across multiple carbon markets with low correlation, we achieve a lower risk profile.

 

Jeff Malec  28:43

And so what are the what’s the volume and liquidity on the ice contracts look like? Like, do you have an equivalent to you mentioned crudo before? Is it a 10th of crude oil? Or what do you know those numbers?

 

Mike Azlen  28:55

Yeah, I don’t know. I don’t have the numbers relative to crude. That’s that’s a very good question. But I can tell you that most of the liquidity in the futures is in the European market, it’s probably trading about half of that 4 billion daily traded value about probably 50 to 60% of that is the European market with the rest of the futures value traded being split between the UK market which is also becoming more and more liquid, the California market and the Regi market all three have listed futures on ice

 

Jeff Malec  29:28

real quick back to that so if I’m but the actual factories are buying certificates right now, they’re buying from the government. So that’s that kind of counterparty risk there. It doesn’t totally matter. Yeah,

 

Mike Azlen  29:41

so So you know, certainly in our fund, we hold daily liquidity, futures and options. We also hold the physical carbon certificates. They do trade on a daily basis, but they don’t have the same liquidity as the futures market by any means. So for most players to in order to register for physical carbon It’s quite onerous to be become a registered entity to be able to participate in those auctions. It’s really designed for big emitters, like electric utilities and whatnot, but you can do it. And we find it’s useful for an arbitrage, you know, obviously, you want to be able to arbitrage the cash against the futures market. So, yeah,

 

Jeff Malec  30:21

I was just gonna say, I think, yeah, you’d have to be a ECP. Right? Eligible contract participants, and it’s 10 million minimum. You mentioned the font a couple of times. Let’s switch gears a little bit. Where did the idea come from? Start a hedge fund trading this stuff. So So yeah, where you coming? From? Like, I want to make a lot of money, or I want to save the planet? A little bit of both.

 

Mike Azlen  30:46

Yeah. So what happened was, when I learned about these markets, my first thought was once I understood it took me about a couple of weeks to really understand the mechanism. I had no idea was trading these markets even existed trading half a billion a day. At the time, I thought maybe I should own some of this in my personal portfolio. I like the fact that you have a commodity with lowering supply every year and kind of demand is correlated to economic growth with higher prices. So I but I wanted to get the stats. I have been teaching on the graduate degree program at lbs for 18 years. One of the things I teach is this is long run asset class returns over 100 years 17 countries, equities, bonds, real estate, etc. So my first question on carbon was what what does the return one of the statistical properties of carbon and I could not find the data. So I hired a PhD student from the LSE, Grantham Research Institute on climate change. And we have written a full academic paper on carbon as an emerging asset class. That paper will be published this summer. But the CFA Institute has already published a case study with the with the core conclusions of that. And broadly speaking, there were three noteworthy things. One carbon has been going up at about 20% annualized rate of return for the last eight years. Volatility is between 15 and 20. So it can be quite volatile, even as a portfolio. And thirdly, very low correlation. That point I mentioned about lack of fungibility between the permits means you have effectively zero correlation between carbon markets. But carbon itself has effectively zero correlation to equities, bonds, real estate, and commodities. And this was the really important thing for me in my analysis, being an investment professional. And I presented this research Jeff at a conference, and I was approached by the CEO of a Swiss private bank. He said, I want to back you, Mike to launch this fund, he took a stake in the GP, a minority stake, and so that I formed a environmental asset management business, our current company carbon cap, and we have these dual goals. So you’re quite right. First goal is we want to generate 13 to 15% annualized return with 13 to 15, Vol, low correlation, monthly liquidity, so that’s pretty standard. But the second objective is we want to have a direct impact on climate change, both through softer things like my teaching, my speaking at conferences, and educating people about climate change and carbon, but we commit 20%, hard of the performance fees are used to purchase carbon, and permanently cancel those permits. And that is a direct impact on climate change. So to put some numbers on that, if you invest 5 million in the fund, if we generate a 10% return, then that will cancel about 500 tons of carbon, which is approximately the carbon footprint for 50 people in Europe, or we take out the footprint for a family office.

 

Jeff Malec  33:49

Right? And but that ties back to that voluntary, that’s the

 

Mike Azlen  33:54

know, when I cancel carbon, we buy compliance, highest quality carbon and cancel it, it costs us a lot more money to do that. But I think the price tells you a lot about the quality.

 

Jeff Malec  34:07

I like it, but you’re I was gonna catch you. They’re like, Hey, you were saying that voluntary stuffs a little shady, but you get and then so is it is it holding I think I read some it’s holding most of there’s a portion that’s just long this stuff. Right?

 

Mike Azlen  34:23

So I wouldn’t say just long. So let me let me take you through very quickly the investment strategy. So the first thing is because carbon emissions mainly come from electric utilities. A lot of electrical utilities are the biggest emitters of carbon dioxide. So they have quite sophisticated hedging programs. Many utilities sell their electricity three years forward. They then buy the coal, the gas and the carbon in the forward market. So they buy the inputs, sell the outputs and they lock in their forward margin quite interesting. Once they’ve hedged up their carbon, then Electricity, which cannot be stored electricity volatility, which has very high NOx on to their hedging programs and coal, gas carbon. So this makes carbon sometimes very volatile, because electricity, of course, cannot be stored industrially yet. So I’ll give you some numbers. I mean, European carbon has 50%, annual standard deviation, three and a half times the volatility of the stock market. It’s very volatile. So the first thing that we decided I’ve got a lot of my personal money in the fund, is we wanted to have a hard risk cap. And this is hard, we must be under it. And we’ve set that at 15% Vol. So stock market volatility, one five, that translates to 2.2% Daily Value at Risk at a 97.5 confidence interval. So we calculate this risk number on our portfolio every day. And we must be below we report this to a third party independent compliance regulated compliance entity. So that’s the first thing about what we’re doing is we’re trying to do this in a risk controlled manner. We then you’re quite right, we then have two strategies in the fund. The first strategy is long bias, we call it core long plus hedges. So this is where we use physical carbon futures and options to build a portfolio across these five markets to capture that long run bull market. But we tactically underweight and overweight the markets based on deep fundamental research to say, hopefully, we can add some alpha versus a simple buy and hold approach. The second strategy we call alpha, and this is mainly intraday, but idiosyncratic trades around the fact that most carbon trading is done by the end users. So I’m not trading against Goldman Sachs and trading against a steel company or cement company. And there’s some very interesting strategies that we have developed our goal is four to 6% a year on this piece. So if we can add an additional four to 50 basis points a month through these alpha strategies, that that puts, so you have these two strategies that operate under this risk limit?

 

Jeff Malec  37:10

And then and so on the on the core lawn, plus the hedges, what are the two questions, one, this based on the supply getting taken away? Right, this must be a very steep contango. So how do you buy and hold that in the futures do pay a big role? Cause, um, and then to what are those hedges look like?

 

Mike Azlen  37:30

Yeah. So I think probably a better name for core instead of core long plus hedges is probably core long plus convexity. So because we have that that hard cap on our risk exposure, if we have a high conviction view that a common market is going higher, we can’t load up on the market, because we would breach our var risk limit. So the only way to make that bet is to purchase typically out of the money call options. And that gives us that upside convexity. So we’ve done that quite successfully. On the downside, we can hedge using puts for if we think there’s a policy event or a macro event that might affect that. And the way we allocate between the two strategies, is using a weekly Investment Committee meeting where we score the markets. Before I go into that, though, I want to answer your question. Carbon markets are not in excessive contango currently. And really, if you look at the history, they never have been, they typically trade at a small amount of a contango, that is in excess of short term interest rates in that particular market. The one exception to this is California, the California market is trading at about a 3% contango, so it’s not extreme. But in California, if you’re a buy and hold investor like us, you would like to hold the physical carbon rather than buying the futures in rolling. Right. So that’s where the contango sits in the other markets. There’s very little contango.

 

Jeff Malec  38:52

It doesn’t that doesn’t make sense to me, right, if you know, the supplies coming down every year by, you know, edict, so to speak by the governments that would seem to be, you know, like the mother of all contango markets, I guess, the risk of policy change and whatnot.

 

Mike Azlen  39:06

So so the interesting bit is that is that supply and demand analysis. And just just to put a very broad brush on that the supply of carbon, everyone knows because the government discloses, we know in Europe 1.6 billion permits is going to be sold, so we know the supply. So we spend all our time Jeff folk trying to work out the demand for carbon. And in the case of electricity generation, of course, you’re quite right. If the economy grows, we have we need more electricity. And you might think, Okay, we got to turn on more coal and gas and more carbon. But of course, what’s happening at the same time is renewable power, solar, wind, hydro, and other forms are coming on the grid. And those are pushing thermal generation off the grid, which means less emissions. And that’s a big picture way of saying there’s a lot of complexity when you drill in trying to identify where is that supply and demand? And is a carbon market tight? Or is a carbon market loose? And I think we’ve built some very, very interesting tools there. And then

 

Jeff Malec  40:11

on the Alpha strategies that Rodrigo Gore do and resolve asset management, he likes to talk about the different economic incentives, right, so a pension that has to come in and by quarter end to meet their obligations, right at basically at any price. So is that kind of a similar structure there of these, you know, the players, you know, some of the things they have to do, they’re not as concerned about intraday price probably, and you can kind of harvest seminar.

 

Mike Azlen  40:39

So there, there’s a whole ecosystem of participants, from short term speculators to the you know, the the longer term, buy and hold investors and indeed, but still, it’s dominated by the hedgers, the companies that have to buy a certain amount of carbon over the year, they might give their trader a V Whap target. If the trader can beat the V whap. Over the course of the year, the trader gets a bonus, this kind of this kind of structuring on the for the big emitters, so they can be quite sophisticated in how they trade their carbon hedges, will, I’ll just take you through maybe one or two of our alpha strategies. So again, in total, we’re trying to trade these idiosyncratic strategies to generate four to 6% per year, in addition to what we’re making in the core. So the core we hope is going to generate more like 10 to 12. One, the first strategy is the auction. So this is quite unique to carbon. So every day in Europe, between two and 6 million tonnes of carbon is sold at a daily auction at 10 o’clock in the morning. And we have done a lot of quantitative work around the auction. We participate in the auction every day on either long or short basis. We’re typically in and out within 30 minutes. So we participate in the auction long or short. And then we exit in the secondary market. And we extract a small amount of alpha almost every day from that process. And we’re providing liquidity into the whole oxygen window as well. So that’s a very unique Alpha strategy. I would say that’s unique to carbon. No, it doesn’t.

 

Jeff Malec  42:14

I heard your Canadian roots their

 

Mike Azlen  42:19

AD, AD Bratton, our head carbon traders been trading carbon in Europe for 15 years. So he, he knows the the brokers very well. So most of trading in the futures is screen based, of course. But there’s also four big blocks of carbon, if you’re trying to move a block that’s voice brokered, and so we’ll see a lot of those flows. And we will facilitate blocks of carbon in the market. Typically, we hold for only a few minutes, if you understand the facilitation trade, we buy it a couple cents under the market. As soon as we buy it, we blow it out in the market. And we we take a one or two cents, but the real value there is seeing those flows of carbon,

 

Jeff Malec  42:57

who’s tobacco, as we call it, and like the grain cash markets. So yeah, buying it unless you know, you can sell it over here.

 

Mike Azlen  43:04

Yeah, I mean, we’re buying a block of futures. And then we immediately are on screen selling out those futures in a few a few minutes later. So we have a number of facilitation trades. We do like we do a lot of analytics in the carbon options market, we’ve developed some really nice tools in the options market, we like looking at skew, we’d like to look at looking at the level of implied volatility in different parts of the of the curve. We think that that’s also provide some alpha opportunities.

 

Jeff Malec  43:32

And about that when you said you’re getting some of that convexity with the call options, like, is that skewed? Like what is the skew look like in that market? It seems like most everyone would be on the call set?

 

Mike Azlen  43:44

Yeah, it’s it’s interesting. Like most markets, you do have that option smile. So you’ve got you know, the out of the money’s are at a higher implied and and it does still tilt to the put. So the put out of the my deep out of the money puts Yeah, even though you have this upward bias to the markets. It’s like that, we really like to look at that skew and how that skew changes as a short term technical signal for our more shorter term trading strategies.

 

Jeff Malec  44:14

And then, and I think we covered it was all just so your your mandates absolute returns, it could be, but you also have that core. So it’s there couldn’t be a case where it’s carbons up to 100%. And you guys are flat or down or something like you’re, yeah, there could be but you hope Sure. Hope not. Yeah, hopefully

 

Mike Azlen  44:31

never. So I’ll give you a good example. So the first thing is you’re quite right, we are absolute return targeted. So we have this absolute return objective over a rolling 12 month window. So we can have a down month or a down quarter, but we’re hoping over 12 months to be positive and therefore in the core. While we think it’s kind of probably long bias for the foreseeable future because it was an upward trend in carbon prices. However, I can say we did our first big short position in carbon In September, so really interesting scenario happened in September, you probably have seen in Europe, we had this huge gas spike in gas prices. Gas prices went up more than 100% in September, in Europe. And as I was saying, if you’re an electric utility, you can burn either coal or gas, coal for the same amount of electricity production kolam. It’s twice the carbon dioxide. So when the carbon price went up, burning coal was uneconomic, you’d lose money if you made if you burn coal, so they shut the coal off. But when the gas price went up, 100% burning coal became profitable again. Right? So coal was in the money, as we say, Yeah, from the point of view of the profitability of coal. So they turned on the coal generation, of course, that emits more carbon and the carbon price really had a big pop in the UK, we were long UK carbon, the price went up significantly. And then a second factor happened in the UK, we have lots of wind generation on the grid in the UK, much higher than other European countries. And we had this weird 10 day period where it was becalmed, there was no wind. So they had to turn more coal on. And the UK carbon price went up to over 100 US dollars a tonne equivalent. When it hit that 100. I sold our long UK carbon. And we went short UK carbon. Looking at the fundamental supply and demand modeling, it just did not justify such an increase it went up I think over 42% 43% UK carbon prices, we shorted that the next month wind of course, it started to be windy again. And that pushed the coal off the grid emissions came down and the the UK carbon price fell 26% The next month. And you know, we did extremely well. So that’s a good example of how being long, short or flat. We can participate or not in the markets.

 

Jeff Malec  47:02

And then if you if you make a bunch of money being short carbon, you’re sort of pro emissions, but then you’ll you have that where you can put it back through your incentives by those credits. So I like that. The I had a meteorologist on here about a year ago, Jim. I’m forgetting his name right now. But uh, I was asking like, all these wind turbines, like, isn’t it taking go wind out of the global equation? Right? If you’re turning that into power, and the turbines are capturing him, and they’re all he kind of said, yes. So it could be like, the more wind turbines you buy, the less global wind there could be, which seemed like a an Wow,

 

Mike Azlen  47:41

I’ve never heard that before. And I need to I need to think about that. I mean, because I mean, it’s interesting, isn’t it?

 

Jeff Malec  47:49

Yeah. Like it can’t You can’t destroy power, right? Like you can’t, if you’re getting it pulling something out of the system, pulling this energy out of the system. Where does that come from it?

 

Mike Azlen  48:00

Yeah, no, it’s really it’s really interesting. I think, I think my, my quick thought on that would be and I don’t know what the numbers are. But I would think of all the wind energy that’s generated on the planet, the amount that we’re pulling out for wind turbines is probably something like, I don’t know, 1/1000 of 1% or something. So perhaps it’s insignificant, but it is growing rapidly.

 

Jeff Malec  48:23

I was Dr. Jeff masters. That’s why it was so well. Okay. Well, yeah, he founded Weather Underground and flew hurricane hunters, great guy. How, when you’re talking to investors, when people are investing in this space, how do they view it as an asset class? Is it a? Is it just a do good investment helps with their ESG scores? Or is it actually diversifying? And how do you view that?

 

Mike Azlen  48:47

Yeah, so I can tell you my experience with investors. So we launched the fund with 10 million, it’s grown to 80 million now. So we’re still very small, the most investors are focused on absolute return, monthly liquidity, low correlation and risk management kind of classic, you know, I’d say about 10% of the investors really like the climate impact side of what we’re doing, but expect that 10% will grow over time as more people are focused on it. But that’s kind of the mix between environmental impact versus traditional kind of hedge fund investing.

 

Jeff Malec  49:24

Got it but just from an end, but you view it as a classic diversify, right? Like it’s not gonna necessarily track inflation or do well when the economy grows all that it’s just a classic absolute return diversify.

 

Mike Azlen  49:36

The two interesting areas is because carbon carbon costs can be passed through to consumers as the carbon price rises. It could be a natural inflation hedge. In fact, the California carbon market has a floor and ceiling in the market where they take away supply or release carbon supply. And those floors and ceilings go up every year at 5% plus inflation. So there’s an again, a natural inflation linked to carbon. And we’ve done quite a bit of work for one big institutional client looking at carbon as an inflation hedge. And it turns out, if you look at rolling 36 month correlations against the CPI, the US Consumer Price Index, as an inflation measure, carbon is actually a better inflation hedge than traditionally something like equities. So that’s one aspect of carbon. The other one is the hedging capability. So now it’s becoming much more recognized that if you own a diversified portfolio, or an ETF, you have climate risk of some type embedded in there. And therefore owning some carbon could be a natural hedge against that climate change risk. And that’s an infrastructure, private equity, fixed income, it’s really in every asset class. So some of our investors see owning our fund as a way of hedging against that.

 

Jeff Malec  50:57

So, one, it also has like, who’s, we’ve kind of covered this, but who’s selling like, it seems like it’s just a natural buyers market, who you just said, you’re selling. So mainly speculators?

 

Mike Azlen  51:10

No, you have, yeah, you have obviously, when a company that is receiving a free allocation, so most of the industrial emitters will get a free allocation of carbon, but it goes down every year. So they are getting these out permits allocated to them, very similar to what their emissions are. But if they then cut their emissions, they will have excess permits that they can sell back into the market to monetize. So if they let’s say, do a debt issuance, they raise, you know, 300 million of debt to put new low carbon technology in the factory, and then they cut their emissions by 50%, then they’ll have these permits, they can sell in the carbon market and recover some of that investment they’ve made in low carbon technology.

 

Jeff Malec  51:52

And these certificates sit on the balance sheet, like their assets, just like anything else, and they could rehypothecation them and borrow against them and all sorts of stuff. Yes, they

 

Mike Azlen  52:00

can. That’s that’s another advantage. They are an asset. Obviously, they’re they’re a bit of an esoteric asset. So I don’t know what banks lend against them. Or, you know, I’m not involved in the repo market there. I do know there is a repo market in carbon.

 

Jeff Malec  52:12

Yeah. Interesting. And then you talked about that power spike in Europe. All those dynamics, we also had our own one in Texas last year, like what are your thoughts on that? Sort of? It seems like the far limits of deregulation and free markets to me, right of like, I can’t remember what Texas went up to $43,000 per kilowatt hour or something, you know, and then right back down to $4. But like, what are your generally your thoughts on that? Is that beneficial to the ecosystem? Is that dangerous to him?

 

Mike Azlen  52:43

Well, I think that, you know, generally, volatility is never a good thing. You know, policymakers would, they would love to see carbon just slowly, you know, going up and up and up in a slow way. But that’s not how markets work, especially commodity markets, where you get squeezes where, you know, entities have to buy whatever the commodity is to deliver on their underlying promises. And so you do get these dislocations in commodity markets. And that’s why risk management I think, is so so important. But but in terms of the development of this, I think that that carbon price signal is the single most important factor in helping transition to a low carbon technology. Because when you look at that price per ton, it has so many impacts throughout the throughout the supply chain throughout the development of low carbon technology. It’s just in my view, it’s just the most important signal if we are going to get to decarbonisation.

 

Jeff Malec  53:39

Yeah, my my worry is you get the the evil specular back in oh seven, everyone was had like a little long commodity index in their portfolio. Prices were huge oil is at $140 a barrel. And you started to get this, Hey, the evil speculators are driving up commodity prices, right, you could kind of get the same pushback of the evil emissions traders are driving up carbon prices, which is causing your electricity be higher, and we need to come in and do something about it. Which Yeah, well, in

 

Mike Azlen  54:09

California, in California, they have a holding limit of 11 million tons of carbon. So about $300 million is the max position that one entity can hold in Europe. We don’t have that yet. I mean, the markets much bigger and much more liquid in Europe, but perhaps they will bring in you know these types of regulations. And and of course, we have the CFTC has its own position limits for hedgers and speculators in in the carbon markets.

 

Jeff Malec  54:36

Yeah, um, yeah, and at the end of the day, it might be a good thing even right if they, if the prices get shot up, it’s better for the plant. Ultimately, and what’s the end game look like for others? I have this idea in my head like that. It eventually feeds on itself right? If it gets super successful carbon is up here. All the carbon goes away. This this particular game is All right.

 

Mike Azlen  55:00

Yeah. So there’s it’s really interesting when you when you take a step back and you think about the development of the markets, the first thing to say is we’re probably in the first or second inning today, looking at 10 or 20 years as more companies roll out. And as we, as we slowly decarbonize, so that so there’s a long time to go but quite interesting to think about, you know, you’re quite right, what we want is we want this market to disappear when we want when carbon emissions hit net zero, of course, everyone’s talking Net Zero, net zero net zero. Now, one of the interesting things here is to look at the concentration of carbon in the atmosphere, most scientists and pundits now say, at some point, we are going to have to remove co2 from the atmosphere, because, you know, today we’re emitting another 100 and 50 million tons. And that concentration is just gonna keep going up and up and up. So at some point in the future, maybe 10 or 15 years from now we’re gonna have to start at scale sucking co2 out. So I think what happens to carbon markets, Jeff, is they they change from being one tonne, allowing you to emit to representing a carbon marker represent one tonne that has been removed from the atmosphere. Now the cost of removing carbon from the atmosphere today called direct air capture is about $600 a tonne. So but that will come down with technology just like solar and wind came down

 

Jeff Malec  56:21

emissions are like $75 a tonne. Which are what Yeah, emissions price? Yeah,

 

Mike Azlen  56:27

yeah. Yeah. About let’s, let’s say in US dollars about in Europe are at 75. California is $30. Reggie is only $13. So different markets

 

Jeff Malec  56:38

is infinitely more than those. Yeah, yeah, it’s

 

Mike Azlen  56:41

much more. So I think as these prices go up, in terms of emitting carbon, you they could introduce the ability for if you can prove you have sequestered and pulled a ton out, you will get issued a permit. So then offsetters, like all these corporates that are currently using the voluntary market, which have already said, there’s a lack, in my view, a lack of veracity there and certainty about what’s being emitted, but they could buy in this much more regulated market, and then truly make a net zero claim. And I think it’s quite likely that these markets will morph into carbon removal permits. So that probably extends the life of the carbon markets of the asset class by another 20 or 30 years.

 

Jeff Malec  57:25

I had this in my notes, I didn’t know if we’re gonna get but we had another guy, Michael cow on the pod who was not on our pod, but in some of his tweets is saying the infrastructure needed to actually capture all that carbon is insane, like three times for his that’s the amount of pipeline that we currently have in the US that took 100 plus years to build. Yeah. What are your thoughts on that? It’s doable. That’s a pipe dream.

 

Mike Azlen  57:52

I think it I think it is doable with the right incentives and the right amount of time. I think that’s why when I say, you know, another 2030 years, this is the timescale and when, again, when you step back and say, Well, where are we, you know, we only have eight years of run rate emissions now before we hit 1.5 degrees. So you know, we rea