The Carbon Trade, Without the Illusion ft. Mike Azlen

[00:00:07] Mike

I think at a systems level, very logically, you could make a very strong argument that the voluntary carbon market, in its current format, is actually exacerbating climate change. I think the key words in the voluntary market are ‘moral hazard’. Moral hazard looms large. There has been project after project. There has been scandal after scandal, and a lot of legal things. And our advice, very strongly, to clients is to avoid any involvement in the voluntary market until it comes under proper financial regulation.

[00:00:48] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

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[00:01:38] Niels

Welcome to another episode in the Open Interest series on Top Traders Unplugged, hosted by Moritz Seibert. In life as well as in trading, maintaining a spirit of curiosity and open mindedness is key. And this is precisely what the Open Interest series is all about.

Join Moritz as he engages in candid conversations with seasoned professionals from around the globe to uncover their insights, successes and failures, offering you a unique perspective on the investment landscape.

So, with no further ado, please enjoy the conversation.

[00:02:14] Moritz

Hello and welcome. I’m Moritz Seibert and this is episode number 18 of the Open Interest Series. My guest today is Mike Azlen, the founder of Carbon Cap and manager of the world’s largest carbon focused hedge fund.

Carbon Cap is based in London where Mike started the firm in 2018. They launched the World Carbon Fund in 2020, and the objective of that fund is to generate absolute returns from active management in the global compliance carbon markets.

In this episode, Mike and I will speak about which markets they trade in, how these markets function, the differences between carbon allowances and carb credits, why these markets offer rich alpha potential, and how their trading has direct and positive impact on climate change.

But before we start, let me give you some background and tell you that Mike has been involved in the trading and investment management space since many years, including the roles of founder and CEO of Asset Alliance International and Frontier Investment Management, a firm which he sold in 2017. Mike holds a Sloan Master’s degree in Leadership and Strategy from the London Business School. He is a Chartered Alternative Investment Analyst and has completed the Economics and Governance of Climate Change course at the London School of Economics.

Let’s stop there, Mike. Let’s get started. I’m really looking forward to that. It’s great to have you here. Thanks for joining me today.

[00:03:35] Mike

It’s a real pleasure to be here, Moritz.

[00:03:38] Mortiz

So, this is going to be fun. This is going to be a different topic. We’ll be focused on carbon. We’ll be speaking about carbon markets, compliance carbon markets, carbon credits.

You run the world’s largest carbon fund, which is super interesting, and we’d like to learn how these markets work, how you trade in these markets, what the inefficiencies are, and all the rest of it. But I was thinking that we should broadly segment our conversation into two parts. We start with, what are these markets? How do they function? How large are they? Where are they? How can you access them?

And then in the second part, we’ll speak about how to trade them, what the alpha opportunities are, where you think these markets will be going, and much more. So maybe to start, what are these markets? I mean, how many compliance carbon markets are there? What’s the difference between compliance carbon and carbon credits? The floor is yours.

[00:04:33] Mike

Thanks, Moritz. There’s a lot of things to unpack there. The compliance carbon markets originated after the US introduced a very successful cap and trade program for sulfur dioxide emissions in the 1990s. And off the back of that success, Europe launched the world’s first compliance carbon market in 2005. And since it was launched in 2005, it’s been very, very successful as a climate policy mechanism.

Emissions in Europe have declined by approximately 1.1 gigatons. That’s billion tons per year on an annual run rate basis. And about 75% of that decline has come from the big emitters who are the compliance entities inside the European carbon market. So it’s been a very, very successful mechanism. Now, there are many markets around the world and, very exciting, there are many countries who are at some stage of preparing to launch their own compliance carbon market.

So we trade five markets: Europe, of course, the longest standing market, also the most liquid; number two is the UK; number three is the California carbon market; number four is the REGGI carbon market, which is 10 states together on the east coast of the United States; and market number five is New Zealand – it’s a small carbon market, but one that we think, in particular, is very interesting, provides diversification and alpha opportunities. So, those are the five markets.

And in a nutshell, these markets, they are designed as a compliance tool to manage emissions. So, the government sets the supply of permits each year and that supply declines by a fixed amount. Typically it’s between 3% and 5% per year. So, there’s built in scarcity in this asset class and that scarcity over time, what all participants are hoping (except for the companies of course), is for the price to rise.

So, every CEO of a big emitter in Europe, they look at two carbon prices. They are audited by the government every year. So, at the end of the year, if you emit 3 million tons, you must, within 3 or 4 months, then you must give the European government 3 million permits. Now you can buy the permits at auctions. There’s a daily auction in Europe, governments sell the permits. And, of course, there’s a very liquid secondary market.

The secondary market in Europe now trades about US$2 billion per day. So, it’s very, very liquid. Mainly in the futures market. Like many commodities, carbon liquidity is concentrated in exchange listed futures. So, that company, that CEO, knows that today the European carbon price is €70 for every ton.

And they will ask their head of engineering to calculate what is our internal cost to cut our emissions. And if the internal cost is 60, well then, obviously, as a profit seeking CEO, they will choose to invest the money to cut their emissions at a cost of €60 per ton, instead of giving the money to the government and buying the permits at €70. And herein lies the huge power of this mechanism.

Because if you think about what I just said, it means that the invisible hand of the profit motive, the strongest driver of corporate decision making – profit seeking, results in the three magic words (What are they?), least cost abatement. We want to decarbonize, we must decarbonize, but we want to do it at the lowest cost possible.

And so, how does a carbon market do that? It doesn’t just cut emissions at any price, because all 7,000 CEOs in Europe, they all do the calculation: external price, internal price. And those with the lowest internal price to cut their emissions (we call that the abatement cost), they self-select. They self-select themselves to cut their emissions. And therefore, when the supply is reduced every year, we know that someone within the ecosystem has to cut. But we allow the invisible hand and the profit motive to guide self-selection among the constituents. And those companies, indeed, who have the lowest cost of cutting, they cut.

And the reason they cut? They’re not green, Moritz, they’re not ESG focused (they may be), but the primary reason they choose to cut their emissions, they’re profit seeking. They just want to make more profit. So, you harness the profit motive to achieve the magic of least cost abatement.

So we reduce emissions every year and we do it at the lowest possible cost. And so that’s how the mechanism effectively functions.

[00:09:45] Moritz

And I think this is probably one of the reasons why it works and why it works better than a carbon tax, which could be an alternative solution, right? You could just tax pollution. But then that takes the profit motive away because a tax is kind of like just there and you have to pay it.

[00:10:01] Mike

It’s very, very interesting. At LSE we studied all of the main climate policy mechanisms that governments had attempted to bend the curve of emissions downwards. Almost nothing has worked. The two things that have, probably not surprisingly in a market based economy, have been carbon pricing.

Carbon pricing can take the form, as you said, can be a tax or you can have a cap-and-trade market. Theoretically, in economics terms, if the price, carbon price in a carbon market is €70 and the carbon tax is €70, you achieve the same level of abatement, theoretically.

But I would be with you, Moritz, I think there are a number of psychological and legislative reasons why a carbon market is preferable. Number one, no one likes the word tax. Politicians don’t like the word tax, people don’t like the word tax. So, you have this psychological barrier to introducing. Whereas a carbon market, oh, it’s a market, it’s a free market solution, it’s a market-based solution.

The second interesting thing about a carbon tax versus a carbon market is, normally, in most western liberal democracies, to implement a tax on carbon, you require a 2/3 majority. Whereas to launch a carbon market, often this can only be a straight majority in your House or your Senate or in your bi-cabinet legislative system.

So, there are some interesting things. The other point is, of course, politicians love revenue, and a carbon market generates revenue through the auctioning of the permits. In most carbon markets, when they auction the permits to the polluters (so, it’s a polluter pay principle) that revenue is segregated and 100% (in the case of the EU and California), that revenue is reinvested into energy efficiency and low carbon initiatives.

So, you have a primary benefit that it caps emissions and lowers them. A secondary benefit, it does the lowering at the least cost because of the invisible hand. A third benefit, all the auction revenue is recycled into energy efficiency. And the fourth benefit, which there’s been a little bit of research on this, if you’re trying to commercialize low carbon intellectual property, if you have a carbon market, it’s much easier to get venture capital backing for that IP because you have a pathway to monetize.

If you’re trying to commercialize some low carbon intellectual property and there’s no carbon price, the venture capitalist says, well, who’s going to buy? Where’s your pathway to monetize? So this is the fourth key benefit and we certainly need all hands to the pump.

I mean, the overarching issue above everything we’re speaking about, of course, Moritz, is the terrible situation that exists with regard to the concentration of CO2 in our atmosphere. We’ve just hit a new all-time record, over 430 parts per million. Temperatures are out of control. Wildfires are out of control. Annual damages, economic damages, and human migration due to extreme weather, these are becoming very serious issues. So, that’s the macro tailwind behind why we’re dealing with climate change.

[00:13:32] Moritz

Very interesting. The thing is that there’s no singular price for a carbon molecule in the same way that, currently at least, there’s no singular price for a gas molecule. Like TTF trades at a different level than Henry Hub natural gas. And maybe there’s going to be an integrated LNG based market at some point that’s global.

But in the carbon markets it’s even more extreme. Like European, the EUAs, they trade at what did you say, around €70 per ton. California carbon allowances trade at $28, so that’s €25 per ton. So, let’s just say it’s about a third. And then New Zealand is different, and the UK is different, and there’s a bunch of other markets that I think are starting to develop in Brazil and China, or China I think is already active. And everything is driven in kind of like a unique way by local policies and local rules and regulations, which is why there is no one price for carbon in the world.

[00:14:30] Mike

Absolutely correct. And just to be clear about this, the intention of purveyors of carbon markets is for carbon markets to link. So, Switzerland had its own separate carbon market for years, and then around four or five years ago, Switzerland linked with the European market and we had price converge. And I think what we will see, because you’re right, China launched four years ago. South Korea launched six, seven years ago. Japan’s launching next year. Brazil and India are both moving plans through to launch. And there’s probably another six, seven countries around the world that are launching.

We will probably see regional linkages. So, you know, maybe North American linkages, and then South America, and then, over time (perhaps it takes 10 or 15 years), eventually the markets will link and we’ll have one global carbon price.

But until then and, certainly, based on our academic work and our quantitative work, the pairwise correlation between the five markets that we trade is effectively zero. And, of course, that has very important implications around portfolio construction. If you have five assets that have zero pairwise, by combining those, you really crush portfolio volatility without necessarily crushing returns. So, you’re out of sample Sharpe, it can be very attractive.

[00:15:55] Moritz

Yeah, it’s already happened a bit, with the Western Carbon Initiative where we have the CCAs in Quebec, I think, linked.

[00:16:03] Mike

Correct, yeah. So, California has linked with Quebec. Now, the state of Washington launched their carbon market about two years ago and the State of Washington is currently in negotiations to link with the California/Quebec market. And, as you say, the name of that initiative is the Western Climate Initiative. And interesting, New York State has announced that they will use the WCI framework for a cross-economy carbon market they intend to launch in New York.

[00:16:35] Moritz

We should speak, Mike, a little bit about the difference between credits or offsets and compliance markets. I think a lot of listeners might be familiar with offsets or they may have come across them. That’s the stuff that you can buy on top of your airfare if you want to offset your carbon footprint for a flight from A to B, or when you go to the gas station and you fill up your car. Some of these gas stations offer you offsets.

But these markets are different. They are certainly less transparent. There is not a futures market or any central market where these things trade. Why don’t you run us through the differences and also the complexities that go along with offsets?

[00:17:17] Mike

Yeah, I always encourage people (having done a very deep dive on the voluntary carbon market), to try to dilute it down to five key points. So, if we look at the voluntary carbon market, and you’re quite right, when you say ‘carbon’ to most people, they say, oh yeah, I heard about a project where they plant some trees, and of course as the trees grow it sequesters carbon dioxide, which is true. And then somebody calculates how much has been sequestered and they issue these credits.

Unfortunately, the five key points that people should perhaps write down, if you’re listening to this, and you want to explore it, is number one, regulation. Those carbon credits trade and they are a financial asset, but there is no financial regulation.

And I think just a combination of a financial asset and no regulation, already you can see trouble potentially brewing. The market is very, very small. I’ll come back to that in a moment. It’s illiquid. This is a private equity asset, as you explained. It’s very complex and opaque to understand the calculation methodology. There’s so many different methods of how they calculate these credits. And number five, unlimited supply. There is virtually an unlimited supply.

And of course, when you have an unlimited supply of a commodity, that tends to mean a low price. And it’s very important to always remember that abatement decision… “So, do I abate, do I cut my emissions or, oh, I could buy a credit for $2. My internal cost is $10 to cut my emissions, but then someone brings me a $2 credit, I’ll just buy that.”

But if the $2 credit isn’t equivalent to a ton of actual emissions, by buying the credit and not cutting my emissions, which was my other option, now we’ve just exacerbated climate change. And I’m afraid that, at a systems level, if one steps back, I think at a systems level, very logically, you could make a very strong argument that the voluntary carbon market in its current format is actually exacerbating climate change.

Now, let’s take the compliance markets, the regulated markets, and go through the same five points. Number one, they’re highly regulated, run by the governments. Number two, they’re very large. So let’s just go to this size point.

So last year, the global compliance markets traded just under US$1 trillion and the voluntary market did a little less than US$1 billion. So, this isn’t 10 times or 100 times, this is 1,000 times difference in size. Number three, liquidity. The regulated markets are very liquid. They’re trading US$60 billion per month. Number four, transparent. The government publishes all the rules. It’s completely transparent on how it works. But most importantly, number five, the supply of permits is capped and every year the supply goes down. It’s not unlimited supply. And that induces higher price. And what does a high price induce? Abatement. Abatement.

And that is what we need. We need dramatic abatement. And so, these two markets, there’s huge clear blue water. And unfortunately, that lack of rate regulation, I think the key words, in the voluntary market, are ‘moral hazard’. Moral hazard looms large. There has been project after project. There has been scandal after scandal and a lot of legal things. And our advice very strongly to clients is to avoid any involvement in the voluntary market until it becomes under proper financial regulation.

[00:21:18] Moritz

It would be great if they’re cleaning this up because I do agree with you. There are some, if listeners don’t know that, there are some registration agencies (not going to be naming names). But it’s kind of like what price you pay for an offset of a tree that would not have otherwise been planted in a country in Asia. That’s kind of like, it’s a big question mark, and the price can be anything they say it is. So you’re completely left in the dark.

And that is something that I just found… Well, that’s just not how markets should be working. It cannot work that way. It just gives rise to what you’ve said, the moral hazard and some third party lining their pockets in the process, as a middleman.

Speaking to that, just quickly related that came to my head is carbon capture. What’s your view on this, which is massively expensive to suck carbon dioxide out of the atmosphere and store it? Do you think that should be playing a larger role or no role? Is it just too complex and too costly?

[00:22:19] Mike

So, within the voluntary carbon market, less than 1% of the projects are involved in what I would call novel carbon dioxide removal, CDR, carbon dioxide removal. And one of the methods of removing carbon dioxide is direct air capture, which you mentioned. And that’s where you can extract air. And carbon dioxide is present in the atmosphere. It’s very dilute, but you can extract it, liquefy it under pressure, transport it, and inject that liquefied CO2 deep underground and cap it off and store it permanently. That is actually removing a ton. That I would pay for. But as you point out, to do it properly is very, very expensive. This can be US$500 per ton. But there are other novel CDR methods. And the key metric here, Moritz, is permanence and durability.

In other words, when the carbon is removed, like when we plant a bunch of trees, they grow over 30 years and they remove carbon, then either one of two things happen. They get old and die. And the trees then release the carbon back into the atmosphere, slowly. But they do release it back, or they’re burned down, or there’s pests, or there’s a storm that knocks them down, and in either case it’s released.

So, you can say, okay, if I had multiple of these projects, I can estimate the average life of the permanence of the CDR. And there’s now a growing wish among some buyers like Microsoft. They want longer duration, permanence of the removal and they want less (these are the key words) risk of reversal.

So once you remove it, what’s the risk it reverses? And with forestry we’re getting hotter, we’re getting drier. The risk of the forest burning and releasing all the carbon back into the atmosphere is becoming, in my view, very, very high now. So that’s not a safe place where we would sit around and say let’s store a whole bunch of carbon in the forest, because it’s simply not a safe place.

So, my view is take a step back. We’ve breached all of the levels in terms of our emissions and we’re still going to emit another, I don’t know, 40 billion tons this year. So, we’re way behind. And therefore, the IPCCC has come out and said, over the next 75 years we will have to overshoot and then remove billions and billions of tons of CO2 from the atmosphere. So, this will be an extremely big industry. So we should support carbon dioxide removal.

It’s the one area within the voluntary market where I’ve got some time. As long as I understand the method and if I can see, feel, and touch the carbon that’s been removed, and I know it’s long-term storage, then I’m saying, I really like this.

So, CDR is growing. It’s growing very, very fast, but it’s starting from a very small base. Other methods are biochar, soil carbon burial – organic biomass burial. There’s other methods of novel CDR and I really would like to see that industry expand and grow.

[00:25:44] Moritz

Great. I think we can slowly move toward the trading side of our conversation. And I think from what you’ve described in our conversation about the compliance markets and the way these, you know, you’ve called it the invisible hand and the profit motive. Probably also one of the reasons why you started your fund is because you think these markets, over the long run, will go higher over the next five to 10 years. In our pre call, Mike, you said that you believe that there is a risk premium included in the compliance carbon markets. Can you explain why that is or why that risk premium exists?

[00:26:21] Mike

Yeah. So, from a classic academic perspective, of course a risk premium is present in an asset class that produces a cash flow. So, equities produce a dividend stream and fixed income have coupons.

And so classically, academically speaking, these asset classes have a formal risk premium. Carbon does not have any cash flow, so there’s not a formal risk premium. But when you understand that the carbon market can only achieve the objective of the politicians and all the people behind it if the price rises.

Because every time the price rises another set of constituents choose to cut their emissions instead of buying the permit. Again, they’re driven by profit. Then the price rises again, and another set of constituents cut their emissions. So, the market will only achieve its objective if the price rises. And the question is, what level of the price does it have to rise to, let’s say, be in line with the 1.5 or 2 degree levels of the Paris Agreement?

Now, what we’ve simply done in our academic paper is we’ve taken four really well respected estimates. And they’ve calculated the Bank of England, the IEA, and we took the average. And they have said that we need a carbon price, globally, of about US$120 per ton by the year 2030 in order to stimulate enough reductions to be in line with between the 1 1/2 and 2 degree threshold. So, in our mind, at Carbon Cap, we have this kind of price level of US$120 a ton across all the markets.

And then you simply look at where is the price today. So, if you create a cap weighted index of the five markets, they finished last year at around US$60 a ton. So, the risk premium is simply the trajectory. If you bought today, as a passive investment, at US$60, and if we reach US$120 by the year 2030, this works out to about a 13% annualized return for a passive buy and hold. And you’re quite right Moritz, supply is being cut every year in this market. So, as an investor you want to sit with the regulator, you want to be long.

But carbon markets don’t go up every single year. As you know, the last three years, after a very powerful bull market in carbon in 2021, markets fell in ‘22, fell in ’23, and fell again last year. And they’re actually down a bit this year. And we believe, as they’ve fallen, that prospective risk premium, of course, has been increasing because we do believe we will achieve that level.

So, we think that, big picture, this is a very attractive entry point with someone with a medium-term horizon. Even as a passive investment, of course, we aim to add significant alpha. But just speaking about the asset class, it’s uncorrelated, it’s liquid, and it has this very attractive forward looking policy risk premium.

[00:29:31] Moritz

I think we should be touching, at that point, on the differences between spot or physical permits and the futures markets. And I know that you’re also trading options, OTC, or maybe you then clear them on the exchange.

But I think for a longer or medium to longer-term buy and hold position, where you just want to have the long exposure, you probably prefer to be in the physical markets, and participate in the auctions, and just pay cash for the position and then hold it in the registry.

[00:29:57] Mike

Yeah, it really depends on a whole bunch of factors. Certainly, the futures price trades at a premium to the physical carbon price, and that is called contango in commodity markets. And in most carbon markets that contango is roughly equivalent to the cost of carry – the short-term funding rate.

However, in a market like California, it trades at a significant additional contango. So, if risk-free rates are 4.5%, the contango in California is more like 7%. So, for us, because we principally trade futures, we have lots of free cash in the fund. We deploy some of that cash by buying the physical in California, shorting the futures contract. And of course, those converge on the expiry date and we harvest a 7% effective synthetic T-bill return on that cash.

So, you’re quite right. Certainly in the case of California, you really would like to just hold the physical and avoid that negative roll yield by buying the futures and holding them.

[00:31:02] Moritz

Cash and carry trading.

[00:31:04] Mike

Yeah. The problem, of course, in California is you can’t get an account to hold the physical. These accounts in California are administered by the government. In California there’s now more than a year to a year and a half waiting list. It took us one year to get our physical account with the state of California. And I’ve heard, anecdotally, that waiting list is now year to year and a half long.

[00:31:28] Moritz

Is it easy to get a physical account for the EUAs and the UKAs or do you have to be kind of like within the realm of compliance and be an emitter to get there?

[00:31:37] Mike

No, I think there’s a real recognition among the regulators in these carbon markets that they want a full ecosystem of participants in the market to bring liquidity and price discovery – very important. In the EU market, the biggest traders are the big power companies. They burn coal and gas to make electricity. They sell their electricity up to three years forward to buyers like BMW and Volkswagen who want to lock in their electricity prices.

And having sold their power forward, they buy their coal and their gas and their carbon forward and therefore they lock in that forward margin. And so, they’re very sophisticated in how they trade the carbon.

And certainly, the regulators recognize they want a nice blend between compliance entities, who trade the carbon, and financial actors, speculators who bring liquidity and price discovery and allow that hedging activity to take place.

[00:32:35] Moritz

Why do you think the funding premium or the excess funding spread in the California carbon allowances are so large, like, 4.5 short-term rate where we’re kind of like a T-bill or a SOFR rate. And I think you mentioned 7. Why is this excess there?

[00:32:51] Mike

So interestingly, if you track this, let’s call it the unexplained contango, over time (and we’ve done that extensively in all of the markets) and you’ve tried to answer your question like what’s the driver? There’s nothing we have found to indicate what drove this unexplained additional contango or, for instance, in the REGGI market there’s almost a negative contango. In other words, you put the cash and carry on in REGGI, you get less than you get in bills. What’s behind that?

So it’s very interesting this, this contango phenomenon in the different carbon markets. Probably, if I were to guess, in the state of California it’s the difficulty of holding the physical. You know, many people would like the physical. They can’t get an account so they buy the futures and it keeps it at a premium.

[00:33:38] Moritz

Got it. So, it’s a political or legislative bottleneck, so to say. Not enough people can get access to the physical market and therefore the market isn’t exactly arbitrage free.

[00:33:48] Mike

Correct.

[00:33:50] Moritz

Now with respect to your trading, you run the world’s largest carbon fund, carbon hedge fund. You have some, I think you call it core strategies where you have exposure on the long side. Call that a beta exposure, if you will, in these five markets. You’ve mentioned that you’re holding physical as well as futures, maybe you also implement some of your delta with options for additional convexity. But then you also have several alpha driven strategies. I think some of them are systematic, some of them use qualitative inputs or fundamental research. Could you run us through these?

[00:34:30] Mike

Yeah. So, there are two sub strategies. We begin with a prospectus limiting VAR budget. So, we decided to set a hard VAR limit on the fund at 2.2 VAR, so around a 15 annual volatility. That was just a decision we made, which I think has been very, very wise given the last five and a half years of vol in these markets.

So, we’re capped out on our volatility. We then divide that risk budget into these two strategies, the core and the second strategy we call alpha. And you’re quite right, the core has two objectives really. First, the core is long biased. We do want to capture that long-run risk premium. But secondly, we want to add significant tactical alpha by going long, flat, or short in these carbon markets based on a whole range of fundamental and technical factors. And the drivers of that, I’m happy to talk a little bit more about those, but they are 75% quantitatively driven and 25% qualitatively driven.

And our bias as a firm is definitely on the quantitative side of things. Repeatable investment performance and alpha generation out of sample, we think, comes from a disciplined, more systematic approach. So that’s the core.

It has these two goals. Get the risk premium, number one, and then add tactical alpha. And if we, if we say the risk premium is 5% a year instead of that number I quoted earlier of 13%, and we want to generate 5% tactical alpha, we have a return expectation for the core of about 10% per year.

The second strategy is called alpha and, as you say, this is effectively like a short-term CTA packaged in inside the fund. We currently have approximately 20 completely systematic strategies here, ranging from hourly intraday strategies, to daily, to strategies that might last for two or three weeks. And those are 20 systematic strategies. They have an entry signal, an exit, a stop loss, and a profit take. So it’s all completely systematic.

And our goal there is 5% per year of completely idiosyncratic and uncorrelated alpha. And the two strategies are just completely uncorrelated to each other. So, if you put those building blocks together, you get this 15% kind of total return expectation.

[00:36:53] Moritz

in the short-term CTA bucket. I guess that encapsulates mean reversion, trend following some other things. Now, you’ve mentioned relatively short term hold periods there, like from intraday, daily, you know, a few weeks.

So, in the EUA market, and the UK market, where you have kind of on-screen liquidity in the futures contracts, you can buy probably execute these relatively easily. But would you also be able to run that on the CCAs and the New Zealand markets? Because these are still markets that are much more OTC, and then you kind of like do a block trade, and clear it at the close of business on the exchange?

[00:37:36] Mike

Yeah, I would say that 90% of our alpha strategies and of the volume that we trade in alpha is in the single market of EUAs.

[00:37:46] Moritz

Because that is the most liquid.

[00:37:48] Mike

We’ve got the daily auction. We have four auction arbitrage strategies. So, we have four buckets within alpha. We have arbitrage, relative value, short-term directional, and then the carry. And the carry we have on in multiple markets. And as you know, that’s effectively a synthetic T-bill kind of strategy.

So, the other three buckets are arbitrage, relative value, and short-term directional. And the bulk of those strategies are implemented in the EUA market simply because narrow bid offers high liquidity, low slippage, and market impact.

We do have a number of strategies in the UK. We do have a couple strategies in CCA and REGGI, but the bulk of it is in the EUA market.

[00:38:29] Moritz

So, relative value could be like a spread of UKAs to EUAs, or EUAs to CCAs, or whatever, stuff like that?

[00:38:37] Mike

It is exactly that. It’s like the core strategy but on a much shorter-term timeframe and driven more by shorter-term factors, technicals (I would say); technicals, volatility, and volume factors to create that long/short exposure within alpha in the relative value bucket.

[00:38:55] Moritz

And arbitrage may be conceptually the most interesting part of this. I mean, because these markets, they have these actors, they have these firms that need to comply and it is therefore driven by different dynamics as far as supply and demand is concerned.

So do you see these patterns where there’s just liquidity coming into the auction or missing from the auction and you can kind of like find arbitrage opportunities between, say, settlement prices on futures contracts and auction participation. Are these the type of things you do?

[00:39:27] Mike

The bulk of the arbitrage strategies are governed around the EUA auction. It’s a daily auction. The UK auction is every two weeks, so it’s less frequent. We have strategies we deploy there in the arbitrage bucket as well. And of course, they’re not pure arbitrage in the sense of immediate taking a spread out, but they’re, you know, high probability transactions that are for very short periods of time that harvest a nice alpha at a high probability rate.

We’re very numbers driven. When we back test in sample, out of sample, and we look at all of the metrics, win/loss ratio, size of average win versus average loss, all those kind of classic trade statistics that you would expect. We built all our own code there so that the strategy development process is now quite speedy.

I would also say that these alpha strategies, they decay. They decay sometimes quite quickly. So, you know, these auction arbitrage strategies, we’re on the fifth iteration of these strategies from where we started. So, they work, they work, they work. Then you start losing money, you shut them off, you go back to the drawing board, testing, testing, and then you reimplement.

[00:40:42] Moritz

Of course, I mean, these markets, especially the EUAs, they have become larger and hedge funds and CTAs are trading in them. You’re not the only one.

One thing I’d like to touch on at the very end, or as we kind of like finish this conversation, which by the way, I think was really interesting or is still remains interesting, is actual impact and positive impact. And we did speak a little bit about the offsets and planting trees and these type of things. But you’ve decided to go a different route.

From what I remember, I think you are taking 20% of your performance fee income and you’re using that money to cancel allowances. So you’re essentially buying allowances and you burn them up. Poof, there they go, they’re gone.

Which means that nobody else can use them to emit carbon. That’s the way you’re going about this. Right? Which does have impact. I would say that’s direct and positive impact. And that’s one of the reasons why you are an Article 9 fund.

[00:41:39] Mike

Yeah. So very, very good summary I think you did there. After having done that very deep dive on the voluntary market and determining that it simply isn’t a place you can have confidence of buying these credits or offsets and having any impact at all, we then said, where can we go? We want to try and create some alignment. It’s quite unusual for a hedge fund with performance and impact.

And it was my partner’s idea. He said, well, we want to perform. That’s the first primary objective we must perform and generate absolute returns. But why don’t we then link the impact side to the performance?

And that’s where the idea came to take 20% of our annual performance fee. When it’s crystallized, if we’re fortunate to crystallize a positive year, we take 20% and we use that to purchase regulated permits.

Now remember, if voluntary is trading at US$2 a ton, US$8 a ton, US$10, we’re buying at US$50, US$60, US$70, US$80. So you’re paying much more. But as we said earlier, you’re really getting what you pay for.

And we believe this is the highest impact spend that you can make, especially in a carbon market where the supply is quite tight. By taking those permits out, you’re really preventing those tons of emissions from ever hitting the atmosphere.

And the best ton, Moritz, is the ton that never is released. That’s the best ton of CO2.

So, since launch we’ve crystallized, we’ve had five positive years and so we’ve had crystallized five times, and approximately US$1.3 million has gone towards that. Now the fund’s much bigger. Those numbers could start really escalating and therefore we’ve decided to take a portion of the funds and look at other highly impactful activities.

And one of those is we’ve sponsored a piece of research at the London LSE Grantham Climate Institute to update the seminal academic paper that proves the effectiveness of the European Emission Trading System. Because we think it’s very important for new governments around the world to be able to point to high quality academic research and say, look, this mechanism they did in Europe, it’s very successful.

So, the seminal paper there, by Frank Venmans and colleagues, we’ve sponsored the update of that paper and that should be released in the next couple of months. And the preliminary results really are very positive. So, we’re going to expand our impact activities as that pool of money grows. And it’s something we’re all very passionate about at Carbon Cap.

[00:44:22] Moritz

Not speaking about performance, but given that we’ve mentioned that the current compliance markets are relatively uncorrelated to one another, maybe with the exception of UKAs and EUAs where you do have relatively persistent positive correlation, but then also the combination of your alpha strategies and the beta exposure that, I guess, makes your overall return stream very much uncorrelated to anything including CTAs or the hedge funds, just directional exposure. So great portfolio addition.

[00:44:53] Mike

Yeah, certainly, as I said before, I mean, I think you can make a very strong argument for a passive long-only exposure to carbon. And there are some ETFs that are available out there. Because the asset class is very interesting properties, it’s liquid, it’s completely uncorrelated and it has this forward looking risk premium. We are not even correlated to the asset class and it’s not correlated.

So, investors, and we now have nine big institutions, you know, they’ve done their deep homework on our five and a half year track record and, you know, there is no correlation. You’re absolutely right.

So, it’s a liquid strategy but with low correlation and, as you say, it has this impact element, if that’s something that is interesting for the investor.

[00:45:39] Moritz

Excellent, Mike, I think this makes for a very good time to wrap it up. We’ve been going for a long time, it’s been super interesting. And for our listeners, where would you like to send people if they would like to find out more about you or Carbon Cap?

[00:45:53] Mike

Yeah, certainly. Please go to our website. We have a lot of video content, it’s all educational content because that’s part of our mission to educate on emission trading systems, how they work. So, it’s carbon-cap.com is our website, and if you have any questions, just click on the info and send us information and someone from the team will come back to you.

[00:46:18] Moritz

Great, Mike, thanks once again for coming onto the Open Interest series today. It’s been great speaking with you.

I think this episode, especially, includes some really interesting and valuable takeaways for our listeners as we’ve been speaking about a new topic. We didn’t cover that on this show before and I don’t think it’s widely covered in other podcasts either. So, it’s been great.

As ever, we’ll include the most important points of today’s discussion in our show notes and should you have any questions or comments, please send us an email to info@toptradersunplugged.com where we’ll pick it up and respond. Thanks again for listening and until next time.

[00:46:56] Ending

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