Carbon offset ETFs: A new way of achieving passive ESG?

Uncovering how Europe's first carbon offset ETFs work and where they should be positioned in the effort to decarbonise the global economy

Jamie Gordon

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The arrival of Europe’s first carbon-offset ETFs coincides with a growing chorus accusing passive investment products of doing little more than paying lip service to environmental issues. What now needs to be ascertained is whether the arrival of these ETFs creates a tangible impact or just another layer of greenwash.

A report published by InfluenceMap in August, titled Climate Funds: Are They Paris Aligned?, illustrated just how short supposedly ESG products are falling from the emissions targets set out in the Paris Agreement.

It found, of the 593 equity funds falling into the broad ESG category, 421 scored negatively for Paris Alignment and 42% allocate to companies with fossil fuel reserves. Similarly, of the 130 climate-specific funds in Europe, 55% do not score positively on Paris compatibility, while this product class alone had $153m of aggregate exposure to the fossil fuel production value chain.

Given this sobering backdrop, investors might be forgiven for seeking out different ways of greening their portfolios, such as with carbon offsets. Refinitiv’s 2021 carbon market survey also confirms companies’ clients, investors and future employees are keen to see more “carbon neutral” products, with 57% either somewhat or strongly disagreeing that achieving such ends via voluntary offsets can be considered “pure greenwashing”.

In fact, almost 80% of respondents think carbon offsetting allows companies that do not emit greenhouse gases to contribute to emission reductions elsewhere, however, more than half of the respondents agree that having the option to offset emissions reduces firms’ incentive to cut their own emissions.

Explaining how offsets work in practice, Gabriela Herculano, CEO and co-founder of impact ETF issuer iClima Earth, said: “Offsetting is the action of displacing or reducing emissions at the source, and the action will generate a carbon credit. Offsets should not be misunderstood as purely the action of sequestration through trees. It is more complex. Offsets must be real, additional, quantifiable, permanent, verifiable, and enforceable, and can only be issued through a closed registry following a registration and verification process. Every offset creation is overseen and controlled”.

Once verified by an auditor and issued by a registry, offsets can be transferred within the registry until they have been “retired” or used for compliance or a claim of carbon neutrality. Crucially, an offset needs to be retired to be claimed.

Guilt-free passive?

Doing precisely this are Europe’s first ETFs featuring a carbon offsetting mechanism, the HANetf S&P Global Clean Energy Select HANzero UCITS ETF (ZERO) and the Saturna Sustainable ESG Equity HANzero UCITS ETF (SESG), which both launched in July via white-label ETF issuer HANetf.

Both ZERO and SESG rely on two Verra-accredited schemes to offset their emissions, the Topaiyo forest conservation project in Papua New Guinea and the Musi River hydro plant in Sumatra, provided by offset specialist South Pole.

Nik Bienkowski, co-CEO and co-founder of HANetf, said: “Once we buy those carbon offsets, they get retired in a carbon registry, never to be traded or sold ever again. Buying it and using it is an expense”.

For each product, HANetf relies on emissions data from the providers of their underlying indices to gauge the offset quantity needed to keep their ETFs carbon neutral. In ZERO, for instance, data from S&P Global is used to calculate CO2 emissions per million dollars of investment, per annum. On a quarterly basis, HANetf then takes the accrued sum of emissions and new assets and buys the necessary sum of new offsets.

As an example, the S&P Global Clean Energy Select index produces approximately 50 million tonnes of carbon per $1m of investment per annum, Bienkowski said, so through the course of the year enough offset capacity will have to be purchased to sequester 50 million tonnes of emissions.

A natural next question one might ask is how companies’ emissions data are calculated. In the case of ZERO, this job is given to S&P’s environmental data branch, Trucost. However, companies are allowed to self-report on Scope 1 and 2 emissions produced by their operations.

Noting the limitations of this process, Bienkowski said: “These companies are estimating these numbers as well because there is no one that is telling you how much air conditioning was used during the year or how much power or roughly how many flights you have been on. For most indices ETFs might be tracking, data will be available for 80-99% of constituents. As time goes on, estimation procedures will get better and the number of companies reporting their emissions will also increase”.

While arguing Scope 1 and 2 emissions are the main types produced in companies’ daily operations, he admitted Scope 3 is a harder area to calculate. Unfortunately for ZERO and its clean energy focus, Scope 3 is where most of the emissions will be found.

At this point in the supply chain, copper, lithium and nickel are mined and polysilicon is often produced using coal, with the end products being the computer chips and cables which are essential to clean energy production. While not a problem in itself, these processes are usually carried out externally to clean energy utilities companies, and therefore likely to be left out of their reporting on emissions.

Being fair, it is not yet industry standard to incorporate Scope 3 during emissions data collection, however, in a burgeoning product class reliant on accurate emissions data, and as data collection improves, one might imagine these considerations will become the norm.

Virtuous ETFs or enablers of vice?

Also, looking at the potential applications of carbon offsetting in ETFs, it is unlikely fairly inoffensive exposures such as a basket of clean energy companies are going to be the centre of the controversy sparked by this product class. More likely, once the issuers of more experimental products, such as HANetf, have established a foothold for carbon offsets in ETF industry canon, investors might see these mechanisms appearing on core, multi-sector benchmarks.

At this point, the fear would be that investors might put less pressure on ETF issuers to engage with the boards of the highest-emitting companies – and paying a few extra basis points in fees may be seen as a fair price for exoneration from climate responsibility.

Camilla Ritchie, senior investment manager at 7IM, commented: “I do not want to sound too negative on the subject but carbon offsetting can get used by unscrupulous large emitters as a cheap way to get out of actually doing something about the amount of carbon emissions they produce – oil companies come to mind”.

An argument in favour of offsets becoming more commonplace in ETFs is based on the idea that fund providers buy offsets that are already in existence. If more products launch with these mechanisms attached, providers such as South Pole may pre-emptively construct new offsets in anticipation of new demand for greater offset capacity.

Refuting this, Herculano said: “For an investor to claim the benefit of an offset, the investor has to retire the carbon credit. It takes a long time to get the projects that give rise to carbon offsets in place. The new ETF offset demand is not driving the process”.

On the potential impact of carbon offset ETFs on sustainable investing, Herculano said they highlight the importance of climate change mitigation but unfortunately, they risk diluting what can be considered a “real” impactful investment from an environmental point of view.

She added: “Offset strategies are not a better concept than ESG, they are quite distinct. The ESG products are trying to reward the companies that are good corporate citizens which operate with robust E, S and G standards. The best way to reduce carbon in the atmosphere is by not emitting in the first place. The answer to the question ‘do you want to own a portfolio of downstream, midstream and upstream oil and gas companies?’ should not be different if an investor adds carbon offsetting to it or not”.

However, a recent article from iClima’s Chris Searle and Nuseed’s Rina Cerrato noted carbon offsetting may play a key role in achieving 2050 decarbonisation goals, especially in sectors that might have to settle for “net-zero” rather than “absolute zero” greenhouse gas emissions.

In industries such as aviation, for example, the authors said offsetting can play the dual role of providing a final push towards companies achieving net-zero and also the initial impetus, by getting more challenging companies to engage in carbon markets and buy time to plot their decarbonisation plans.

Within an ETF context, such considerations are important. If carbon offsets can slow the capital flight being led by ESG products with sector exclusions, perhaps the world’s worst polluters can focus their resources on greening their operations, rather than paying lofty yields to attract investors.

This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue, click here.