Carbon credit futures can be the next big thing for markets

This emerging sector opens up opportunities for financial hubs across the GCC

By Dr Ullas Rao

January 17, 2024

Men use machetes to cut back plants so young pine trees can grow in a forest near Capulálpam de Mendéz, Mexico. Their work earns the community money on carbon credit markets

Now that the UAE has ticked “hosting Cop28” off its to-do list, it can work on encouraging companies to take greater responsibility for cutting emissions.

Much attention has been focused on carbon credits – whereby companies invest in reduction schemes to offset high-emitting operations – but carbon credit futures are an untapped opportunity.

These instruments enable the buyer to balance emissions through offset projects, without directly investing in those projects.

UAE financial markets are well set to offer these futures as a tradeable product for a portfolio of participants, from hedge funds to oil and gas majors. As a derivative security, the primary role of futures is hedging or risk management. Growth in these futures will provide a natural incentive to develop an underlying spot market – namely the carbon credit itself.

Carbon credit futures provide a platform for the Gulf’s oil and gas giants to diversify risks further, while contributing to climate action positively.

Corporations with significant exposure to carbon assets stand to benefit by hedging the underlying volatility through futures contracts. Such investments have the potential to create an economic buffer as hydrocarbon companies transition towards a sustainable future.

To decipher the scope and substance of these futures, we need to look critically at the underlying asset – the carbon credit – which is much discussed but little understood.

Carbon-intensive operations purchase carbon credits to reduce their footprints with a well-intentioned goal of directing cashflow into green investments. Despite the capital expenditure devoted to carbon neutrality, many climate activists view the credits as paying lip service in the absence of structural changes.

Here, carbon credit futures could instil the necessary discipline by ensuring that transactions meet the criteria both in letter and in spirit. Growth in the derivative asset should lead to a maturing of the carbon market, helped by robust governance and effective regulation.

As with other commodities, such as gold futures, sponsors need to develop a deep secondary market underpinned by active trading to boost volume spreads and liquidity. Specialist financial institutions such as hedge funds can ideally support this function as their goal is to maximise profits through speculative bets.

Regulation is critical to promoting responsible trading, with appropriate amendments to existing rules as investors’ protection assumes significance. As an example, restricting trading in carbon credit futures to institutional investors will ensure that retail investors who often lack capital and knowledge are not affected adversely.

With the market for carbon credit futures in its nascent stage, few exchanges in the world offer an efficient trading platform. This opens up opportunities for financial hubs in the GCC.

At present, most trading of carbon futures is conducted over-the-counter with incremental costs in the form of commissions and charges. Exchanges in Abu Dhabi and Dubai have an opportunity to expand their product offerings with automated trading.

Funds focused on sustainability can benefit from exposure to carbon credit futures. Investment in the region’s carbon credit futures market by active, globally managed funds is another attractive proposition.

If sharia scholars can be persuaded, the reservoir of Islamic funds could be tapped too.

The GCC has an opportunity to translate energy resources into an enduring asset by tapping this emerging sector. The growing chorus to produce tangible efforts on climate action needs innovation in financial products to merge profit with purpose.

By creating markets for sustainable financial products, the region is well placed to turn oil into gold. What better way to cement a positive legacy for Cop28?

Dr Ullas Rao is assistant professor of finance at Heriot-Watt University Dubai