The case for thematic investing in carbon funds

Ryan Fan: Welcome to The Sustainability Agenda, a podcast series focusing on the evolving complexities of the sustainability landscape. I’m your host, Ryan Fan. Please join me as we explore today’s most pressing issues with special guests that will give you some new perspectives and help you make sense of what really matters.

Felix Boudreault: Most funds currently in existence trade a lot of futures instead of the physical credits. And in that case, there are really zero environmental benefits. Whereas when you buy allowances at governmental auctions, which is what we do, the money is immediately reinvested in the economy to fund climate solutions.

Ryan Fan: In today’s episode, we’ll discuss investment solutions with a carbon thematic, enabling investors to position for the energy transition and net zero carbon emissions. In particular, we’ll dive deeper into an investment strategy for compliance market carbon fund. Within the carbon markets, there are differences between compliance or allowance markets and carbon offsets of credits. Allowances are issued by governments or regulators with a compliance system, whereas carbon credits are voluntarily purchased by companies and individuals in an unregulated environment. To provide further insights into today’s topic, I’m joined by a special guest, Felix Boudreaux, managing partner and co-founder of Nordis Capital and Sustainable Market Strategies. Felix is an experienced engineer and MBA working in the areas of climate change, energy transition, and sustainable finance. His career spans several years working in Africa on infrastructure projects. He has also worked in strategic advisory and public policy analysis, including as the chief of staff to the deputy minister of Environment Canada, and as a consultant for think tanks, private companies, and international organizations such as the IFC and OECD. Good afternoon, Felix. Welcome and thank you for joining us on today’s episode of the Sustainability Agenda.

Felix Boudreault: Thanks, Ryan. It’s a pleasure to be here.

Ryan Fan: Okay, so let’s dive right in. Felix, for context, can you give our audience a bit of an overview of Nordis Capital and sustainable market strategies? And what is the ethos of your firm?

Felix Boudreault: Sure. Back in 2017, I was working on the issue of green growth for clients like the IFC and the OECD. I was basically doing scenario analysis on which sector or which technology would come out of a winner of the transition to a low carbon economy and which would face more headwinds. So at the same time, my co-founder, François Dufresne, was working in macroeconomic research, and he had the feeling that sustainability was a macro megatrend that investors should probably know about. So in 2018, we joined forces and we created SMS, so Sustainable Market Strategies, to essentially fill a gap that started to appear. So portfolio managers, especially in Europe, were increasingly being pressured to integrate sustainability related elements in their analysis. But the existing research at the time were really not actionable. So we’re talking NGO or academic reports with more pictures of polar bears than financial charts. So we started publishing weekly notes, and we haven’t stopped since. So that’s about 350 notes and counting. And that’s over 2,000 pages of actionable sustainability research that we make available to our clients. And then in February 2020, just before the start of the pandemic, Francois and I were in London in a client meeting who was saying they liked our research. But they also said something that had us thinking. So they said if you’re so smart, why don’t you manage money yourself? So we took on the challenge and use the COVID months to basically start what is now Nordis Capital. And then another Francois, Francois Bourdon, joined us in September 2020 from Fiera Capital, where he was a global CIO for a number of years. So fast forward a year later and we were managing institutional money thanks to the emerging managers program in Quebec. And now we’re running half a dozen live strategies and we have eight employees. And then you ask about the ethos of our firms. So for us, it’s very clear. The collective we, all of us have to accelerate the deployment of capital towards what we call high care, low carbon solutions. You know, as someone who worked on the international development projects and then governmental policy making, I really believe that finance has the best chance to move the needle enough to succeed the transition to a low carbon economy.

Ryan Fan: Yeah, the mobilization of capital will certainly be a key driver, I think, in our collective success in this energy transition. Carbon management is obviously a large part of that energy transition. So with that said, Nordis manages a range of global sustainable and impact investment solutions, including the carbon fund. What is your investment strategy for this specific fund?

Felix Boudreault: Yeah, you’re right, Ryan. So we’re currently managing a sustainability themed long short fund, an impact fund, and a bunch of thematic funds like Energy Transition, Natural Capital and the Basic Needs Fund as well, and this carbon fund as well. So for the carbon fund specifically, we focus on compliance credits from the regulated markets. So as you alluded in your intro. There are different types of credits. And even more specifically, we’ll focus on the Western Climate Initiative market, so the WCI market, which right now includes the state of California and the province of Quebec, and should eventually include Nova Scotia, the Washington state, and even New York state down the road. We’re a few years away from that, but that’s the plan. The investment thesis is pretty easy to understand. So just a little 101 on cap and trade systems. So the WCI is a cap and trade system, just like the European emission trading scheme is also a cap and trade system. And there’s a number of features that are kind of built in with just one goal and that’s to reduce the emissions by certain dates, so by 2030, 2040, 2050, depending on the target date. And the mechanism they use is they establish annual caps of emissions that are declining year after year. And obviously, as your smart audience already knows, all else being equal, the price of a commodity of a good will rise if you limit its supply. That’s pretty basic economics. The only case would be if the demand falls faster than the tightening of the supply, but we don’t believe that’s the case for carbon emissions anytime soon, unfortunately. So the fact is that the cap and trade schemes reduce the cap faster than emissions would normally fall so it creates scarcity. Pushing up prices in the long run, of course, there could be a lot of volatility. There are other factors, of course, that have shorter term impacts on the prices. For instance, one of the reasons we’re more bullish on the WCI market, for example, rather than the European market is that the price increase has been much more constant in North America versus the EU and we’re seeing right now that there is a bit of a distortion between the two markets. The European markets have been going down in the last few months, whereas the North American markets have been catching up. And so I think that supports our thesis. And also the carbon allowances, especially in the WCI, so in the Western Climate Initiative, have a guaranteed floor price that increases every year by 5% plus inflation. So it creates this downside protection system and so we think that considering that plus a diminishing supply and the demand that is not going anywhere, that it makes a compelling investment case

Ryan Fan: That certainly makes a lot of sense.There are a number of different ways to deploy capital in the carbon markets. So why invest in assets in the compliance markets?What are some other considerations beyond just the cap and trade structure?

Felix Boudreault: That’s a good question because again, as you mentioned earlier, there are different types of carbon credits. You know, the voluntary carbon credits that are often called offsets, and then you have the regulated market. So we could have a whole episode on the differences between the two different types of credits. But in essence, the voluntary one, you know, is slightly less regulated. They trade over the counter. There’s less regulations around them. There’s, the supply is difficult to quantify depending on the price and so on. Whereas the compliance carbon allowances are very strictly regulated. They are emitted by governments. They are much more liquid. They have this floor price I was talking about. And that floor price keeps increasing every year. And another main reason we prefer the physical carbon allowances, as opposed to other ways to invest in carbon markets, for example, the derivatives like the futures, is that by buying and holding the physical credits, the money is almost immediately reinvested in the local economy through climate solutions funds, both in California and in Quebec, it’s a way to have a more direct impact with the money invested in the funds.

Ryan Fan: Yeah, that’s a very good point. So Felix, you know, there are some well-known challenges to the voluntary carbon market, such as carbon credit quality or price variability. There are many initiatives underway in the voluntary market, obviously aimed at setting standards to help distinguish high quality, high integrity credits. There’s also new market infrastructure that will help enhance transparency and price discovery, such as, you know, the Global Credit Transaction Network Carbonplace, which CIBC is a part of. As credit quality improves and price the discovery becomes more transparent. Would this alter your investment strategy for voluntary credits? 

Felix Boudreault: So you’re right that there’s a lot of new initiatives. So the voluntary carbon credit space is evolving very quickly. And every initiative that will help improve the quality, the transparency, the integrity, and restore any type of credibility back to that market would be most welcome. And we’ve seen some of those initiatives and that’s great. So there was the Mark Carney initiative from a couple of years ago. It then merged with another initiative that was there to improve the whole system’s integrity. And they came up with something very useful that the entire carbon market space really benefited from, and that was the core carbon principles. So the CCPs, and even from a climate change integrity perspective. So I would say it’s getting better. Certain platforms where you can buy these credits, they offer additional due diligence verification systems. Some include, for example, satellite imagery tracking, or some other will offer it. Site visits so they make sure that they visit some of the projects themselves and so they can they can really keep track on progress of these offset projects. Even the certification agencies, which have been a bit of pressure in the last couple years, they’re also getting obviously much better and more cautious and they’ve been developing way more credible reserve credit pools in case of loss of permanence of credits. So for example, forest fires or any type of events that could shorten the permanence of the credits. So they have this mechanism where they can swap credits and then offer a credit that was in a reserve pool for that. All these initiatives are making the space way more credible and scientifically sound. And so that’s a welcome thing. And then while it’s not our focus and in our strategy, others are launching different vehicles, funds to invest in that market. And it’s a different strategy, but it’s just as good.

Ryan Fan: Now, talking about investment management for a second, investment management isn’t just about earning a decent return for your investors. It’s about earning a decent risk-adjusted return and managing those risks appropriately. So for the carbon fund specifically, what are the risks that you face as the manager of this fund and how do you mitigate them?

Felix Boudreault: Yeah, obviously a very good question, very important points. There’s no free lunch in life in general, and particularly in finance. There are some risks that investors should be aware of, of course. I would say the biggest risk is political. Cap and trade schemes are regulatory fabrication designed by policymakers, which are not known to always do the right things. And as a recovering bureaucrat myself, I should know that. But in this case, it happened to be a pretty ingenious system that has been proven to work. So notably by solving the issue of the acid rain in the 1990s. But obviously the reality is that politicians in California or in Quebec could decide to change the rules or do whatever they want. Even though we think it’s highly improbable, given the way that the system is governed, it’s still a risk that people should be aware of. But the consequence is manageable. And we know that because we’ve seen this in the past. So Ontario was part of the program and then left in 2018 following the election of Rob Ford. And the impact on the community was minimal. People didn’t lose money. The credits were just reimbursed to the investors and the rest of the system kept working fine. Obviously another risk is the macroeconomic situation. So carbon market is designed to be stable during mild economic downturns but a crash would obviously have an impact as the demand for industrial emissions would fall drastically. So we’ve seen that in Europe for example in the 2008, 2009 events. Even the systems like WCI have learned from this, and they’ve put some mitigation systems in the design. So for example, the compliance periods are covering three years. So large emitters would actually be incentivized by any major correction, knowing that they can bang the credits for three years, when the economy and probably the carbon price would most likely have recovered.

Ryan Fan: Yeah, it sounds like there’s a lot more resiliency in the carbon markets now with a lot more learnings from prior iterations. It’s good to see. So what makes Nordis and this strategy unique? And also what is your outlook for the carbon fund over the next three years?

Felix Boudreault: Yeah, I think a few things makes us unique, I think. So for one, the type of credits we buy. So again, most funds currently in existence trade a lot of futures instead of the physical credits. And in that case, there are really zero environmental benefits. Whereas when you buy allowances at governmental auctions, which is what we do, the money is immediately reinvested in the economy to fund climate solutions. Secondly, we have partnered with another asset manager, also based in Montreal, called Plant E-Corp, which specializes in electricity trading. And electricity trading is a very niche skill set, but it happens to help a lot in the carbon markets due to some similarities in the way these commodities trade. Thirdly, at Nordis, we have what we like to call cognitive diversity. So in the team, we have people from different background. We have a mathematician, an actuary, a couple of economists, of course, and myself, an engineer who work mostly on climate change for both the federal government and international organizations for more than a decade. For the outlook of the fund, we believe that there are structural tailwinds in the carbon markets and that the concept of carbon pricing is only going to get more prevalent. And this is in spite of who the tenants at the White House and 21 Sussex might be at the end of the year.

Ryan Fan: Yeah, those are really important considerations. Look, Felix, I want to thank you for taking the time to join us on the show today. You’ve given us some really good insights, both into the strategy of your carbon fund, but also into a little bit of optimism in the carbon markets in general on how they’re helping the climate. So thank you very much for joining the show, and thank you to our listeners for tuning in. Please join us next time as we tackle some of Sustainability’s biggest questions, providing different perspectives to help you move forward. I’m your host, Ryan Fan, and this is The Sustainability Agenda.

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