Commodities markets and the financialization of carbon

Introduction

As the carbon market continues to develop, much can be learned from other, more mature markets. Earlier this month, Dr. Lauren Gifford put out a call for examples from commodities markets that may offer useful references and Tommy Ricketts published an article suggesting the bond market as a better reference. Based on 25 years of experience working across markets, I believe that gold presents a relevant market structure example for the voluntary carbon market.

Gold’s price & form factors

A maxim in the precious metals market goes, “Gold is gold is gold.” Gold is a commodity, a metal, and in theory, one ounce of gold should be perfectly fungible with any other ounce of gold. To a degree, this is true and one of the reasons that gold has functioned as a currency through roughly 5,000 years of human civilization. But it isn’t that simple.

The price of gold is impacted by a myriad of factors.

Format: Gold products come in many shapes and sizes, but in the context of gold as a financial asset, the format is predominantly bars and coins. The price of an ounce of gold as a financial asset is determined by several characteristics, some of which are temporal:

• Was it produced by a commercial refinery or sovereign mint?
• Is it pooled (e.g. the owner owns a generic quantity of gold held in inventory someplace) or allocated (the owner owns a specific physical gold asset with a serial number)?
• When was it produced (vintage)?
• Is there artwork on it?
• Does it have historical significance (e.g. Roman coins, sunken treasure)?

The range of carbon credit formats echoes the heterogeneity in gold products.

Fineness & weight: The purity of the ounce of gold, which typically ranges from 99.5% to 99.999%. Stated fineness and weight may be accepted at face value if the gold has remained in a “trusted chain of custody”, but gold that has been outside the chain of custody must be re-verified by being assayed and weighed.

Measurement and verification add costs that can also impact price. Pouring molten metal to cast a bar of a given weight is an imprecise process — a 400 oz bar may actually be approximately 400 oz. The costs to get to extreme precision aren’t worth the extra investment relative to the weight of the gold above/below the target.

In carbon, this may be analogous to measurement, reporting, and verification (MRV), and in soil carbon, there’s a similar trade-off of cost vs. precision.

Security: To combat forgery and fraud, refiners and mints have developed various security measures, including embedded systems such as the Royal Canadian Mint’s Bullion DNA™.

In carbon, this may be analogous to credit issuance and retirement — whereby transparent tracking can help protect against duplicate sales.

Provenance: The lifecycle of the gold begins with the original source of the gold, traced back to the mine. Buyers may be concerned with how well the mining companies manage their environmental impact and compliance with employment laws. Who has owned the gold is also a factor — gold previously owned by a famous person may add value while gold previously owned by criminals or sanctioned countries may have virtually no value.

In carbon, this may be analogous to the methodology, source, and trading history (if any) of a given carbon credit.

Location: The price of gold can be impacted by its spatial location as a function of the supply/demand of that location. A 400 oz bar of gold physically stored in London may be priced higher than an identical bar physically stored in Ottawa because there is greater trading liquidity for 400 oz bars in London.

In carbon, this can be compared to the jurisdiction in which a project is administered.

Standards & eligibility: Gold-backed financial products/markets such as derivatives (e.g. the COMEX gold futures contract) and the London Bullion Market Association (LBMA) spot market have specifications and standards that determine what types of gold are “eligible” to settle trades:

• COMEX futures: 100 oz bars in COMEX-approved warehouses 
• LBMA spot: “London Good Delivery” 400 oz bars within the London delivery network

In carbon, this may be analogous to the various standards-setting bodies.

Inflation: A purely financial factor affecting the price of gold. Some investors view gold as a hedge against inflation, so when inflation is expected to rise the demand for gold, and hence its price, can also rise.

In carbon, buyers may view credits as a hedge against future compliance requirements.

Point-of-purchase: Retail gold products can be purchased directly from online gold dealers, in physical stores, and in secondary markets. A new product purchased from a reputable dealer may fetch a higher price than a secondary market purchase with uncertain provenance and authenticity. Wholesale market purchases in larger volume and/or between dealers are typically at prices lower than retail purchases.

Carbon has both retail and wholesale markets as well. In fact, Deloitte recently published an article about the potential growth of the consumer carbon credit market.

The list above is not exhaustive but should suffice to establish that an ostensibly straightforward fungible physical commodity is, in fact, heterogeneous across many facets including physical, risk, standard, and more. It is also worth noting that the gold market is extremely mature, and gold may be the most financialized commodity in existence.

Commodity market making & “making same”

The purpose of commodity derivatives is to enable risk transference from “hedgers” to “speculators”. Regulated derivatives must be standardized instruments that reference standardized underlying commodities definitions. For example, the COMEX gold futures contract specifies that the underlying gold must meet the 100 oz good delivery format and be stored in an eligible warehouse. This “makes [it] the same”.

Standardization of products on a regulated exchange with guaranteed clearing and settlement via a regulated clearinghouse fosters market participation from a broad range of actors (mining companies, refineries, mints, jewelers, electronics manufacturers, market makers, arbitrageurs, hedge funds). By bringing together a diverse group of participants with various objectives and price outlooks for gold, the futures contract can create a liquid market and a tool for price discovery — which, in fact, the COMEX gold futures contract does.

But what about gold products that don’t adhere to the standard 100 oz gold bar stored in the COMEX eligible warehouses? How are they priced?

Gold buyers’ product preferences for mint, refinery, vintage, and standards vary. For example, like in the carbon market, buyers must take into account the risk of fraud or non-compliance for a given supplier. Hedge funds that hold physical gold typically own large format (100 oz or 400 oz) bars whereas retail buyers typically own 1 oz coins. 

The benefit of having a standardized price reference in the COMEX gold futures contract is that it allows the market to ascertain the “price” of gold. All of the other products’ prices are then set in reference to that accepted gold price. Yet even in this mature market, there’s more than one source of price discovery and prices may vary across regions and countries depending on their local regulatory treatments, supplies, and market infrastructure.

Market makers post bids and offers in the market. The difference between the bid price and the offer price is called the “spread”. Market makers seek to “earn the spread” by buying (lower) at the bid and selling (higher) at the offer. Arbitrageurs seek to profit by identifying price dislocations across products. For example, if the price of the COMEX future looks low relative to the price of the LBMA gold spot product the arbitrageur will buy the future and sell the spot, profiting on the dislocation. Through their activities, arbitrageurs bring the prices back toward “fair value”.

Carbon market implications

There will continue to be a range of “carbon products” that meet different formats, specifications, and standards designed for a variety of market segments and objectives. The integrity of the standards, products and actors will be essential for the market to function well and encourage trust and a broad range of participants.

The voluntary carbon market market structure is currently immature relative to other markets but is quickly evolving. Spot voluntary carbon markets and regulated derivatives exchanges will develop to offer increasingly standardized products, based on increasingly agreed standards (commercial and governmental). Sophisticated speculators, market makers and arbitrageurs will enter to provide liquidity and keep prices in line with “fair value”, benefitting commercial and retail consumers who wish to hedge production risk or ensure they are getting a fair price. 

Commodity derivatives evolved to help create standards and manage risk. The resulting efficiencies vastly improved the markets, enabling massive scale. The process happens in stages, and a spot commodity is necessary before standards and derivatives can be created.

The voluntary carbon market is early in its market structure development but drawing lessons from other markets can help accelerate the growth in scope, scale, participation, and in the case of carbon, positive climate impact.