DBS - Carbon Exchange

DBS recently announced a collaboration with SGX, StanChart and Temasek to launch a global carbon exchange called Climate Impact X (CIX). While it'll be some time before we can see how well received it is, I figured that I'll run through a few fundamental things, including the motivation, working principles and what sets DBS's initiative apart from others.

1. Market and Externalities

A core principle behind economics is a balance between demand and supply. With the assumption that the market participants are rational, the idea is that participants would come to a consensus on how much goods to consume/produce, and at what price, taking into account the benefits and costs of the transactions.

Some products have impacts that reach further than the individual consumer. For example, tobacco is detrimental to public health, but individual consumers either do not know or do not care enough to factor it into their decision making (which is entirely reasonable as rational actors in a market).

These broader impacts are known as externalities, which can be either positive or negative. In order to account for the detriment to public health, authorities often regulate and impose taxes, which serve to quantify the negative effects and get it "priced in" in the market. In the case of tobacco, a higher tax would lead to greater costs for consumers that end up lowering demand.

2. Economic Motivation behind Sustainability

Global warming and climate change have been getting more attention over the years (for good reason). With this, consumers are caring more and more about their "consumption footprint", which causes a change in a corporate mindset as well. Companies are now serious about ESG - Environmental, Social and Governance, and they want to adapt and be more "green" to cater to this changing consumer preference.

Alongside consumer pressure, governments are also accelerating this change, by imposing taxes on carbon emissions. This impacts a company's finances, making it a more direct incentive for companies to reduce their carbon footprint.

3. Carbon Exchanges

Carbon exchanges basically allow for the "outsourcing of green initiatives" as I would like to call it. Here's a simple example to illustrate the core concepts.

Here, we have two main parties, a factory owner and a forested land owner. 

The forested land owner does not generate much revenue at all from the undeveloped land, since it isn't involved in any economic activities. Hence, from a financial standpoint, the land owner would logically look towards redevelopment, maybe building a mall or something. However, redevelopment would result in heavy environmental impact (eg. release of carbon). 

Carbon credits come into the picture, and is provided to give an incentive for the land owner to preserve the forest. But what's the use of these credits anyway?

From the factory owner's point of view, try as he may, he might not be able to achieve net-zero emissions from the factory operations (due to the nature of the work). Let's say that even after finetuning and optimizing the manufacturing process, the factory still outputs 1000 tons of CO2 per year. 

In order to offset this last 1000 tons of CO2, the factory owner can purchase an equivalent amount of credits from the forested land owner, and thus account for all his carbon emissions. In short, the often costly process of reducing carbon footprint is monetized and traded between two parties with different circumstances (and hence different operational difficulties), through a central Carbon Exchange.

4. Recent Trends

This chart from McKinsey & Co. shows that adoption of carbon credits have risen quite sharply in the past 5 years. Note that both demand and supply of carbon credits recorded healthy growth. The relative disparity would reflect in price movements, but from an exchange's point of view, I believe that volume would be more important.

In Dec 2020, CTX (an existing Carbon Exchange with over 10 years of operation) hit an all-time-high monthly trading record at $14 million. 

Lastly, financial analysis company Refinitiv reported a 20% growth in the global carbon market, to $272 billion in 2020, expanding over 5 times since 2017.

5. DBS's Innovation

So what makes the proposed CIX stand out amongst current solutions/exchanges? Here's a direct screenshot from their website!

Of note is the usage of satellite monitoring, as well as machine learning and blockchain technology. I think these prove extremely useful in automating and improving processes that make sure that carbon credits are tied to actual conservation/environmental efforts, as well as making it more efficient to transact on the carbon market.

I think that the "committed forward volumes at agreed reserve pricing" is also very crucial in stabilizing a "young" market, allowing credit suppliers to plan in advance and commit to larger, more risky projects without having to worry as much about profitability and volatility.

Conclusion

With a year-end target for rollout, it remains to be seen whether this new venture would be successful, both in the financial sense as well as in how effectively it supports the growing market. 

That aside, I think that this project is definitely important in the "grand scheme of things". Facilitating carbon credit trade would help curb net emissions in the short term, and also help to channel more resources into sustainability and environmental projects that could make a deep impact in years to come.

I will definitely be following up with this initiative in the future. Being an investor, I would love to see a profitable venture that also plays a part in tackling the environmental issues, so fingers crossed!

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Cheers, 

InvestingNugget 

Author's note:

At the point of writing, I am a shareholder of DBS. I have put in my best effort to ensure that the facts are accurate, but I do not guarantee it. Opinions are my own and do not constitute any recommendations.