📊Carbon Derivative Market

Overview of the Carbon Derivative Market

Overview

Derivatives are an integral financial instrument in the carbon markets. Companies under carbon compliance regulation use carbon derivatives to meet their emission quota and hedge risk in the most cost-effective way. Investors can also use price signals from carbon derivatives to spot opportunities and effectively manage portfolio risk.

The carbon derivative market plays an essential role in unlocking scale and enhancing transparency for the VCM. A functioning carbon derivatives market incentivizes long-term investment by providing forward information on the price of carbon. In addition, derivatives can be used as a tool to hedge "transition risk" to a net-zero economy by reducing uncertainty over future prices. In doing so, they have the ability to transform unpredictable cash flows into expected returns, which is essential to secure funding for GHG offsetting projects. Most importantly, a functioning derivatives market incentivizes long-term investment, which is required to meet ambitious sustainability obligations while satisfying corporate and social responsibility (ESG) goals. Ultimately, the Carbovalent protocol is committed to scaling the VCM by building the market infrastructure to do so.

Applications of On-Chain Carbon Derivative Market

• Boost ESG ratings

• Reduce exposure risk to carbon pricing

• Facilitate transparent price discovery and signals

• Hedge "transition risk" to the carbon economy

• Hedge against inflation

• Act as an anchor price for the VCM

• Incentivize long-term investment

• Inclusive trading landscape

• Efficient capital allocation toward sustainability projects

Carbon Forward (Future) Contract

The asset-agnostic definition of a future contract is an agreement to buy an asset at a predetermined date (expiry) at a predetermined price (strike) but to be delivered and paid for later. In the case of a fungible carbon forward contract, the offset provider commits to deliver emission reductions to the buyer at a certain strike (price) and expiry (date). It is also important to note forward contracts can either specify a fixed or proportional amount of tokenized carbon credits.

For both custodians (provider & buyer), a forward future eliminates market price risk and secures the desired transaction price, even though the actual sale of credits may not happen for months or years. As a result, investors who buy carbon futures are protected from price volatility and a shortage of volume in the future.

Graph of EU Allowance (EUA) futures that represent the carbon credits traded in the EU Emissions Trading Scheme (ETS).

Source: carboncredits.com