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  • Writer's pictureCourtney Burton

Corn, Cattle, and Carbon: Carbon Credits as Physical Commodities

Updated: Nov 14, 2023

By Courtney Burton and Stewart Maier

It's generally well-recognized that corn and cattle are tangible assets in the commodities market. But, you might be surprised to learn that carbon credits share this classification too. In this article, we discuss the reasons behind categorizing carbon credits as a physical commodity. While our title might hint at a direct comparison with corn and cattle (a little attention-grabbing tactic!), our actual focus is a parallel analysis with the commodities of natural gas and electricity.

This article will: (i) explain the physical attributes of carbon; (ii) discuss why regulators treat carbon as a physical derivative: (iii) compare carbon as a physical commodity to electricity, and finally (iv) compare carbon as a physical commodity to natural gas.

Carbon Credits as a physical commodity

Due to the attributes described below, carbon credits are analogous to other physical commodities. They are often discussed in the same context as traditional energy commodities in terms of market behaviour, strategic importance, and global trading patterns.

  • Physical Basis: A carbon credit has a direct physical basis—it represents a metric tonne of CO2 or the equivalent amount of a different greenhouse gas that has been prevented from being released into the atmosphere. This quantifiable relationship to a physical basis gives it a grounding in the physical world.

  • Quantifiable and Measurable: Like other physical commodities, carbon credits are quantifiable and can be precisely measured. This allows them to be traded with specificity regarding the amount of emissions they represent.

  • Regulatory Frameworks: They are created and traded within the structured and regulated frameworks of carbon markets, much like physical commodities are traded on regulated commodity exchanges.

  • Market Dynamics: Carbon credits are subject to the same market forces of supply and demand as physical commodities.

  • Verification and Tracking: The life cycle of a carbon credit involves verification through third-party verifiers to ensure that the represented emission reductions have indeed occurred.

Carbon credits regulated as a physical commodity (derivatives)

Carbon credits are regulated as physical commodities under Canadian and U.S. derivatives regulations because they are financial instruments that derives their value from an underlying asset, in this case, the measured reduction of carbon emissions. They are treated like a physical commodity from a regulatory perspective for several reasons:

  • Price Derivation: The value of carbon credits is derived from the physical quantity of greenhouse gases reduced or offset, which is a measurable and verifiable commodity. Therefore, they behave like physical commodities in how they are traded based on their underlying value.

  • Risk Management: Like other physical commodities, carbon credits are used by businesses to manage risks associated with future price fluctuations in the cost of carbon emissions.

  • Trading Platforms and Products: Carbon credits are traded on exchanges and through over-the-counter markets, much like physical commodities.

  • Regulatory Oversight: The regulation under derivative regulation helps ensure that the trading of carbon credits is conducted fairly and transparently, with adequate reporting and compliance checks.

  • Market Integrity: The inclusion under derivatives regulation helps to maintain the integrity of the carbon markets. It ensures that carbon credits meet certain standards and that their creation, verification, and retirement follow specific rules, which are crucial for them to be recognized as instruments for compliance with emissions regulations.

  • Financial Instrument Characteristics: Although carbon credits do not represent a direct physical holding, they share many characteristics with commodity-based financial instruments. They can be bought and sold, require settlement, and carry counterparty risk, all traits that make their regulation under financial and commodity derivatives laws appropriate.

While carbon credits are not "physical" in the traditional sense, their treatment under derivatives regulations in Canada and the U.S. is due to their nature as financial instruments that serve a similar economic function to physical commodities. This regulatory approach helps to provide the structure and certainty that market participants require to trade these instruments effectively and responsibly.

Electricity and carbon credits (compliance carbon market example)

Carbon credits and electricity are unique commodities because they both represent physical phenomena but are not tangible in the traditional sense, like corn or cattle. Both are traded as commodities because they have quantifiable physical attributes and economic value, yet neither can be stored easily or displayed on a shelf.

Electricity is generated the moment it's needed and consumed instantly; it flows through power lines like water through pipes, from power stations to homes and businesses. The trading of electricity is based on the physical delivery of electrons across the grid, and contracts for electricity specify the amount to be delivered over a certain period at a particular location, making it a physical commodity despite its intangible nature.

Carbon credits represent the right to emit a metric tonne of CO2 or the equivalent amount of another greenhouse gas. They are born out of environmental regulations and policies that put a cap on emissions and require certain industries to hold enough credits to cover their CO2 output. Each credit corresponds to a physical quantity of greenhouse gas that can be emitted into the atmosphere or, alternatively, that has been prevented from being emitted or has been removed from the atmosphere through projects like reforestation or renewable energy. Though you cannot touch a carbon credit, it is considered physical because it's tied to the physical presence (or absence) of greenhouse gases in the Earth's atmosphere. The lifecycle of a carbon credit starts with the quantification of CO2 emissions (or reductions), followed by a certification process, and culminates in its use by an entity to offset their emissions.

Both carbon credits and electricity are traded on specialized exchanges and over-the-counter markets. Their prices are subject to supply and demand dynamics, and both must be carefully measured, tracked, and settled upon delivery, which occurs through a complex infrastructure of registries for carbon credits and transmission networks for electricity. The "physicality" of both these commodities lies in their direct link to real-world, measurable phenomena and their ability to cause real-world impacts. Electricity's power to energize and carbon credits' influence on our carbon footprint make them substantive, even if you can't hold them in your hand.

Natural gas and carbon credits (compliance market example)

Natural gas and carbon credits as tradable commodities share the conceptual space where their physical properties underpin their economic exchange, but the ways they traverse the market highlight the peculiarities of each. Natural gas is a fossil fuel consisting mainly of methane, physically extracted from underground reserves. It's a tangible commodity that you can measure in cubic feet or meters and store in vast containers or within the infrastructure of pipelines. Its physical journey from extraction to combustion is a story of tangible transit: through pipelines, on ships as liquefied natural gas (LNG), and eventually to homes and businesses where it's burned for heat, electricity, or other energy needs. The physicality of natural gas is unquestionable—it's a resource that can be seen, measured, and requires a physical space to occupy.

Now, let's consider carbon, specifically in the form of carbon credits. While CO2 itself is a physical gas, as a tradable commodity, we're dealing with the concept of carbon emissions or reductions. Again, a carbon credit is a permit that allows the holder to emit a certain amount of carbon dioxide or other greenhouse gases. These credits can be bought and sold as a way to incentivize the reduction of emissions. Like natural gas, carbon credits are traded, but the marketplace exists in a more abstract regulatory and accounting space rather than a physical space. When companies engage in carbon trading, they’re not exchanging barrels or tanks of CO2; they’re trading the right to emit or the claim to have reduced emissions. This trading is critical for managing the carbon footprint of businesses and countries, and the market for it is detailed and regulated, ensuring that these non-tangible trades have real-world impacts on emissions.

Despite their intangible nature, carbon credits can be compared to natural gas in terms of commodity trading because both have units of measure, both can be inventoried in some form, and both have markets that determine their price. For natural gas, this price fluctuation is based on supply and demand, storage levels, production changes, and geopolitical developments. For carbon credits, pricing can be influenced by emission reduction targets, the results of climate policy negotiations, the availability of sustainable technologies, and overall market sentiment regarding the urgency of climate action. The comparison illustrates the evolution of commodity markets, expanding from traditional physical resources to encompass environmental and climate-related products. Both markets play crucial roles in shaping economic and environmental strategies on a global scale.

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