David Lebovitz: Welcome to the Center for Investing Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on carbon and deforestation, and has been recorded for institutional and professional investors.

I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Dr. Sarah Kapnick, Senior Climate Scientist and Sustainability Strategist and European Global Market Strategist. Welcome to the Center for Investment Excellence.

Dr. Sarah Kapnick: Thanks for having me. I'm happy to be here with you both.

David Lebovitz: So as we all know, policymakers around the world, have adopted net zero emissions targets as they aim to reach them in the next several decades. Obviously, reducing emissions is critical to achieving this goal. But at the same time, completely eliminating emissions simply isn't possible.

And so more and more of what we're finding is that strategies to offset emissions are really a crucial piece of the puzzle. And so with that as the backdrop, I'm really happy to have both Sarah and (Meera) here joining me today for a discussion on these topics, as we work to unpack exactly what investors should understand going forward.

And so with that said, you know, Sarah we'd love to have you kick things off. In the current environment, the primary way to offset emissions is very much through carbon pricing initiatives. But what are the types of carbon pricing initiatives and really how have they evolved over the course of the past 20 years?

Dr. Sarah Kapnick: Carbon pricing mechanisms for creating - to create an external cost of greenhouse gas emissions, is actually not just carbon. It's actually all greenhouse gases. Which the majority of it is carbon dioxide, but it also includes methane and nitrous oxide and fluorinated gases. The idea ofthe pricing mechanism is to lead to this more efficient management of emissions.

Because ultimately, the cost of it is borne by societies and ecosystems. It's damages to crops due to heatwaves; due to drought. It's damages to property as the sea levels rise. The idea is to create a mechanism that is now pricing these issues and these damages that can happen. So specifically, a carbon tax such as specific price of carbon dioxide equivalent per ton, it generates revenues from greenhouse gas emitters.

Then an emissions trading scheme is referred to often in the United States as cap and trade, puts the limit on total emissions. And the price can actually fluctuate. So it fluctuates with all the trading activities. So those are carbon tax and emissions trading system. They can be sector-specific or they can cover multiple sectors.

What we've been seeing internationally, is they've often started with the biggest emitters in energy, and then they've expanded to other sectors like cement or agriculture, or others, to try and limit greenhouse gas emissions across different sectors. This also really developed because of expectations for international agreements and starting to regulate emissions worldwide.

Often people start talking about the Paris Agreement and how that was really a turning point in regulations globally. So the Paris Agreement was signed in December of 2015, 196 party countries signed onto it. It was the first legally binding agreement for nations to combat climate change through emissions reduction goals.

And when it was signed, the vast majority of regulations at the time were only in Europe. It was only 10% of emissions globally were covered. But since then there's been some slow growth and emissions covered worldwide under these regulations. With this explosion over the last year we're now over 21% of all emissions globally, are now covered under regulation.

And the reason for that is this lead up into (COP 26), which is happening in Glasgow in November. It is expected that there'll be another treaty, another agreement on how to regulate emissions worldwide. And so countries have been trying to push for their regulations so they can show leadership leading into (COP 26).

David Lebovitz: Excellent. That was a great intro. I would love to get a little bit more color here and really get a sense of how carbon pricing needs to improve in order for us to achieve net zero in line with the various targets that have been laid out by policymakers and governments, around the world.

Dr. Sarah Kapnick: So right now there are two different ways that we're regulating carbon worldwide. The carbon taxes have been set on like a minimum value of carbon. Academic analysis, the true cost of carbon and how it affects everything, plus policy analysis, sets this price. So the highest price worldwide is actually in Sweden. It's $140 per metric ton of carbon.

However, on the exchanges, the pricing is more like $50 US and below. And so there's this mismatch between the carbon taxes worldwide. It's set much higher. And there are expectations that with more regulation, with more expectation of pricing into carbon, that these prices may go up going in the future, particularly with more regulation and international regulation on carbon.

Academics have been putting more of a price on carbon, above $200 potentially. And seeing it going higher than that. And so I think we should expect the pricing of carbon will go up more as the damages also are seen and become greater with climate change, the cost of carbon also from that, becomes much higher.

 In Europe, also to try and deal with problems with the facts that Europe is trying to regulate carbon within the EU versus externally; in the EU Fit for 55 package they just included a cost order of carbon adjustment. And the reason that they did that, is they're worried about leakage. They're worried that carbon activity is trying to limit activities within the EU which just leaves activities outside the EU.

So trying to put now adjustment for the fact that they've been regulating in Europe and there aren't necessarily regulations externally. And so I think we'll see an increase in this type of regulation that will try and monitor carbon and try and make sure that activity is, if it's regulated in one place, will not lead to higher emissions externally.

David Lebovitz: I certainly agree that when it comes to a lot of this, when there's a will there's often a way. And I think that global coordination is probably particularly important in allowing the proverbial shift to continue sailing forward here. And (Meera), I'd love to bring you into the conversation. You know, we're talking about taxes, investors more often than not, are wary of any environment or situation where taxes are moving higher.

But at the same time, there's a clear revenue implication of carbon taxes. And so how might that revenue generated, be used? We talk a lot about in the United States, increasing taxes in an effort to pay down our debt. But thinking more about the environmental side of things, what are some possible applications for these revenues, in an effort to achieve net zero over time?

(Meera): That's right. I mean while tax is designed to change the behavior of the largest emitters, it's still a source of revenue. And in fact, global revenue from carbon pricing is at $45 billion. And it can be used in several ways. One way is to fund green initiatives, so you're not only facilitating that reduction in emissions, but also you're advancing some of these green projects.

And that could mean funding for infrastructure like upgrading our grid to make it more suitable for renewables. It could mean building more electric vehicle charging stations. On the research and development side, we still need to develop better batteries, alternative fuels and materials, carbon capture technology.

And what you see in Europe is dovetailing with Sarah's comments, they've proposed this import tariff called the Carbon Border Adjustment Mechanism. And basically that's in order to ensure some more global competitiveness with different regulations in different countries. So the proceeds of that would be part of the EU's budget.

And that actually would be used to finance out of the EU's recovery, some of its green transitions, and more broadly, it doesn't only need to be these green initiatives, it could be social or community projects as well, particularly for some of those communities that are most exposed to the worst impacts of climate change, or are just simply underserved by some of our current resources.

Another option is funneling it back to consumers more broadly, because a lot of these carbon pricing initiatives are expected to drive up the cost of energy. And they're going to impact input prices. And those might be passed onto the consumer in many cases.

So if that is the case then either revenue from those taxes can go back to the consumer through funding specific programs; you could see a cut in payroll taxes; or even direct rebates, sort of like a dividend back to the consumer, such that then the consumer doesn't have to bear the brunt of this energy transition.

Lastly, I would say the US and countries around the world, have really driven up their deficits over the last year and a half just due to the pandemic. So deficit reduction is also not another bad option.

David Lebovitz: Excellent. I think you're onto something with the idea of the climate dividend. I think we should coin that term here today, because it sounds like that's going to be definitely a piece of the puzzle here as we look forward. You know, speaking of the other pieces of the puzzle, Sarah, we've talked about carbon pricing up until this point.

You know, obviously another way of offsetting emissions is vis a vis forestry. So I guess for somebody who isn't terribly informed on the world of forestry, let's start with a simple question. I mean how many trees would we need to plant in order to offset global emissions? And furthermore, what is the underlying capacity to expand and extend forestry efforts here over time, given that it can be used in conjunction with things like carbon taxes, to help us achieve those long term emission reductions?

Dr. Sarah Kapnick: If we wanted to be able to offset the entire Russell 3000, we would need to double the amount of forestry worldwide. So every single tree and plant that is currently in existence around the world on the land surface, we would need to actually double that. And that's just the Russell 3000 of US stock market. For global emissions, it's actually five times that.

So this problem of how many emissions there are globally versus what we have available right now in terms of forestry, is limited. However, the only technology that we really have today to be able to offset emissions are these nature-based solutions, of which forestry is the one that is the major solution that we have today.

And so if you look at the voluntary carbon markets right now, roughly 40% to almost as much as 90% on some of them, relates to forestry actually, because it's the only technology that we really have, is this nature of technology right now, to be able to create offsets and be able to pull carbon out of the atmosphere.

So the way that carbon offsets through forestry are done right now, is three main ways - so one of them is reforestation. It's places where trees have been cut down or they've been lost through whatever process. Sometimes also post-wildfire, major storm event that causes damages. And it's replanting those trees and then sequestering carbon in new trees where trees have previously been.

The second one is afforestation. It's actually planting forests and having a tree farm where forests have never existed before. These have come under increased scrutiny in certain parts of the world whether they're planted where people thought that could have trees, and they put these fast-growing trees into the ground. And they've resulted in massive removal.

Water actually from the water table has actually increased drought susceptibility in those regions. So afforestation has to be done extremely carefully for understanding local ecology, to be able to not leave those negative impacts on the water tables. The third one has been avoided deforestation, saying that if you pay me money for this plot of land, I will not cut these trees down.

And again, that's another one that's come under increased scrutiny over time, sort of this leakage problem. If you don't cut down one plot does the plot next door get cut down? So the three main ways are reforestation, afforestation, deforestation. So forestry programs when they're being built and when they have them, they could actually lead to all sorts of other positive impacts.

So really high quality forestry offset program, also allows for building of biodiversity, thinking about biodiversity and conservation and local communities and their engagement in the conservation projects. Because many of these projects require the forests to stand there for several decades, 40 years, up to 100 years.

And so for the longevity use projects to be able to sequester that carbon for those really, really long time, you need the whole community engaged in it, to be able to not cut it down, and to be able to support this effort. Beyond that, I expect that there'll be new tiers for forestry going into the future. What I've mentioned with this biodiversity is conservation.

There are many different sustainability goals to a really good forestry project that could be developed to make really high quality forestry offsets, that also clear your pricing mechanism to deliver our multiple sustainability goals.

David Lebovitz: Very helpful. As I look out my home office widow at some forever green space, I certainly hope that they leave it here. But I think your point is very well-made and very well-taken. You know, (Meera), while we're talking about forestry and the offset market, whether it's pricing initiatives, forestry, will the offset market end up becoming inflationary?

You know, we usually talk about inflation as being driven by a mismatch between supply and demand. Given what's happening from a regulatory angle, we see the demand for a lot of this stuff is increasing. And arguably, based on what Sarah just said, in the case of forestry, we're still looking at somewhat of a limited supply.

And so what are your thoughts around pricing in the offset market over time? And how worried should we be about inflation in that market in particular?

(Meera): The energy transition itself, is likely to be pretty inflationary. I mean a carbon tax would increase the prices of coal, of natural gas, of retail electricity, of gasoline prices. And the people again, who are going to feel this the most, are often the consumers and particularly even those lower-income households for whom utilities and gasoline are pretty big portions of their household budgets.

And then of course, for companies, higher energy prices mean higher production costs, and that's going to be a headwind for profits. And we're seeing this happen right now. So there have been some wind intermittency issues in Europe that have helped to drive up the cost of natural gas. And I think this is a great example of what we're likely to see going forward.

We're going to see a bit more price volatility during episodes like this, particularly in natural gas, which is kind of considered one of the cleaner fossil fuels. It's often that transitional energy source for those trying to move from fossil fuels to renewables. And look, this is a necessary transition overall. It's going to feel painful at times for both consumers and companies. But it's going to also require a lot of care and preparation to get it right.

And if we think about forestry in particular, look to Sarah's point, the supply/demand imbalance is certainly there and that's going to drive up prices in that sector. But let's think about it in a slightly different perspective. If we think about forestry as an asset, more specifically something like timber, I think that could actually be viewed in a portfolio context more as an inflation hedge.

It is a real asset. It is an uncorrelated asset when we think about other components within a portfolio. And it's also again, an asset that's likely to experience this price appreciation when we think about the supply and demand dynamics. So from a portfolio perspective, it can actually serve multiple purposes.

David Lebovitz: I think that's a really important point. And in a world where the bond market effectively offers you one of two things, either protection without income or income without protection, we see clients increasingly looking to real assets, things like real estate, infrastructure, timber, just to name a few, because not only do they provide that inflation protection that you highlighted, they tend to lack correlation to both stocks and bonds.

And furthermore, provides streams of income that are comparable to what one could get from the credit side of the equation. And so, you know, I think that there are really two angles here - one, obviously trying to reduce carbon emissions is arguably the right thing to do, but two, there are some beneficial portfolio implications stemming from this, given what investors have on their mind in the current environment.

Sarah, sticking with the topic of forestry, just kind of wondering from my vantage point, do you have a perspective on carbon avoidance offsets versus carbon removal offsets? And maybe we can just start by talking about the difference between those two and then, you know, a preference that you may or may not have one way or the other.

Dr. Sarah Kapnick: I think you're getting to the point and (Meera) was also touching on this, that standards around offsets are still developing and vary across voluntary and compliance markets. For these registries, they each create their own standards of what you need to do to be able to get an offset.

It's still the really early days for this. And they've been evolving even over the last decade that they've come into existence. So avoidance ones are becoming much more tenuous to be able to do. The whole point of it was to create financial incentives for projects. And avoidance projects in the early days, really were created to provide these financial incentives to do these extra fees for carbon removal.

That is carbon becomes more valuable and its leakage issues with avoidance offsets also occur and is continuously monitored and there are reports of it out. That's damaging the ability to use those avoidance offsets. And it's also becoming increasingly a reputational risk for purchasing some of those avoidance offsets.

If the reputation of using those offsets with the bad examples of what have happened in the past for an avoidance offset for one plot of forestry land leads to the next plot over being removed. That isn't really sustaining the goal of having that stop and having the carbon sequestered in the forest. And so I think increasingly, these avoidance offsets will come under increased scrutiny, and also be seen as reputational risks.

There might also be tiering of the different types of forestry offsets between and avoid an (process) for (unintelligible) offsets due to reforestation or deforestation. And so the quality of these offsets, the potential of our reputational risks may lead to changes in pricing across different types of offsets going forward.

David Lebovitz: Certainly a lot to chew on with this topic in general. And I know we're getting close to the end of our time together here today. And so I would love to have both of you share some thoughts. You've been a great team in terms of helping us understand where we are today and how we've gotten to this point over the course of not just the past couple of years but the past couple of decades, you know, thinking ten, 15, 20 years down the road.

And (Meera), maybe starting with you, what additional technologies could be developed to offset emissions that could present interesting investment opportunities in the future? You know, a lot of our listeners are investors. The majority of our listeners are investors. And so I would love to kind of wrap up our conversation here today by tying everything back to the underlying investment opportunity set and how it may be changing in light of what we've talked about here, over the course of the past 20 or so minutes.

(Meera): Well about 45% of emissions reductions need to come from technologies that are just not commercially viable yet. So we have a lot of work to do when it comes to R&D. And we're going to hopefully see more funding from the government on that. They really need to kind of lead the way. But what we've seen more recently is huge fundraising efforts on the private side, from both private equity investors, also venture capital.

 And what they're really targeting here is the next generation of green innovation. So I'm pretty excited to see what comes out of that.

Dr. Sarah Kapnick: And I would say all the IPCC scenarios to be able to stay below 2 degrees or 1.5 degrees Celsius, they require the mechanical removal of carbon dioxide from the atmosphere and ocean by 2060. And they require that scaling up to be on par with what forestry is today, to be able to limit global warming, but also to start reducing global warming by the end of the century.

And so those types of technologies as (Meera) commented, they don't really exist yet. They don't exist at scale. There's one factory that is doing carbon capture from the atmosphere right now in Iceland, and it's in Iceland because there's tons of renewable energy available to be able to power it because it's so power-intensive to do that.

And so the emergence of these new types of technologies to be able to sequester carbon, be able to remove it from the atmosphere and either bury it under land or be able to remove it and even create new products from it, because these new technologies are starting to remove carbon from the ocean, actually turn it into plastics.

So it gets us away from using plastics that our oil-based to be able to use plastics that are now sequestering carbon from the ocean. And so there'll be a proliferation of these new types of technologies. And they're all in the very early stages right now. And there's hope that in the next ten, 20 years, these will be the technologies that will develop and will scale, be the technologies that we need for the future to be able to reduce climate change going forward and potentially reverse it by the end of the century.

David Lebovitz: Fantastic. First of all, both of you, thank you so much for joining me today. I know I learned a lot. I thought this was eye-opening in a number of different ways, both in terms of bettering my own understanding about what's going on in the world of emission reduction and movements toward a more sustainable approach within the context of the environment more broadly, and then doing a nice job of tying it to the investment implications, which is obviously front of mind for a lot of our listeners.

So thank you both again for joining me. And I think we'll have to bring you both back soon for part two.

Dr. Sarah Kapnick: Thank you for having us.

(Meera): Thanks, David.

David Lebovitz: Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Thank you. Recorded on September 28, 2021.

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