In the landscape of exchange traded products (ETPs), we have exchange-traded funds, exchange-traded commodities (ETCs) and exchange-traded notes (ETNs). Legal structures are the main differentiator, with ETFs falling under Investment Act of 1940; physical commodity funds under 1933 Securities Act Grantor Trust rules; and ETNs under 1933 Securities Act Debt Securities rules. Let's look at what an ETN is and then get into an alternative type of ETN that has been working for investors so far this year.
Unlike an ETFs or ETCs, which provide exposure to the strategy by holding underlying securities or physical commodities, ETNs are subordinated debt securities. This means they promise to deliver a certain return stream (usually based on an index) to investors, but not the same way a traditional fund does. They do this by contracting with a trading desk, which essentially sets up a swap, which buys the underlying securities of the index and delivers those returns in exchange for a fixed fee, which is then passed on to ETN shareholders. That same desk, or another desk, puts a hedge on that exposure, so that the issuer's balance sheet is protected.
Often, ETN issuers also act as primary market makers for these products. What issuers like about ETNs is that virtually everything that is contracted to third-parties in an ETF or ETC can be handled internally by the ETN issuer, which translates into some healthy margins on these products. Investors generally like ETNs, because these products often provide exposure to unique strategies or assets. What investors are often wary about with ETNs has to do with their status in the issuer's capital structure. Unlike an ETF, which is a structure that shields investor assets from whatever is happening at the issuer, ETNs are unsecured bonds.
In the event of some financial catastrophe (think Lehman) or the issuers risk desk instructing the issuer to protect its balance sheet (think Credit Suisse and Velocity Shares' VIX-based products) ETNs can either simply go away or see major disruption in regular way trading. Don't forget, in the capital structure, subordinated debt is essentially on par with equity shareholders. This means they have no claim to anything in the event of a bankruptcy. While this sounds scary, it just means that ETN investors have one more thing to keep track of (issuer credit quality) when investing in these products. If you're interested in learning more on these differences, check out this SEC bulletin.
Carbon Credits
For a couple of decades, manufacturers, electricity producers and others in Europe have been subject to carbon emission quotas. They have been issued Carbon Credits based on carbon offsetting projects permitting 1 tonne (metric, or long ton = 2,200 lbs) of emissions per credit. Unlike corporate tax credits here in the U.S., which are non-transferrable, if a company comes in under their allotted carbon emissions limit, it is able to sell the unused credits to other companies through the EU Emission Trading System. As this market developed, it wasn't long before a futures market sprang to life and investors could participate in the ups and downs of these markets.
Carbon Credit Plays: GRN / GRNTR
Back in June of 2008 Barclay's Bank issued an ETN that traded and still trades on the Over-The-Counter (OTC) market. In September 2019, the company issued a "Series B" of this product and listed it on the New York Stock Exchange Arca exchange. Both ETNs still trade on their respective venues and are the iPath Global Carbon ETN (GRNTF) and the iPath Series B Carbon ETN (GRN) . While Barclays discloses that these notes track the Barclays Global Carbon II TR USD Index, I was unable to find a methodology document through them or Bloomberg, who acquired this and other Barclay's indexes in 2017. I was able to find this filing (pages 28 - 34) on the Securities and Exchange Commission's website, which describes the index as being "heavily weighted toward futures contracts on carbon emission credits in the European Union" and references December futures contracts (contracts go out to 2028) that trade on ICE Europe Future Exchange (Intercontinental Exchange (ICE)). Index constituents are liquidity weighted meaning more heavily traded contracts get bigger allocations in the index. Rebalances occur annually and the associated trades are spread out over five days so any price discovery impact due the fund rolling in and out of positions is limited. If you're interested, here is a link to the specifications for those contracts.
My Take
GRN provides a truly unique exposure. Some maintain that the carbon credit system is a case of yet another loophole for some companies who can afford it to resist or delay improving their environmental impact profile and I don't disagree. One thing that is influential is that the E.U. has set schedules that over time to reduce the issuance of credits. In theory, that should reduce the amount of carbon emissions. From an investing perspective, a declining supply in the face of stable or increasing demand means? Higher prices. To be clear, there are a lot of factors that play into the valuation of carbon credits, but if you feel that the carbon credit system presents an opportunity then perhaps carbon credit markets and GRN are worth a closer look.
