The European Union Emissions Trading System (“EU ETS”) was set up in 2005 and is the world’s oldest emissions trading system. It is a cornerstone of the European Union (“EU”)'s policy to combat climate change and its key tool for reducing greenhouse gas (“GHG”) emissions cost-effectively. Since it was launched in 2005, it has contributed significantly to achieving the EU’s overall target of reducing GHG emissions by 20% by 2020 from 1990 levels. The EU surpassed this target and reduced GHG emissions by approximately 31% below 1990 levels in 2020. The EU ETS will play a major role in achieving climate neutrality in the EU by 2050, including the intermediate target of at least 55% net reduction in greenhouse gas emissions by 2030.

The EU ETS works on the “cap and trade” principle. A cap is set on the total amount of certain greenhouse gases that can be emitted by the installations (or companies) covered by the system. The cap is reduced over time so that total emissions fall. In addition to ensuring that total emissions fall via cap reduction over time, the “cap and trade” principle is the most transparent method for emission allowances allocation, setting the opportunity cost of emitting carbon, and puts into practice the principle that the polluter should pay.

An “installation” is defined and regulated under the EU ETS as a stationary technical unit within which one or more activities under the scope of the EU ETS are carried out, and any other directly associated activities which have a technical connection with the activities carried out on that site and which could have an effect on emissions and pollution. Examples of installations include power plants, oil refineries, metal miners, and manufacturing plants.

Within the cap, companies buy or receive emissions allowances, which they can trade with one another as needed. Each allowance permits the holder to produce one metric tonne of carbon equivalent greenhouse gases (“tCO2e”). The limit on the total number of allowances available ensures that they have a value.

After each year, a company must surrender enough allowances to cover fully its emissions, otherwise heavy fines[1] are imposed. The companies covered by the EU ETS have a legal obligation to participate. If a company reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another installation that is short of allowances.

Allowances are either auctioned or given to the emitters (known as free allocation). Historically, utilities have generally had to go through auction, while industrial emitters were largely given free allowances. More heavily emitting industrial companies may have to also go through auction to receive enough allowances to cover their activities.

Within the foregoing “cap and trade” principle, the price of emissions allowances would be impacted by the cap level each year, as well as the level of demand, which may be affected by factors such as:

• Efficiency of energy usage – Higher efficiency of energy usage by carbon emitters may result in a lower demand for emissions allowances, A lower demand in emissions allowances may lead to a decrease in the price of emissions allowances, and vice versa,
• Economic growth – Economic growth is generally correlated with an increase in carbon emissions from economic activities such as mining and manufacturing. Such increase in economic activities may lead to increased demand for emissions allowances, An increase in demand in emissions allowances may lead to an increase in the price of emissions allowances, and vice versa,
• Relative commodity prices – An increase in the price of higher carbon-emitting commodities (e.g. coal) may lead to lower demand in such commodities and thus carbon emissions allowances, whereas an increase in the price of lower carbon-emitting commodities (e.g. natural gas) may lead to higher demand in higher carbon-emitting commodities and thus carbon emissions allowances. A higher demand in emissions allowances may lead to an increase in the price of emissions allowances, and vice versa, and
• Seasonal weather patterns – Unusually cold weather, for instance, normally results in an increase in the use of various heating appliances which lead to increased carbon emissions from power plants, and thereby may result in higher demand for emissions allowances. A higher demand in emissions allowances may lead to an increase in the price of emissions allowances, and vice versa.

According to Refinitiv[2], EU ETS represents nearly 90 percent of global value and accounts for most of the record high global traded volume of 10.7 gigatonnes. Over 8 billion emission allowances changed hands in the European carbon market in 2020.

[1] Regulated entities must pay an excess emissions penalty of €100/tCO2e for each metric tonne of CO2 emitted for which no allowances have been surrendered and buy and surrender the equivalent amount of allowances.

[2] Source: Refinitive Carbon Market Year in Review 2020, January 2021. Includes futures but excludes options.

A European Union Allowance (“EUA”) is the official name for Europe’s emission allowances, which in 2008 was defined as the official Kyoto allowance for countries in the EU. One EUA entitles the holder to emit one metric tonne of carbon dioxide or carbon-equivalent greenhouse gas. The EU member states issue new EUAs on 28 February in every year to each company subjected to the EU’s emission trading scheme. These awards follow the allocation plan approved by the European Commission and are based on the Kyoto protocol’s obligations. EUAs are awarded for one year at a time. By 30 April, companies are obliged to surrender the number of EUAs corresponding to their actual emissions in the preceding year. EUAs can also be saved from one year to another if a company releases less carbon dioxide than the EUAs it holds.

Further information about EU ETS and EUA can be found on the European Commission website (https://ec.europa.eu/clima/policies/ets_en).

EUA Supply

EUA Supply is determined by the number of EUAs made available by each EU member state through national allocation plans (NAPs) in consultation with the European Commission. In a given year, the supply of EUA is primarily driven by the cap, auction and free allocation. The actual EUA supplied through auction and free allocation could be different from the cap in any given year, as the actual volume in auction and free allocation may be adjusted by supply adjustment mechanisms introduced by the EU ETS from time to time, such as Market Stability Reserve and “backloading”.

The cap is the maximum absolute quantity of GHG emissions that may be emitted by entities covered by the EU ETS to ensure the ETS emissions reduction target is met, corresponding to the number of allowances put into circulation over a trading period. In Phase 3 (2013-2020) of the EU ETS, the Union-wide cap for stationary installations decreased each year at an annual rate of 1.74%. In Phase 4 (2021-2030) of the EU ETS, the cap on emissions continues to decrease annually at an increased annual rate of 2.2%.

Auction is the primary method of distributing allowances in the EU ETS, accounting for 57% of the cap since the beginning of Phase 3 (2013-2020). In 2020, total auctioned volume is 778,505,000 allowances. The auction is governed by the Commission Regulation (EU) 1031/201033 (Auctioning Regulation), which specifies the timing, administration and other aspects of how auctions should take place to ensure an open, transparent, harmonised and non-discriminatory process.

Free allocation of allowances is provided to sectors covered by the EU ETS, with the exception of most of the EU power sector to assist with their transition towards a low carbon economy.

EUA Demand

The largest source of demand comes from the major emitters covered by EU ETS. These include entities such as large utilities with a substantial share of fossil fuel fired power plants, cement companies, steel producers, chemical producers, oil and gas majors and airlines. Their holdings in EUAs are typically built over time and ultimately surrendered at time of compliance.

Demand is driven by various factors, including but not limited to weather conditions (temperatures, precipitation and wind speeds), economic activity (economic growth and activity on financial markets), regulations and policies related to climate and energy, the efficiency of energy usage, and relative commodity prices (coal, electricity, oil and gas).

EUA Prices

The price of the EUAs is primarily determined by the market mechanism of supply and demand. While the EU ETS does not publish an official spot price, spot prices of EUA generally refer to the continuous prices quoted and/or the settlement prices of the EUA daily futures contracts on ICE Endex (Bloomberg Ticker: ICEDEU3 Index) or EEX (Bloomberg Ticker: EEXX04EA Index). The settlement price of ICE Endex’s EUA daily futures contract is the volume weighted average price (VWAP) of all valid trades which were executed during the settlement window, from 17:05 CET. to 17:15 CET. The settlement price of EEX’s EUA daily futures contract is governed by the EEX’s settlement pricing procedure which take into account the valid trades and orders during the settlement window, from 17:05 CET to 17:15 CET. The foregoing prices on the ICE Endex and the EEX may be different. However, the price of EUA quoted on the ICE Endex is considered the most representative, since trading of EUA daily futures contracts concentrates on the ICE Endex, where the number of contracts traded has historically been substantially higher than the number of contracts traded on the EEX. The current year December expiration EUA Futures Contracts (Bloomberg Ticker: MODEC1 Comdty) is often quoted as EUA price as well. These market prices are available on the exchanges’ websites and the Bloomberg terminal.

EU emissions dropped significantly following the 2008/09 Financial Crisis, resulting in the EU ETS having an over-supply of allowances in Phase 2 of the ETS (which was concluded in 2012), and consequently Phase 2 EUA prices dropped significantly as no emissions abatement was required. As an increase in decarbonisation emissions at that time was politically unrealistic, the EU Commission instead implemented two measures within Phase 3 of the EU ETS.

First, in 2014, the EU implemented "backloading", which temporarily withheld 900 million allowances from the market to stabilise the market with the aim of encouraging faster decarbonisation.

Second, in 2017, the EU followed up with the implementation of the Market Stability Reserve, which institutionalises a supply adjustment based on emission trends. This has made the EU ETS more resilient against external impacts and reduces the likelihood of future regulatory intervention.

COVID lockdowns caused a short term price fall as immediate demand crashed when industrial production was shuttered in Spring 2020 (amongst other COVID effects), but the EU's Green New Deal and announcement of more ambitious decarbonisation targets under the Paris Agreement have led to increases in the price of EUAs in 2021 to record highs.                            

Further information about EU ETS and EUA can be found on the European Commission website (https://ec.europa.eu/clima/policies/ets_en).

Each EUA Futures Contract is euro-denominated and represents a lot of 1,000 EUA that are deliverable to or from the Union Registry under EU ETS. Each EUA is an entitlement to emit one metric tonne of carbon dioxide equivalent gas. EUA Futures Contracts trade on ICE Endex and clear on ICE Clear Europe.

ICE Endex is ICE's exchange based in continental Europe.  As the leading energy exchange in continental Europe, ICE Endex provides liquid European gas, emissions and power markets that enable energy firms, EU ETS compliance entities and financial participants to effectively manage price risk.

EUA Futures Contracts are the deepest and most liquid carbon allowance futures contract globally. There are up to 7 December EUA Futures Contracts, 6 quarterly EUA Futures Contracts  and 2 monthly EUA Futures Contracts (or such other number of contract expirations as otherwise determined and announced by ICE Endex from time to time) available on the ICE Endex, but trading concentrates on December contracts.

An EUA is an emission allowance which entitles the holder to emit one metric tonne of carbon dioxide or carbon-equivalent greenhouse gas, whereas an EUA Futures Contract represents a lot of 1,000 EUA that are deliverable under the EU ETS.

                                         Source: Bloomberg

Investors should note that the Sub-Fund does not invest directly in EUA but instead invests in EUA Futures Contracts with an aim to provide investment results that, before fees and expenses, closely correspond to the performance of the Index, which measures the performance of  EUA Futures Contracts rather than EUA. The Sub-Fund invests in current year / next year December expiration EUA Futures Contracts and the price of such an EUA Futures Contract reflects the expected value of the EUA upon delivery in the future in current year / next year December, whereas the spot price of an EUA reflects the daily immediate delivery value of the EUA with daily expiry on ICE Endex. A variety of factors can lead to a disparity between the expected future price of EUA and the spot price at a given point in time, such as interest charges incurred to finance the purchase of the EUA and expectations concerning supply and demand for the EUA at the delivery date. The price movements of an EUA Futures Contract are typically correlated with the movements of the spot price of the EUA, but the correlation is generally imperfect and price movements in the spot market may not be reflected in the futures market (and vice versa). Accordingly, the Sub-Fund may outperform or underperform a similar investment that is linked to the spot price of EUA.

The Sub-Fund uses the ICE EUA Carbon Futures Index (Excess Return) (Bloomberg Code: ICEEUA) as its underlying index. The Index measures the performance of a long-only basket of EUA Futures Contracts. Each EUA Futures Contract is euro-denominated and represents a lot of 1,000 EUA that are deliverable to or from the Union Registry under the EU-ETS. Each EUA is an entitlement to emit one metric tonne of carbon dioxide equivalent gas. EUA Futures Contracts trade on ICE Endex and clear on ICE Clear Europe.

The Index is an excess return (and not a total return) index and therefore represents the return attributed purely to price movement of the constituent EUA Futures Contracts and excludes the interest earned on the collateral. The Index is denominated in EUR.

The index provider is ICE Data Indices, LLC. The Manager (and each of its connected persons) is independent of the index provider.

For further details please refer to the website of the index provider, ICE Data Indices, LLC, at https://www.theice.com/market-data/indices/commodity-indices/carbon-futures.

The return of the Index is calculated based on the change in price levels of all of the current year December expiration contract month and (during the rolling period only) the next year December expiration contract month.

The Sub-Fund’s Net Asset Value tracks the index performance (which take into account the roll cost (or roll yield)) when the Sub-Fund repeatedly buys the longer-term contracts at a price higher than the selling price of the near-term contracts and the higher price of the EUA Futures Contracts converges to the lower spot price of EUA.

Save for the transaction cost incurred, “rolling” in itself is not a loss or return-generating event. That is, the Net Asset Value of the Sub-Fund does not suffer an immediate loss or enjoy an immediate gain due to “rolling”.

The Manager seeks to carry out the rolling of the Sub-Fund according to the rolling strategy as stated in “What is the Index Methodology?” above with the aim to closely track the Index.

The Index undergoes its roll over the three-month roll period falling in September, October, and November.

The index roll period runs from the first to the fifteenth business day of the months of September, October, and November. The EUA Futures Contract rolls in 33.33% increments per month (distributed evenly over the first to the fifteenth business day of each month) over the three-month roll period from the current year December expiration contract month to the next year December expiration contract month. For example, at the beginning of September 2021, the EUA Futures Contract will start rolling from the December 2021 to December 2022 expiration contract month.

 where:

• Roll-In Contract is the next year December expiration contract month during the Roll Period.
• Roll-Out Contract is the current year December expiration contract month during the Roll Period.

Investors should be aware of the following specific risks when trading the Sub-Fund. Investors should note that investment involves risks, including possible loss of principal, and investments in the Sub-Fund may not be suitable for everyone. Please also note that the below listed risks are not exhaustive. Investors should read the offering documents of the Sub-Fund in detail, including the full text of risk factors stated therein, before making any investment decision.

Carbon emissions allowance market risks

Concentration / single commodity risk: The Sub-Fund’s investments are concentrated in current year December expiration EUA Futures Contracts. This may generally result in higher concentration risk and price volatility of the Sub-Fund than a fund having a more diverse portfolio of investments or which holds future contracts with different expiring months. The value of the Sub-Fund may be more susceptible to adverse economic, political, policy, foreign exchange, liquidity, tax, legal or regulatory event affecting the EUA market.

Carbon emissions volatility risk: The Sub-Fund invests in EUA Futures Contracts the value of which may be impacted by carbon emissions prices, which in turn may fluctuate widely and may be affected by factors including global and local supply and demand of carbon emissions allowances, the inclusion of new industries in the European Union Emissions Trading System (“EU ETS”), global or regional political, economic or financial events and situations, investors’ expectations with respect to future rates of economic activity and inflation, and investment and trading activities of various investors. The NAV of the Sub-Fund may consequentially be affected by the foregoing.

Energy Sector Risk: The energy sector is a major emitter of greenhouse gases and its activities may thus significantly impact the supply and demand of emissions allowances. For instance, further advances in renewable energy technology, improved efficiency of energy usage and/or unusually warm weather patterns may result in an increase in supply and/or decrease in demand for such allowances which in turn may have a negative impact on the Net Asset Value of the Sub-Fund.

“Cap and Trade” Principle Risk: The EU ETS works on the “cap and trade” principle, whereby a cap is set on the total amount of certain greenhouse gases that can be emitted by the installations (or companies) covered by the system, and companies trade emissions allowances within such cap which is reduced over time. Whilst the cap is reduced over time, should the rate or level of reduction in such cap be lower than market expectations, the prices of emissions allowances, and thus the Index level and the Net Asset Value of the Sub-Fund, may be negatively affected. Where greenhouse gas emitting companies have limited means of passing the cost of emissions allowances to its end investors, the financial health of these companies may deteriorate and the demand for emissions allowances may thus decrease, adversely impacting the Index level and thus the Net Asset Value of the Sub-Fund.

In addition, compared to a carbon tax system, a “cap and trade” system may lead to greater volatility in carbon emissions prices where the allocation of emissions allowances may be larger or smaller than is expected or needed, and there is no guarantee that there is adequate liquidity in the EUA Futures Contract market for its participants, including the Sub-Fund, to efficiently trade EUA Futures Contracts, particularly where the allocation of emissions allowances for the relevant period is inadequate. As the EU ETS is relatively new, investment in or based on such scheme may potentially be riskier than investments in more traditional markets, and there is a shorter track record that demonstrates that this scheme will continue to exist. These features of the “cap and trade” system may have an adverse impact on the NAV of the Sub-Fund.

Futures contracts risks

Contango and backwardation risk: The Index and thus the Sub-Fund’s rolling strategy involves the replacement of shorter-dated EUA Futures Contracts with longer-dated EUA Futures Contracts. The value of the Index (and so the NAV of the Sub-Fund) may be adversely affected by the cost of rolling positions forward where prices of the EUA Futures Contracts with later expiration dates are higher than those with earlier expiration dates, i.e. a “contango” market, thereby creating a negative "roll yield”. By contrast, if the market for these contracts is in “backwardation”, where the prices of the EUA Futures Contracts with later expiration dates are lower than the prices of EUA Futures Contracts with earlier expiration dates, the sale of these EUA Futures Contracts would take place at a price that is higher than the price of the EUA Futures Contracts with later expiration dates, thereby creating a positive “roll yield”.

Volatility risk: The price of EUA Futures Contracts can be highly volatile and is influenced by, among others, trade, fiscal, monetary and exchange control programs and political changes.

Leverage risk: Because of the low margin deposits normally required in futures trading, an extremely high degree of leverage is typical of a futures trading account. A relatively small price movement in an EUA Futures Contract may result in a proportionally high impact and substantial losses to the Sub-Fund thereby having a material adverse effect on the NAV. A futures transaction may result in losses in excess of the amount invested.

Liquidity risk: The Index is calculated with reference to EUA Futures Contracts exposing the Sub-Fund and the investor to a liquidity risk linked to EUA Futures Contracts which may affect their value.

Mandatory measures imposed by relevant parties risk: Regarding the Sub-Fund’s futures positions, relevant parties (such as clearing brokers, execution brokers and ICE Endex) may impose certain mandatory measures under extreme market circumstances. These measures may include limiting the size and number of the Sub-Fund’s futures positions and/or mandatory liquidation of the Sub-Fund’s futures positions without advance notice to the Manager. In response to such mandatory measures, the Manager may have to take corresponding actions in the best interests of and without prior notice to the Unitholders and in accordance with the Sub-Fund’s constitutive documents, including but not limited to implementing alternative investment and/or hedging strategies. These corresponding actions may have an adverse impact on the Sub-Fund.

Margin risk: The Sub-Fund’s investment in EUA Futures Contracts involve the posting of margin or collateral. Increases in the amount of collateral or margin or similar payments may result in the need for the Sub-Fund to liquidate its investments at unfavourable prices in order to meet collateral or margin calls. This may result in substantial losses to investors.

Risk of material non-correlation with spot/current market price of EUA

The Index measures the performance of EUA Futures Contracts rather than EUA. The Sub-Fund invests in current year / next year December expiration EUA Futures Contracts and the price of such an EUA Futures Contract reflects the expected value of the EUA upon delivery in the future in current year / next year December, whereas the spot price of EUA reflects the daily immediate delivery value of the EUA with daily expiry on ICE Endex. As such, the performance of the Index may substantially differ from the current market or spot price performance of EUA. Accordingly, the Sub-Fund may underperform a similar investment that is linked to the spot price of EUA.

Risk related to unscheduled roll of the Sub-Fund

Under exceptional market conditions, the Manager may in its discretion and without prior notice to investors deviate from the rolling strategy and/or rolling schedule stated in the Index methodology in the best interests of the Sub-Fund and the Unitholders and for the protection of the Sub-Fund. There is a risk that the tracking error and tracking difference of the Sub-Fund may increase.

New product risk

The Sub-Fund is a futures-based ETF investing directly in EUA Futures Contracts. The novelty of such an ETF and the fact that the Sub-Fund is one of the first few futures-based ETFs in Hong Kong makes the Sub-Fund potentially riskier than traditional ETFs investing in equity securities.

New Index risk

The Index is a new index. The Sub-Fund may be riskier than other ETFs tracking more established indices with longer operating history.