Most commodity ETFs fall into one of three categories: producer equities, physically backed, or synthetically based. The first one includes examples like The Energy Select Sector SPDR Fund (XLE (NYSE:XLE)), which holds commodity producer stocks. The second one includes examples like the SPDR Gold Shares ETF (NYSE:GLD), which hold physical deposits of precious metals in a vault. The third one includes examples like the Teucrium Agricultural ETF (TAGS), which uses futures contracts.
A new example of the third category is the CNIC ICE (NYSE:ICE) U.S. Carbon Neutral Commodity Futures Index ETF (AMPD) recently launched on NYSE ARCA. Managed in collaboration by CNIC Funds, LLC and Tidal Financial Services, LLC, AMPD tracks the ICE U.S. Carbon Neutral Power Index. This ETF is a bit complex, so we'll be breaking it down today and delving into its possible use cases and risks.
How does an ETF become carbon-neutral?
As noted earlier, AMPD tracks the ICE U.S. Carbon Neutral Power Index, which is primarily comprised of liquid U.S. electricity futures and carbon allowance futures contracts. In tandem, they provide exposure to the broad U.S. electricity market on a carbon-neutral basis.
This means that for all the electricity that the index assumes would be produced (represented by contracts called futures), there are also enough carbon allowances (also represented by futures contracts) to offset the carbon emissions that the electricity production would generate.
Unfamiliar with electricity and carbon allowance futures? They're not too different from other types of futures, which are simply an agreement to buy or sell something at a future date at a set price today. They can be used to speculate on price movements in a commodity, or hedge risk.
In this case, the ETF is dealing with two kinds of cash-settled futures contracts:
- Electricity Futures Contracts: These allow the buyer to purchase a certain amount of electricity at a future date and a price set today. In AMPD, the futures contracts come from each of the six independent system operators (ISOs) and Regional Transmission Organizations (RTOs) that form the U.S. power market, either at the hub level or sub-component level.
- Carbon Allowance Futures Contracts: These give the right to emit a certain amount of carbon dioxide. If a company thinks it will emit more carbon than it's allowed, it can buy more allowances. Conversely, if a company emits less than its allowance, it can sell its extra allowances. AMPD's index will track ICE California Carbon Allowance Futures Contracts and ICE Regional Greenhouse Gas Initiative Futures Contracts.
This fund invests in these futures contracts by putting money into both electricity futures and carbon allowance futures. This way, it mirrors the performance of the electricity market based on the underlying index, while also considering the cost of carbon emissions.
To put it simply, the quantity and value of carbon allowance futures contracts selected will represent enough carbon emission credits to offset the carbon represented by the index's electricity futures. Thus, achieving a carbon neutral stance.
AMPD breakdown
AMPD's index and portfolio tracks electricity futures for six major U.S. power markets, and for each of these markets, it looks at the futures for the next 12 months. So that's 6 markets x 12 months = 72 electricity futures. Once you add the two carbon allowance futures, you get a final portfolio of 74 futures contracts – 72 electricity and 2 carbon.
However, during certain times when AMPD needs to replace ("roll") the contracts that are about to expire with new ones, the ETF may temporarily have a few extra contracts. That's because AMPD will be holding both the old futures that are about to expire and the new ones that are replacing them.
The ETF also keeps some short-term U.S. Treasury securities as collateral, at around 12-20% of the notional value of its futures. AMPD also does not directly invest in physical power generation assets, utility companies, or physical carbon offset contracts.
Finally, its worth noting that the ETF does not attempt to exactly replicate its index. Rather, AMPD will use a representative sampling approach. This is because some futures contracts may be too illiquid or mispriced to practically invest in.
Why consider AMPD ETF?
The whole point of AMPD as I see it is to provide exposure to the returns of the electricity market while maintaining a carbon-neutral stance. This is achieved by its underlying index, which balances the electricity futures with an appropriate number of carbon allowance futures.
In its prospectus, AMPD's management team believes that the ETF will offer some diversification from traditional investments like stocks and bonds. This would likely be due to the low correlation of the futures contracts, which is not atypical for commodities.
AMPD's management team also expects the ETF to be closely correlated to the Consumer Price Index. This is to be expected given the nature of its electricity futures. As such, the ETF could be another way for investors to hedge against inflation while still adhering to a carbon-neutral philosophy.
As usual, the normal risks of commodity futures ETFs apply to AMPD: negative roll yield, also known as contango, high volatility, tracking error when the futures differ from the spot price of electricity, and greater than average fees (AMPD currently charges a 0.95% expense ratio). Investors should also be aware of risks pertaining to the energy sector, such as large fluctuations in commodity prices, changes in regulations, or even poor weather.
This content was originally published by our partners at ETF Central.