Barclays Offering Carbon Emissions ETN

I wrote in a recent post how Barclays was getting into the physical trading of crude oil. Now IndexUniverse.com is reporting that Barclays is launching a new iPath Exchange Traded Note (ETN) targeting carbon emissions - the iPath Global Carbon ETN (ticker GRN). As cap-and-trade becomes more prevalent, it is expected that ETN funds tracking carbon emissions will become more popular. Some estimates have the global carbon market being worth more than $50 billion a year. Talk about making money out of thin air.

For the uninitiated, Investopedia (here and here) and Wikipedia give an overview of ETNs. In short, ETNs were first introduced by Barclays in mid-2006 and represents a type of senior, unsecured, unsubordinated debt security that is similar to other forms of debt (since it has a maturity date), but is different in that ETN returns are based on the performance of some other primitive (be it a stock, index, carbon emissions, or anything else). Unlike normal bonds, no periodic coupon payment are made, and your principal is not protected. On the other hand, they can be traded on exchanges and shorted, similar to ETFs. Since they are like bonds, the value of the ETN is affected by the credit rating of the issuer, and is therefore impacted by credit rating changes. This may explain why more ETNs have not been issued in the current environment.

Why use them instead of ETFs? There are a number of advantages (see Wikipedia for an overview), but basically they offer flexibility and tax advantages (see iPath for additional overview of ETN characteristics). Since there is no interest payments and dividend distributions, neither incurs a tax. Capital gains also only occur when the investor buys or sells the ETN - not when gains and losses are taken by the fund, as with a mutual fund, or when securities must be sold due to composition changes in an index, as with ETFs. ETNs are essentially treated as a prepaid contact (like a forward contract), allowing the difference between the sale and purchase to be treated as a capital gain, deferring the tax payment. ETNs also have no tracking error, unlike ETFs which have to buy the underlying assets or futures, thereby producing an inevitable, albeit usually small, tracking error. ETNs do not hold the underlying asset, but simply promise the match the index. This is another area where credit risk potential creeps-in. In a sense, you are trading tracking error risk for credit risk. ETNs also offer the flexibility to gain exposure in areas that are difficult for ETFs to replicate (such as carbon emissions), and allow for the deployment of strategies, such as momentum investing.

Of course, not everything is rosy (see the April USA Today article). In addition to credit risk issues, ETNs also have the disadvantage of being illiquid at times, although as they become more popular, it is hoped that this will be less of a problem for individual investors. Redemption issues do exist for institutional investors. There is also a worry that current tax benefits will be removed/modified by the IRS, which is still considering tax treatment of ETNs (see update) and likes to say "show me the money." There is the potential that the IRS will tax profits as interest, and not capital gains (which long-term are currently only 15%). Single currency ETNs have already been ruled on, and are now being taxed at ordinary income tax rates. Finally, as with all products that offer a specific investment strategy, there are risks with each strategy. Yet, for ETNs this gets magnified since there are now more options available, and as a result, more potential risks for those choosing strategies without understanding the goals, risks, and fit to their current investment portfolio. After all, not everyone wants to worry about whether sub-prime credit problems are going to affect their carbon missions ETN investment, or whether crude oil being in contango is good for their commodity spread ETN.

Note: When researching about ETNs to see if there was any new information to include for this post, I did run across the following on the Investopedia site: "While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The advent of ETN is no different. However, as with any new product, there are unanswered questions." Given all the negative connotation around the term financial engineering, this is refreshing. Then again, this article may not have been updated for a while. Nonetheless, every now and then you have to take what you can get.