Earlier this year, Lakeside invested $13 million of its endowment in Molecule, an investment fund that trades in the carbon allowances market which gives companies economic incentives to invest in low-carbon technology. Molecule is one of Lakeside’s larger single investments, comprising around 4% of its $320 million endowment. Lakeside relies on growth of this endowment for 25% of its day-to-day operations, so the investment in Molecule was first and foremost motivated by financial incentives. “Make no mistake,” says CFO Birage Tandon, “the purpose of the endowment is to grow.” Along with financial necessities, the school wants to make sure its investments align with its values. This involves divesting as much as possible from mining or fossil fuel companies and, when the opportunity arises, investing in sustainable firms like Molecule.

Molecule was launched in June 2020 by three co-founders, Nick Kracov, Nik Mittal, and Gary Claar. I talked to Mr. Kracov, a Co-Portfolio Manager who is well-versed in the environmental sector; before founding Molecule, he worked on renewable energy projects and earned a master’s degree in Sustainability Management from Columbia University. Mr. Kracov says that there are two ways in which governments can regulate carbon emissions: a carbon tax and a cap-and-trade program. Importantly, in a cap-and-trade program, regulators set a limit for emissions that decreases each year. With a carbon tax, regulators can make emitting costly, but emissions can continue to rise if polluters pay the associated tax.

In California’s cap-and-trade system, the amount of legal pollution is divided into a finite number of allowances, with each allowance equalling 1 ton of CO2 (or CO2-equivalent) emissions. Thus, for each ton a company wants to emit, they need one allowance. And the price for emitting more than they are allowed to is steep: they owe the state the price of four allowances for each one they lacked. Over time, the pollution limit decreases (meaning that fewer allowances are available) and the minimum cost to buy allowances from the state increases. To polluters, this signals that the cost of pollution will only increase over time and prompts investment into clean energy.

Molecule and other investors come into this market as middle-men who buy emission allowances and sell them at higher prices. The system is structured so that the pollution limit will decrease faster than the energy sector is able to decarbonize, meaning that the demand for them will outpace their supply and cause prices to rise. When investors hold onto allowances (as tax structures encourage them to), they create an artificial shortage of allowances that further increases their price.

For a long time, carbon allowances traded at a price close to the “floor,” the minimum price at which they are sold by the state in quarterly auctions. However, they have recently begun trading much higher than the floor. Mr. Kracov attributes this to “increased investor interest in climate-conscious assets as well as a rapidly decreasing supply of allowances.”

All this is to say that investment in carbon funds offers promising financial and environmental returns for Lakeside and others. Lakeside’s endowment growth was in the top 20% of independent school endowments around the country as the stock market grew in 2020 and 2021, despite the economic downturn experienced by the majority of the country as a result of the pandemic. California’s cap-and-trade system has also delivered stellar returns. The program has generated the state $15.4 billion in profit that gets reinvested into climate-friendly projects. At least 35% of that money must be invested into low-income communities, by law. Washington State, for its part, recently approved a cap-and-trade bill modeled on California’s system. Taking a broader scope, 20% of global emissions are already covered by some sort of carbon pricing instrument, be it a carbon tax or a carbon-allowance program, and more taxes and cap-and-trade programs are currently being considered in various countries. In the words of Mr. Kracov, the double benefit of the cap-and-trade program is “driving returns for investors while also driving the price of pollution higher.”