Commentary

Investors’ Commodities Exposures in Transition

Julian Poulter, Head of Investor Relations at the Inevitable Policy Response, explains how a new initiative could overhaul the commodities narrative for investors.

The commodities sector is at the heart of the energy transition, which is driving both the coming structural decline of fossil fuels and demand for the new economy critical materials. There is also the delicate matter of future nature-based land-use and food production conflicts facing investors and soft commodity-driven deforestation, representing other potential clouds on their net zero commitments.

The reality is that many investors are reluctant to talk openly about commodities because of the negative perceptions of the sector. To date, the commodities narrative has been mostly characterised by high-emitting energy production from fossil fuel companies and mining companies that are misaligned with a sustainable future, not forgetting their negative climate lobbying activities, which are still to be effectively curbed by those very same investors.

References to the role of commodities also often brings visions of irresponsible corporations and nations with issues beyond their environmental impact, including poor human rights records and a sometimes dubious influence on governments. In certain cases, the list of broader ESG issues associated with commodity production reads like a list of investor red flags. If the global commodities sector were a single business, the CEO would be straight on the phone to Saatchi & Saatchi for an urgent rebranding.

A rebalancing in indices

Investors increasingly recognise that the future of the energy transition – and in turn emissions outcomes – relies on the rapidly shifting balance in commodities trading from fossil fuels to critical minerals including metals, many of them in key transition sectors. Markets in copper, cobalt, lithium and others are already exploding but their demand is not yet represented in the current fossil fuel-laden commodities indices that most investors use.

To better reflect this inexorable trend, Dutch pensions provider APG is looking to launch a forward-looking commodities index that will be constructed based on future demand for these commodities rather than their historical counterparts, a move that will help shift some of the existing negative perceptions away from fossil fuels. The forward-looking demand profiles will be taken from the Inevitable Policy Response (IPR) Forecast Policy Scenario database.

As any investor will tell you, exposure to futures indices is not a key driver of change. Altering fundamental economics takes early-stage investment, R&D, and pro-active policy designed to accelerate commercialisation and regulation to advantage the new over the old. Further complicating the role of indices as a lever of change is that investors’ existing underlying exposure to commodities is often whispered in quiet corridors, blamed on supply chains where their influence is thin or on mining monoliths that no investor can afford not to hold in their portfolio. This has limited the opportunity for open debate.

To assist this debate, the new indices will retain their investment value as a portfolio diversification tool. Commodity indices do not correlate with stocks and bonds; they are also an excellent inflation hedge. However, while the new forward-looking indices move away from fossil fuels, they bring a range of other ESG issues relating to the mining of the new transition materials, as well as increased representation of soft commodities (food-based) where many investors are already addressing ESG issues relating to deforestation or human rights. The latter investor efforts are almost entirely engagement based.

With the development of these new forward-looking indices, investors can now acknowledge their positive expectations of the new commodities exposure. And then start the difficult discussions necessary to explore those social and environmental downsides. This can be far easier at the commodities level than at the company level, which often degenerates into a complex jurisdictional or commodity divestment discussion that shuts doors rather than opens them. As the IPR shows in its 2023 Forecast Policy Scenario, most residual emissions by 2050 will be in emerging markets and developing economies (EDMEs). The transition will reflect a rapid transformation in those economies even though it is too slow to save us from a significant overshoot past 1.5°C. Embedded in this inevitable future is the change in the commodities landscape that mirrors the change in the economies that produce the new materials.

To understand how the future will unfold, the history of commodities is worth recalling. The significance of the primary commodity sector in any national economy generally declines as the process of economic development improves. Nations start by digging up their land for resource wealth or utilising land in some productive way and a tipping point arrives when the benefits of this activity create a secondary manufacturing and service economy which fuel property and other booms to even the global playing field.

For example, the US’s reliance on the primary sector for GDP contribution was around a quarter at the turn of the 20th century but had shrunk to just 5% by 1960 once Henry Ford and a couple of technology-fueled world wars had washed through. History may well repeat itself regarding the new commodities, many of which will be produced in developing nations, some of which will send you scurrying towards an atlas.

The coming commodities shifts

Understanding how commodity shifts will manifest during the energy transition is vital for investors, both at a sector and at a jurisdictional level with complex geo-politics. It is easy to point at investments in certain sovereign states in the most difficult and controversial of commodity producing destinations. China’s desire to influence nations in Africa is well documented and investors need only peek at their sovereign and corporate debt portfolios to see that these broader ESG issues are inherent in their investments.

Some commodities are already a major story in themselves with cobalt in the Democratic Republic of the Congo (DRC) being the most recognised example, the country languishing 136th in The Economist’s Global Democratic Index out of 167 countries. When countries like Zimbabwe and Burkina Faso are deemed more stable areas to mine commodities in comparison, you have an important investment jurisdiction with some major issues. Rare earth mining is also beset by some prickly ESG challenges in a number of jurisdictions.

However few investors can afford to be without cobalt in their portfolios whether they like it or not. Nothing short of total auto and battery divestment is required for an investor to look clean if they want to keep the DRC out of portfolios. This reflects how tightly integrated the world’s supply chains have become.

If no investor can look you in the eye and say they are totally clean on myriad ESG issues, it further highlights that the real issue is about how to influence the future of commodities as transition shapes new demand, rather than how to avoid them. This is the debate that the APG indices can help promote whilst simultaneously advancing financial returns.

Additionally, once agriculture and nature-based commodities join the picture and you accept that the 1.5°C overshoot is a coming reality, then investors may be forced into a new approach to commodities. Conflicts between bioenergy and food production are looming in future decades (an emerging issue the just-released IPR Land Use & Bioenergy Outlooks both explore) with forestry playing a critical role in carbon removals to redress the temperature outcome towards the end of this century.

Attempts to divest commodities and drive change through engagement have so far been difficult and if investors are going to tackle the ESG issues embedded in new transition metals, then a broader range of approaches is going to be required including sovereign debt engagement. But it won’t be easy.

The controversial debates surrounding elements of their portfolio climate strategies are increasingly difficult for investors to ignore. They cannot avoid Scope 3 emissions in their portfolio, for example, and external stakeholders have pointed out how illogical it is to have net zero alignment based on just Scope 1 and 2 emissions. As a result, Scope 3 (with upstream supply chains being prevalent) is gradually being recognised as essential to any logical framework for analysing emissions and pathways for reductions.

Similarly, commodity exposure is also unavoidable for investors, even those committed to do the right thing on climate, just transition and stewardship. Divestment hasn’t worked as a theory of change and for large investors never could work once Scope 3 emissions were accounted for.

Investors should now treat commodities in the same way, realising they are an inherent part of any portfolio and thus it is better to try to manage the inherent ESG issues as best they can whilst supporting the development of the critical minerals that the transition so desperately needs.

Within that framework, a new commodities index would not only be a tool to manage climate-related risks within a commodity futures portfolio but would help drive this new narrative which in turn can influence positive capital allocations towards these new commodities.

Given that the Inevitable Policy Response has shown that investment in developing and emerging economies is the key to minimising an overshoot past 1.5°C, and that many of these new transition commodities are in developing economies, the intersection of these two themes is a great opportunity for leading investors.

Julian Poulter is a partner of Energy Transition Advisers (ETA) and Head of Investor Relations at the Inevitable Policy Response (IPR). The views expressed in this article are personal and do not necessarily represent the views of IPR.

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