FORESIGHTLong read

Commodities and sustainable investing: a new approach

Commodities form a vital asset class but one which investors often exclude. This framework is among the first to help investors reconsider their exposure to the sector while maintaining social and environmental considerations.

11/03/2024
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Authors

Ben Popatlal
Multi-Asset Strategist
Stephanie Williams
Sustainable Investment Analyst
Blake Shefford
Fund Manager, Multi-asset

Recent global events, such as the post-Covid reopening and renewed geopolitical tensions, suggest the world is at a crucial turning point. In this new paradigm – which we’re calling the "3D Reset" – we anticipate central banks to prioritise inflation control over growth, alongside more proactive fiscal policies, deglobalisation, and intensified climate change responses.

These factors are leading to disrupted supply chains, insufficient investment in commodities, and ultimately, structurally higher inflation compared to the 15 years following the global financial crisis.

Consequently, as we wrote recently in “Commodities: a structural allocation for the next decade?”, we believe the rationale for structurally increasing allocations to commodities is gaining momentum.

Historically, commodities have served a crucial function, typically generating attractive returns during the late economic cycle stages and acting as an efficient hedge during inflationary periods.

Today it is commonplace for commodities to be excluded from investors’ investment universe, removing an important asset class in the new regime ahead. Many point to their post-financial crisis insignificance, while others consider commodities as simply incompatible with their increasingly prevalent sustainable investment objectives. While is it challenging to dispute commodities' substantial negative impact on people and planet, we feel that investors can benefit from a deeper understanding.

In this paper we introduce a quantitative framework to better assess commodities’ impacts across their lifecycle, covering environmental and social factors, from extraction to production, utilisation to end of life. We believe this framework is one of the first to consider impacts beyond carbon emissions or environmental factors alone.

Ultimately, we hope to encourage more investors to include commodities in their investment universe, serving as a first step to building commodity exposures which can improve the impact on social and environmental factors. We anticipate growing data and understanding of commodities' sustainability over time and will adapt our framework accordingly.

How do we assess commodities' sustainabiilty characteristics?

It is well understood that intensifying sustainability pressures impact commodities’ supply and demand, and therefore price. Schroders’ commodity investment teams have been integrating sustainability analysis into their investment process for several years.

For example, the energy transition is expected to lead to a surge in demand for battery metals, such as nickel. Similarly, mounting public pressures against traditional fuel investments are likely to negatively affect oil supply, supporting prices, potentially before we reach peak demand.

Until now we have not quantified the other direction in which sustainability works: commodities’ impact on people and planet.

Developed in collaboration between Schroders’ Multi-Asset, Commodities and Sustainable Investment teams, we have created a framework to evaluate commodities’ sustainability characteristics. The result is a scoring framework for each commodity in the Bloomberg Commodity Index (BCOM), evaluating their impact on people and planet based on social and environmental factors.

Adopting the lifecycle approach to commodities' sustainability

When most investors consider the sustainability of commodities, they tend to focus on the negative impacts of extraction and production – stages which are undoubtedly carbon intensive, can be disruptive to biodiversity and may contribute to worker exploitation.

We group these two initial stages of commodities’ lifecycle into the “production” stages, which are largely negative for people and planet. However, considering the production stages alone often overlooks other benefits, such as agriculture's feeding the global population and the future environmental benefit of metals’ use in the energy transition. We group these stages under “utilisation”.

Accordingly, we believe this lifecycle approach can help to identify a range of positive and negative impacts that may be initially overlooked. We split the lifecycle into five phases as shown in Figure 1.

Figure 1: Commodities through their lifecycle

Commodities and sustainable investing: a new approach

1 Extraction (production): a phase which is largely negative on both environmental and societal factors.

2 Production (production): the processing of metals and refining oil is notably energy intensive.

3 Use (utilisation): here agriculture feeds the global population and metals contribute to clean energy technology. However, energy combustion is a key contributor to climate change.

4 Recycling (utilisation): recycled metals allows for renewed supply without the negative impacts from extraction and production.

5 End of life (utilisation): largely focussed on the negative environmental disruption from waste.

Quantifying the impact on People and Planet

To help investors with sustainable objectives assess commodity investments, we have developed a scoring framework to assess the impacts of each commodity within the BCOM on people and planet.

Our framework incorporates over 20 factors throughout the commodity lifecycle, resulting in a scoring dashboard that evaluates production and utilisation based on both social and environmental factors. The factors are detailed in Figure 2 below.

Our data inputs for assessing the different factors fall into two categories: Geography-based and commodity specific. In the case of geographical metrics, we attribute impact based on countries of production.

Figure 2: Factors in assessing commodities' impact on people and planet

Commodities and sustainable investing: a new approach

With any multi-factor model, the weights assigned to each factor are crucial. As highlighted previously, our core philosophy is that commodities have a net negative impact on people and planet. However, we believe investors should consider the bigger picture by assessing the entire commodity lifecycle.

Inherent in these beliefs is our view that commodities’ production typically has net negative impacts, while their utilisation typically has net positive impacts.

We therefore start scoring with the negative impacts of production and then improve scores by the positive impacts of utilisation.

These views shape the manner in which we weight the factors in our model and ultimately mean that we score commodities relative to one another, as opposed to scoring them each in isolation.

Figure 3: Structure of the Commodities scorecard methodology

Commodities and sustainable investing: a new approach

The resulting scores are in Figure 4, below, where a greater negative score reflects a more negative impact on people and planet.

Figure 4: Commodities’ impact on people and planet

Commodities and sustainable investing: a new approach

Illustrating our methodology with copper vs. zinc

Below we provide an illustration of how we compare copper and zinc for a single factor using geography-based data. For simplicity, we will limit the analysis to the countries within the top 10 producers of either commodity, and we use Yale’s Biodiversity and Habitat Index (BHI) as the sole factor.

Each commodity’s country of production is distributed as shown below.

Figure 5: Zinc and copper geographical distribution of production

Commodities framework charts

We now examine the BHI scores of the production countries. This dataset evaluates countries' efforts in preserving natural ecosystems and protecting biodiversity within their borders. Scores range from 0 to 100, with higher scores being better.

Figure 6: Biodiversity and Habitat Index score by country

Commodities framework charts

Next, the BHI scores are weighted by country of production for each commodity. By summing these weighted BHI scores across total production, we obtain scores of 57 for copper and 40 for zinc (45 and 31 respectively for the top 10 countries of production as depicted below).

This finding suggests that copper is produced in countries with greater concern for biodiversity and habitat protection compared to zinc. We therefore infer that copper production is likely to have a lower negative impact on biodiversity and habitats.

Figure 7: BHI weighted by country of production

Commodities framework charts

By applying the same analysis to other indicators and normalising the output, we can generate combined production and utilisation scores across social and environmental factors.

As shown in Figure 8, below, both metals have similar impacts on the production side, but copper performs better on measures of environmental utilisation given its key role in the energy transition. This greater credit for utilisation is a key reason for copper’s better overall score compared to zinc.

Figure 8: Copper is better than zinc overall

Commodities and sustainable investing: a new approach

Addressing the relatively favourable energy scores

Given their high carbon emissions, it may come as a surprise that the two energy commodities – oil and natural gas – perform relatively well overall. While it is not surprising that they score relatively poorly on environmental scores, particularly those related to climate, they fare better than many soft commodities (or "softs") by having better social scores within production.

While there is notable community conflict and consequent controversies associated with oil and gas projects, production is not as prominently linked to forced or child labour risks. In addition, energy commodities are often overlooked for their social benefits. We calculate positive social scores to reflect energy’s necessity for daily life and economic growth, particularly in poorer countries where access to electricity is lacking or where renewable energy infrastructure is less mature.

Within Energy, natural gas and oil have similar scores, with natural gas benefitting from a slightly better social score. It is well understood that natural gas has lower carbon emissions than oil, but it scores worse on measures of environmental degradation and is associated with greater risks of deforestation and acid rain.

On social factors, oil has a worse community controversies score and its production is centred in countries with worse rule of law and workers’ rights, implying a higher risk of corruption and weaker labour protections than for natural gas.

Industrial metals are heterogenous while precious metals are broadly neutral

Industrial metals is the sector with the most variability, rendering sector-wide conclusions more challenging. Relative to other sectors, we consider their social scores to be worse than average. For example, a relatively high proportion of production is found in countries susceptible to armed conflict risk and with higher representation of indigenous populations.

We see far greater differences in their environmental scores, notably in their energy transition demand. Nickel, copper and to a lesser extent aluminium score favourably, while we see limited future transition demand for zinc and lead. This drives the dispersion in scores, alongside differing exposure to factors such as water stress and biodiversity degradation.

Precious metals have broadly neutral overall scores. However, their social scores are weighed down by production in countries of higher perceived corruption and higher impacts on indigenous populations. Their environmental scores are some of the more positive, largely due to the use (silver transition demand) and end of life phases (high recycling rates), as well as the industry’s relatively low impact on total carbon emissions.

Agriculture scores relatively unfavourably, driven down by soft commodities

Grains and oilseeds score relatively well, driven by some of the highest social scores. In this case, their social scores benefit from utilisation, where we acknowledge the positive benefits of these commodities providing nutrition for the global population.

Their social scores also fare well on issues of forced and child labour, with production located in countries with lower corruption and higher community protections. Environmental scores are less positive given that production occurs in countries with lower ecosystem and biodiversity protection and higher water stress.

Wheat, soybean and corn score similarly, while soybean meal and soybean oil receive considerably less positive utilisation given their lack of direct impact on feeding the population. Livestock similarly benefits from the positive contribution to nutrition for social scores, although labour factors perform worse. Environmental scores are worse, notably due to associated deforestation.

Softs are undoubtedly the worst sector in our scorecard. On the social side, much of their production is centred around countries with relatively poor labour rights, with greater impacts on indigenous populations, higher chances of armed conflict, and higher corruption. Unlike grains, oilseeds and livestock, we do not assign any positive utilisation scores, arguing that these are discretionary rather than essential items. They are also rated poorly on environmental factors, from the lower ecosystem protections in countries where they are produced, to the higher prevalence of acid rain due to fertilizer use and some of the worst waste management scores in the universe.

Asset owners can use these scores to build custom commodity exposures

The discussion above has illustrated how investors could use these conclusions to build sustainability-enhanced commodity exposures, focusing on commodities with less negative impacts as rated by environmental, social or combined scores, according to asset owner preferences.

Building on our scores, Figure 9 provides examples of how different asset owner priorities may affect the creation of their enhanced commodity exposures.

Figure 9: Possible commodity under/overweight based on different sustainability priorities

Commodities framework charts

Conclusion

We acknowledge that it is far from straightforward for investors to integrate sustainability into their commodity exposures, depending heavily on individual asset owners’ sustainability priorities and philosophy.

As a result, many asset owners with sustainability objectives simply exclude commodities. We believe there’s a smarter approach, which can help investors to still access commodities which we consider as an important asset class for the "3D Reset" ahead.

We have detailed a flexible, quantitative framework to measure commodities’ impact, providing a more balanced assessment on some of the common assumptions about commodities’ negative impacts on society and the environment. Commodity investors have been incorporating sustainability-related investment impacts for some time. But by considering the impact that commodities have on people and planet, investors can better target their sustainability objectives at the overall portfolio level.

We accept that there’s no one-size-fits-all approach. While one investor may focus on the environment, or simply carbon emissions, others may prioritise social factors.

We welcome the opportunity to discuss with asset owners on how we can adjust the model output to their own sustainability preferences.

Authors

Ben Popatlal
Multi-Asset Strategist
Stephanie Williams
Sustainable Investment Analyst
Blake Shefford
Fund Manager, Multi-asset

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