Investing in commodities poses meaningful challenges for investors looking to incorporate environmental, social, and governance (ESG) metrics into their investment criteria. As a start, commodities are a broad and diverse asset class with different financial, environmental, and social implications.
While it may be possible to apply carbon footprint and ESG risk metrics to underlying commodities, and by association to commodities derivatives, such sustainability metrics have not been developed with these financial instruments in mind (see Exhibit 2).
Exhibit 2: Commodities and ESG – Metrics, Standards and Methodologies
Source: S&P Global Trucost. Data as of February 2021. Chart is provided for illustrative purposes.
Financial participation in commodity derivatives markets does not directly influence a particular company’s actions, as it can with equities or bonds, nor, arguably, does it come with the ability to affect the underlying spot commodity price. This makes applying ESG principles difficult. Moreover, the causal link between commodity derivatives and physical commodity production and consumption remains unclear, given that investing in commodity derivatives does not directly translate to physical commodity ownership (Danielson, 2020).
Indeed, there is also the question of whether commodities prices should be forced higher or lower to encourage production and consumption changes that are considered desirable from an ESG perspective. Commodities investors are passive participants in the ESG ecosystem, albeit ones who, depending on their mandate, have the ability to funnel their investments between different commodities or sectors. They may also have the ability to influence the rules and conventions adopted in the marketplace. For commodity derivatives, this points to engaging directly with the derivative exchanges.
Nevertheless, the main objective of commodity derivative markets is to facilitate risk. This objective aligns with many of the principles of ESG, specifically the need for transparency, risk mitigation, and market access. For centuries, speculators have assumed the price risk of commodity producers and consumers, and the markets themselves have aided the price discovery mechanism.
For those market participants looking to adapt existing ESG metrics to commodities, environmental issues will take center stage as arguably the most pressing and directly relevant ESG pillar. In such cases, the carbon footprint of various commodities can help inform ESG-minded decisions. Using lifecycle analysis (LCA) databases is a relatively straightforward approach to computing carbon footprints of individual commodities, and such metrics can likely be integrated into index methodologies. Exhibit 3 illustrates the estimated greenhouse gas (GHG) footprint associated with a selection of agricultural commodities. While one can lessen the weightings of the worst fossil-fuel-heavy commodities (or exclude them) to create an ESG-screened commodities index, it is not clear that it would result in a suitably diversified commodities index nor one with superior risk-adjusted performance.
As market participants increasingly incorporate ESG metrics into all aspects of investing, it is inevitable that commodities investing would collide with ESG. Since we cannot live without commodities, commodities market participants should advocate for more efficient and sustainable production and usage, but the commodity ESG conundrum will not be an easy one to solve.
Exhibit 3: Estimated GHG Footprint for Select Agricultural Commodities (million metric tonnes of CO2E)
Soybeans
Corn
Sugar Cane
Wheat
Coffee
Source: CE Delft. The CE Delft study is based on the agricultural phase of each commodity’s life cycle, including on-farm factors such as land, machinery, fertilizer, and water, but excluding processing, retail, transport, and the consumer. Data as of February 2015. Table is provided for illustrative purposes.
