By Tim Pickering – CIO and Founder
Brennan Basnicki, CFA, CAIA, CMT, SCR – Director and Product Specialist, Partner
Auspice Capital Advisors Ltd, Calgary, Canada
Introduction
While many would agree that commodity related investments are amongst the best ways to protect against inflation risk, it has become complicated for many investors given ESG considerations. To date there has been little discussion about commodity futures within ESG frameworks - neither the Organization for Economic Cooperation and Development (OECD) nor the UN Principles for Responsible Investment (UNPRI) provides comprehensive guidance on commodity futures.
We have researched this and published a comprehensive white paper entitled “Commodity Investing in the Age of ESG and Inflation” available on SSRN and at auspicecapital.com.
In the white paper four key ESG considerations related to commodity futures are discussed:
- Well functioning futures markets are critical to the development of commodity markets important in the green transition.
- Futures markets are essential to companies for managing risk, improving transparency, and providing liquidity. This aligns with many ESG principles, particularly the often underemphasized societal and governance considerations.
- Futures offer exposure to commodities with zero environmental impact.
- Futures offer superior risk management and diversification benefits for investors, particularly with respect to inflation protection.
This blog post summarizes the third consideration above, that futures offer exposure to commodities with zero environmental impact.
Commodity Futures - Lowest Impact Commodity Exposure
A study conducted by researchers from the University of Chicago and Harvard published in the Nation Bureau of Economic Research (NBER) concluded that divestment was a less effective approach than active engagement in addressing climate change (divestmentfacts.com, 2020). In contrast, a recent think tank study claims that the active engagement of leading Canadian pension plans “may be more talk than walk” (Canadian Centre for Policy Alternatives, 2021).
To date there has been significant progress, but there remains uncertainty and debate around the measured impact of divestment and active engagement. Divestment proponents will note that an active investment in the equity of a resource company that is making significant, proactive changes still represents an investment in a company that has a (often large) carbon footprint. Further, the measured impact of various green initiatives in reaching net zero is often minimal, and greenwashing is increasingly a concern.
What is less uncertain however are considerations around commodity futures investments, such as Commodity Trading Advisor (CTAs) and ETFs backed by commodity futures. Consider that the equity and bonds of a company make up its’ capital stock. If one purchases the equity or bonds of a company, it is directly involved in its’ financing and is entitled to various rights associated with the financing. For a resource company, purchasing equity or bonds directly finances the production of a resource. A company’s capital stock at any given point in time is finite and can be directly tied to its’ carbon footprint.
This relationship does not hold with futures, and there are no associated rights. Futures investments do not require physical extraction to back, as is the case with traditional equities and bonds, and they do not link to the environmental impact from resource extraction, an inherently invasive process. There is a clear difference between the ownership of a company versus having exposure to a commodity risk factor.
“what ultimately matters for carbon accounting is who ‘owns’ a company. All the owners of a company together provide the capital that enables its economic activities and emissions.” (Markwat, 2021)
Consider a large energy producer that has completely hedged its production through short positions in energy futures. If futures have a carbon footprint, and the producer has hedged its price risk through short positions in futures, are they carbon neutral? What about an investor who has a stake in the company’s equity or bonds and an equivalent stake in an offsetting short futures position -is that a carbon neutral investment?
The answer to these questions should be an unequivocal no. Futures do not affect consumption or production – they affect exposure to risk, and these are fundamentally different. The ability to invest in an instrument that’s value is affected by nothing other than the underlying price of the commodity itself is undeniably the lowest impact method of attaining valuable commodity risk exposure.
Broadly less than 5% of commodity futures contracts are taken to delivery (Hecht, 2021). In the case of CTA funds and futures backed commodity ETFs, this number if effectively zero. Delivery of physical commodities often is explicitly prohibited by the investment policy statements of these funds. With no delivery there is no increase or decrease in production, no financing, and importantly, no consumption.
Conclusion
Commodity futures do not create or consume the underlying commodity. As opposed to an equity or bond investment, with futures there is no resulting increase or decrease in production, no environmental impact.
While the environmental considerations of commodity investments often take precedent, we encourage you to review the white paper to fully consider the importance of the futures market. The benefits not only align with ESG principles, specifically societal and governance considerations, they are essential in this green transition.
Commodity futures historically have also provided strong inflation protection – particularly important in today’s inflationary regime. Considered alongside low equity correlation, the collective characteristics are compelling. It is not surprising that some of the most sophisticated investors are including CTAs in “Risk Mitigating Strategies” and “Crisis Risk Offset” portfolios. The white paper expands on this while also looking at the historical benefits of commodity futures during inflationary periods.
A responsible investor must consider ESG factors alongside investment merit and portfolio considerations. Commodity futures and CTAs offer compelling attributes and may be preferable to investments in equities and bonds of resource companies.
References
Canadian Centre for Policy Alternatives. (2021, August 12). An Insecure Future. Canada's biggest public pensions are still banking on fossil fuels. Retrieved from https://www.policyalternatives.ca/publications/reports/insecure-future
divestmentfacts.com. (2020, September 2). New study: divestment is media-grabbing, but ineffective. Retrieved from https://divestmentfacts.com/new-study-divestment-is-media-grabbing-but-…
Green is not always clean. (2021, May 19). Retrieved from Aviva Investors: https://www.avivainvestors.com/en-gb/views/aiq-investment-thinking/2021…
Hecht, A. (2021, July 31). Taking Delivery of Commodities via the Futures Market. Retrieved from The Balance: https://www.thebalance.com/taking-delivery-of-commodities-via-the-futur…
Markwat, T. (2021, September 2). The CO2lumnist: Should derivatives have a carbon footprint. Retrieved from Robeco: https://www.robeco.com/en/insights/2021/09/the-columnist-should-derivat…
Original article: http://www.auspicecapital.com/alt-invest/2021/11/1/commodities-esg-resp…
About the Authors:
Tim Pickering is Founder and CIO at Auspice, a quantitative investment specialist established in 2006 in Calgary. He was elected to the Board of the Calgary chapter of Pheasants Forever, a globally respected habitat organization dedicated to wildlife, land management, conservation, and education.
Brennan Basnicki, Director and Partner at Auspice, was in the first cohort to complete the Sustainability and Climate Risk Certificate (SCR) offered by the Global Association of Risk Professionals (GARP) in 2020. He has also completed four further certificates in climate action and sustainable finance.
