S&P DJI and J.P. Morgan contributed equally to this paper.
Executive Summary
The focus of the paper is on the environmental footprint of commodities and the incorporation of environmental metrics into transparent, rules-based commodity indices.
In the first section, we identify and discuss the various challenges associated with investing in commodities from a sustainability standpoint. The focus is on environmental impacts, and while we do not specifically address social and governance considerations, we acknowledge that they are important and a key area of future research.
We then present a new dataset that measures the environmental footprint of the S&P GSCI constituents. The dataset provides robust and comprehensive physical and financial impact data on GHG emissions, water consumption and land use at the commodity level, based on life cycle impact assessment factors and natural capital valuation metrics. We then introduce the concept of commodity valuation intensity, which ascribes an economic value to environmental impacts on a per unit of commodity production or per dollar invested (or dollar per contract value). This allows for comparison across commodities and types of environmental impacts. We begin the process of building our index frameworks by redefining new commodity “sectors” to reflect the changing dynamics of the global economy. We divide the components into three economic sectors: energy systems, food supply and other, based on their impact on the environmental transition and potential substitutions within each category.
The paper describes two index framework approaches to adjusting the S&P GSCI to incorporate environmental data. The first is the Optimization Approach, which seeks to reduce the environmental footprint of the index while minimizing weight and sector deviations from the S&P GSCI. The optimized constituent weights are constrained to help maintain diversification, investability and liquidity for the index. There is also an embedded transition mechanism that seeks to decarbonize the index year-on-year. The second approach (Substitution Approach) incorporates both negative and positive environmental externalities. Specifically, we introduce the concept of the environmental displacement ratio to measure the overall impact of those commodities that have a net positive role to play in the transition. This approach also incorporates a glidepath to changing allocations over time and considers an allocation to carbon emission allowances.
We conclude that it is possible to build commodities indices that incorporate environmental footprint data while maintaining the similar inflation sensitivity and diversification benefits as the benchmark. In the final section of the paper, we consider the need for additional research and discussion on the topic.
Introduction
Commodities are the building blocks of the economy. They are essential for the provision of shelter, sustenance, warmth and light. They are real, investable assets, and they can be highly relevant to multi-asset portfolios in relation to diversification and inflation protection.
Since the beginning of 2020, commodities markets have been trading through a period of heightened volatility, grappling with multiple sources of uncertainty, including the conflict in Ukraine, the return of high inflation, tightening monetary policy, U.S. dollar strength and the economic repercussions from COVID-19, as well as a series of supply shocks across individual commodity markets.
This volatility is based on a plethora of geopolitical issues in the short term, but longer term there are additional constraints that affect supply and demand imposed by the energy transition and the incorporation of sustainability considerations. These market dynamics present both opportunities and challenges to those involved in the broad commodity investment ecosystem.
Sustainability considerations have become a major focus for many institutional investors. Some asset classes such as equities and fixed income have led the way, as granular information is already available to incorporate them in to a portfolio composition. Commodities, which play a key role in current environmental impacts and in the transition to come, have paradoxically lagged this evolution.
In this context, market participants have expressed their desire for a framework to begin to incorporate sustainability considerations into their commodity portfolios. To date, the investing community has not grappled with this issue in regard to commodities, as much as it has with other asset classes.
The commodities market currently lacks some of the tools necessary to address this demand completely. This paper seeks to outline potential solutions for incorporating environmental considerations in commodity indices and identifying some of the remaining gaps. In doing so, we hope to not only provide market participants with considerations for their own analysis, but also help the industry identify those tools needed for further progress.
Contributors:
Fiona Boal, Managing Director, Head of Commodities and Real Assets, S&P Dow Jones Indices
Stephane Audran, Managing Director - Co-Head, Global Strategic Indices, J.P. Morgan
Steven Bullock, Managing Director, Global Head of Research and Methodology, S&P Global Sustainable1
Kimberly Gallant, Executive Director – Co-Head, Investable Index Solutions, Americas Lead, Global Markets Sustainability Center, J.P. Morgan
Adam Denny, Senior Analyst, Global Research & Design, S&P Dow Jones Indices
Gwen Yu, Executive Director – Global Markets Sustainability Center, J.P. Morgan
