From the June 2009 issue of Wealth Manager Web • Subscribe!

June 1, 2009

A Conscience for Commodities

The answer, perhaps surprisingly, is: remarkably few--not just here in the U.S., but anywhere.

According to Craig Metrick, U.S. head of Responsible Investment for Mercer, a N.Y.-based provider of global consulting, outsourcing and investment services, "there really aren't that many SRI or environmental commodities investment options in the marketplace as of yet."

One of the few people to have done any work in this area is David Wood, director of the Institute for Responsible Investment (IRI) ( index.cfm) a project of the Boston College Center for Corporate Citizenship. Together with his co-authors, he has produced b the institute's "Handbook on Responsible Investment Across Asset Classes" and its "Handbook on Climate-Related Investing Across Asset Classes," both of which actually include chapters on commodities. But as the first handbook states: "Unlike other asset classes, few opportunities to incorporate environmental, social and governance (ESG) factors into commodity trading currently exist." Rather, responsible investment in commodities, "remains more an idea to be explored than a developed practice."

Wood suspects that after looking first at the "public equity space" and then having moved on to fixed-income, "for institutional investors concerned with SRI/ESG, commodities are going to be at the tail end of these asset class considerations."

However, quite apart from commodities coming, as it were, at the end of the pecking order for consideration in this context, not only is there the very nature of commodities themselves to contend with, but also, as importantly, that of the markets on which they are traded.

Dealing with the commodities markets first, three important features of modern commodities futures markets significantly complicate any SRI/ESG considerations.

In the first instance, exchanges function on the principle that not only are contracts standardized, but also that there is substitutability under these contracts. While standardization is, of course, necessary, for any socially responsible investment, the standards also need to be appropriate such as those used to define fair-trade cocoa or coffee, for example. At the present time, however, exchanges do not standardize contracts incorporating SRI/ESG considerations.

In the second instance, the principle of substitutability means that except insofar as the contract specifies--buyers of a contract have no idea of where the commodity being traded actually comes from, or indeed, under what conditions it has been produced. And if there should be physical delivery, the buyer just has to accept what is delivered. Traceability does not enter the equation.

Finally, when commodities futures are traded on an exchange, the exchange usually stands in the middle, constituting the counterparty to both seller and buyer. Because of this, the concept of counterparty choice ceases to exist. As a producer you will not be able to identify the consumer and vice versa.

Commodities as an asset class

And then there is the nature of commodities themselves. Although as an asset class, they may not be open to all the same analyses and ESG considerations as say, equities or fixed income, this should not be regarded as an insurmountable problem--particularly if you believe, as does Steven Lydenberg, CIO of Domini Social Investments in New York, that "a responsible investment (ESG) strategy should be asset class specific."

While currently, there may be no suitable products available, for investors looking for an "ESG play" in commodities, a number of different strategies can be used "to integrate ESG issues into their commodity selection processes," according to the authors of the IRI handbooks. These strategies include focusing either on the commodities themselves or on their geographical source, or on how they are actually produced.

If the focus is on the commodities themselves, individual commodities can be included or excluded on the basis of their positive or negative impact. Ethanol could be excluded because, despite its usefulness as a biofuel, growing it uses large quantities of water and it also can be shown to have negative effects on the food supply. If the focus is on source, for example, investors might exclude non-fair trade coffee and cocoa.

And, finally, if the focus is on how the commodity is actually produced, aluminum--despite its lightness and the fact that it makes cars more fuel-efficient--could be excluded because the amount of electricity consumed in its production is prodigious. On the other hand, palm oil may be included because of both its high yield and its ability to save large tracts of forest.

However, one large dark cloud looms over any effort both to shed light on the various ESG factors affecting an investment in commodities and, indeed, to design, in the words of the IRI's Wood, "a product that would appeal to someone who is looking for an ESG play"--and that is lack of information.

With commodities traded on many exchanges, it is the lack of information as to their origin and how they are produced that are serious obstacles. However, Wood believes that "it's not impossible to imagine overcoming those within certain niche categories, and certainly we can devise all sorts of tracking systems. But, right now, they don't exist."

When it comes to analyzing the various ESG factors associated with investing in individual commodities, however, the current lack of information is a considerable hindrance. While KLD Research & Analytics, Inc. in the U.S. (click) out of London provide vital data covering public companies--including those that produce various commodities--no one yet provides such information across the range of commodities themselves. Says Amanda McClusky, head of sustainability and responsible investment at Colonial First State Global Asset Management in Sydney, Australia--a signatory to the Principles of Responsible Investment (www.unpri.org/): "You can only operate in an environment with the information you have."

For most investors, therefore, this will mean that, in practical and economic terms, executing a satisfactory socially responsible commodities investment program based on investment selections from across the full range of commodities may be very difficult. Not only is relevant information scarce, but also the costs could prove prohibitive.

Various compromises may, however, provide acceptable short-term solutions until such time as the necessary information is available, suitable investment products appear in the market, and suitable contracts are quoted on commodities exchanges. Investors could, for instance, choose a single ESG consideration as a proxy and base their selections around that. Climate risk could be one such factor; environmental risk another.

Another option would be to forego investment across the range of individual commodities for investment in just one or two--like timber or carbon--in which ESG work has been done. Investors can gain exposure to both through a number of different vehicles including mutual funds, managed accounts, ETNs or--in the case of carbon--directly on one of the exchanges.

As for the future, keeping abreast of the market, socially responsible commodities investors should also be aware of work that is currently being done with water, and also with more exotic "commodities" such as fishing quotas.

Thomas Butcher (thbutcher@me.com) is a New York-based financial writer.

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