Commodities and the climate

Commodities can play several key roles for investors, such as helping diversify portfolios, providing a potential hedge against rising inflation and offering growth opportunities. However, this important asset class presents challenges when you want to make any adjustments based on potential climate-related impacts of the underlying assets. It requires a different approach than equities and bonds. Here, we explore the challenges and how they can be addressed, illustrated with the industry’s first broad commodity ETF classified as an Article 8 fund under SFDR.
 

The demand: climate-focused solutions

While environmental, social and governance (ESG) exposures have taken in around half of all ETF flows in Europe over the past few years, demand for climate-related strategies has been the dominant theme most recently. They have captured 35% of all ESG net new assets this year to end-September, up from the 33% in 2022 when it was also the top ESG category in terms of flows¹.

The category includes equity ETFs tracking Paris-aligned benchmarks (PAB) and others with specific climate objectives, such as reducing carbon emissions. Some climate-conscious investors are now looking beyond their core equity and fixed income holdings to other areas within their portfolios.

The challenge: commodities need a different approach

An equity or corporate bond fund with a climate objective will usually adjust allocation to reduce the portfolio’s carbon intensity. With a tilting methodology, for example, you would either increase or decrease a security’s weighting based on certain characteristics, such as the company’s carbon footprint. It’s designed to give you more exposure to what you want, and less to what you don’t.

Many commodity investors would like a similar outcome – a reduction in the overall carbon intensity of the portfolio – but this requires a different approach for several reasons. First, a commodity fund’s assets are not stocks or bonds, so evaluating their carbon footprints is not as straightforward as comparing like-for-like entries in corporate accounts.

You need outputs from multiple entities – from small producers to multinational enterprises – operating in various territories around the world and across the entire chain of the production process. We need an approach that identifies and measures the emissions from all direct and indirect inputs and processes involved in producing the commodity, like scope 1 and 2 emissions.  

Further complications arise when you consider that commodity ETFs provide exposure via the futures markets. Every futures contract has a specific set of criteria applicable to the commodities deemed suitable for delivery. This normally includes minimum quality standards and could also define the countries of origin. For example, coffee beans grown in countries not listed in the contract specs are excluded. Ideally, you will want to isolate only the data that relates to the narrower subset of commodities underpinning each of these contracts.
 

The solution: allocation based on impact

In May this year, Bloomberg launched a broad commodity benchmark with a novel approach to measuring and adjusting for carbon emissions, while maintaining the characteristics that are so compelling for investors wanting to include the asset class in their diversified portfolios. In July, we launched the first ETF in Europe that provides investors with access to this index.

The fundamental concept is similar to many equity indices that apply tilting to the constituents but with an aim of producing low tracking to the standard index. You overweight those constituents with a characteristic you want, while underweighting those lacking or with less of the characteristic. And you can reduce tracking error by maintaining similar weighting at the broad sector level.
 

About the index

The Bloomberg Commodity Carbon Tilted Index (BCOMCA) adjusts the weight of individual commodities based on the greenhouse gas (GHG) emissions associated with their production lifecycle, while minimising tracking error to its standard Bloomberg Commodity index (BCOM). It targets a 20% reduction in the implied GHG emissions per unit of production compared to BCOM.

The BCOMCA index comprises futures on the same 24 commodities as the standard BCOM, grouped into commodity sectors based on their production processes. Within the broader agriculture and energy groups, BCOMCA separates primary and derived commodities into subgroups to avoid the double-counting of emissions, for instance between soybeans and soybean meal. 

The weight of each commodity is adjusted using a group-specific tilting factor, which is derived from a Life Cycle Assessment (LCA) of the underlying commodity. These LCA models aim to estimate GHG emissions at each stage of a production process or service, and across the production cycle of each commodity. The models account for geographical and process variations. This input is conducted by Sphera, a leading provider of LCA models, ESG performance and risk management software, data and consulting services focusing on Environment, Health, Safety and Sustainability. Emissions are estimated from more than 100 environmental impacts within the LCA models and calculated through the different stages of the production process.

The following example shows the weightings of agriculture commodities in BCOMCA, relative to their weightings in the standard BCOM index, after this tilting has been applied.

The carbon footprint in the production of soybean meal is less than that in the production of soybean oil, resulting in a tilting towards bean meal and an equivalent tilting away from bean oil. The overall (net) weighting of each commodity group is equal to the weighting of the same group of commodities in the standard BCOM index. That is an important feature as it reduces the expected tracking versus BCOM.  

Final thoughts

The tilting approach used should indirectly support producers of the lower GHG emitting commodities in the index, while we also believe the transition to a low carbon economy will result in those same commodities becoming economically more significant. 

Our Invesco Bloomberg Commodity Carbon Tilted UCITS ETF is testament to the fact you can factor in the climate impact of assets that don’t necessarily fit into a traditional approach. The ETF may be particularly appealing to environmentally conscious investors who want broad commodity exposure with a performance profile expected to be similar to that of the standard BCOM benchmark.

An investment in this fund is an acquisition of units in a passively managed, index tracking fund rather than in the underlying assets owned by the fund. Any investment decision should take into account all the characteristics of the fund as described in the legal documents. For sustainability related aspects, please refer to www.invescomanagementcompany.ie/dub-manco.