Commodities: Grub first, then ethics

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Passions run high and evidence is mixed. Nina Röhrbein finds pension fund investors often play safe when it comes to food futures

The CIO of French reserve fund FRR Philippe Aurain recently said that the fund would remain largely passive in commodities because it wants to steer away from the debate about speculation and prices. His position was backed up by the socially responsible investment (SRI) study of Germany-based strategy consultant Funds@Work, which found that active SRI investors in Austria, Germany and Switzerland do not invest in commodities at all.

With food prices reaching record highs in February and evidence that futures contracts affect spot prices being hotly contested, can investing in agricultural commodity futures, in particular, really be ethical?

For the most part, investing in the food and agricultural sector is uncontroversial.
"There is no inherent ethical dilemma in investing in the food and agri space, provided these are investments in the true sense of the term - such as investments in companies that make products and/or services that create value for customers and society as a whole," says Christophe Churet, analyst responsible for the SAM Smart Materials Funds at Swiss-based SAM. "Examples include companies that provide nutrients and crop protection products, agricultural equipment and machinery, irrigation technologies, grain processing, storage and transportation services. While these companies exploit a basic human need - the need for food - it is not more unethical than investing in an energy, water or educational services company. In short, it is not the area of investment but rather the investment vehicle that determines whether an investment is ethical in nature or not."

Historically, commodity futures have mainly been used by farmers to manage the volatility of commodity prices by guaranteeing a set price at some point in the future, making it easier for them to plan investments, manage their operations and access credit. This function is still valid.

Asset owners, on the other hand, have been interested in gaining exposure to commodities mainly for two reasons - diversification benefits, and protection against inflation.

"Historically, commodity futures have served a purpose, both for farmers and asset owners," says Churet. "However, commodity investing has changed over the years. The most apparent change in the past 10 years is the ease with which investors have been able to gain exposure to commodities, via a broad range of commodity indices and ETFs, which has resulted in a significant increase in the amount invested in commodities."

While over the longer term real commodity prices should continue to be driven by technological progress and substitution, which leads to stable or declining real prices over time, Churet says that increased financial investment has led to three unintended shorter-term consequences: a notable increase in the volatility of commodity prices over the past decade; short to medium-term inflationary pressures; and the erosion of diversification benefits of commodity investing. "It is on the back of these considerations that one can argue investing in commodity futures is somewhat unethical," he says.
Responsible investors are increasingly concerned about investments in agricultural commodities, particularly in trading and the whole area of speculation, according to Sheila Oviedo, associate sustainability analyst at ESG research provider Sustainalytics.

"One US-based responsible investor network actively engages with pension funds and asset mangers to review their commitments to agricultural commodities," she says. "There is a social and reputational risk involved in investing in commodity index funds because they contribute to increased price volatility. Increasing food prices can be good for large corporate food producers and net exporters but a lot of developing countries are net importers of food. And as an actual buyer of food commodities, a lot of food companies would like to see more stability."

But others believe that these investments are ethical. The main arguments are that speculators do not take physical delivery of commodities and therefore cannot affect the physical market; and that higher commodity futures prices act as an incentive to farmers to increase production, which benefits consumers in the long term.

"Speculators can certainly move the futures prices of food," concedes Adam Taylor, assistant portfolio manager of the commodities fund at hedge fund manager Liongate Capital Management. "However, eventually those contracts come to expiry and speculators will then sell to physical commodity market players who only buy at a price where they can make their margin, which brings the futures price back to where the actual supply and demand is."

Jason Lejonvarn, commodities strategist at fund manager Hermes, attributes the volatility to declining storage levels and the historical swing producer, the US, growing grains at maximum capacity, while other potential producers, such as Brazil, continue to be faced with infrastructure and other problems.

"Another important point is that, according to a study by the World Bank, 80% of grains in poorer countries is grown and sold locally, while the agricultural contracts in all the major indices are US-based," he says. "Countries like Egypt and Algeria also use food as an issue to mediate their potential unrest internally. This was demonstrated by the issuing of big tenders for wheat around the time that the unrest kicked off in North Africa in order to cap food prices and appease their citizens, all of which equates to increased volatility. But while there is a lot of nervousness around inflation and speculators, ultimately there is a shortage of supply."

Lejonvarn also points to a study by the Commodities Futures Trading Commission (CFTC) that found that during spikes in volatility investors owned a smaller proportion of the open interest - in other words, when volatility went up speculators actually decreased their holdings.

Taylor attributes the concerns on society's search for a scapegoat. The reality, he says, is that world population is growing, diets are becoming more protein-heavy and changing weather patterns affect production. "An easier scapegoat is US ethanol policy because 40% of its corn goes towards ethanol production, which is subsidised by the government," he says.

Sustainalytics is not aware of any pension funds that do not invest in commodities for ethical reasons or have a separate ESG policy for commodities. "Investors are unlikely to opt out of commodities," says Oviedo. "For them, it is more about applying responsible investment (RI) policies to mitigate those risks involved."

RI policies in commodity futures require a lot more articulation than policies governing direct equity investments but a report by Swiss consultancy onValues, in collaboration with the UN PRI and Global Compact initiatives, offers a set of recommendations for investors to implement. These range from having multiple investment channels, setting limits on the number of futures contracts they hold, to insisting on greater transparency and careful selection of commodities to invest in.

But Hermes has come across boards that were nervous about investing in commodities because they might leave themselves open to criticism. As a consequence, they invest less in the space than they otherwise would have done.

"The short or long-term impact on, particularly food, prices by investments in commodity futures was one of our major concerns when we moved into the space," admits Tom Mergaerts, CFO/actuary at Belgium's €1.3bn Amonis pension fund. "However, limited available research and discussions with market participants led us to believe that the impact was minimal - although we continue to follow this issue closely."

"We do not think that investments in agricultural futures are unethical," says Clark McKinley, information officer at the office of public affairs at the California Public Employees' Retirement System (CalPERS), which has $250m invested in tracking the S&P GSCI Total Return index and $2.5bn in fully collateralised commodities swaps. "The large share of the S&P GSCI Total Return index is in petroleum products. The price of oil strongly influences the prices of producing and shipping food - beyond the prices of agricultural products alone. So the larger question is about the ethical status of all commodities, including oil. The ethics question was raised a few years ago as CalPERS and other investors were blamed for speculative activity that increased commodities prices. Our response to those allegations are the same now as they were then."

CalPERS 2008 factsheet, which was published during the debate, stated that there appeared to be no single cause of commodities inflation and that there is no empirical evidence of any correlation between commodity index investments and rising commodity prices. It referred among others to the 2008 study by the US Department of Agriculture.
As often in the ESG area, responsible investors take their own view on the matter. The ethics of investments in agricultural commodity futures, is clearly still a touchy subject, as demonstrated by the unwillingness of responsible investors to comment on their commodities policy.


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