With corn prices at record highs, grain stockpiles at their lowest level for years and dramatic increases in food costs stoking inflation, agriculture has become the sector that investors cannot afford to ignore.  According to the Food and Agriculture Organisation, global food production will require investment of about US$80 billion a year over the next 40 years to grow volumes by 70% required to meet ongoing demand.

Prices of agricultural products have soared globally, in part because of bad weather and export controls in some countries, but also due to strong demand from both livestock producers and urban consumers across Asia.  Burgeoning demand in emerging markets is accompanied by considerable supply constraints, with good quality arable land shrinking, fresh water becoming a scarcer resource and climate change events creating risks to the production of field crops.

From a basic economic standpoint, therefore, investing in the sector seems a clear winner.  At the same time, though, food and agriculture involve a range of potential risks throughout the value chain which investors need to understand and manage.

A recent study published by Bank Sarasin: “Food and sustainability: Will the seed bear fruit ?” highlights three central sustainability themes that affect food producers: sourcing raw materials from sustainable agriculture, working conditions and health and nutrition for the final customer.

Sustainability in the supply chain

One of the key challenges facing the industry is procuring more raw materials from sustainable sources.  This is not simply a question of ensuring long-term supply and environmental responsibility. Consumer companies with many leading global brands, such as Unilever and Heinz, are seriously exposed to reputational risk from issues such as child labour, indigenous land rights or the destruction of the rain forest.  Nestle, for example, was targeted by Greenpeace in the controversial and gory KitKat campaign highlighting its use of palm oil from indigenous forest areas in South East Asia.

Clearly, food companies that have greater control over their supply chain are less exposed to these kinds of risks, and most of the biggest players have begun to develop their own strategies for promoting sustainably produced raw materials.  In addition to environmental concerns, the working conditions of most of the raw material producers in agriculture and plantations attract public criticism.  As yet, health and safety conditions in the food producers’ own manufacturing plants have not come under heavy scrutiny.  However, Sarasin’s report points out that many workers in the industry are employed without contracts and that working conditions are sometimes poor.  Only Danone has signed a framework agreement with the International Union of Food concerning globally valid employment standards.

Investors in food processing firms also need to be aware of the health aspects of a company’s product portfolio.  In developed markets, obesity is a serious problem and governments have shown an increasing willingness to intervene through regulation.  Consumer preferences are also moving away from foods which are high in fat and sugar.  Other controversial products in some markets include bottled water, milk formula and genetically modified ingredients. 

Basic food safety is a more critical issue in some emerging markets, most notoriously China.  Just last week, the South China Morning Post in Hong Kong reported outrages ranging from rotten meat and fertiliser in sausages to soy sauce made with unpurified industrial salt.  It seems that few lessons have been learned from 2008’s international scandal arising from Chinese milk powder contaminated with melamine.

Professor Li Duo of Zhejiang University said that actions announced by the government to tackle the problems are insufficient, with most punishment being insignificant.  The National Food Safety Law, implemented in 2009, capped financial penalties at ten times the value of products seized.

Investment versus speculation

Given such horrors in the food production business, investors may prefer simply to focus on the raw commodities.  Over the past decade, institutional and retail investments in commodities have jumped from roughly US$10 to US$400 billion, and are still rising rapidly, according to Barclays Capital.  While the concept of sustainability is well developed for some asset classes, especially public equities, a definition of responsible investing in commodities has not yet been established.

Most financial investors gain exposure to commodities through derivatives, for whom “responsibility” arises primarily through their potential influence on commodity prices.  To the extent that they contribute to short-term price movements which increase price volatility, investors may find a cause for concern.  Excessive commodity price volatility creates significant uncertainty for the real economy, and large fluctuations in food prices may impact very badly on poorer Asian countries.  The Asian Development Bank estimates that domestic food inflation this year may push 64 million people into extreme poverty.

A recent paper by OnValues suggest a range of possible actions for responsible investors wanting to minimise their potential influence on commodity prices, including avoiding both agricultural markets where price volatility has a severe effect on vulnerable populations and small, illiquid markets where the likelihood of influencing prices is particularly high.

Down on the farm

As an alternative approach, investment in productive assets has emerged as an increasingly attractive means for institutional investors to gain exposure to commodities.  Real assets, including farmland, provide stable income streams and a hedge against inflation.  Owners of these assets, of course, are responsible for all the sustainability issues associated with agricultural production, but they should have information and control over the process, though this varies based on whether they own the asset directly or indirectly via a fund.

Investing in farmland in emerging markets is a phenomenon which has created a great deal of debate, especially when the investors are foreign pension and sovereign wealth funds.  Critics argue that it is a land grab that drains important resources and leaves indigenous people poorer.  Those in favour of farmland investing argue that, done correctly, it brings improved resource and land management, improved farming techniques, technology and education. 

Alexandra Tracy is the Hong Kong-based chair for the Association for Socially Responsible Investment in Asia (ASrIA)