To answer this question, we need to understand the role of energy-based commodities within the economy. Since crude oil, natural gas and the distillates are either a direct or indirect input for all sectors (including the energy sector itself), estimating the emissions due to the production processes already incorporates combustion-based emissions. Since the assessment is contained to the production process and covers the full commodity universe, the emissions from the uses of energy are captured by the analytic framework. Explicitly adding the downstream emissions from energy will lead to double counting of emissions.
What about carbon credits?
Over the past five years, the use of carbon credit futures to ‘net-out’ emissions from traditional derivatives-based commodity portfolios has become increasingly popular. The stated aim is to neutralize the emissions embedded within the production cycle of commodities. Part of the popularity of carbon credits has stemmed from the strong returns delivered by these futures for a variety of reasons including anticipated regulatory changes. However, there are three key reasons for circumspection.
First, carbon credits were intended for use by companies seeking to offset physical emissions; akin to the initial use-case for credit default swaps purchased by bond holders. The need to adhere to a ‘carbon budget’ might require the purchase of carbon offsets, which can be viewed as a tax on emissions. Since derivatives holders’ do not produce any physical emissions, it is difficult to see how this use-case is applicable to financial investors. In fact, in our previous blog on this topic (‘Can you extend sustainable investing to commodity indices?’), we discuss the need to construct an alternative interpretation for investors to measure the impact of their investment (‘funding support’) instead of the traditional equity and fixed income view of ‘portfolio emissions’.
Second, if investors intend to use carbon credits to compensate for the exposure to commodity futures, the carbon futures would need to be held to expiry—effectively writing-off the investment. This would be punitive from a portfolio return perspective and as expected. the most common implementations simply roll exposure to a deferred contract prior to expiry—effectively avoiding the offset. Indeed, even if investors did hold the carbon futures to maturity, the aggregation of GhG emissions across all commodities does not seek to over/underweight commodities by per unit emissions—instead treating the basket as a single entity. This implies a different objective from a traditional tilted portfolio.
Lastly, for a given commodity, the ‘price’ of a unit of GhG emissions differs by region. The price dynamics of carbon credits vary by region since it is a framework that is effectively geographically localised by regulation; governed by governmental policy which dictates the supply and demand for credits and local company efficiencies. Accordingly, if an investor should choose to offset the assigned emissions within the commodity portfolio, what is the carbon credit basket comprised of? This raises further computational, liquidity and operations questions such as: does the mix of carbon credits need to be matched to the geographical production profile of each commodity and what are the contracts available for offsetting? Given the complications raised above, incorporating carbon credits within the carbon titled framework can be viewed as premature; with reasons ranging from traditionally intended use-cases to implementation.
What are investors’ implications?
Financial exposure to commodity markets has traditionally been gained through the futures markets. Investors seeking to gain exposure to the economic cycle, hedging inflation and diversifying equity and fixed income returns, roll futures positions prior to expiry. The purely financial exposure without receiving physical delivery results in investors (1) having a role as liquidity providers with no direct link to the demand and supply of the commodity and, (2) no ability to specify the downstream use-case including geographical location. Given the role of investors, consistency in measurement would require the calculated emissions for each commodity be restricted to the production processes. The aim of carbon credits along with the geographical specificity of carbon pricing make it challenging to incorporate within a framework whereby the goal is to reweight commodities within a traditional benchmark in-line with the principles of sustainable development.
The Bloomberg Carbon Tilted Commodity benchmark (Bloomberg Terminal ticker is BCOMCA Index) is an index that reweights the Bloomberg Commodity benchmark (BCOM) based on the calculated emissions from the production processes of each commodity. The reweighting process is restricted to the individual sectors to reflect the weak substitutability requirement for commodities that are over/underweighted.
Bloomberg
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