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What impact is “greenflation” having on commodities?

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Investors in the US need to wake up to ESG implications

Under-investment in the supply of commodities across energy, metals and agriculture, as a result of policies to mitigate climate change, is limiting supply growth and driving prices higher.

Commodities outperformed bonds and equities for the first time in almost a decade in 2021. Even before the Russian invasion of Ukraine, these trends looked set to continue in 2022 due to very low inventories, improving demand and a muted supply response to higher prices.

Overtaken by events?

A key question now is whether increased European focus on security (of both energy supply and military security) will alter the effects discussed above. In some markets, the answer is likely yes. However, the effect of the renewed focus on energy security and reduced reliance on Russian energy will likely be a doubling down in commitments to renewable energy and transport electrification.

A short-term loosening of energy de-carbonisation plans (for example, keeping coal-fired energy plants open longer than initially planned) might also be necessary to reduce the risks of disorderly trends in energy markets.

Greenflation takes hold

The fact that climate mitigation policies bolster demand for commodities such as copper and nickel is well known and gets a lot of attention. However, the impact in changes to the supply side are arguably both larger and affect a wider range of commodities.

The focus of producers, governments and investors on supporting strategies that are consistent with policies to mitigate the effects of climate change and achieve these goals is directly limiting investment in new supply growth in fossil fuels and metals. This in turn is leading to so-called “greenflation”, which is defined as a sharp rise in the price of materials used in the creation of renewable technologies.

In a world focused on electrification and a shift to renewable power sources fears of fossil fuel assets becoming “stranded” (those assets suffering from an unanticipated or premature write-down or devaluation) have increased. At the same time, fossil fuel producers face significant pressure from both investors and governments over their current environmental footprint.

As a result, the incentive for oil producers to invest in very expensive, long-cycle projects, where long-term demand is very unsure and investor support is minimal, has been severely diminished.

Discover more by visiting Schroders’ insights or click the links below:
– Follow: Live blog: what does Russia’s invasion of Ukraine mean for markets
– Listen: ESG in the US – why it’s time for investors to wake up
– Learn: How climate leaders will trump complacent companies

Much investment focused on decarbonising, not raising production

Mineral producers are also more focused on cutting their current carbon footprints than on increasing supply. An increasing proportion of investment funding is being earmarked not for increased production of critically required metals but for decarbonising current supply chains to meet ever tougher targets.

The importance of governmental influence should not be downplayed here. The Chinese government’s commitment to climate goals is having dramatic impact on the demand for cleaner “bridging fuels” such as natural gas as well as severely limiting investment in areas like aluminium smelting.

Indirect impacts are also key factors to be aware of. While high European and Asian natural gas and LNG prices have almost no direct impact on commodity index returns, the very high fertilizer prices they have created may increase the production costs of various agricultural commodities globally.

Usual rules no longer apply

The end result of this dramatic shift is that the normal cycle of higher prices driving increased investment and production in the future has been broken.

Oil prices are at a level which would in the past have triggered increased investment. Demand for oil will likely exceed pre-pandemic levels in 2022. However, capital expenditure in the sector is not rising and the Organization of the Petroleum Exporting Countries (OPEC) is struggling to even hit its current quotes, which should drive prices higher.

This lack of investment generates a mismatch between supply and demand. When demand remains robust but supply is limited, the result is higher prices. This is a theme which will be evident across commodity markets in 2022.

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