How institutional investment affected the structure of commodity markets, and what it might mean for carbon markets

It’s difficult to imagine today, but at the beginning of the century commodities were not considered a true asset class.

That began to change after the publication of a report from two academics, Gary Gorton and K. Geert Rouwenhorst. Their report, ‘Facts And Fantasies About Commodity Futures’ supported the belief that adding commodities to a portfolios gave investors diversification, strong returns and a hedge against inflation.

Examining commodity futures returns over the period July 1959 to December 2004 based on an equally-weighted index they found that a portfolio of fully collateralized commodity futures offered the same average return and Sharpe ratio as U.S. equities. In addition, and depending on the investment horizon, commodities had low or negative correlation with equity returns and bond returns. Distinct from stocks and bonds, they also found that commodities had a positive correlation with inflation.

The type of participants in commodity markets has changed over the past 20 years. As well as commercial firms (farmers, manufacturers and consumers etc.) and non-commercial firms (such as hedge funds), there has been a large inflow of investment capital too looking for the benefits that Gorton and Rouwenhorst uncovered.

Financial innovation accelerated this demand, and meant that anyone could take a stake in one or a basket of different commodities. Commodity index investors (CITs) seeking exposure to commodities as part of a broader portfolio strategy, made use of instruments linked to broad based indices, like the Goldman Sachs Commodity Index (GSCI).

The GSCI was created in 1991 and was the first practically investable commodities futures index. For the first time, a broad-based price exposure to a balanced basket of commodities could be achieved. This innovation negated the need for institutional investors to construct complex portfolios themselves. Investors who followed the portfolio advice were well rewarded as the commodity super-cycle accelerated through the 2000’s lifting returns to investors.

Between 2000 and 2010 total assets allocated to commodities rose from negligible amounts to nearly $400 billion. The large inflow of capital into commodity markets generated heated debate about whether “financialisation” had distorted commodity prices, perhaps resulting in consumers paying higher prices than underlying fundamentals would suggest.

Hedge fund manager Michael W. Masters has the charge against investor interest in food prices, arguing that unprecedented buying pressure from new financial index investors has created a massive bubble in agricultural commodities at various times in recent years. However, other studies have found little evidence to support this. This is not to say that the large influx of index investment did not have any impact in agricultural futures markets.

There is some evidence that index investment may have resulted in a very slight upward pressure on futures prices before contracts expire and also contributed to a small narrowing of price spreads during the period when index investors roll trades across futures contracts. It is essential to understand that investors in index products are also regular sellers of futures, because they must routinely roll their positions as contract expiries near.

Moreover, because they often target certain dollar exposures as a share of their total portfolio – as prices rise, the index investors’ demand for futures falls and they buy less during roll periods. Conversely, when prices fall, the portfolio weights also fall below target and the index investor will buy more to offset the shortfall. In this way, it can be argued that the index investor adds to the overall stability of the market, because the index is a net seller when the market calls for supply and a net buyer when the market calls for demand. Investors often try and front-run this rebalancing, anticipating what the fund might have to buy, and sell.

We’re starting to see these factors at work in the carbon market. The KFA Global Carbon exchange-traded fund (KRBN) is the worlds largest carbon fund. It began trading in July 2020 and currently has around $1.4 billion under management. The index is benchmarked against IHS Markit’s Global Carbon Index which tracks the most widely traded carbon futures contracts.

Up until the end of November around two-thirds of the fund was invested in the EU ETS, with the remainder mainly focused on the North American carbon markets. To avoid any single ETS becoming too dominant in the fund the weightings are rebalanced on an annual basis. This year the fund cut exposure to the EU ETS by some 5 percentage points to 63.5%, maintained the 32% exposure to the North American markets, while also adding in roughly 5% to the UK’s ETS (the latter started trading on 19th May 2021).

In contrast to the passive commodity index investors, more active speculators have a much more prominent role to play in price discovery. Speculators who expect wheat to be in short supply and see wheat prices rising in the future can back their hunches by purchasing wheat futures contracts on a commodity futures exchange. Wheat futures contracts represent claims to wheat to be delivered at a specified price and at a specified date and place in the future. But remember, buying a futures contract for wheat does not reduce the quantity of wheat that is available for consumption.

If many speculators share the view that shortages will worsen and prices will rise, then their demand for wheat futures will be high and, consequently, the price of wheat for future delivery will also rise. This then provides the incentive for farmers to plant more wheat and/or increase yields to serve this demand, helping to alleviate future shortages.

Speculators also perform a much needed service for physical traders. Commercial sellers, such as farmers intending to hedge next season’s crop, tend to be on the short side of the futures market, ie, they are intending to sell. Financial investors (in particular CIT’s) tend to be on the long side of the futures market, ie, they are intending to buy.

Commercial buyers, however, are less likely to hedge. In contrast to commercial sellers who face concentrated price risk in the commodity that they produce, commercial consumers tend to face price risks across multiple commodities and so the cost of trading deters them from hedging risk. As such, speculators provide a much needed source of liquidity, while reducing the discount that commercial sellers might otherwise need to offer to get a buyer.

These same principles of price discovery and liquidity provision also apply in the carbon market. High carbon prices encourage innovation in low carbon technologies and encourage consumers to switch to less carbon intensive energy. Meanwhile, investors - both index and active - help to provide physical compliance buyers and sellers with additional liquidity, enabling them to manage their risk more effectively.

Institutional investment in carbon markets is still at a nascent stage in comparison to the broader commodity complex. However, as I’ve written about previously, many are now recognising the potential benefits that carbon markets offer. As the experience of institutional investment in commodities illustrates the greater the interest, the higher the degree of scrutiny there will be.

Investors need to be able to demonstrate that their goals are aligned with the goals of the carbon markets.