Chris Ailman, chief investment officer of $317.8 billion CalSTRS, spent much of his childhood surfing on America’s west coast and dreamt of becoming a lifeguard until he discovered the world of investment. Fittingly, he tends to describe seismic events as waves, and an investor’s job to time and ride them.

Reflecting on his tenure as he prepares to pack up his desk after 23 years in his Sacramento office (a process, he jokes, that could take some time given the junk accumulated) he says the pension fund has been dragged under twice.

First losing $15 billion when the tech bubble burst 18 months into his leadership – he took the CIO job in October 2000. Then, much worse, when $55 billion disappeared from the portfolio over a period of 120 days during the GFC. A traumatic time that led to a long-term collapse in CalSTRS’ funded status and an experience he still calls the most difficult time in his career (See Top1000funds.com’s interview with him in 2009 Back to basics as CalSTRS rethinks active/passive mix).

Now that wave is the energy transition, stirring and building in the deep and which Ailman says must hit the shore by 2030 if the world is to have any chance of preventing devastating climate change. CalSTRS’ investment team is paddling hard, mindful of both timing it right to not get crushed, but also that the waters will get very choppy if the world doesn’t transition as one.

“If CalSTRS achieves net zero alone, it doesn’t do anything. We need everyone around us to change behaviour. By 2030 we need to be looking out of the window and see a very different life, otherwise we will be in real trouble,” he says.

Top1000funds.com has followed the evolution of sustainability at CalSTRS including how Ailman questioned the morality of  divesting non-US coal assets back in 2016; why the fund hired ESG-specific equity managers and more recently, CalSTRS’ net zero path and engagement wins, like its driving support of Engine No.1, the activist hedge fund that campaigned for directors with climate experience at oil giant Exxon.

But it’s the role of investors when it comes to financing the transition where much of Ailman’s thinking currently focuses.

He says it’s expensive cleaning up dirty industries, and the world needs and should welcome people who see the economic benefit from a green premium down the road. Building this new cohort of investors involves encouraging people like CalSTRS’ one million members (who he describes as “long-term, reasonable people,” a nod, perhaps, to the politicisation of ESG) to invest in greening industries.

It involves carving a middle ground between climate “zealots” who insist on divestment and boycotts, and a more unscrupulous bunch who continue to invest in high emitting sectors but won’t improve them.

“We still have investors who are willing to hold and buy coal,” he despairs.

Emerging risks

Ailman says he leaves his long tenure at CalSTRS as other risks also gather on the horizon, playing to his tendency for pessimism despite buoyant economic statistics like strong US GDP and historically low unemployment.

Geopolitical uncertainty and two regional wars concern him. And he believes November’s US election will see unprecedented levels of AI and deepfake from “bad actors” peddling misinformation to create instability and cynicism amongst an already weary voter population. “We need to be more sceptical about what we read and where it comes from,” he says.

The irony that America’s tech giants and the (worryingly few) companies leading the digital revolution are facilitating so much instability but have also provided some of the best returns for US equity investors isn’t lost on him.

Describing himself as “not generally a fan of regulation” he says the US urgently needs to draw up rules around AI and the internet, a Wild West that now poses an existential threat. “This is an area where we need regulation. If you think back to all types of communication in the past from postal services to TV and radio, the government had regulatory authority.”

Ailman may be calling for government action in one area, in another he is increasingly mindful of the risk ahead from policy maker largesse.

He predicts the cost of servicing US debt and financing the deficit in a climate of higher rates will be one of the biggest risks for the next President, whoever it is. “The cost of US debt will be the biggest budget line item by far.”

The risk (and opportunity) for investors will come with a new level of volatility in fixed income. Investors will face Treasury tails, the reaction from bond markets if auctions go badly and the government is forced to pay more to issue and service debt, for the first time in decades. “Ordinary people know what it is to go to the bank; ask for money, and the bank won’t give it,” he says. “We are just beginning to see the US struggle to finance its deficit.”

Riding the career wave

It’s not surprising that Ailman also compares his own career to riding a wave. In this case the growth of institutional investment off the back of pension fund reform in the 1980s before which CalSTRS was still part of CalPERS and run by around 40 people, hidden from view. “No one knew they existed!” he says.

He spent the 1980s as CIO of Sacramento County Employees Retirement System and joined the then $100 billion CalSTRS as CIO in 2000 after a four-year stint at Washington State Investment Board. Climbing up the ladder from financial analyst to investment officer, and ultimately CIO, in lock step with the growth of the industry and pension funds’ assets under management. “My job never changed. I got lucky, and caught a wave.”

Over the years, he was tempted to work for the sell side and join a Wall Street firm. But he says institutional investment always pulled him back, primarily because working at a pension fund in California best suited his family. The members of which pepper the conversation from his three-year old grandson to the influence his wife has played on his career. Or hearing how his sister and daughter, who both had careers in teaching, hold him to account over a crowded table. “I never wanted to move or meet demands that would have an impact on my family,” he says.

But his motivation has been purpose as well as personal. Namely his connection with CalSTRS’ beneficiaries and the fulfilment he derives from knowing they will be supported.

“Teachers spend their career on a modest income, and I love the fact we can provide a lifetime guaranteed income to help them in that trade off they’ve made.”

It was also CalSTRS’ beneficiaries who he credits with getting the investment team through some of the toughest days in the aftermath of the GFC, a connection that helped them all, him included, take ownership of what had happened and rebuild for the future.

Overseeing the growth of the investment team and championing them at any opportunity is, perhaps, his most important legacy.

“They are recognised as one of the best money managers in the world,” he says.

Grown from 35 when he joined to 230 today (and 70 per cent are women) they are responsible for managing $150 billion in house. The strategy has helped save more than $1.6 billion in costs since 2017 and CalSTRS currently targets an additional saving of $200 to $300 million a year over the next five years, a cost saving that is also supported by getting tough on asset managers about fees. He told Top1000funds in 2015 there was no need for the pension fund “to be friends with its asset managers.”

Ailman downplays his influence on the team’s success or his role in developing an investment mix that includes new portfolios introduced over the years like total portfolio management (begun during the GFC to bring asset class heads together to locate mortgage exposures and liquidity pockets), inflation sensitive and risk mitigating strategies. Insisting instead – in another glimpse of his light touch – that he just “hired the right people, gave them the right tools, pointed them in right direction and got out of their way.”

Typically, he spent much of the recent January board meeting when his retirement was made public celebrating the tenure of another CalSTRS employee. But he does allow himself one boast.

CalSTRS’ previous CIO lasted just three years in the role and at Ailman’s 2000 interview he promised the board he’d try and stay longer.

“I’ve smashed it,” he says.

Brunel Pension Partnership chief investment officer David Vickers recently flagged the risk of today’s “Goldilocks” economic scenario not delivering for investors. Although recession risk is receding; markets have priced in three rate cuts in the US and the inflation dragon appears slain, the reality might be different.

Vickers, who joined  as CIO in 2021 to oversee around £40 billion in assets at one of the eight LGPS pools, warned that conflict in Ukraine and the Middle East, and weakening economic data pose substantial investor risks. He said equity is, on aggregate, more expensive and warned that investor compensation for investing in debt markets is low. “It is plausible we get a Goldilocks scenario, but [investor] disappointment if we don’t will be keenly felt.”

Brunel Pension Partnership goes into 2024 with a raft of ambitions but also facing challenges, states the asset manager’s recently published Annual Review. One of the biggest unknowns is UK government plans for the LGPS pools. Following a consultation on the future of the LGPS, policy makers laid out ambitions for pools to transition all assets by March 2025, a process some local authority pension funds like West Yorkshire, part of Northern LGPS, have been slow to complete.

The government also targets further consolidation, suggesting pools reach £200 billion by 2040. Brunel says it has appointed “a third party to enable us to consider options for consolidation.”

Pools also face government pressure to invest more in unlisted assets and venture. In its 2023 Autumn Statement the government said it will revise guidance that the LGPS double its allocation to private equity to 10 per cent.

Brunel has also stated new commitments to raise manager reporting duties. In its latest climate policy, which updates an original policy first published in 2020,  the investor promises to “turn the screws” on managers and its holdings via increased RI expectations, seeking to drive whole-economy change for the long term  and “not simply buff our portfolios.”

Brunel was one of the first out of the gates regarding pooling assets and integrating sustainability. In 2018 it was the first UK pool to sign up to TCFD reporting and the first to launch its own RI policy. One year later, it had transitioned 50 per cent of client assets. In 2021, it formally committed to net zero, co-launched new Paris-aligned benchmarks and had introduced a suite of 17 multi-client portfolios – adding a local impact portfolio in 2022. Last year it introduced a fourth cycle of private markets portfolios and began developing a new RI priority – biodiversity.

The investor will spend much of this year beginning to integrate nature risk having committed to adopt Taskforce on Nature-related Financial Disclosures (TNFD) reporting metrics that detail nature dependencies, impacts, risks and opportunities in the financial year 2025-6, one of 320 organisations from 46 countries that signed up as early adopters in Davos.

Brunel’s TNFD commitment builds on earlier biodiversity initiatives. Last year it conducted a pilot project with S&P Global to assess nature risk across its listed equity and fixed income portfolios. Working with S&P Global enabled Brunel to delve into complex themes, like identify companies whose assets overlap with existing protected areas and key biodiversity areas. “Less than a third of Europe’s biggest companies have set biodiversity targets,” it states.

In it’s latest review, Brunel reports that absolute performance was strong across all listed market categories, in a reversal of 2022. Within private markets, whilst performance data is lagged, the last audited NAVs show that portfolios performed well.

Active management struggled, specifically in global equity mandates, given the concentration of returns. Indeed, the global equity index looks likely to have beaten the vast majority of active managers. Brunel’s least constrained fund, global high alpha, kept pace.

Other 2023 milestones include successfully trialing AI internally and strengthening access to data by drawing a clearer line between data managers and data owners.

The Global Pension Transparency Benchmark, a collaboration between Top1000funds.com and CEM Benchmarking, ranking pension funds globally on their transparency of disclosures, will make a number of process improvements to the 2024 survey.

For the first time since the benchmark’s launch in 2020, the survey will be updated this year including removing or improving overly interpretative questions; updating the responsible investment survey; and aligning the cost survey questions with reporting best practice as set out by CEM’s Global Reporting Principles.

Consistent with the benchmark’s approach to be inclusive of the industry to drive better performance, a consultation period on the new survey will be open from February 1 to March 1, 2024. [Click here]

The benchmark scores the five largest organisations in 15 countries on the transparency of their public disclosures across four factors: performance, cost, governance, and responsible investing. This year the five largest funds in each country will be re-assessed, and there is an exploration for ways that organisations outside the top five can participate.

The benchmark will be published in October, 2024.

For last year’s results, including the overall top fund (Norges Bank Investment Management), the winners in each category and the biggest improvers, click here.

PGGM, the asset manager for €237.8 billion PFZW, the Netherland’s healthcare pension fund, invests around 30 per cent of PFZW’s assets in fixed income with another 10 per cent allocated to liquid corporate credits. Portfolio manager Wilfried Bolt tells Top1000funds.com how the end of quantitative easing (QE) has changed PGGM’s hedging strategy and prompted a keen focus on liquidity. He also explains the rationale behind managing more of the corporate bond allocation in house.

Hedging the risk

Today’s new economic regime of higher interest rates has impacted PGGM’s hedging strategy, a carefully choreographed approach designed to keep PFZW’s coverage ratio stable by matching its liabilities and assets daily.

“We invest in long-term maturities with typical maturities of 20- to 30-years but could include up to 100-year maturities,” explains Bolt, who has been at PGGM for 13 years. “Fixed income is the cornerstone of the investment portfolio. The required investment returns are typically calculated versus the risk-free rate, so we only invest in government and SSA bonds with a minimum AA-rating.”

The end of central bank bond buying program means the yield curve is finally starting to steepen again. It is a reversal of a trend dating from 2014 when curves first began to flatten off the back of massive European Central Bank intervention that continued up until last year when the ECB stopped re-investing part of their asset purchases.

“In our strategy we have been anticipating this steepening,” says Bolt. “The inverted 10- to 30-year swap curve means our preference when it comes to hedge duration has focused on these middle maturities rather than longer-dated maturities, ever since 2022.”

The end of QE has also turned PGGM’s focus to liquidity – namely ensuring the continued ability to buy and sell bonds now that the liquidity central banks injected into the market is over. “The ability to access bonds as collateral for central-clearing activities under our derivatives operations has become more prominent on our radar,” he reflects.

Similarly, he says liquidity is also becoming much more important for other market participants, visible in corporate and sovereigns increasing benchmark issue sizes or tapping existing bonds. “This is one of the effects of reduced intervention by central banks that can be observed over the last years,” he says.

Swaps v bonds

In another trend, the disappearance of QE is impacting the yield differential between swaps and bonds, which PGGM manages in one integrated mandate. It has created a window of opportunity to either pick bonds when the team think they are attractively priced or buy swaps if they expect swap spreads to tighten.

“Scarcity of safe bonds was a remarkable phenomenon in 2022, making them extremely expensive versus swaps. Consequently, most of our hedging since then has been executed via swaps. It’s resulted in quite a large net liquidity position to potentially invest in bonds when swap spreads reach a level we deem attractive enough [to invest more in bonds]”

Now that central banks have switched to tightening mode, private investors must absorb huge supply. “As in 2023 we don’t see any hint these amounts cannot be absorbed by the market, however the time when bonds underperform swaps could continue potentially further into 2024,” he predicts.

Bolt reflects that a hard landing could bring more demand for government debt (also more supply) if investors switch out of riskier assets into safe havens once again. It could also see central banks re-emerging as buyers of sovereign bonds. In another scenario, a softer landing would have more ambiguous implications. It could see demand for the safest havens and less demand for smaller issuers, for example. “In both cases, we expect more demand for short-dated government bonds than the ones further out on the maturity spectrum.”

Shaking up corporate credit

PGGM is also changing its approach to corporate credit, covering a wider range of segments in-house. This includes US dollar-denominated corporate bonds, but also in-house coverage of high yield companies, both in the US as well as Europe.

“Taking a global approach makes a lot of sense.,” he says. “We believe covering the entire corporate credit universe, both across currencies and countries as well as across rating segments, allows teams to better take advantage of inefficiencies between the pricing of individual segments. Overall allocations to credit as an asset class have remained stable recently.”

Although he says the corporate bond market is “in relatively good shape,” he flags areas where those inefficiencies and risks are starting to manifest. Namely real estate companies, a segment with large corporate bond exposure and most exposed to the rapid increase in interest rates.

“We have had concerns about both valuations and corporate governance in some real estate firms, especially in Scandinavia. Investor appetite for bonds from such companies quickly dried up, resulting in a significant underperformance especially in so called hybrid instruments.” Going forward he expects the market to start differentiating between the different issuers much more.

Another segment of the market attracting his attention is high yield, especially in the US. High yield spreads still trade at comparatively tight levels versus their investment grade peers, while the ability of a lot of these companies to access the bond market has been hampered.

“With a sizeable amount of refinancing coming up in the next two years, it is likely that companies will need to pay significantly more for funding than what they were used to in the past years of low interest rates, thereby reducing profitability, leading to a normalization of spreads.”

Geopolitics in the bond market

That global approach and managing the allocation in house also helps navigate the impact of geopolitics playing out in the bond market. For example, he describes “excessive demand in euro markets” for scarce, safe, German government debt up until 2022. Since then, the pressure on German bonds has started to alleviate creating tighter spreads for other European sovereign bonds.

Still, he notes that the impact of geopolitics on the investment grade credit market has been surprisingly small. Mostly because the market has been more preoccupied with the path of interest rates on both sides of the Atlantic, pricing in aggressive rate cutting cycles for this year, despite pushback from various central banks. “The interplay between economic activity and inflation numbers seems more on the minds of investors than the various geopolitical risks that are present.”

Integrating sustainability

PFZW invests at least 5 per cent of the fixed income portfolio in bonds that contribute towards achieving the SDGs. But progress moving from investing in specific named SDG issuance to analysing sovereigns on an issuer level, is slow.

“In 2023 we started to calculate financed emissions for investing in sovereign bonds via PCAF’s updated standard but a more complete 3D assessment of our sovereign bonds, potentially as a tool to have a more meaningful exchange with the sovereigns we invest in, is still a work in progress,” he says. Moreover, green and social bond frameworks and initiatives to standardize sustainability-related bond issuances are only effective if multiple, large investors pool their weight and voice.

Still, outside the SDG bond programme, the team are making progress integrating PFZW’s sustainability goals via a carbon reduction pathway and an emerging 3D-investment framework that evaluates risk, return and sustainability of an investment.

It is also getting easier to integrating 3D investments in corporate bonds. For example, the team now measure the sustainability of individual business models and the sustainability targets that a company has put in place. PGGM is also prepared to buy labelled bonds from companies including companies that are ‘transitioning’ if they have presented a credible path to future sustainability.

He concludes that PGGM is more prepared to get increasingly tough on corporates. “If companies fail to deliver on such promises, we have no hesitation in divesting from them. We have become much more selective deciding which companies we engage with, based on where we think we can have a good chance of success. This more selective approach has helped to improve the success rate of our engagement efforts.”

Norges Bank Investment Management, manager of Norway’s sovereign wealth fund, has committed to measuring investee companies’ nature-related risks in its giant portfolio and publishing its own exposure using the Task Force on Nature-related Financial Disclosures (TNFD) framework.

As has sister investor Norway’s KLP, Sweden’s $79 billion AP7 and London-based LGPS CIV, one of eight LGPS asset pools, together comprising a handful of key investors signing up as early adopters of the TNFD recommendations. A process that will increase engagement by asset owners with investee companies and begin to change how financial markets value, price, and approach nature-related risk.

“We will identify those corporates most at risk, using the TNFD to target engagement with companies that we have most exposure to, most influence on and pose the biggest risk on our portfolio,” confirms Jacqueline Jackson, chief sustainability officer at London CIV.

TNFD disclosure recommendations are structured around four pillars (governance, strategy, risk & impact, metrics & targets) consistent with the Task Force on Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB). The framework includes 14 recommended disclosures covering nature-related dependencies, impacts, risks, and opportunities. Since its launch last year, 320 companies, financial institutions and service providers have signalled they will integrate them into their reporting.

The challenge of Measuring intangibLes

Investors adopting the framework face a number of challenges. Unlike climate change where they have been able to focus on reducing emissions in their holdings, nature is complex, intangible, and diverse, making it difficult to hone on a single issue – despite the framework highlighting core global indicators.

“By no means do we yet have a perfect KPI or indicators since there will be no single KPI for biodiversity due to its complexity,” says Flora Gaber, manager, ESG analysis at AP7, already integrating nature and biodiversity loss in its active ownership; conducting TNFD analysis and planning to issue a brief TNFD chapter in its annual report. “The issue of metrics and indicators, as well as targets, will probably be revised many times over in the next few years.”

“Since there is no common indicator for nature like emissions, our approach will vary depending on the company and sector,” Gjermund Grimsby, KLP’s deputy vice president, corporate responsibility, tells Top1000funds.com. “By identifying the key impacts, dependencies, and risks of different sectors, we can find appropriate indicators to evaluate and track companies. We will start with key sectors in our portfolio that we know have material impacts on nature and biodiversity, namely agriculture, aquaculture and fisheries, forestry and paper production, mining and metals, and oil and gas.”

Nature-related impacts and dependencies are also difficult to quantify (particularly for large investors with a diversified portfolio) because they are often localised. “Nature degradation is a global challenge but impacts and dependencies on ecosystems are very often localised, and may even vary depending on the season,” explains Snorre Gjerde, lead investment stewardship manager, NBIM,  an active contributor throughout the design and development of the TNFD. “Take for instance the example of water withdrawal: the impact can be considerably higher if the withdrawal takes place in a water-stressed ecosystem during dry season, versus in another location or even just at a different time of year.”

The localised element – in contrast to a universal carbon footprint – also makes accessing data particularly difficult. “You need to understand where a company has its assets, and the value of nature in this location, as well as its condition and whether it is degraded or not. In certain sectors, assessing a company’s value chain has more relevance. For instance, consider the beef supply chain in the retail sector,” suggests AP7’s Gaber.

But investors also note that access to data is getting easier. New reporting frameworks are emerging and technologies such as satellite imaging and remote sensing are producing unseen information on the state of the world’s ecosystems and natural resources. Data providers are also jumping on board.

“Geo-specific data is a top priority for most data providers, so hopefully this won’t remain a challenge for long,” says KLP’s Grimsby who suggests asset owners looking to get started focus first on the type of information they can easily assess, such as whether the portfolio company at risk has biodiversity on its agenda.

“Qualitative analysis can also provide valuable insights into key impacts and risks and serve as a starting point for integrating nature related risks in risk management and governance,” he suggests. “Like with climate risk, we expect quantifying nature risk in monetary terms will improve over time. Building on experiences from climate risk is valuable, so we try to integrate work on climate and nature instead of having two separate work streams,” he adds that KLP is currently building out capacity and knowledge so that as with climate risk the pension fund will ultimately integrate nature risk in ordinary risk management and governance structures.

A milestone in cooperation

And despite its “tricky” and “extensive” reporting, commentators believe that TNFD integration is easier than it looks given its many comparisons with climate disclosures and the fact investors that are reducing emissions in their portfolio will be familiar with the process. “Carbon reporting has been around for a long time and the accounting principles and available data is a lot stronger. In the early days, climate reporting was complex compared to traditional accounting methods, but the market had to tackle climate metrics, and the same will happen with nature-related risks,” predicts CIV’s Jackson.

Moreover, some investors have already engaged on nature because of its interdependence with the transition. NBIM already combines climate and nature in its engagement with food production and consumer goods groups, mining and extractive industries, for example. “This sector is key to obtaining the minerals and metals needed for the transition, but at the same time it is important to ensure that these can be produced in a responsible manner, with appropriate mitigation of significant environmental and social impacts of company operations,” says Gjerde.

“Climate change and nature loss are deeply intertwined global issues: climate change can cause nature loss, and conversely nature can provide climate change mitigation solutions. We encourage our investee companies to consider the toolkit for their own risk management and reporting efforts. As a global investor, it is particularly encouraging for us to see the broad mix of industries and geographies represented among the early adopters, including many of our portfolio companies,” he continues.

CIV’s Jackson also notes a willingness amongst investee companies to adopt the framework, something she links to acute awareness of the vulnerability of supply chains. “As investors we have diversified risk, but supply chain disruption has a massive impact for an individual company, many of which have already felt the reality of managing these issues and a drop in profits and rising costs.”

TNFD’s similarities with other frameworks also signposts a welcome coming together of shared standards in the regulatory landscape.

The International Sustainable Standards Board (ISSB) will be a global baseline of sustainability information, and the TNFD framework is already referenced by the ISSB, and other standard-setters such as the GRI.

“It has been very important for us that the TNFD framework has been designed to have a high level of interoperability with emerging global sustainability standards to ensure consistent and comparable information to financial markets, and to facilitate ease of application for report preparers, as opposed to causing fragmentation,” concludes Gjerde.

The commodities sector is at the heart of the energy transition, impacting both the coming structural decline of fossil fuels and the demand for the new economy critical materials. There is also the delicate matter of future nature-based land-use and food production conflicts facing investors and soft commodity driven deforestation, other potential clouds on their net-zero commitments.

The reality is that many investors are reluctant to talk openly about commodities because of the negative perceptions of the sector. To date, the commodities narrative has been mostly characterised by high emitting energy production from fossil fuel companies and mining companies that are misaligned with a sustainable future & their negative climate lobbying activities, which are still to be effectively curbed by those very same investors.

References to the role of commodities also often brings visions of irresponsible corporations and nations with issues beyond their environmental impact, including poor human rights records and a sometimes-dubious influence on some governments. In some cases, the list of broader ESG issues associated with commodity production reads like a list of investor red flags. If the global commodities sector were a single business, the CEO would be straight on the phone to Saatchi and Saatchi for an urgent rebranding.

Fossil fuels to critical materials–a rebalancing in indices

Investors increasingly recognize that the future of the energy transition and in turn emissions outcomes relies on the rapidly shifting balance in commodities trading from fossil fuels to critical minerals including metals, many of them in key transition sectors. Copper, cobalt, lithium and others are already exploding but their demand is not yet represented in the fossil fuel laden commodities indices that investors overwhelmingly use.

To better reflect this inexorable trend, Dutch giant APG is looking to launch a new forward-looking commodities index that will be constructed based on the future demand for these commodities rather than their historical counterparts, a move that will help shift some of the existing negative perceptions.

As any investor will tell you, exposure to futures indices is not the driver of change that many think they are. Nothing can alter fundamental economics more than early-stage investment, R&D, pro-active policy designed to accelerate commercialization and regulation to advantage the new over the old. Further complicating indices as a lever is that investors’ existing underlying exposure to commodities is often whispered in quiet corridors, blamed on supply chains where their influence is thin or on mining monoliths that no investor can afford not to hold in their portfolio. This has limited the opportunity for open debate.

However, with the development of these new forward-looking indices, investors can acknowledge their positive expectations of the new commodities exposure and then start the difficult discussions necessary to explore the social and environmental downsides. This can be far easier at the commodities level than at the company level, which often degenerates into a complex jurisdictional or commodity divestment discussion that shuts doors rather than opens them.

As the Inevitable Policy Response (IPR) shows in its 2023 Forecast Policy Scenario, most residual emissions by 2050 will be in Emerging Markets and Developing Economies (EDMEs). The transition will reflect a rapid transformation in those economies even though it is too slow to save us from a significant overshoot past 1.5C. Embedded in this inevitable future is the change in the commodities landscape that mirrors the change in the economies that produce the new materials.

To understand how the future will unfold, the history of commodities is worth recalling as the significance of the primary commodity sector in any national economy generally declines as the process of economic development improves in that country. Nations start by digging up their land for resource wealth or utilizing land in some productive way and a tipping point arrives when the benefits of this activity create a secondary manufacturing and service economy which fuel property and other booms to even the global playing field.

For example, the USA’s reliance on the primary sector for GDP contribution was around a quarter at the turn of the 20th century but had shrunk to just 5% by 1960 once Henry Ford and a couple of technology fueled world wars had washed through. History may well repeat itself regarding the new commodities, many of which will be produced in developing nations and some of which will send you scurrying towards an Atlas.

The Coming Commodities Shifts

Understanding how commodity shifts will manifest during the energy transition is vital for investors both at a sector and at a jurisdictional level with complex geo-politics. It is easy to point at investments in certain sovereign states in the most difficult and controversial of commodity producing destinations. China’s desire to influence nations in Africa is well documented and investors need only peek at their Sovereign and Corporate Debt portfolios to see that broader ESG issues are inherent in their investments.

Some commodities are already a major story in themselves with Cobalt in the Democratic Republic of the Congo (DRC) being the most recognised example, the country languishing 136th in The Economists Global Democratic Index out of 167 countries. When, in comparison, Zimbabwe and Burkina Faso are deemed some of the more stable areas to mine commodities in comparison, you have an industry facing difficult challenges.  Rare earth mining is also beset by some prickly ESG issues in some jurisdictions.

However few investors can afford to be without Cobalt in their portfolios whether they like it or not. Nothing short of total auto and battery divestment is required for an investor to look clean if they want to keep the DRC out of portfolios. This reflects how tightly integrated the world’s supply chains have become.

If no investor can look you in the eye and say they are totally clean on myriad ESG issues it further highlights that the real issue is about how to influence the future of commodities as transition shapes new demand, rather than how to avoid them. This is the debate that the APG indices can help promote whilst simultaneously advancing financial returns.

Once agriculture and nature – based commodities join the picture and you accept that the 1.5C overshoot is a coming reality, then investors may be forced into a new approach to commodities. Conflicts between bioenergy and food production are looming in future decades (an emerging issue the just released IPR Land Use & Bioenergy Outlooks both explore) with forestry playing a critical role in carbon removals to redress the temperature outcome towards the end of this century.

The emissions debate for investors is reaching a stage where difficult investment issues like commodities impacts can’t be avoided either in debate or implementation. The most obvious of these is the Net Zero alignment over reliance on Scope 1 and 2 emissions to make any sense. Scope 3 (with upstream supply chains being prevalent) is gradually being recognised as being essential to any logical framework for analysing emissions and pathways for reductions.

Like Scope 3 emissions, commodity exposure is also unavoidable for investors, even those committed to do the right thing on climate, just transition and stewardship. Divestment hasn’t worked as a theory of change and for large investors never could work once Scope 3 emissions were accounted for.

Investors should treat commodities in the same way, realising they are an inherent part of any portfolio and thus it is better to try to manage the inherent ESG issues as best they can whilst supporting the development of the critical minerals that the transition so desperately needs.

Within that framework, a new commodities index would not only be a tool to manage climate-related risks within a commodity futures portfolio but would help drive this new narrative which in turn can influence positive capital allocations towards these commodities.

Given that the Inevitable Policy Response has shown that investment in developing and emerging economies is the key to minimising an overshoot past 1.5C, and that many of these new transition commodities are in developing economies, the intersection of these two themes is a great opportunity for leading investors.

 Julian Poulter is a partner of Energy Transition Advisers (ETA) and head of investor relations at the Inevitable Policy Response (IPR). The views expressed in this article are personal and do not necessarily represent the views of IPR.