Inside the global clean energy transition
Finance / Sustainable finance

Paying a premium: how commodity exchanges are going green

Buyers get the option of trading natural gas and aluminium based on their environmental impact, to meet demand from climate-concerned consumers and investors.

Pricing pollution is hard. New regulations are fought over tooth and nail. The companies responsible often have deep pockets and persuasive arguments about the threat to jobs, or from foreign competition. And progress is always at risk from the election of a Trump or Bolsonaro.

But what if the push of regulation is replaced with the pull of the market? What if buyers of crucial commodities – energy, metals, agricultural products – could identify and purchase those made with a lower environmental footprint, paying a premium that incentivised cleaner production?

That is the principle behind two new initiatives: one, XCHG, the result of a merger between a tech start-up and an environmental markets pioneer, and another from one of the world’s oldest established marketplaces, the London Metal Exchange (LME).

furnace worker
Heating accounts for more than a third of UK CO2 emissions, with just 5% of homes using low-carbon alternatives to natural gas. (Photo by Maksim_Gusev/Shutterstock)

“Commodity markets were created in a world with lots of resources and little information,” says Joe Madden, CEO of XCHG, a new venture that will allow the sustainability attributes of physical commodities to be identified and transacted. “Now, we have lots of information, but limited resources.”

XCHG was formed by the merger last year between Australia-based CBL Markets, which runs marketplaces for existing environmental commodities, such as carbon offsets, renewable energy certificates and water permits, and Xpansiv, a San Francisco-based tech company with its roots in supply chain digitalisation. It has attracted backing from oil major BP, Australian bank Macquarie and financial information giant S&P Global.

The company provides a marketplace for “environmental, social and governance (ESG)-inclusive” commodities, both existing environmental commodities such as carbon and renewable energy, and “emerging digital commodity products”, says Madden. The company uses what it describes as “digital feedstock” to record information about how a unit of a particular commodity is produced, creating a digital asset that can be traded. These assets include, for example, methane leakage, water usage or sequestered carbon.

The data – which is stored in a blockchain-like digital ledger – can either be traded with the associated physical commodity, or separately, much like the green certificates produced by renewable energy producers to prove a unit of clean power has been fed into the grid.

Responsible gas and low-carbon aluminium

 The approach is most advanced for natural gas, where bilateral, over-the-counter trades are beginning to take place in “premium responsible natural gas products”, which have a better climate performance than traditional products. In late 2018, for example, New Jersey Natural Gas announced the first purchase of gas certified under the TrustWell Responsible Gas programme.

“We are building the infrastructure to provide a central hub of liquidity for ESG-inclusive commodities,” says Madden.

By providing data traceability and asset registration, XCHG will allow the end consumer to track verified and certified environmental attributes up the supply chain.

Similarly, the LME, which can trace its roots to London’s Royal Exchange, founded in 1571, is creating a spot market for low-carbon aluminium. The initiative follows calls from a number of stakeholders, including Russia’s En+ Group, which produces aluminium using hydropower and sees competitive advantage in a market where aluminium producers have to disclose their carbon footprint.

The exchange is in the process of digitising the documentation that accompanies physical metals and which, historically, has contained information on their quality. In future, exchange users will be able to upload all sorts of data, including sustainability attributes, explains LME chief sustainability officer Georgina Hallett.

In a second phase, the exchange plans to establish a marketplace where sellers can specify the environmental and social specifics of the metal they are selling. This will allow “the price discovery that enables a market to build up”, Hallett says. The LME is currently consulting its members; if they are supportive, it expects to launch the marketplace in 2021.

A key challenge is agreeing the metric or metrics used to measure the carbon intensity of aluminium production, given the different methodologies out there. Hallett says the LME is likely to allow a number of approaches. “We would not be saying ‘this is the threshold for inclusion’”, she says.

Creating a sustainability premium

In theory, both the XCHG and LME initiatives should generate a premium price for sustainable commodities, incentivising producers to improve their environmental and social performance.

“Creating a premium pricing mechanism, and making the market pay that, is a great way of internalising an environmental externality,” says Carole Ferguson, head of investor research at CDP, a London-based, investor-backed not-for-profit that runs a leading corporate environmental reporting platform.

“Carbon regulation hasn’t been sufficiently strong to incentivise companies to reposition themselves and take the carbon-intensity out of their processes,” she adds. “A pricing mechanism could help them do that.”

Mark Campanale, a responsible investment veteran and co-founder of the hugely influential Carbon Tracker think tank, which has helped embed the concept of stranded assets in financial thinking, is on XCHG’s advisory panel.

“If we can find a way for the market to pay a premium for leak-free natural gas, it is worth supporting,” he says.

“Getting the financial markets involved can be transformative,” he argues, with XCHG providing an example of the sort of innovation that can help with environmental challenges. The approach to natural gas could be extended to other commodities, he adds, tracking how much water, fertiliser or pesticides are used to produce agricultural commodities, or whether soy, palm oil or timber comes from deforestation-free producers, for example.

Growing consumer demand for more sustainable projects is putting pressure on companies to improve the sustainability of their supply chains. Ferguson at CDP cites the efforts of companies such as The Coca-Cola Company – a massive aluminium consumer – to reduce their environmental footprint. At present, most aluminium is traded bilaterally between producers and large consumers, and there is little data on whether low-carbon aluminium is more expensive, says Hallett at the LME.

Investor pressure

Pressure is also coming from large investors who are concerned about their exposure to climate risk. Companies may be as interested in showing their shareholders they are reducing their climate risk as they are in showing a good face to their customers, XCHG’s Madden suggests.

However, not all supply chain experts are convinced that creating a premium for more sustainable commodities is the answer. Thibault Gravier, who heads up work on supply chains at Business for Social Responsibility, a global business network, argues that for commodities such as palm oil – characterised by large numbers of small-scale producers – bottom-up approaches are more appropriate.

Rather than enabling what he describes as “niche markets” to create demand for sustainable commodities, it is more effective to identify sustainability hotspots within a supply chain, he argues, and address those directly. CDP’s Ferguson has some sympathy for this point of view.

“The danger is that the price signal doesn’t get passed down to smallholders […] That is where things risk falling down,” she says.

In most commodity markets, however, especially those for energy and mining, a sufficient proportion of production is in the hands of companies that could track production practices, she says. The LME and XCHG initiatives will bring transparency – and the power of market signals – to bear on commodity production and trading, Ferguson believes.

“I’m a big proponent of this,” she enthuses. “I think it is fantastic and creative.”