The Growing Impact of Climate Change on Commodity Markets

by 4C Insights | Jun 19, 2022

By definition, a commodity is a basic good used in commerce that is interchangeable with other goods of the same type.

Because of their substantially interchangeable nature, commodities trading has been evolving with humans since 4000 BC, when people in Sumer used clay tablets to denote the number of goods to be delivered. Commodities form an integral part of our everyday life: from the coffee that gives us a boost to start the day on a Monday morning, to the lithium that powers our phones and laptops and to the oil & natural gas that heat up our homes, which have been recently under the spotlight due to the Russian invasion of Ukraine. These examples show how individuals and countries are ultimately reliant on the ready availability nature of commodities. However, alongside the current combination of demand side factors and supply side factors which are causing a rebound in commodity prices, climate change is increasingly emerging as a structural factor influencing global commodity markets and impacting commodity’s production and availability.

This blog will focus on analysing the supply and demand factors behind the surging price on specific commodity categories such as agricultural and energy related commodities, the underlying current and future impact of climate changes, and the growing commodity impacts on consumer businesses that procurement teams need to navigate.

The Demand Side Impact

The recovery of the global economy following the shock of the Covid-19 pandemic, in a context of financial liquidity and an expansionary fiscal policy implemented by the major central banks, has favoured rising commodity prices and fuelled inflation. Easing restrictions on travel and gatherings led to a surge in demand for raw materials at a time when supplies were still largely restrained due to lack of capital spending, weather-driven crop losses and logistic bottlenecks.

The Bloomberg Commodity Spot Index, which tracks 23 energy, metals and crop futures has touched a record this year. The Index also rallied more than 27% in 2021, the biggest gain since 2009 recovery from the great financial crisis. Prices from most commodities from agricultural products to energy products and metals have soared with a negative impact on the customers’ purchasing power, as shown by the recent peak in May’s 2022 CPI to 9.1% in the UK, which is highest since April 1991 representing a 30-year high. The price increase has been mainly driven by surging oil prices and food costs.

Whilst currently strong economic recovery and ongoing geopolitical tensions involving Russia and Ukraine have been boosting demand for crude oil, in the long run as the world is moving away from heavy carbon emitting fuel sources, demand will steadily decline. On the other hand, other commodities will benefit from decarbonisation as they are critical in enabling the low carbon transition. For example, the price of lithium on the international market rose approximately 80% in 2021 according to a Bloomberg index. Many factors will play a role in shifting commodity markets: sovereign agreements to reduce carbon emissions, the regulatory landscape, and fiscal commitment to support the transition. Organisations looking to stay ahead of these shifts can benefit from expert sustainability improvement support to navigate the move towards low carbon operations.

Changing preferences among consumers will also fundamentally alter demand to favour more climate-friendly products. For example, as the larger global consumers of soy—food producers and protein producers—become more conscious of the impact of their supply chains on the environment, they are increasingly demanding proof that their soy is not being sourced from areas subject to deforestation. And they’re willing to change suppliers and increase their costs to avoid that climate impact.

The Supply Side Impact

As mentioned in the previous section, not only energy commodities have been affected by the recent commodity price shocks. The physical risks of climate change are having a considerable impact on agriculture. Agricultural operations impact climate change as land use changes and carbon is produced, and climate change, in turn, affects agriculture. Crop productivity is at the heavily affected by rising temperatures and extreme weather patterns. In fact, we’ve recently seen extreme weather events simultaneously impact wheat harvests in Canada, Australia, China, Russia, and Ukraine. Producers may adapt where and how they grow crops, but costs will still rise.

Heatwaves, drought, and disease have impacted coffee and chocolate producers. Numerous studies point to coming shrinkage in land area suitable for growing these crops as climate change intensifies. Suppliers are exploring drought-resistant crops, but pressures loom. Côte d’Ivoire and Ghana, for instance, supply about 60% of the world’s cocoa but have high deforestation rates, which doesn’t augur well for supply.

According to a recent article published by the International Journal of Climate Change, about half of the land around the world currently used to produce high-quality coffee could be unproductive by 2050. Another paper, in the journal Proceedings of the National Academy of Sciences, suggests that that number could be as high as 88% in Latin America.

In these specific circumstances is key for individual retailers to understand how they can invest to support farmers at the bottom of their supply chains. In El Salvador, Honduras and Nicaragua, Keurig has funded a program to teach farmers how to implement new agricultural practices tailored for times when water availability is limited. Andrea Illy, chairman of Illycaffè, estimates that the coffee industry spends more than $100 million each year to adapt. However, he has also highlighted how the coffee industry would need to invest approximately $1 billion per year to rejuvenate plantations, develop new varieties, improve equipment, even migrate some coffee plantations.

Impact for Procurement Teams

An analysis of the cost drivers quickly shows that it’s not just the cost of energy that’s driving inflation but that non energy commodities indexes have been trading at levels above historic levels for the past year. There is significant risk that pricing on many Agricultural / Food Commodities will stay high when viewed against historic levels pre-Covid. The challenge for procurement teams will be to continue driving the cost optimisation programs to recover companies’ margins but in a very different and more challenging environment.

As companies and countries are becoming more conscious of the need to reduce carbon emissions, setting up future “Net Zero” targets, one segment of the commodity world under the spotlight includes coal and fossil fuels. As the world progressively reduce its dependency from heavy-carbon-emitting fuel sources, demand for these energy stalwarts will steadily decline. This process will eventually knock higher-cost producers out of the mix, with real prices—and profitability—falling.

On the other side of the transitional-demand coin, some commodity segments will benefit, as demand rises for inputs that enable decarbonization. For example, industrial metals such as lithium and copper, critical in enabling the low-carbon transition, will see growing demand, even as oil demand flattens. The world will need more of these metals, which may force buyers to higher-cost sources, putting upward pressure on prices.