As the impact of high energy prices have hit the frontpages, speculators have caught the ire of policymakers looking for a scapegoat. In Europe attention has focused on the role that speculators in the EU’s carbon market. The Spanish government has issued a protest to the European Commission arguing that current “[electricity] price levels and volatility are politically unsustainable”, calling the current crisis, “a threat to carbon cutting initiatives.” In the document they call on the European Commission to adopt measures to prevent financial speculation in its carbon market, the EU Emissions Trading Scheme (EU ETS):
In early May I highlighted some of the potential China related risks facing commodity investors. One of the stories that was not on many investors radar was the Winter Olympics – due to be held in Beijing in February 2022. To see why this is important you only need to look back at the last time China staged the Summer Olympics in August 2008.
A construction boom ahead of the games plus precautionary imports of vital commodities (for example, diesel to avoid the risk of power shortages) were major factors behind the final surge in the late 2000’s commodity super-cycle.
As natural gas prices increase across the globe ahead of winter its worth looking at which industries are most reliant on natural gas, and which have the flexibility to switch to alternatives. The greater the reliance and the lower the ability to switch the bigger the hit there is likely to be on margins, all other things being equal.
Industry structure (i.e. the level of competition) and the degree to which businesses have hedged their gas requirements will affect their ability and their incentive to pass additional energy costs onto their end customers.
“Our competitors are our friends. Our customers are our enemies.” – James Randall, former president of Archers Daniel Midland
We tend to think that higher input costs will automatically be passed onto the end consumer in the form of higher prices. Higher commodity prices, and escalating shipping and wage costs over the past 18 months have consumers, businesses and investors concerned about what that might mean for inflation in the year ahead.
But it may not be that simple. You see the extent to which companies wish to pass on costs to their consumers depends on the degree to which they have market power, and how they wish to use that power. To see how we need to turn to the economic phenomenon that is game theory.
The consequences for economic activity from a change in the price of natural gas will depend on its cause. If the price of natural gas is driven higher by an increase in demand, then the economy is likely to continue to expand, and perhaps at a fast pace. On the flipside, an increase in the price of natural gas that is driven by a reduction in natural gas supply will unequivocally lower productive potential around the world.
High natural gas prices observed in 2021 are the result of a combination of demand and supply side factors. On the demand side, there has been a rebound in manufacturing output, higher aircon consumption due to recent heatwaves and high carbon prices incentivising the burning of gas rather than coal. On the supply side flows of natural gas from Russia have been lower than normal, while LNG cargoes have been diverted to Asia where prices have been even more attractive than in Europe.
Up until now there was really only a few ways in which investors could seek to account for the carbon impact of the companies they invested in. Either engage with management on change but essentially remain invested, divest partially or completely, or alternatively, seek to offset the carbon impact in some way through the purchase of carbon offsets or emission permits.
In a letter to Australian Prudential and Regulatory Authority (APRA), obtained by ‘The Age’ and ‘The Sydney Morning Herald’ in a freedom of information request, hedge fund titan AQR offered an alternative. According to the fund its Australian clients were now exploring the use of short selling stocks to reach net-zero targets in their portfolios: