The Orbitas Lexicon: Climate Transition Risks and Tropical Commodities
Orbitas exists to assess and communicate the often overlooked financial risks tied to climate change responses – climate transition risks – in the tropical commodity sector. One reason for this is that tropical commodities are complex. Even the terms themselves can be confusing.
To aid your understanding, we’ve developed the Orbitas Lexicon that defines the key terms we use in our work, which we hope will also prove useful to others as more actors focus on the financial risks in the tropical commodities sector linked to climate transitions. The Orbitas Lexicon defines the terms Orbitas uses, describes the actors involved, and provides background information on the tropical commodities we examine.
Defining the Orbitas Approach
First, let’s define Orbitas itself.
“Orbitas is a Center of Excellence that uses scenario analysis, consistent with the The Task Force on Climate-related Financial Disclosures (TCFD), to assess the transition risks from emerging climate transition risks to investors in tropical commodities and the sustainable opportunities from changing current business practices.”
But what do these terms really mean? Let’s break it down term by term.
Climate Transition Risks – This term is central to Orbitas’ theory of change and you’ll hear us use it a lot. A climate transition risk can be defined as “the financial risks which could result from the process of adjustment towards a lower-carbon economy” (Mark Carney, 2015). These risks arise due to the efforts undertaken to tackle climate change through policies, commitments and changing consumer preferences and that directly or indirectly affect a company’s GHG emissions.
Center of Excellence – Orbitas builds upon existing work – modeling, mapping and analysis – to undertake cutting-edge research into climate transition risks in the tropical commodity sector. We will be a central repository for the latest quantitative analysis that is designed for use by financial experts.
Scenario analysis – A projection of possible future events through considering alternative outcomes. In Orbitas’ context, this means modeling what forthcoming climate transitions will look like for tropical commodities across a different range of transition pathways.
Task Force on Climate Related Financial Disclosures (TCFD) – A set of voluntary recommendations for companies to disclose information on their governance, strategy, risks and opportunities due to the physical impacts and transitions that occur due to climate change.
Tropical commodities – Commodities produced in tropical countries that often rely on deforestation or land clearing to increase production. Orbitas currently focuses on three major tropical commodities within the agriculture sector – cattle, palm oil and soy.
Sustainable opportunities – The alternative approaches from the status quo of deforestation-based expansion that both improve environmental outcomes and reduce exposure to transition risks.
Key Tropical Commodity Actors
The definitions above encompass the work of Orbitas. But it is also worth taking a closer look at the major actors in tropical commodity value chains – the companies that operate within the supply chain, and the financiers often referred to as capital providers, who invest or lend money to support their operations.
No two tropical commodities are alike. Each commodity has its own specific supply chain. Indeed, a supply chain for a commodity might vary between (or even within) a country. Companies with vertical integration may fulfill multiple elements of the supply chain. However, a supply chain typically includes the following types of businesses:
Input providers – Supplies farmers or ranchers with feedstock, fertilizer, or other critical components for their plantation, ranch, etc.
Producers – Responsible for growing and harvesting tropical commodities. They range from smallholders managing a family plot and tenant farmers renting small plots to major enterprises with significant market share. For example, a palm oil plantation or cattle ranch.
Processors – Owns the assets that prepare, package, and process the commodities ready for use. A palm oil mill or refinery, where crude palm oil (see next section) is processed, for example.
Traders – Facilitates the exchange of the commodity between producers/processors and manufacturers/retailers.
Shipping and distribution – Operates the warehousing, inventory and transportation of commodities from seller to buyer.
Manufacturing – Intaker of the tropical commodity (e.g. palm oil within cosmetics) with the intent to produce the final good sold to consumers
Retail – Sells the final goods to consumers.
Transition risks for tropical commodities impact all parts of the supply chain, though risks may be more heavily concentrated at earlier stages of the supply chain (e.g. a shift towards vegetarian diets impacts supermarkets, but it affects the core business for cattle ranchers). For this reason, Orbitas’ analysis typically assesses risks for the “upstream” section of the supply chain (i.e. production and processing).
Key Financing Vehicles
For Orbitas, the term capital providers encompass anyone providing finance, either debt or equity, to companies whose business is producing tropical commodities. The financial instruments available to tropical commodity producers include the following:
Corporate Loans – Commercial banks typically originate loans to companies operating across the tropical commodity supply chain, either as the sole lender or as part of a syndicated loan across multiple lenders. Firms can also access a “revolving credit facility”, which offers them working capital on a short-term basis. Loans are typical for most companies operating in tropical commodity sectors because they typically cannot raise capital in public markets. Lenders are often regional or local banks, except for those funding the largest conglomerates or multinational companies operating in multiple territories.
Equity – Larger companies, particularly in mature industries such as Indonesian palm oil, issue shares on public exchanges. Orbitas’ research finds that, in monetary terms, equity financing was the most common source of funding for the largest tropical commodity companies.
Issued Debt – Bonds are more common for larger companies in the sector, as smaller firms are deterred from issuing bonds due to their high transaction costs. Bond issuance is particularly common in markets such as the Brazilian beef industry where few companies publicly list their stock. This restricts outside capital to debt markets.
Trade Finance – For globally traded commodities such as palm oil, trade finance offers assurance that the buyer and seller will get paid even if there are trade disruptions. This is achieved through sophisticated instruments providing both up-front payments for goods and the delivery of goods paid for by an importer.
Supplier Finance – Some major traders or conglomerates offer financing to producers they procure commodities from. This financing can provide initial capital to invest in land or capital goods, or a longer term contract to supply goods at a certain price. This model is an avenue for smallholders or smaller producers to access capital if traditional lending or banking is unavailable to them.
Insurance – Insurers offer company policies to tropical commodity producers to hedge against different risk categories. Physical risks, such as supply chain disruptions or hazards at processing facilities, can be covered by insurance. Governments can also offer public insurance to farmers or ranchers in the event that certain risks manifest, such as flooding,
Development Financing – National (or multilateral) development banks, including those specifically designed to serve domestic agriculture, offer financing services such as loans or working capital. Because lending is provided through public institutions, recipients typically access funds on concessional (e.g. below market-rate) terms to meet the lender’s objective of spurring greater commercial activity than would otherwise occur.
Key Financial Measurements
Assessing the financial performance of tropical commodity companies requires an examination of key aspects of their business.
The following metrics and ratios are commonly used by financial analysts covering the soft commodity sector. These metrics are not always useful on their own; they should be used to compare against industry norms or competitors or observed over time to indicate improvement or deterioration.
Capital Structure Ratios – These ratios indicate how a company’s assets and operations are financed (using debt or equity). Examples include Debt-to-Assets Ratio (Total Debt / Total Assets), which can indicate whether a company is becoming overly indebted. Similarly, a Debt-to-Equity Ratio (Total Debt / Total Equity) tells investors the balance between a firm’s ownership and its creditors.
Valuation Metrics – Valuation is calculated to measure whether an investment is priced correctly based on its actual performance. The price/earnings ratio, provides a simple measure of the multiples of stock price per unit of company earnings, is a typical measure. Alternatively, a more all-encompassing method is to calculate Total Enterprise Value, looking at the entirety of a company’s assets and liabilities. Historical precedents can also be measured to evaluate a future investment, such as previously earned returns on equity, debt, or all invested capital.
Credit Metrics – A common measure is to evaluate a company’s Debt Service Coverage Ratios. This ratio measures a company’s ability to pay short-term debt obligations. Specifically, analysts may measure a company’s total debt as a proportion of EBITDA (Earnings Before Interest Taxes Depreciation & Amortization).
Other Financial Metrics – If additional insights are required, company analysts can examine a company’s profitability either through its gross or net profit margin. This can provide insights into its position in the broader market (whether it has pricing power to earn a higher profit than its peers, for example). Investment is also critical, particularly for companies seeking to get ahead of climate transitions. Specific measures, such as a company’s capital Expenditure proportional to its Operating Cash Ratio tell investors how much cash is being used for capital goods such as new plants, upgraded production techniques, or human capital.
Alongside financial metrics used across sectors, there are measures that are specific to evaluating soft commodity companies. The following comprise the key metrics specific to soft commodities:
Landbank – The amount of land available to a company to plant the soft commodity of interest; this metric sometimes includes areas planted plus areas permitted for planting, in which case landbank and concessions are used interchangeably.
Concessions – Areas permitted for palm oil or other agricultural production, regardless of level of permitting or production.
Agricultural Yield – The amount of agricultural product per unit of land area.
Processed or Refined Yield – The amount of processed commodity per unit of agricultural production or per unit of land area of underlying agricultural product (e.g., crude palm oil per fresh fruit bunch or crude palm oil per hectare of area harvested).
Expected value per planted hectare – The relevant comparative valuation metric for investors denoting efficiency of operations within its peer group
Maturity level of plantations – Generally, older plantations will require capital investments sooner, because they need to be replanted, whereas younger plantations will not have reached a mature yield level, making them less profitable currently. Analysts can therefore use this metric to assess future performance of companies.
Explaining Tropical Commodities
Tropical commodities encompass a series of commodities, both soft (agricultural products, etc.) and hard (mining and metals, etc.). Orbitas currently focuses on three commodities susceptible to transition risks because of their greenhouse gas emissions, particularly when linked to tropical deforestation.
Cattle ranching for meat and dairy, or to produce leather, is prevalent in both tropical and non-tropical countries. Tropical production is currently most notable when linked to climate change because of deforestation. For example, 400,000 square kilometers of deforested land in the Brazilian Amazon is now used for cattle pasture. Throughout the Amazon, cattle ranching is the largest driver of deforestation, responsible for up to 80% of current deforestation rates. In addition to land clearing to expand ranching operations, cattle also produce methane emissions. Cattle ranching generates close to 800 million metric tonnes of greenhouse gas emissions, comparable to Canada’s annual greenhouse gas emissions.
It is increasingly important as an economic driver, however. The global beef industry contributes over $300 billion per year to the global economy. It is also an important source of trade – Brazil produces around 15% of the world’s beef and is the largest exporter (2.3 million tons, around 3% of total global beef production).
Common acronyms for cattle:
- GRSB – The Global Roundtable for Sustainable Beef promotes regional and national initiative by providing a common baseline understanding of sustainable beef principles for its members that it expects to be applied across the beef value chain. However, GRSB is not working towards a global certification scheme,
- SAN – The Sustainable Agriculture Network provides a voluntary certification system for cattle ranches that are interested in improving their environmental, social, labor, and operational performance. The principles include integrated management systems, sustainable pasture management, animal welfare and carbon-footprint reduction.
- LWG – The Leather Working Group is a group that conducts environmental sustainability audits for leather products.
- CWE – Carcass weight equivalent refers to the weight of meat cuts and meat products converted to an equivalent weight of a dressed carcass. Includes bone, fat, tendons, ligaments, and inedible trimmings (whereas product weight may or may not).
Oil palm is highly versatile, with uses that range from bioenergy to food to pharmaceuticals. It is also the most productive vegetable oil available and can be 6-10 times more productive than soy, rapeseed and sunflower oil in terms of yield per hectare. Its suitability to tropical climate conditions means that its expansion has largely occurred in places like Indonesia and Malaysia (collectively they comprise over 80% of global production), usually at the expense of clearing of highly valuable rainforest and peatlands. It is a perennial crop with a long productive lifetime of 25-30 years also means that it is a permanent fixture after the initial land use conversion.
At an economic level the industry contributes around $65 billion to the global economy, but at the cost of 447 million tons of greenhouse gas emissions (roughly equivalent to France’s annual emissions).
“Averaged over the last three years for which data is available, palm-driven land use change in Indonesia and Malaysia has emitted roughly 500 million tonnes of CO2e each year, contributing 1.4% of global net CO2e emissions. This is almost as high as global emissions from the aviation sector and more than the total GHG emissions from the state of California.” – The International Council on Clean Transportation.
Common acronyms for palm oil:
- FFB – Fresh Fruit Bunch in raw form from the oil palm plant. Predictably, it is grown on plantations and has a limited shelf life after harvesting. The harvest is only economical if it is transported to a mill quickly. For this reason, most plantations are located within a 50km radius of a mill.
- CPO – Crude Palm Oil is the edible extract from the fresh outer fruit (the pulp) of oil palm. It is refined to produce a wide range of products from biodiesel to oleochemicals to cooking oils like vegetable and lard. It has a high smoking point and is cheaper than its alternatives. Its comparatively lower cost means it is the go-to oil for developing economies like India, China and other emerging markets.
- PKO – Palm Kernel Oil is the non-edible oil extracted from the softer inner part of the fruit – the kernel. It is used in formulations for detergents, cosmetics and other such toiletries. Given its high content of saturated acids, lauric and myristic, palm kernel oil tracks its substitute, coconut oil, rather than crude palm oil prices.
- PKM – Palm Kernel Meal is the main by-product of the palm kernel oil extraction process and used as feedstock for ruminant meats.
- RSPO – The Roundtable for Sustainable Palm Oil is an international certification program for palm oil to ensure it is produced to a specific environmental standard. RSPO certified palm oil typically attracts a market premium because of its desirability for environmentally-conscious buyers
- MSPO – The Malaysian Sustainable Palm Oil is certified within Malaysia to meet environmental criteria set by the national government.
- ISPO – The Indonesian Sustainable Palm Oil certifies producers (and is mandatory for larger producers) to meet environmental standards set out under domestic law, such as plantation management, monitoring, and sustainable business development.
- CPOC – The Council of Palm Oil Producing Countries is an intergovernmental organization promoting cooperation and economic development among palm oil producing countries.
- ESPO – European Sustainable Palm Oil is a project stimulating the uptake of more sustainable palm oil in Europe with an objective of achieving 100% sustainable palm oil in Europe by 2020.
- SPOM – The Sustainable Palm Oil Manifesto is an initiative setting higher standards for growers, traders, end users, and other stakeholders. All signatories affirm their commitment to no deforestation, creating traceable and transparent supply chains, and protecting peat areas, while ensuring economic and social benefits for the local people and communities where oil palm is grown.
The United States, Brazil and Argentina are the world’s major producers of soybeans, whose uses range from bio-composites to animal feed or biofuels. Its use as animal feed means that international demand has risen sharply in recent decades with higher meat consumption in emerging markets such as China. The US Department of Agriculture estimates for 2020 that global soy production will reach 362.5 million tons, a 7.5% increase over 2019 levels.
Brazil, which produces over one-third of the world’s soybeans, exported around $26 billion worth of production in 2019. It has around 30 million hectares of land used for soybean farms, including rapidly growing production in the Cerrado region. This push to meet growing demand means that soy production contributes 129 million metric tonnes of greenhouse gas emissions, roughly equivalent to Belgium’s annual greenhouse gas emissions.
Common acronyms for soy:
- RTRS – The Roundtable for Responsible Soy’s mission is to encourage soybean production that reduces social and environmental impact while improving economic status for producers. RTRS certification is the main certification process in the soy industry with over 150 members representing more than 20 countries
- RSB – The Roundtable on Sustainable Biomaterials is a multi-stakeholder forum promoting biodiversity and ecosystems, reducing greenhouse-gas emissions, and contributing to social and economic development. To date, there is no RSB-certified soy, but there is RTRS-certified soy for biodiesel that is recognized by the RSB.
- GTS – The Soy Working Group coordinates the Soy Moratorium, which brings together various soy indsutry stakeholders.
- ISCC – The International Sustainability & Carbon Certification soy certification scheme is also another major sustainability scheme for the industry,
- 2BSvs – The French 2BSvs certification scheme allows the sale of sustainable biomass or biofuel from cereals, oilseeds, protein crops, other crops or waste and residues.
- USSEC – The U.S. Soybean Export Council optimizes the utilization and value of U.S. soy in international markets by meeting the needs of its stakeholders and global customers.