The Decommodification of Commodities; Why the 2020s will Fundamentally Redefine the Playing Field for the Mining Industry

Less Love, Despite Higher Profits

The last decade saw the industry's strategic focus on operational efficiency, the development of brownfield sites, the implementation of new technologies and digitalisation convert into rising profits and record dividends paid out to shareholders. However, this financial performance is at odds with the market view of the sector. Market capitalisation, a proxy for perceived future value, has dramatically underperformed in comparison to other investment indexes. As highlighted below the MSCI Metals and Mining Index return was substantially lower than the MSCI World Index over the second half of the 2010s.

Cumulative Index Performance - Net Returns (USD) (Jan 2010 - Jan 2020)

Source: MSCI (Two Oceans Strategy Analysis)

The Smart Money is Abandoning Mining

The decrease in demand for mining stocks has in part been a result of a substantial shift in active investing experienced in the 2010s. In line with the rise in conscious consumerism there has been an increase in interest in ensuring investments portfolios align with investor values. Environmental, Social and Governance (ESG) funds have developed from a cottage industry to a USD 31 trillion mainstay. A new generation of investors are demanding a greater social contribution, transparency, higher standards of governance and greater management of environmental risks in their investments.

Cumulative Flows into ESG and Non-ESG Funds Over the Past 12 Months (Feb 2019 - Feb 2020)

Source: EPFR

High energy intensity, social tensions from pollution, water usage conflicts and economic and landscape impacts, and some of the highest environmental risks across all sectors result in a very high industry risk score. This has resulted in mining companies exclusion from the vast majority of ESG funds.

ESG Risk by Sector

Source: S&P

However, the tide is turning against excluding entire sectors toward analysing each company on their own contribution to society and the environment. As the sector matures there is the potential for mining companies to be included in ESG and even impact investment funds, due to the high potential benefit they can generate for society and importance in the green transition if risks are managed.

The Historic Distance Between Consumer and Mine Site is Dramatically Shrinking

Historically consumers of mining’s final products have had limited engagement and interest in the provenance and value chain from which they are created. As a result, mining companies, operating at the very start of the value chain, have traditionally been distanced from the final consumer. They have focused their relationships on the next rung of the value chain: the smelters, furnaces and mills which purchase their ore.

 

However, consumer behaviour is changing. Shifting attitudes and an increasing awareness of sustainability and the ethical agenda have resulted in a greater consciousness around consumerism. The provenance of products is at the core of this trend and is increasingly concerned with the entire supply chain. Alignment of personal values alongside brand values is increasingly important. Development of trusted brands, whose values align with consumer values, and who are known for responsible environmental and social practices will command a premium compared to their peers. However, those who engage in greenwashing and cost cutting at the expense of responsible practices will be exempt from selling to consumer driven markets. This will be especially prevalent in regions where these trends are strongest, such as Europe.

 

Manufacturers and producers of end products such as car manufacturers or producers of consumer durables are increasingly seen as responsible for the practices and materials of all components which make their products. This is emphatically illustrated by a recent legal case filed against Apple and Google which highlights their responsibility all the way to the genesis of the supply chain. Driven by consumer demand manufacturers and producers are increasingly concerned with ESG and sustainability practices. The proximity of the mining company to the consumer is drastically closing.

 

UK Consumer Attitudes to Purchasing Sustainable / Eco Friendly Products

Source: Global Web Index 2019

There is an increasing engagement and demand for data to understanding the components of products to support responsible consumption. This demand for data relates to the energy, water and carbon intensity and social and governance impact of: extraction of the raw materials, beneficiation processes and transportation at each step on the supply chain. This presents a substantial opportunity for mining companies who can demonstrate favourable metrics. They will be in greater demand by consumers and therefore manufacturers.

Conscious Consumerism and an Eruption in ESG Data on Which to Make Purchasing Decisions Creates Massive Opportunities for Differentiation in Seemingly Identical Products

Mining is one of the world’s most energy and water intensive sectors, with the potential for energy to account for 30% of a mine’s operating expenses. Water is set to increasingly be a challenge, with the potential for 25% of mining production to face water shortages.

 

The direction of travel in the 2020s is for a quantification of carbon and water intensity in the production of goods throughout the economy. As a result, two seemingly identical products may be priced differently due to their production methods, fuels and energy intensity used throughout the value addition process and transport to market. As supply chain transparency increases, it is predicted that the in the 2020s, the consumer will be able to quickly interrogate key metrics such as carbon and water intensity, ESG rating and responsible practice certification.

 

The food industry is a front runner of demand for product information, with consumers increasingly able to access data on the provenance and responsible sourcing of the product. In terms of component parts the consumer can access nutritional information for food products in the UK, using a traffic light system. The mock up below suggests that in the 2020s this level of product transparency could be extended to ESG metrics for non-food based products.

Example of product labelling (taking from existing nutritional labelling) which could be a basis to compare energy, carbon, water intensity and social governance metric for goods to meet the demand for responsible consumption

Initiatives such as TRACR and the Life Cycle Analysis offered by Two Oceans Strategy have started this supply chain interrogation and the quantification of environmental and social externalities. The perception of trust in a mining companies’ brand will increasingly add value.

ESG and Green Differentiation Will Fundamentally Redefine the Mining Playing Field. Those Attempting to Win Through Operational Efficiency Will Lose.

As explored in greater depths in an earlier article the mining industry has historically been a price taking industry. Fungible, or mutually interchangeable, items are traded at prices determined by the intersection of supply and demand on volatile global marketplaces. As a result of terminal market price setting, the concentrated focus of the industry in the 2010s has been on reducing costs through operational efficiency, technology and generation of scale. As the long run price of a commodity will clear at the average marginal cost of production, those above the average marginal cost will over time be sub-economic. As a result, the key metric of the industry has been the marginal cost of production and relative position on the cost curve.

 

However, the increasing consumer concern over climate change, the interest in the provenance of products and the sustainability of investments has the potential to create a differentiation between the brands of mining houses. This creates the opportunity for greater producer power in the market and for price setting through social and green premiums over the terminal price.

 

The potential to generate a premium will create substantial winners and losers between those investing and measuring environmental and social sustainability, even if there are greater costs, and those who continue to place operational efficiency at the core of their business strategy and hiring policy. Under a scenario whereby a premium can be earned above the market rate the price will not always revert to the average cost of production. The industry will no longer be in a race to squeeze the greatest margin, with a potential for companies to create sustainable competitive advantage through generation of trusted brands, built on a foundation of ESG, sustainability, communications, and non-financial measurement competencies.

 

These trends will result in a vast opportunity for value differentiation within a previously undifferentiated industry and will convert into premiums on products and share price. Realising this opportunity will require a move away from strategies which revolve around maximising margins by producing ore at the lowest cost and replaced with purpose driven, long-term, stakeholder focused business models which value social and environmental performance.

The existential threats from climate change, an increase in the voice and interest of the consumer in the provenance of investments and products will facilitate social and green premiums which will fundamentally redefine the playing field of the industry over the next decade.