The new imperative for green commodities

Producers of steel, aluminum, cement, kerosene, polypropylene, and other bulk commodities need to decarbonize to meet net-zero goals. Until recently, however, it wasn't clear that decarbonization investments would see a competitive return on capital—and the name of the game in commodities has always been cost competitiveness.

But the rules are changing. The economics of going green have radically improved over the past 24 months, especially in Europe. Energy costs have increased fivefold to eightfold, the carbon market price in Europe increased roughly threefold from January 2021 to February 2022,1Cristian Stet and Pablo Ruiz, "High EU carbon prices are structural, and inaction Is not an option," RaboResearch, March 15, 2022. and the European Parliament approved Fit for 55, the package of proposals aimed at ensuring that EU policies align with climate goals.2"Fit for 55," European Council and the Council of the European Union, June 30, 2022. Moreover, customers are increasingly willing to pay a premium for low-emission products, and capital markets are beginning to show diverging multiples for "green" products compared with "gray" ones (see sidebar, "What are ‘green commodities’?").3"Playing offense to create value in the net-zero transition," McKinsey Quarterly, April 13, 2022.

Historically, a commodity has been defined as a good that is effectively interchangeable with other goods of the same type. Examples of commodities include gold, natural gas, steel, and cement. Since consumers cannot differentiate between such products, competition is often based solely on price.

On the path toward a net-zero future, a new class of commodities is emerging: green commodities. They have the same chemical composition as their nongreen counterparts, but they are produced through clean and eventually eco-neutral methods. Green steel is an example: by using hydrogen, carbon capture and storage, or scrap materials, producers can create steel with very low emissions.

In this article, we mainly focus on carbon neutrality. However, for commodity producers, similar conclusions and implications also hold for other environmental, social, and governance standards.

The war in Ukraine is further changing the energy landscape. Although it may make a clean-energy transition more complicated in the short term, questions around energy security and economics could ultimately converge to force net-zero transition efforts into higher gear.4Harry Bowcott, Dickon Pinner, Hamid Samandari, and Olivia White, "The net-zero transition in the wake of the war in Ukraine: A detour, a derailment, or a different path?," McKinsey Quarterly, May 19, 2022.

The energy and materials transition is fundamentally reshaping the strategic toolbox of commodity players. While producing a commodity has never been easy in a highly competitive, and often global, environment, it hasn't historically been overly complex to sell. Producers didn't need to craft extensive marketing campaigns or complicated price strategies, nor did they need to cooperate considerably with governments or across the value chain.

This has all changed. With the energy and materials transition, differentiating actions are not only back on the table—they also define who captures economic profit. Producers of green commodities will now need to market their products, define standards for commodities, participate along the value chain, and much more. These are all sophisticated activities that didn't exist 24 months ago, and they require rethinking the entire organization, from rebuilding capabilities to redefining processes, updating targets, and reallocating capital.

There is no time to lose: front-runners have already started making big moves. Commodity producers can seize the opportunity to do so as well.5The dynamic of playing offense, and the need for bolder moves to capture green growth opportunities, is something we see across sectors. For more information, see "Playing offense to create value in the net-zero transition," April 13, 2022. In this article, we share seven imperatives that can help commodity producers take action today.

For commodity producers, now is the time for action regarding decarbonization. Green production may not seem financially attractive, and uncertainties are everywhere, from price and technology outlooks to regulations and future green appetites.

Given these concerns, it may seem safer to postpone investment until green production becomes more economically attractive. However, our analysis suggests that this logic does not hold—and, in fact, that the opposite may be true. Three factors play into this.

First, investment decisions should be calibrated to the economic circumstances at the time the asset is completed. Uncertainties may loom right now, but there are a few things we can reasonable expect: it is unlikely that carbon rights and energy will become inexpensive down the road, Fit for 55 will likely change circumstances completely, and consumers are not apt to lose interest in low-emissions products. The economic landscape around energy-intensive industries is changing, and those making green investments today will be well positioned for tomorrow.

But the rush is not driven solely by economic factors. Our analysis suggests that we might be entering an era in which green inputs, such as green hydrogen, green feedstocks, and green fuels, are in short supply (exhibit). Commodity producers that choose to wait for the market to be more prepared for green products could risk losing a strong market position to competitors that invest sooner, be they incumbents or new players. While this reality alone does not create a positive business case, it does increase the risk of waiting.

Finally, the commonly held belief that production should start only when the first ton produced is financially attractive is no longer as compelling as it once was. Of course, there is a learning curve for green production. Some of this learning will be realized by other commodity producers and made available to the market as a whole. But a significant share of the learning will be captive and thereby an inevitable part of the investment. Optimally, an investment with a significant learning component will be made before production becomes financially attractive; producers that postpone green investments until the first product batch is profitable may realize a lower overall return—and could struggle to get their hands on the required inputs.

To ensure they capture returns and mitigate market risks, first movers should seek early offtake agreements and build coalitions among themselves. Tesla and Vestas are not the only companies that have been fast to innovate and scale; early movers in all sorts of innovative sustainable technologies are quickly scaling up, building coalitions across the value chain, and attracting capital on favorable terms.

After moving in early, commodity producers can set a new standard. Formal standard setting is the role of governments, standardization agencies, and branch associations, which intervene to standardize product characteristics for compatibility or consumer safety when necessary. But increasingly, nongovernmental organizations (NGOs) are developing standards with the goal of accelerating the net-zero transition—an objective that can intersect with the interests of commodity producers and the public. A producer with a head start on green production can further enhance this forward-leaning position by setting a high bar for the industry's green efforts.

A commodity producer can start setting the standard today in three interrelated ways:

Industry standards can be underpinned by industry-wide labels—which would ideally be supported throughout the value chain, including by retailers and financial institutions—to affect buying behavior and investment portfolios. Often it is the first movers that set standards for the sector, its customers, and its investors. An example of a broadly supported initiative is the Dutch Betonakkoord (Concrete Agreement), which has succeeded in setting higher standards for home building in all parts of the concrete value chain.

Most commodities also have other commodities, such as energy, iron ore, and naphtha, as inputs. These are sourced on the market, where supply, demand, and production costs dictate prices of inputs without much room to negotiate better deals.

The case for inputs for green production is different. Most green-inputs markets are early in development, with potential producers hesitant to scale up due to a number of uncertainties. Getting sufficient volume of the critical inputs is a real concern—as can be observed, for example, among automotive OEMs and steel producers—so a passive sourcing strategy is most likely inadequate.

The availability of sufficient inputs is not just a general concern in the market; it is every commodity supplier's particular concern, and it requires active strategic interference. Commodity producers may consider a form of risk sharing or co-investing with traditional players or new entrants. Additionally, an option that has long been disliked by management and investors is now on the table: vertical integration, or companies producing some of their own green inputs. Indeed, some companies are financing innovation and production-capacity increases for the low-emissions materials they require. Mercedes-Benz and Scania, for example, have each acquired equity stakes in H2 Green Steel, a Swedish start-up that is constructing both a green-steel plant and a green-hydrogen plant that will produce the fuel needed for steelmaking. Similarly, BMW announced an investment in Boston Metal, a US-based green-steel start-up. These types of investments are expected to continue.

Historically, the terms "commodity" and "price premium" had almost nothing to do with each other. By nature, commodities do not command premium prices over comparable products; at most, commodity producers may occasionally achieve additional value for related services. But the transition to net-zero emissions offers opportunities for better deals on products that are molecularly identical.

In a recent phenomenon, B2B customers are increasingly willing to pay a premium for decarbonized products, similar to how some consumers have been willing, in recent years, to pay extra for humanely raised meat and low-pesticide, fair-trade products. Indeed, in a number of cases, such as with recycled plastics, renewable power, and zero-carbon aluminum, this customer willingness to pay a "climate premium" has already translated into higher green-commodity prices—sometimes multiples of the gray-market price. For example, in plastics, recycled polyethylene terephthalate (PET) now has an average price premium of $300 per metric ton over virgin PET. (This premium was, on average, $40 per metric ton from 2011 to 2019.)7IHS Markit.

But this premium does not end up in companies’ profit and loss statements automatically. It is not comparable to the usual pricing of a commodity, through which the market dictates a uniform "take it or leave it" price. Realizing this potential premium requires a few actions:

Until recently, most companies communicated about their carbon footprint at a corporate level. That information was primarily of interest to investors and NGOs. Today, business customers are increasingly interested in the carbon footprint of the individual products they buy because they want to source inputs that will help them realize their Scope 3 targets. Consumers are also showing mounting interest in the footprint of products, although they often express this interest in terms of recycled content or organic origins of components. As a result, companies are increasingly competing on the carbon content of their products. To enable differentiation and capture the price premium described above, companies must have an accurate accounting of carbon content (see sidebar, "Discover the Sustainable Materials Hub").

McKinsey's Sustainable Materials Hub empowers organizations to solve the sustainable materials challenge and achieve carbon reduction commitments through the production and sourcing of low-carbon materials. We bring together experts at every step of the value chain and offer in-depth insights on the supply, demand, and low-carbon premiums across a wide range of commodities.

We focus on sustainable, lasting materials with the highest potential to close the carbon emissions gap while supporting our clients in the design of value-creating strategies to produce, commercialize, and source low-carbon and circular materials.

The term "carbon footprint" should in this context be understood as the cumulative amount of embedded carbon dioxide–equivalent (CO2e) emissions in the production (and potentially use) of a product. This goes beyond the operations of commodity producers (Scope 1). To truly differentiate a product—and to credibly convey that it is a green commodity—producers also need to account for the required electricity demand (Scope 2) and resulting value chain emissions (Scope 3). Producers can choose to communicate either the "cradle-to-gate" footprint (all Scope 1 and Scope 2 emissions and the upstream part of Scope 3) or the "cradle-to-grave" or "cradle-to-cradle" footprint (if they know the emissions downstream of their operation).

Carbon accounting can therefore be a way to express a certain green competitive advantage. It can also be used to introduce incentives in the value chain to reduce overall emissions during production.

Through carbon reallocation, which is being considered by the European Union, the footprint of one product could be reduced on paper while the footprint of a corresponding amount of product increases, even though the two products may be physically identical or produced in the same batch. Producers can reallocate the carbon footprint between products using a mass balance approach.9The mass balance approach equals a set of rules for determining the use of recycled content in a product. These rules are currently being developed by the European Union. Commodity customers that reduce total emissions by recycling more, improving the recyclability of their products, or paying extra for greener inputs benefit from a better footprint.

Carbon accounting and reallocation at a product level has the added benefit of helping to unlock specialized brown-to-green financing solutions for commodity producers, such as green bonds. Many public and private financial institutions have committed to reallocating their capital to ensure their assets under management are in line with a 1.5° pathway.10Financial institutions responsible for more than 130 trillion of capital have declared that they will manage their assets in line with a 1.5º pathway (via the Glasgow Financial Alliance for Net Zero). This reallocation of capital is expected to flow toward enterprises, projects, and products that exhibit readiness for a net-zero future. Through credible measurement and accounting, commodity producers could tap into this green financing opportunity more effectively.

In these ways, carbon accounting and reallocation can be used as strategic tools to differentiate a product from the competition and encourage actors throughout the value chain to further reduce emissions.

Some of the most economically rewarding sustainability programs were not originally designed as sustainability initiatives. Companies that have made successful efforts to decrease emissions while simultaneously improving financial results, employee satisfaction, and customer loyalty are among the best performers on all these fronts. A comprehensive approach is less about trade-offs and more about mutually reinforcing actions that create a lasting, sustainable difference.

One example of such a holistic approach is Solvay, a chemical company with a target of achieving carbon neutrality before 2050 and a 30 percent reduction in emissions by 2030.11"Climate," Solvay, accessed July 8, 2022. To achieve this goal, the Belgian firm has integrated a clear change story, incentives, and behavior change from the C-suite to the operational level. In addition, a dedicated team of experts continuously seeks and promotes cleantech solutions, a focus that leads to bottom-up innovation—both on operational efficiency (and thus bottom-line results) and on new-product innovation (and thus top-line results). In 2021, 53 percent of net sales came from sustainable solutions, and an estimated 75 percent of research and innovation (R&I) pipeline revenue is expected to come from sustainable solutions.

When it comes to the net-zero transition, many governments are still looking for the answers and policies that will get them to net-zero emissions without net job losses and in a way that residents and consumers can accept. As COP26 showed, the objectives of businesses and governments are aligned in terms of the net-zero transition. Commodity producers should engage governments on strategy, ideally aligning private-sector strategy and public policy with public goals—while abstaining from old-school lobbying that is purely focused on the specific interests of a particular company.

The Industrial Deep Decarbonization Initiative (IDDI) provides an example of alignment of public and private interests around net-zero targets. The governments of a coalition of countries, including Canada, Germany, India, and the United Arab Emirates, signed a pledge to buy low-carbon steel and concrete. Given that governments account for 25 to 40 percent of the domestic market for such commodities, this initiative creates fertile ground for first movers—and aligns government action to create and scale low-carbon markets.

As producers of bulk commodities start down the decarbonization road, they may worry that new products could cannibalize existing ones. It's true that demand for gray products will eventually be replaced by demand for green ones, but this is essentially an autonomous development, independent of green investments. There is no need for a hard switch from gray to green. Normally, additional commodity production capacity—a company's own or that of a competitor—will influence the market price because the supply curve is stretched. In the case of a green alternative, this direct effect is significantly less strong. Green and gray products, although chemically identical, will increasingly be regarded as separate markets. That is true decommoditization—and an opportunity that commodity producers can't afford to ignore.