Reliable market liquidity is essential to global commerce because it promotes price discovery. But should liquidity come at any cost?
What if promoting liquidity meant compromising the environmental, social and governance (ESG) objectives of market participants? Would that market still be 'fit for purpose'?
If participants in the LME are grappling with these questions, what might it take for Australia (or any other ESG-conscious jurisdiction for that matter), to establish a Green Metal Exchange (the GME) as a credible rival to the LME?
Why is the LME important?
It is an understatement that efficient price discovery sits at the heart of the commodities markets that drive globalisation. Real-time pricing in an open and liquid market is essential to inform global policy and investment. All purchasing behaviour, at least to some degree, responds to the influence of that price discovery at each level of the supply chain.
Commodities exchanges, such as the LME, not only enable price discovery via actual trade volume directly on exchange: they also facilitate trading off-exchange through publication of pricing information, such as via each LME daily am/pm 'fix', which is integrated in principal-to-principal trading or offtake arrangements.
The jewel of the LME is its global warehousing and delivery system, which is vital to the physical trading of metals and provides a bridge between the physical and financial aspects of global metals markets.
The LME’s regulation of what is, and isn’t, an acceptable physical delivery standard for that system determines the depth of liquidity of that material. And as we have recently seen in relation to LME nickel, maintaining reliable market liquidity is fundamental to sustaining reliable price discovery.
So what is it about nickel that deserves a closer look?
It is useful to think of nickel in terms of its two classes, each of which is closely linked to one of two types of deposit:
Class I: electrolytic nickel, nickel powders/briquettes and carbonyl nickel, which generally meet or exceed 99.8% purity standard for LME delivery; and
Class II: nickel pig iron and ferronickel, which are integral to stainless steel manufacturing, but have nickel content below 99% and cannot meet the standard for LME delivery.
Then there are the two source types of nickel ore:
Nickel sulphide: ore with higher grade yields (primarily suitable for Class I nickel), and usually mined utilising underground or open-pit methods, followed by smelting and refining. Sulphide deposits, while generally higher grade and accordingly less emissions-intensive, are becoming more scarce globally; and
Nickel laterite: ore with typically lower grades (usually suitable for Class II nickel), which uses much more energy and creates more CO2 than nickel made from sulphide ore because, to yield Class I quality nickel, nickel laterite producers need to employ rigorous (and costly) hydrometallurgical processes.
In Indonesia, the processing of laterite ore into Class I nickel typically employs high-pressure acid leaching, which is up to 300% more CO2 emissions-intensive than the processes associated with turning nickel sulphide ore into a Class I product.
Trouble begins: the LME nickel 'squeeze'
The LME’s troubles began over three trading days in March 2022 when a nickel short squeeze caused an unprecedented 270% price spike. LME nickel trading was promptly suspended and over $12 billion in trades were cancelled.
An independent review commissioned by the LME found that one of the most significant causes of the squeeze (and its adverse effects) was the sudden withdrawal of market liquidity.
Capacity needed urgently to be added to the LME to rebuild that liquidity. Therefore, in 2023, the LME added around 91,600 tonnes of annual production into eligible material for its nickel contract. The sources of a large proportion of this material rely on production from Indonesian laterite nickel operations.
That caused a rapid convergence between the pricing of Class I and Class II nickel products.
The consequences of price convergence
The consequences of that resulting nickel price convergence continue to reverberate. In Australia, this has created significant difficulties for nickel producers, including globally competitive producers of Class I material such as BHP, who are already facing considerable challenges to running their operations at a profit.
For example, the disadvantage is obvious when comparing an Australian nickel producer who creates Class I products with lower carbon emissions to an Indonesian nickel producer who produces the same Class I product in-country using an emissions-intensive, high-pressure acid leaching process.
Both producers are competing in a global market under the same LME-based pricing framework, but one producer is less profitable than the other due to its higher, but more environmentally sustainable, cost structure. That producer is justified in questioning why it should suffer for adopting more sustainable and responsible environmental practices.
What seems to be the response?
The LME has defended its actions, pointing out that liquidity has returned to the nickel market and that there are several electronic spot exchanges that facilitate trade in differentiated products. LME's partner Metalshub is a key example. Another is Abaxx Exchange, which this year introduced a physical-settled nickel sulphate futures contract.
Initiatives like these are welcome drivers of liquidity and price discovery. However, Class I nickel and nickel sulphate referenced contracts continue to remain tied to the dual sources of nickel sulphide ore and nickel laterite ore (involving the emissions-intensive processes mentioned above). They do not, therefore, present the global market with an option that recognises, and ideally rewards, the more environmentally conscious producer.
The LME has also made clear it has no plans to change the brand specifications for its nickel contract, nor list a parallel LME contract (whether “green” or otherwise). That said, the LME has also noted, justifiably, that significant complexity is involved in applying ESG considerations to an exchange-traded contract which, by definition must have uniformity in its application. The LME also believes that a set of industry-wide standards need to be settled before green price premiums can be established.
Encouragingly, Metalshub (with assistance from the LME) has very recently started reporting monthly on the volume of Class I nickel traded that has a registered carbon footprint lower than 20 tonnes of CO2 equivalent per tonne of material. Metalshub has said that if there is an increase in transactions, it could publish a Class I premium index which could, in time, potentially be extended to become a ‘green’ nickel premium index by considering additional sustainability characteristics.
Could establishing a green rival to the LME provide a solution?
This all points to the start of a constructive trend. But what if some more radical thinking were to inform the next step?
Could establishing a rival exchange to the LME, especially one which facilitates trading in metals with strong ESG credentials (perhaps called a Green Metal Exchange or the GME), provide the solution to these concerns?
A bold step like this would first require some foresight, as well as some careful planning, the least of which would take account of the following:
1. Market research
Because an absence of reliable and deep liquidity was the original cause, or perhaps the catalyst, of the issues now facing the nickel market, extensive research and stakeholder engagement with as wide a range of participants as possible will be required to identify the producers and products with the strongest and most readily and objectively verifiable ESG credentials.
That survey will need to establish that sufficient appetite for trading both the derivative and physical products exists and that a sufficient volume of deliverable physical products will be produced. Building partnerships and offering incentives to establish a critical mass of traders and producers will be essential.
In addition to nickel, contracts for other battery metals such as lithium (either as spodumene or some other intermediate product) and graphite might also be traded on the GME, as a means of broadening interest and stakeholder engagement.
2. Market differentiation
To compete with the LME, the GME will need to offer a unique value proposition to participants and stakeholders that lies beyond merely advertising the products as 'green'.
Increasing global regulation of ESG standards in metal extraction and processing is likely to provide a useful push for the establishment of the GME. In generating critical points of difference, it’s also useful to consider incentives for pull on the demand side of the product market, which for ESG purposes, now typically requires a product to be consistently validated throughout the supply chain. ESG metals used in consumer end-products may hold strong appeal given the growing demand for sustainable and responsibly sourced metals and, purely by market forces alone, could start to create, or reveal, a pricing premium.
Promoting and verifying sustainable purchasing practices among participants in the supply chain could also conceivably assist in promoting demand.
3. ESG certification
ESG criteria for traded contracts must be capable of being transparently and verifiably linked to their physical product equivalents in the supply chain.
To authentically focus on ESG metals, establishing a rigorous certification process for metals and participants is key. Distributed ledger technologies and similar conventional systems have already been used to enhance transparency and traceability in similar situations.
This could also involve the creation of partnerships with ESG rating agencies, environmental organisations, and other related industry groups to develop and monitor ESG standards. The process may be assisted by the global adoption of the International Sustainability Standards Board’s inaugural standards (known as IFRS S1 and IFRS S2) on sustainability-related disclosures. These types of partnerships naturally add credibility and attract participants who are committed to sustainable practices.
4. Governance
The governance of a GME should be carefully designed to ensure transparency, accountability, and fairness. A hybrid ownership model that includes core stakeholders (such as producers, consumers, and financial institutions), external investors, and independent directors, supported by robust regulatory oversight, could provide a balanced and effective governance structure.
This approach could also address potential conflicts of interest while leveraging the strengths of diverse ownership to promote the long-term success and integrity of the exchange.
5. Innovation
All exchanges face the ongoing challenge posed by the need to innovate in a global marketplace.
As a new market entrant, and therefore free from legacy internal systems and processes, a GME has an opportunity to differentiate itself from competitors by fostering a culture of innovation, embracing the newest available forms of technology, including blockchain, creating new financial products that support ESG objectives, as well as creating greater opportunity to trade those products and enhancing the user experience while doing so.
6. Education and advocacy
All of the above initiatives would need to rely on extensive promotion of awareness and understanding of the importance of ESG in the metals market. This would be crucial for the success of any new exchange.
Incentives for innovation
Establishing a GME as a rival exchange to the LME could assist Australian metal producers to reap financial rewards for adopting sustainable practices that would otherwise penalise them in a global market.
Thinking more broadly, a GME also presents a singular opportunity for Australia as it grapples with various different means of commercialising the enormous economic opportunity created by the green energy transition.
With the right combination of ideas, purpose and incentives to execute its delivery and operation, a new exchange like a GME could not only compete with established players like the LME, but it could also drive positive change in an industry critical to humanity’s future prospects.