1. Introduction
Environmental, social and governance
(“ESG“) concerns are fast becoming a
major driver of investment flows. Investors are increasingly
seeking out and prioritising ESG investment opportunities, while
many corporates strive to align their business models with ESG
principles. In the middle sit the banks and broker-dealers who are
scrambling to meet the sky-rocketing demand for ESG-driven
financing solutions. At the EU level, authorities are keen to both
promote and regulate this emerging area, in an effort to ensure
that socially responsible economic activity is adequately financed
while also protecting investors. Initiatives like the Sustainable
Finance Disclosure Regulation
(“SFDR“)1 seek to prevent “greenwashing” in the financial sector, while the
Taxonomy Regulation2 aims to establish a common language
to facilitate ESG-related discourse and disclosure. Matheson’s
ESG Advisory Group has previously issued a number of publications
in relation to these important pieces of
regulation.3
Derivatives play an important role in financing economic
activity and managing investment risk, so it is to be expected that
their use will influence, and be influenced by, trends in the
broader finance sector such as the focus on ESG. Furthermore, the
flexibility afforded by derivatives means that they can be (and
increasingly are being) used to pursue and promote ESG objectives
in various ways. Industry bodies, such as the International Swaps
and Derivatives Association (“ISDA“) and
the International Emissions Trading Association
(“IETA“), have been pro-active and
enthusiastic in fostering the growth of ESG-related derivatives,
both by engaging with regulators and by developing standardised
template documents to allow parties to trade these instruments
efficiently. ESG themes dominated the discussion at ISDA’s
European Annual Legal Forum in March, for example, and more
recently ISDA has published a new US Renewable Energy Certificate
(REC) Annex to its flagship ISDA Master Agreement, allowing market
participants to more easily trade in renewable energy
certificates.4
In this briefing note we will look at how derivatives can be
used to promote ESG objectives – and, conversely, how this
new focus on ESG concerns might impact on the use and regulation of
derivatives.
2. Some examples of ESG derivatives
In some areas – such as the green energy sector –
derivatives have played a central role in the ESG story for some
time. In addition, “vanilla” derivatives such as credit
default swaps and interest rate swaps are commonly used to hedge
the risk arising from ESG activities (such as green bonds,
ESG-focused investment funds, etc). Increasingly, however, market
participants are employing derivatives that have ESG components
built in. ISDA recently published a report outlining several
examples of this innovation.5 Below we discuss some of
the main categories of ESG derivatives that are emerging.
(a) Virtual PPAs
A power purchase agreement (“PPA“) is
an agreement for the purchase of renewable energy from a specific
seller. The energy is usually generated by solar and wind sources.
PPAs are an important way for sellers of renewable energy to
finance new projects and hedge the risks associated with market
price volatility. They also allow energy purchasers to hedge market
price risk, making green energy a more attractive proposition.
PPAs can be settled physically (resulting in the actual delivery
of electricity) or “virtually” (“Virtual
PPAs“). Upon the settlement of a Virtual PPA, a cash
payment will be made by one party to the other based on the
difference between the strike price specified in the Virtual PPA
and the wholesale market price of the energy. A Virtual PPA is a
derivative instrument, described by ISDA as a cash-settled
fixed-for-floating commodity swap. Matheson’s ESG Advisory
Group is seeing an increasing preference from both corporate buyers
and renewable generators for Virtual PPAs in the Irish market. We
have been at the forefront of the corporate PPA market in Ireland
over the past 5 years and have advised on all but one of the
corporate PPAs which have been entered into to date in Ireland.
(b) Emission allowances
Many jurisdictions, including the EU, operate emissions trading
schemes (“ETS“), which (i) limit the
amount of pollutants that companies can emit, and (ii) allow
companies to trade the unused portion of their emission allowances.
ETS are a cornerstone of the global fight against pollution and
climate change. Derivatives play a key role in facilitating the
trading of emissions allowances. The IETA has worked with ISDA and
other industry bodies to create the International Emissions Trading
Master Agreement, a standard form template document that allows
market participants to enter into forwards, swaps and options
(among others) relating to emissions allowances. ISDA has also
published the ISDA EU Emissions Allowance Transaction documents,
which supplement the ISDA Master Agreements and allow market
participants to trade swaps, options and forwards on EU emission
allowances.
(c) Sustainability-linked interest rate swaps and
foreign exchange derivatives
These instruments are similar to the “vanilla”
interest rate swaps (“IRS“) and foreign
exchange (“FX“) derivatives that are
often used by corporates to hedge their interest rate or currency
risk. However, these instruments include additional terms which
alter the payment and other obligations of the parties based on the
ESG performance of one or both of the parties. For example, an IRS
might contain a provision that increases or decreases the effective
rate payable by or to a company based on that company’s future
performance against ESG metrics. Other examples include FX hedging
agreements that oblige counterparties to donate to charities or
invest in reforestation projects when certain events occur. There
has also been some discussion in the market recently about
potentially including additional termination events linked to
ESG-related performance metrics in derivatives documentation. These
instruments, and others like them, are now embedding ESG related
criteria and performance in traditional hedging strategies.
(d) Exposure to ESG-focused corporates through
derivatives
Increasingly, derivatives are being used to provide investors
with an efficient and convenient way to gain exposure to baskets of
corporates which are considered to be strong ESG performers. For
example, the iTraxx MSCI ESG Screened Europe Index is a credit
default swap (“CDS“) index tracking
European corporates screened based on ESG factors. The CDS markets
play an important role in the pricing of corporate credit risk, and
a growing body of research suggests that ESG-related risks –
and the disclosure of those risks – can impact on a
corporate’s risk profile.6 Many of the major
exchanges have also launched exchange-traded futures and options
which track ESG indexes, such as CBOE S&P 500 ESG Index options
or EURO STOXX ® 50 Low Carbon Index futures.
(e) Catastrophe derivatives
Catastrophe bonds – debt instruments which have a reduced
payment (or no payment) where a specified catastrophe occurs
– have been much discussed in the media, but less has been
said about the increasing use of catastrophe derivatives, either in
conjunction with or as an alternative to catastrophe bonds. In
2017, for example, the World Bank issued $105 million in swaps,
alongside $320 million in bonds, as part of its Pandemic Emergency
Financing Facility (“PEF“). Catastrophe
swaps have also been used as part of facilities to protect against
the risks posed by hurricanes and earthquakes.7
3. Regulatory impact
(a) Recent regulatory developments
ESG considerations are now relevant to virtually all areas of
economic activity, and the EU’s regulatory response is
similarly broad and multi-faceted. Derivatives have not yet been
the direct target of ESG-driven regulatory changes. For example,
the European Market Infrastructure Regulation
(“EMIR“) – the primary EU
regulation governing the use of OTC derivatives – is not
among the various regulations that have been (or are being) amended
to incorporate ESG considerations. However, due to the widespread
use of derivatives in the financial sector, there are various other
legislative developments that will be of relevance to
counterparties.
A prime example is the SFDR – arguably the cornerstone of
the EU’s regulatory response to the rise of ESG investing.
While the SFDR does not directly regulate derivatives or their use,
it may nevertheless be relevant to counterparties. Market
participants who use derivatives as part of their broader
investment, financing or portfolio management activities may be
subject to the disclosure requirements of SFDR by virtue of those
activities. Where market participants use derivatives to pursue
sustainable investment objectives, they may be required to disclose
on their use of derivatives and to explain how those derivatives
attain their objectives.8
The EU’s approach to ESG investing is to facilitate, as well
as to regulate. For example, the Benchmarks Regulation9
was revised in 2019 in order to provide for two new categories of
ESG benchmarks. An “EU Climate Transition Benchmark” is
linked to assets which are selected, weighted or excluded in in
accordance with the objective of carbon neutrality. An “EU
Paris-Aligned Benchmark” is a benchmark which is aligned with
the Paris Agreement goal of limiting temperature increases to below
2°C. The introduction of these new benchmark categories
potentially opens the door to a new asset class of carbon- or
climate change-linked derivative products.
The EU and global ESG regulatory framework is still very much in
its infancy. As further regulatory developments are implemented in
the coming years, it will be important for market participants to
be aware of how those developments could directly or indirectly
impact on the use and users of derivatives.
(b) ESG derivatives and the “traditional”
regulatory framework
While counterparties to derivatives should be mindful of new
ESG-driven regulations, it is equally important for financial
market participants in the ESG space to be aware of the existing
regulatory framework for OTC derivatives, given the important role
that OTC derivatives are coming to play in ESG financing. For
example, green energy market participants will have seen EMIR
provisions (including EMIR reporting requirements) being included
in their Virtual PPAs and financially settled corporate PPAs.
Even seasoned users of derivatives will need to reflect on the
potential legal and regulatory implications of including
ESG-related terms in their trading documents. For example,
introducing ESG-linked payments into traditional hedging
instruments such as IRS or FX swaps could complicate the valuation
of those instruments, which could have knock-on effects on
parties’ portfolio reconciliation, dispute resolution,
margining and other risk mitigation procedures. These risk
mitigation procedures, as well as being commercially important to
counterparties, are also required and regulated by EMIR, meaning
that the challenges posed by ESG derivatives have a legal as well
as a commercial dimension.
Counterparties should also carefully consider how any
ESG-related payments will be handled, and how this may impact on
the legal or regulatory analysis of their derivatives. For example,
where ESG-linked payments are introduced into hedging derivatives,
counterparties may need to assess whether such instruments can
still be considered to be entered into for hedging purposes. OTC
derivatives entered into for hedging purposes are treated
differently for certain purposes under EMIR (for example, a
non-financial counterparty is not required to count those
derivatives when determining whether it exceeds the clearing
threshold under EMIR). In addition, where one party to a derivative
is obliged to make payments to a third party (such as a charity or
conservation project), this may impact on the netting
enforceability analysis. While the introduction of ESG-linked
payment obligations into OTC derivatives can be a powerful tool in
aligning parties’ commercial incentives with ESG objectives,
they must be carefully scrutinised to ensure that they do not alter
the legal or regulatory treatment of contracts in an unforeseen or
unintended way.
4. Conclusion
It is clear that derivatives have an important role to play in the
growth of ESG investing. While “conventional” derivatives
are increasingly being used to manage the risks associated with
ESG-related economic activity, we are also seeing the emergence of
innovative new types of derivative contract, which are tailored to
the needs of ESG-conscious investors and corporates. These
developments bring with them many opportunities, and some
challenges. Market participants dealing in ESG-linked financial
instruments should be mindful of their legal and regulatory
obligations under both the new, ESG-driven regulatory framework
and, where applicable, the traditional regulatory framework for
derivatives.
Footnotes
1 Regulation (EU) 2019/2088 of the European Parliament
and of the Council of 27 November 2019 on sustainability-related
disclosures in the financial services sector.
2 Regulation (EU) 2020/852 of the European Parliament and
of the Council of 18 June 2020 on the establishment of a framework
to facilitate sustainable investment, and amending Regulation (EU)
2019/2088.
3 [Links to Matheson
pieces]
https://www.matheson.com/insights/detail/specific-requirements-for-article-8-light-green-funds
https://www.matheson.com/insights/detail/esg-bonds-and-ireland’s-offering
https://www.matheson.com/insights/detail/greenwashing-and-the-eu-taxonomy-regulation-part-one
https://www.matheson.com/insights/detail/esg-the-european-green-deal
6 https://www.unpri.org/pri-blog/how-disclosing-transition-and-physical-climate-risks-affects-credit-default-swaps/7418.articleOpens
in new window; https://www.msci.com/documents/10199/19248715/Foundations-of-ESG-Investing-in-Corporate-Bonds-How-ESG-Affects-Corporate-Credit-Risk-and-Performance+(002).pdfOpens
in new window
8 Final Report on draft Regulatory Technical Standards
with regard to the content, methodologies and presentation of
disclosures pursuant to Article 2a(3), Article 4(6) and (7),
Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of
Regulation (EU) 2019/2088.
9 Regulation (EU) 2016/1011 of the European Parliament
and of the Council of 8 June 2016 on indices used as benchmarks in
financial instruments and financial contracts or to measure the
performance of investment funds and amending Directives 2008/48/EC
and 2014/17/EU and Regulation (EU) No 596/2014
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
