The article provides an overview of ESG and ESG-linked derivatives, and how environmental, social and governance considerations are impacting the derivatives market. In particular, this article discusses:
- What’s in an ESG Derivative
- How ESG derivatives can support sustainability goals;
- EU and US regulatory initiatives to promote ESG principles; and
- Current issues for the ESG derivatives market.
In the six years since the UN General Assembly adopted the global sustainable development framework in the 2030 Agenda for Sustainable Development,1 market participants have begun to put ESG under the spotlight. With national, regional and international initiatives, ESG Finance is influencing both ESG derivatives and ESG-linked derivatives. In Europe, for example, under the European Green Deal2, the Commission has set out a clear vision of how to achieve climate neutrality by 2050 and has already started to modernise and transform the economy with the aim of climate neutrality.3 To achieve the ambition set by the European Green Deal, there are significant investment needs. The Commission has estimated that achieving the 2030 climate and energy targets will require €260 billion of additional annual investment.4
What’s in an ESG Derivative?
Generally speaking, any ESG financial instrument would involve assessing non-monetary environmental, social and/or governance criteria. Strictly speaking, an ESG derivative would be a trade measuring certain ESG components (e.g. sustainability targets, ESG-oriented investments or maintaining certain ESG criteria or ratings). This is in contrast to traditional “ESG-linked” derivatives, which typically involve an environment-linked commodity (e.g. carbon credits). Terminology in this space is not uniform. Indeed, the derivatives market also lacks a uniform standard to measure ESG performance. The role of derivatives can be crucial in facilitating the development of certain standards, as market players evolve and adapt to ESG principles.5
Parties are becoming more interested in linking their derivatives to ESG targets, and a number of ESG-linked products already exist in various forms. On the over-the-counter (“OTC“) side, there are structures in which a counterparty may be incentivised to meet pre-set ESG targets by having to pay a premium on an interest rate swap if it misses those targets or by adjusting the premium down if the relevant target is met. Other structures may require a counterparty to make a payment to a bank if it misses an ESG target, which the bank will then put towards a “green project”, or the counterparty may require a bank to donate to a non-profit organisation if the counterparty improves its ESG score. This not only creates an incentive for counterparties to comply with their ESG-related targets, but may also guarantee a sustainable outcome if they do not.
The OTC ESG derivatives market is still developing, but has already seen a number of deals involving new ESG derivatives technology.6 By contrast, the ESG index-based derivatives (futures and options, “F&O”) market has been one of the fastest growing segments for exchanges.7 These F&O track equity indices with companies weighted and evaluated on different ESG standards, such as the E-mini S&P 500 ESG Future, the Euronext Eurozone ESG Large 80 Index Futures and the MSCI Emerging Markets ESG Leaders NTR Index Future.
The ESG derivatives market is still nascent, but the number of ESG investments is expected to grow dramatically in light of current political and legislative drivers. Several major investment banks have begun incorporating ESG-linked derivatives into their portfolios, and with ESG Finance becoming increasingly important for financial participants across the world, there is no sign of this progress slowing down. ESG products are gradually becoming a staple of the financial markets, as market players increasingly take ESG considerations into account in their financings.
How can derivatives support sustainability goals?
Derivatives, broadly, can reduce or mitigate different types of risk and have the ability to replicate cash flows and other features of the relevant underlying asset. This is why they can easily be used in different financing structures across capital markets, structured finance, private equity, project finance and banking. As such, they are intrinsically designed to incorporate new features such as addressing the needs of sustainable finance.
While “ESG-linked” derivatives have long been used by market participants (e.g. carbon credit derivatives), derivatives referencing ESG standards or benchmarks have not yet been fully embraced by the derivatives market. Derivatives on ESG-focused indices provide a ready means for selective investments based on ESG parameters. High profile ESG-linked derivative trades can also benefit ESG Finance initiatives related to the European Green Deal (and potentially the increased emphasis on ESG initiatives supported by the new US administration) by not only directing finance towards environmentally friendly areas, but by also incentivising financial participants to meet their ESG targets.
With the continued focus on ESG Finance, it is just a matter of time before we see increased use and development of ESG derivatives. Derivatives will continue to play a role in financial transactions by reducing credit and market risk, which will not change under new ESG principles. Derivatives have already proved to support climate change and this trend will only continue as the underlying market develops.
- Derivatives can encourage sustainable investment.
Sustainability-linked derivatives transfer the risk associated with, for example, an ESG investment in the form of sustainability-linked bonds and loans, to a financial intermediary in exchange for a fixed, recurring payment.8 Generally, this would require two conditions: (a) the hedge provider is prepared to offer better conditions to the end-user in exchange for a commitment to engage, participate, invest, etc. in certain ESG areas (e.g. hitting certain sustainability targets, contributing towards a pre-agreed ESG charity or water irrigation or sanitation project, climate change, combatting hunger, etc.); and (b) the end user agrees to commit to an ESG activity.
This may be designed as an incentive to the end-user in order that it obtains more favourable terms if it agrees to certain ESG-related activities. This can also take the form of an obligation on the hedge provider to invest, for example, part of the premium or the fees in a sustainable initiative if the end user meets certain ESG obligations, e.g. investing part of its profits in climate change initiatives.
In the context of interest rate derivatives, the relevant rate may be subject to a positive or negative spread, which moves in either direction depending on whether the counterparty meets a pre-established set of ESG targets. In bonds, for example, the coupon payment could increase if the ESG targets are not met and any related hedge may need to reflect this mechanic. The actual rate under the hedge may be subject to the underlying instrument’s ESG classification such that the issuer’s rate may increase if the agreed ESG condition fails. A similar mechanic could be used for ESG loan hedges.
In the context of foreign exchange ESG-derivatives, the counterparty may receive a discount or preferential rate provided it agrees to contribute to one or more of the ESG segments.
Also, parties investing directly in ESG compliant companies could use derivatives to hedge their investment against relevant ESG taxonomy indices (once created), or to reduce transaction costs.
- Derivatives allow investors to hedge climate-related risks.
Since hedging is a primary role of derivatives in modern finance, ESG derivatives can offer parties a mechanism to manage the financial risks related to ESG. For example, a bank may wish to protect itself against a counterparty whose financial results are sensitive to climate change risk. If a bank enters into an ESG-linked derivative with a counterparty structured such that the counterparty has to pay an increased amount if it misses a pre-agreed ESG target, the bank may be concerned about the counterparty’s creditworthiness if it fails to meet those targets and is faced with a higher payout. The bank could protect itself in these circumstances by using a credit default swap. Similarly, a bank may have to pay more if the counterparty meets a pre-agreed ESG target and it may wish to hedge itself against this potential increase in expenditure.
- Impact on ISDA documentation
So far, there have been no market wide amendments to ISDA documentation to reflect ESG principles. Tailoring of transaction documentation has only been effected to the extent necessary on a trade by trade basis. As the ESG derivatives market develops, further standardisation in documentation (e.g. development of specific ESG derivatives definitions or template confirmations) may be anticipated.
The EU and UK regulatory initiatives
The success of new ESG Finance models will rely heavily on legislative measures which incentivise the adoption of these principles by market participants. Europe’s regulatory landscape has been shifting towards sustainability, as the EU is implementing a number of regulatory changes to help the EU reach its goal of net-zero carbon emissions by 20509. This new block of legislation includes the Taxonomy Regulation10, which recognises that “in view of the scale of the challenge and the costs associated with inaction or delayed action, the financial system should be gradually adapted in order to support the sustainable functioning of the economy”11. Financial instruments like derivatives are neutral for the purposes of the Taxonomy Regulation (i.e. they are not automatically considered “green” investments).
UK Chancellor Rishi Sunak recently announced that the UK would be implementing a new “green taxonomy” to ensure firms and investors know what is meant by “green” investing and are able to better understand the long-term impact of their investments on the environment.12 This, alongside the UK’s announcement that it will issue its first Sovereign Green Bond in 2021, shows that the UK Government sees financial services as a crucial enabler in reaching its net zero target for 2050.13
The US regulatory initiatives
US ESG regulatory development trails behind Europe, and relies largely on an existing regulatory framework which at best is neutral to the development of ESG Finance. On the positive side, the Federal Reserve Board joined the Network of Central Banks and Supervisors for Greening the Financial System in late 2020 to better monitor the regulatory development in other jurisdictions. In its semi-annual Financial Stability Report released in November 2020, the Federal Reserve Board recognised climate change as a key risk to U.S. financial stability.14 On the other hand, the US Department of Labor recently published final rule (effective 12 January 2021) that requires plan fiduciaries (such as pension fund advisors) to always focus on the economics and pecuniary effect of the investment – the corollary of which is that these “fiduciaries must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals” such as ESG.15
Other US regulators such as the Securities and Exchange Commission (“SEC“) and the Commodity Futures Exchange Commission (“CFTC“) take on a largely productive but cautious tone, recognising that ESG Finance should be an area of focus by regulators and emphasising the importance of transparent standards and disclosure. In his remark to asset managers in May 2020, SEC Chairperson Jay Clayton reaffirmed that he thinks that ESG issues are material to an investment decision, but commented that “[he has] not seen circumstances where combining an analysis of E, S and G together, across a broad range of companies, for example with a “rating” or “score,” particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise”16. Similarly, the Report of the CFTC Climate-Related Market Risk Subcommittee cautioned over ‘greenwashing’ (i.e., misleading claims about the extent to which a financial product or service is truly climate-friendly or environmentally sustainable) and remarked that “existing disclosure regime has not resulted in disclosures of a scope, breadth, and quality to be sufficiently useful to market participants and regulators”.17 US regulatory efforts on ESG focus primarily on disclosures. In May 2020, the SEC Investor Advisory Committee urged the SEC to update reporting requirements for issuers to include material, decision-useful environmental, social, and governance, or ESG factors.18 In December 2020, the ESG Subcommittee of the SEC Asset Management Advisory Committee recommended the SEC to adopt standards for corporate issuers to disclose material ESG risks.19
Since the beginning of the new Biden Administration, US regulators have significantly stepped up their focus on ESG financial products. On February 24, 2021, Acting SEC Chair Allison Herren Lee issued a statement directing the Division of Corporation Finance “to enhance its focus on climate-related disclosure in public company filings” and update the SEC’s 2010 climate change disclosure guidance.20 Lee noted that it is the SEC’s “responsibility to ensure that investors have access to material information when planning for their financial future.” On March 15, 2021, Acting Chair Lee further solicited public comments on and directed SEC staffs to evaluate SEC “disclosure rules with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change.”21 Two days later on March 17, 2021, the CFTC Acting Chair Rostin Behnam announced the establishment of a Climate Risk Unit that will focus on the role of derivatives in understanding, pricing, and addressing climate-related risk and transitioning to a low-carbon economy – the CFTC stated the Climate Risk Unit is being established as a response to the global call to action and is intended “in support of industry-led and market-driven processes in the climate—and the larger ESG—space.”22
We can expect ESG Finance will continue to rise in prominence at a rapid pace in the US under the new administration led by President Joe Biden.
Conclusions
It is expected that public and private institutions will gradually take into account ESG principles in their treasury activities and therefore derivatives may play a critical role in facilitating the efficient mitigation of sustainability risks. For example, the United Kingdom is determined to “harness the international reputation of the UK’s world leading financial sector to encourage private investment into supporting innovation and manage climate financial risk”.23 However, derivatives will only play the role demanded by the market – and only if ESG financial products are profitable.
Since private capital will need to be mobilised to meet the needs of the various global green initiatives, e.g., 2030 Agenda, the European Green Deal or the Ten Point Plan for Industrial Green Revolution in the United Kingdom24, it is expected that ESG derivatives will play a greater role in the following years.
Derivative contracts can easily adapt to different regulatory requirements and commercial needs. They can also channel and distribute cash in very efficient ways. It is likely that ESG derivatives will be bespoke products tailored to meet the demands of investors and issuers, although it is likely that some standardisation will occur as the market becomes more mature.
However, there will be challenges, the key one being defining and scoping what we mean by an “ESG derivative”, with the market developing standards to ensure it is more than just a label. ESG derivatives will only thrive and develop insofar as ESG Finance creates a demand for them. It is critical that investors establish that the referenced or underlying assets are indeed sustainable.
It is clear that the current legislative drive and ambitious national green projects will create the right landscape for ESG derivatives to develop and eventually become permanent instruments integral to modern finance.