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June 1, 2021updated 10 Jun 2021 8:33am

The positive emergence of ESG-linked derivatives 

Building trust in the nascent ESG-linked derivatives market is vital. But the hunt for liquidity could affect the impact of the new products. This will be a long-standing tension that needs to be monitored closely.

By Daniel Flatt

ESG-linked derivatives are increasing in popularity. (Photo by Madrolly via Shutterstock)

  • As demand for ESG derivatives increases, listed contracts are pushing the innovation envelope.
  • The over-the-counter market is also forging ahead with new types of ESG contracts.
  • The trade-off between liquid and highly tailored contracts will determine how successful derivatives will be in driving capital towards sustainability.

Eurex, one of the world’s largest futures and options exchanges, yesterday (31 May) launched a new raft of derivatives products promising to push the boundary of what listed derivatives can do to support a sustainable future.

Rather than merely screening for undesirable companies, the five new futures contracts track companies in the MSCI ESG Enhanced Focus Indexes that have a “stronger ESG profile”. The indexes are weighted by companies that can help drive a 30% reduction in exposure to carbon dioxide and other greenhouse gases, and to “potential emissions risk of fossil fuel reserves, by 30%”.

The launch comes amid a surge in demand from investors keen to gain exposure to the sustainability story. Eurex surpassed 100,000 ESG derivatives trades in one day in February, a landmark event. Most were options traded on the Stoxx Europe 600 ESG-X.

As Capital Monitor has commented before, the creation of more financial instruments and contracts that align with broad ESG goals should be welcomed, but cautiously. There is a risk that the proliferation of products comes at the expense of well-designed and transparent financial engineering underpinning them.

Magnus Linder, a Sweden-based senior trader at Swedbank Robur, a prominent investor in listed ESG derivatives, raised a similar concern to NordSIP. “Lately, it has turned into a veritable war between exchanges… all competing to launch new creative ESG products,” he said. He sees this happening potentially at the expense of ESG derivatives already being traded.

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Liquid versus bespoke

One fundamental benefit of the listed ESG derivatives market is that such products require contractual standardisation. To ensure a safe and liquid marketplace, it’s important that trust in the ability to find a buyer is high. With regard to the creation of listed ESG derivatives products, there will always be a tension between granularity and marketability. One would expect the latter to always win out.

Liquidity is not as critical in the over-the-counter (OTC) derivatives marketplace, but recent developments indicate that trust in this arena needs bolstering.

In what was seen as a minor update, in early May the International Swaps and Derivatives Association (Isda) published technical information enabling traders to trade US renewable energy certificates (Recs) under the Isda Master Agreement, a crucial document that supports the running of the OTC derivatives markets.

All this may sound rather dry and technical, but it has important implications for the creation of a liquid Rec market. It provides surety that, should a Rec not be delivered or payment not supplied, there is clear legal recourse for action. Isda’s membership comprises some 950 institutions and owners of capital, for whom certainty on their obligations and rights when trading Recs was a priority.

While they have their critics (and for good reason), Recs are a useful way for companies to obtain equity and debt financing on the back of their creation.

Put simply, the buyer of a Rec has the exclusive right to claim the environmental benefits associated with the renewable energy generation that underlines the certificate. The original seller of the Rec is the developer of the renewable energy project. The seller can obtain financing with the promise of future revenue attached to the sale of the Rec.

In this example, the standardisation of a contract is a vital means to increase trust in the nascent ESG derivatives market.

Tailoring can deliver impact

Bespoke in nature, OTC derivatives are a handy solution for managing very specific sustainable risk. It is early days, but the transactions that have come to market so far highlight how effective they can be in establishing transparency and impact via key performance indicators, especially in comparison to their listed peers.

In all cases so far, the transactions are based on traditional OTC derivatives contracts, such as swaps and options, but contain unique pricing components that are tied to a bilaterally agreed set of targets specific to the corporate counterparty.

“Transactions can reduce one counterparty’s payment in the event it achieves some pre-agreed sustainability performance target,” says Isda. “This mechanism provides market participants with a financial incentive for improved ESG performance.”

The world’s first sustainability-linked derivatives contract was structured in 2019 and involved Dutch bank ING and SBM Offshore, a supplier of floating platforms for the offshore energy sector.

It is designed to hedge the interest rate risk of SBM’s $1bn five-year floating rate revolving credit facility. SBM pays a fixed rate on the swap and receives a floating rate. The sustainable component kicks in with the creation of a positive or negative spread to the fixed rate of the swap and based on the company’s ESG performance, as determined by Sustainalytics.

At the start of each year, ING sets a target ESG score for SBM. If this score is met, a discount of 5-10 basis points (bp) is applied to the fixed rate paid by SBM. If not, SBM must pay a 5-10bp penalty.

Similar transactions have emerged in the foreign exchange market, including Deutsche Bank and Olam’s novel one-year US dollar/Thai baht FX forward linked to ten out of the 17 UN Sustainable Development Goals.

There have also been examples in the commodities space – one was announced on 4 May. Trafigura, a commodity trading and logistics house, teamed up with Standard Chartered to link the cost of hedging against commodity prices with “reducing greenhouse emissions – from owned or controlled sources – and to sustainable sourcing in base metals”. The KPIs are monitored by ERM Certification and Verification Services.

More than just an ESG label

Given how bespoke these contracts are, the development of a deep secondary trading market for them seems unlikely. That said, with the trend towards mandatory corporate disclosure on climate change, both in the EU and increasingly the US, growing standardisation of reporting on sustainable issues could give counterparties more confidence to create and trade such contracts.

A key challenge is defining and scoping what we mean by an ESG derivative and ensuring it is more than just a label. Julia Smithers Excell, White and Case

“A key challenge is defining and scoping what we mean by an ESG derivative and ensuring it is more than just a label,” says Julia Smithers Excell, a London-based partner at law firm White and Case. “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.”

White and Case says it expects to see further standardisation in documentation as the ESG derivatives market develops.

For now, it seems the development of both the listed and OTC ESG-linked derivatives markets are following a natural and broadly beneficial trend, in keeping with increased demand for ESG-related products. However, the tension between standardisation and measurable impact will be at the heart of how truly beneficial these products will be in driving real sustainable change.

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