The need for ESG-related derivatives products
The shift to a sustainable economy will require significant amounts of capital and, in particular, longer term investment than we are currently seeing. While investors are calling for this shift and financial institutions and corporates are keen to play their part, certain obstacles still stand in the way, including a paucity of ESG risk mitigation tools and a lack of clarity around the meaning of “sustainability”. Much work has already been done in respect of the latter to create standards, including the development of the EU Taxonomy Regulation, in relation to which ISDA actively engaged on behalf of derivatives market participants.
Consistent with this approach, ISDA has recently released a paper providing an "Overview of ESG-related Derivatives Products and Transactions" to help market participants further understand the potential role derivatives can play in sustainable finance. The ISDA paper builds on the recent European Capital Markets Institute (ECMI) report which noted that derivatives can "enable more capital to be channelled towards sustainable investments; help market participants hedge risk related to environmental, social and governance (ESG) factors; facilitate transparency, price discovery and market efficiency; and contribute to long-termism".
Key products identified by ISDA
While recognising that this is an emerging area, with bespoke transactions and relatively low liquidity, ISDA’s paper focuses on some key examples of how derivatives can promote the sustainability agenda in order to educate market participants. Below is a high level summary of ISDA's (non-exhaustive) list of product structures that are currently on offer and are being further developed:
- Sustainability-linked derivatives: These derivatives add a bespoke ESG pricing component to a conventional derivative, such as an interest-rate swap or cross-currency swap. They can be used to help or incentivise companies to achieve specific sustainability targets and are tailor-made for the client. The ISDA paper highlights 11 notable transactions done in this space.
- ESG-related credit derivatives: Credit default swaps can be used to manage the credit risk of a counterparty that might be affected by climate change. Indices derived from ESG criteria can be used to gain exposure to, or hedge against, ESG corporate risk in particular regions.
- ESG-related exchange-traded derivatives: Equity index futures and options contracts tied to ESG benchmarks can help managers to hedge their ESG investments, implement their investment strategies and more efficiently manage cash flows in and out of their ESG funds.
- Emissions trading: Companies subject to carbon cap-and-trade programs can use derivatives based on carbon allowances and offsets to meet their obligations and manage their risks in a cost-effective way.
- Renewable energy and renewable fuel derivatives: These derivatives allow market participants to hedge against the risks associated with fluctuations in renewable energy production and encourage more capital to be directed to sustainable investments.
- Catastrophe and weather derivatives: Catastrophe derivatives protect companies against losses from specific natural disasters while weather derivatives mitigate risks associated with unexpected weather patterns.
Next steps
Please get in touch with us if you’re interested in exploring developing market standards for ESG-related derivatives and their role in achieving sustainability targets.
In addition to the ESG-related derivatives explored above, conventional derivatives, such as cross currency swaps, also have an important role to play in achieving sustainability goals. You can read our insights on how derivatives can help firms, investors and governments manage the financial risks created by the climate crisis here, including consideration of the ECMI report.
Authored by Jennifer O'Connell and Emma Burrell.
