Hogan Lovells - ESG Derivatives: new tools unlocking sustainable capital
ISDA published a paper in January 2021 that provides an overview of ESG-related derivatives products and transactions to help market participants further understand the potential role of derivatives in sustainable finance.
Annalisa Feliciani / Jennifer O’Connell, Hogan Lovells, 28 Mag 2021 - 15:30
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; although much of the detail will be developed over the years to come, this is a good first step toward setting definitional standards as to what economic activities and investments can be considered environmentally sustainable
When considering the taxonomy, it’s important to make a distinction between derivatives that contribute directly to achieving the sustainability agenda and derivatives that are more indirectly linked to sustainable finance. The benefit of these types of transactions is that they allow capital to flow more easily into companies and projects that have clear sustainability goals. ISDA has actively engaged with a view to creating market-wide standards. Consistent with this approach, in January 2021, ISDA released a paper providing an "Overview of ESG-related Derivatives Products and Transactions" that builds on the recent European Capital Markets Institute (ECMI) report, which noted that derivatives are a key part of sustainable finance.
Key products identified by ISDA
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 (some of which are new and some of which are more established):
- 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, and can be used to help or incentivise companies to achieve specific sustainability targets.
- 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. Various derivatives instruments have been created over the years to trade renewable energy and renewable fuels.
- Catastrophe and weather derivatives: Catastrophe derivatives protect companies against losses from specific natural disasters while weather derivatives mitigate risks associated with adverse and unexpected weather patterns.
The derivatives market is known for innovation and we look forward to watching and assisting the industry to bring new products to life. Standardization of ESG terms and metrics in turn will lead to market standards for ESG-related derivatives and foster creative development of new products . We will continue to monitor the market and look out for updates to the list of product structures set out in the ISDA paper.
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