In the past century, humanity has experienced economic growth that can only be described as extraordinary and miraculous – from 1975 to 2015, the global real GDP has increased by nearly 400%. However, with rapid societal developments and technological advancements also comes unprecedented challenges. Humans are destroying nature at a rate higher than the average over the past 10 million years; income inequality has not only persisted but increased to new heights; human actions have caused irreversible changes such as global warming. These challenges necessitate a more sustainable economy which give rise to the Environmental, Social and Corporate Governance (ESG) criteria as an approach to firm valuation. In recent years, the use of ESGs has expanded into the derivatives market, providing investors with more opportunities and ways to mitigate risk when investing in the sustainability sector.
What is ESG?
The term ESG was first coined in 2005 in a landmark study entitled “Who Cares Wins.” In 2018, ESG investing is valued at over $20 trillion in assets under management or around a quarter of all professionally managed assets around the world. In less than 20 years, the ESG movement has grown from a corporate social responsibility initiative launched by the United Nations into a global phenomenon.
Environmental, social, and governance (ESG) criteria are a set of standards that seeks to measure a company’s level of social consciousness in its operations. Specifically:
Environmental
Environmental criteria takes into account a company’s use of renewable energy sources, its waste management program, deforestation issues (if applicable), and its attitude and actions around climate change issues.
Social
Social criteria cover a vast range of potential issues that arise from a company’s social relationships, such as its relationship with employees and customers. These issues may include fair treatment of employees, workplace diversity and inclusion, consumer rights protection, etc.
Corporate Governance
Governance criteria measure how well a company is managed by its top executives. Key issues surrounding corporate governance may include transparency concerning full and honest disclosure of financial and non-financial information; internal auditing and anti-corruption; and appropriate compensation for executives based on the company’s performance.
What are Derivatives?
With a notional value of $610 billion USD at end-June 2021, the derivatives market is by far the biggest in the world, by dollar value. The vibrance of the derivatives market has contributed to the rapid growth of the financial services industry. However, the lack of regulation and the inherent volatility of these financial instruments have also led to disastrous outcomes, most notably the 2008 Global Financial Crisis.
A derivatives contract is a financial instrument whose value derives from that of an underlying product, which could be a commodity, share, market index, interest rate, currency, etc.
There are three main types of derivatives: futures/forwards, swaps, and options.
The International Monetary Fund defines financial derivatives as “financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in the financial market in their own right”.
A type of ESG related financial derivative is the interest rate derivative. It’s a financial instrument whose value is linked to the market movement of an interest rate. These derivatives may be in the form of futures, options, or swaps contracts. They are often used by investors to hedge their portfolio exposure to changes in the market interest rate.
One of the first interest rate derivatives is issued by SBM Offshore, an international supplier of offshore energy production. This transaction was executed by the International Nederlanden Group (ING). It is designed to hedge the interest rate risk of SBM’s 1 billion five-year floating rate revolving credit facility.
The transaction is called the sustainability improvement derivative (SID) — an interest rate swap that receives additionally positive or negative to its initial fixed rate based on SBM’s ESG performance, which is scored by Sustainalytics.
SBM’s ESG target score is set by ING at the beginning of every year during the life of the IRS. If SBM meets the score, a discount of 5-10 basis points (bp) — a basis point is an increment of 0.01% — is applied to the fixed rate paid by SBM. If SBM doesn’t meet the score, it needs to pay a 5-10bp penalty.
An example of ESG financial derivatives in the secondary market is ESG-related Exchange-Traded. Since the market is beginning to focus on ESG strategies, global exchanges like Eurex, CME Group, Nasdaq, and Japan Exchange Group have released new equity index futures and options contracts linked to the ESG benchmarks. These futures and options allow institutional managers to better hedge their portfolios.
Since ESG index derivatives are linked to ESG indices that are based on a selection of ESG oriented companies from the parent benchmarks, investors can eliminate certain types of exposures whilst remaining similar risk to return ratio to the parent benchmark. For example, they can exclude companies that are considered to violate certain ESG criteria, e.g., by emitting excessive carbon emissions, or tobacco products.
The current ESG-linked derivatives market is still young and therefore has liquidity problems. However, in the future, these issues will likely be resolved as the market grows.
Future Implications of ESG Derivatives
Assuming the trend of firms increasingly committing to more sustainable practices in the transition towards a greener and more ethical future continues, the financial sector and financial markets will naturally be key components in this movement. Firms will inevitably require funding for their projects and investments that facilitate this positive adaptation and will want to meet risk management requirements by reducing their exposure to risks stemming from this investment and other ESG related factors.
The Role of ESG Derivatives in Funding and Risk Mitigation
Projections from the European Capital Markets Institute (ECMI) estimate that for the European Union (EU) to meet its climate and energy goals set out by the United Nations (UN) and the Paris Agreement, they require €11.2 trillion in investments by 2030. They also estimate that currently, investments that promote the achievement of these targets fall short around €177 billion per year. Although the European Green deal proposes that over 2021-2027, 25% of the EU budget will be devoted to climate relevant spending, the issue is clear that there is an underfunding for climate change driven investments.
Climate change appends another aspect of risk to the usual financial risks that result from factors such as currency, credit and interest rate risk. This comes in the form of factors such as the dwindling level of resources, increased weather risk due to climate hazards via changes in weather patterns/increasing commonality of extreme weather and environmental degradation. Firms inherently require funding for their investments into new projects; projects that champion sustainability and ethicality are no different. However, in addition to the usual financial risks such as project risk, interest rates, credit and currency exchange, the climate change risk is also appended onto that list. As a result, firms that are required to meet certain risk tolerance levels for investors to inject capital into them, will be looking to ESG derivatives as a means to mitigate the financial and climate related risk simultaneously.
ESG derivatives provide firms with the opportunity to hedge against the significant financial and ESG-related risks that corporations are exposed to nowadays, and increasingly exposed to in the future. Firms that take positions in ESG derivatives can protect themselves against future fluctuations in price, converting volatile cash flows to more predictable ones whilst bounding themselves to ethical actions, if not for simply the financial sake. Not only this, but investors can also take protective measures against future losses and volatile investments in climate-relevant industries that may be adversely impacted by climate change.
Conclusion
ESG derivatives have the potential to be an essential part of the drastic change that the world requires going forward, serving as a means to simultaneously mitigate firms’ exposure to financial and ESG-related risks as well as increase the probability of the reallocation of funds towards ethical investment. Furthermore, ESG derivatives and the reporting that surrounds them and the corporate efforts to do so voluntarily, have the double effect of enticing firms to commit to long-term focuses that aid in economic development and the movement towards a sustainable future rather than the simple chase of short-term profits. The increasing adoption of such financial instruments will be crucial in the economic metamorphosis into a supportable economy that promotes inter-temporal efficiency.
There are however problems with ESG derivatives despite the positives that surround it; namely “ESG Washing”. With firms targeting certain KPIs to attain the positive impacts of the ESG derivative, and ESG reporting being fairly new, there are still yet stricter rules and regulations to be imposed on the reporting and classification on ESG derivatives. The International Swaps and Derivatives Association (ISDA) are taking measures to address this important issue as under-regulation can serve to birth investor confusion, which can ultimately lead to decreasing the positive impact that these derivatives can have on ESG factors going forward.
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
