Lynn Strongin Dodds assesses the sustainability evolution of the derivatives market but why it may take longer than its equity and bond counterparts
As sustainability becomes an ever more important feature in the equities and fixed income spheres, attention has naturally turned to derivatives. It is still early days and embedding environment, social and governance (ESG) criteria into these instruments presents their own set of challenges especially in terms of building liquidity.
As Ahmad Chaudry Executive Director, Markets Structuring at UBS Investment Bank, puts it, “There needs to be a financial incentive to be more ESG-compliant but one of the problems is that there is no uniform definition of what ESG is. There is a degree of subjectivity in assessing the sustainability issues of a company which makes it difficult to quantify how much should be allocated and to equate ESG and risk.”
Chaudry does not see a “massive” increase in ESG-linked derivatives. He notes that to date the bulk of the activity has been in the macro space.
Others though believe that it is only a matter of time and that the explosive growth in ESG investing will infiltrate the derivatives market in a more widespread manner. “Investments are expected to reach $1 trillion by 2030 and that globally the assets under management of funds incorporating ESG principles are more than $30 trillion,” says. Michael Stark, Research Analyst at brokerage firm Exness.
“Recently, significant advancements have been made in ESG, for example with United Airlines ordering net zero carbon supersonic jets, S&P Global Market Intelligence launching a solution measuring the credit impact of climate risk within companies, and Unilever unveiling paper bottles for laundry to reduce plastic waste,” he adds. “Investors trading derivatives linked to these markets can definitely take advantage of movements due to the knock-on effects of the ethical decisions for changes made by global corporations.”
Derivatives exchanges are being encouraged by different industry trade groups to develop a framework. A recent paper by International Swaps and Derivatives Association (ISDA) stresses that the derivatives market can play an important part in the transition towards a sustainable economy. “Derivatives enable more capital to be channeled 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,” the report states.
The paper notes that sustainability-linked derivatives typically add an ESG pricing component to conventional hedging instruments, such as interest rate swaps, cross-currency swaps or forwards. These transactions are highly customisable and use various key performance indicators (KPIs) to determine sustainability goals.
ISDA points out there is a variety of derivatives structures and transaction types already on the scene including sustainability-linked derivatives, ESG-related credit default swap (CDS) indices, exchange-traded derivatives on listed ESG-related equity indices, emissions trading derivatives, renewable energy and renewable fuels derivatives, and catastrophe and weather derivatives.
A recent report from the World Federation of Exchanges (WFE) and the United Nations’ Sustainable Stock Exchanges (SSE), an advisory group of 71 representatives from derivatives and stock exchanges highlighted the problems with data and suggested exchanges introduce data to support the listing of new tradeable products based on ESG values to promote the transition to sustainable economy.
The guidelines not only include driving standardisation and introducing ESG data products but also engaging in partnerships, enhancing transparency, listing tradeable ESG contracts and linking market participation to sustainability. Read more on the six-action sustainability action plan set out by the WFE/SSE paper.
The report notes that as the relevant product set expands to include more geographies, indices and ESG preferences, users will have greater ability to manage their portfolio risks and exposures. It also points out “that regulatory developments, such as the EU taxonomy, will undoubtedly create demand for new products particularly when coupled with regulatory incentives for investors to ‘green’ their portfolios. These could include demand for new types of taxonomy-aligned index derivatives.”
The role of market infrastructure
“Exchanges are already responding to market demand for sustainability-aligned products, and this is set to continue,” the report states. On the commodity side, it cites the London Metal Exchange’s strategy to develop derivatives contracts that support price risk management for battery materials and electric vehicle industries, as well as CME’s used cooking oil contracts, as examples.
Several global exchanges have also been busy launching equity index futures and options contracts tied to ESG benchmarks. Their aim is to enable asset managers to allocate their target ESG investment more efficiently without directly investing in underlying stocks. They also want to help investors better hedge their ESG investments and implement their ESG investment strategies in a more cost-effective manner.
Eurex has been at the forefront as the first exchange to establish derivatives contracts on ESG versions of the major Stoxx European benchmarks. The German exchange started with the Stoxx ESG-X Factor Indices which target similar levels of factor exposures as the Stoxx Factor Indices but has a screening methodology that relies on the research of Sustainalytics, an independent global provider of ESG data.
Companies involved in controversial products including weapons, tobacco production, and thermal coal, as well as companies in breach of the Global Standards Screening principles, are excluded from the benchmark universe.
Eurex’s stable also includes futures and options on DAX 50 ESG and EURO Stoxx 50 ESG Indices and more recently in May it launched the ESG Enhanced Focus versions of the benchmark indexes MSCI World, USA, Emerging Markets, Europe and Japan. These indexes aim to maximise exposure to companies with a stronger ESG profile and reduce carbon exposure while maintaining risk and return characteristics similar to the underlying parent index.
Stephan Flaegel, Chief Product Officer, Indices and Benchmarks at Deutsche Börse’s index provider Qontigo believes that these products have to be more bespoke because of the nature of the derivatives market. “I don’t think the market currently supports a one size fits all product because there are not only different regulations in countries and regions but also investors have different sustainable investment goals,” he says. “We started out with our screened Stoxx ESG-X which is the most traded future in the world but are launching a spectrum of products that cater to different investment goals.”
Randolf Roth, Member of the Eurex Executive Board echoes Flaegel’s comments. “These products have to be tailored made,” he says. “There are probably more than 1,000 ESG indices but very few are liquid in the derivatives space. Our aim is to build bridges between a specific benchmark, trading interest and liquidity. This can only be done in a few products. It is a step-by-step process and most asset managers investing with ESG principles are using standard futures because they are more liquid.”
Euonext has also been active and last year teamed with ESG research provider Vigeo Eiris, part of the Moody’s Group, to create an ESG index family focused on climate, the Euronext Eurozone ESG Large 80 Index, or Euronext ESG80. It comprises the highest-ranking companies from their sector supporting the transition to a low-carbon economy and reducing climate impact with a minimum score of 30.
It also excludes the 20% lowest-ranking companies in terms of social and governance assessment, Companies facing critical controversies with regards to the United National Global Compact or those involved in coal, tobacco or weapons are also off the list. “The index was in response to a group of market participants wanting to have a Eurozone ESG benchmark, but with strong convictions”, according to Charlotte Alliot, Head of Institutional Derivatives at Euronext.
“They were interested in a public climate action benchmark, with real exclusions, that was representative of the real economy and not just an index that focused on performance,” she adds. “We have the support of four market makers, including BNP Paribas, DRW, Optiver and Société Générale sand I think one of our differentiators is fair pricing. Our competitors tend to launch ESG derivatives that are more expensive than the normal benchmarks.”
While the bulk of the activity has been equities and commodities, bond markets are also poised to join the fray with futures based on two Bloomberg ESG focused fixed income indexes expected to make their debut in the autumn. They will be based on will be based on the Bloomberg Barclays MSCI Global Green Bond Index and the Bloomberg Barclays MSCI Euro Corporate SRI Index. The derivatives will track the Euro investment grade corporate bond market while applying ESG criteria for those wanting exposure to the global green bond market.
As to the future, Alliot believes that there will be further growth, but it will be a gradual process. “The appetite is growing for ESG products, and the pandemic has accelerated the trend. While it is a moment for derivatives to step into, ESG is a complex world and there are many different labels that need to be harmonised. We work with market participants, experts and the scientific communities to establish an index and it takes time.”