ESG derivatives are increasingly vital in today’s sustainable finance landscape due to their inherent flexibility and adaptability. However, inconsistent regulation across jurisdictions, data challenges and a lack of standardisation still creates challenges for wider use. In a DerivSource Q&A, Dr. Ligia Catherine Arias-Barrera, author and associate professor, Universidad Externado de Colombia, discusses these obstacles and the opportunities these instruments offer as part of a lengthier exploration of the evolution of ESG derivatives in her book – “The Law of ESG Derivatives: Risk, Uncertainty, and Sustainable Finance” (Routledge 2024). Read on for insight into lesser discussed risks, such as home bias, and the potential for ESG derivatives to bridge the gap between managing risks and contributing to sustainability and social goals. (Book Launch 24 June in London – find out more here.)
Q: ESG derivatives are not new. As a refresher for our audience, how do they play a role in sustainable finance today?
A: ESG derivatives are increasingly vital in today’s sustainable finance landscape due to derivatives’ inherent flexibility and adaptability. These instruments are specifically designed to address environmental, social, and governance (ESG) criteria, providing counterparties with the tools to raise capital and manage a variety of risks while aligning with sustainability goals.
Derivatives can be tailored to hedge against risks associated with climate change, invest in projects with positive environmental impacts, or promote governance practices that enhance social welfare.
“By enabling precise pricing and risk management, ESG derivatives help market participants make informed decisions that align with their sustainability objectives. Furthermore, the data collected through these transactions can provide valuable insights into the performance and impact of ESG investments, promoting greater transparency and accountability.”
By enabling precise pricing and risk management, ESG derivatives help market participants make informed decisions that align with their sustainability objectives. The data collected through these transactions can provide valuable insights into the performance and impact of ESG investments, promoting greater transparency and accountability.
Their ability to be customised to meet specific client needs, combined with their role in enhancing market efficiency and transparency, positions them as key instruments in the advancement of sustainable finance. In the book, the exploration of different types of ESG derivatives further demonstrates how these instruments can effectively support sustainable finance initiatives.
Beyond simply advocating for the inclusion of sustainability clauses in financial or commercial contracts, we argue that the primary objective of these contracts should be aligned with specific and measurable sustainability metrics, known as key performance indicators (KPIs). This perspective is especially pertinent to the analysis explained in the book (Chapter 4), which examines the use of ESG derivatives in the market.
Q: Who tends to be using them – buy or sell side firms or both?
A: On the buy side, institutional investors such as asset managers, pension funds, insurance companies, and hedge funds are prominent users of ESG derivatives. These entities employ derivatives to manage various aspects of their investment portfolios. For instance, they may use these instruments to hedge against specific environmental risks, such as carbon emissions or water scarcity, which could potentially affect their investments. Additionally, ESG derivatives enable buy-side parties to enhance returns by leveraging opportunities in sectors or companies that perform well on ESG metrics. These investors integrate derivatives into their strategies to align with their broader ESG goals, ensuring that their investment decisions are consistent with ESG criteria.
On the sell side, financial institutions, banks, and brokerage firms play a pivotal role in facilitating the trading and market-making of ESG derivatives. Sell-side participants act as intermediaries that provide liquidity and market access for ESG derivative products. They fulfil the critical function of creating, pricing, and trading these instruments, enabling buy-side clients to execute their ESG-focused investment strategies. Sell-side entities innovate by developing new ESG derivative products tailored to meet market demand and regulatory requirements. This innovation expands the range of available instruments, catering to the evolving needs of investors seeking to integrate ESG considerations into their portfolios.
While buy-side parties focus on integrating ESG criteria into their investment decisions and risk management strategies using derivatives, sell-side participants facilitate market liquidity, create innovative products, and support the execution of these strategies. Together, they contribute to the growth and development of the ESG derivatives market, driving forward the integration of sustainability factors into global financial markets.
Jurisdictional Differences for Sustainable Finance
The regulation of sustainable finance, particularly in relation to ESG derivatives, is currently evolving, with notable variations across different regions and jurisdictions.
In the European Union (EU), regulatory reforms have significantly transformed the derivatives market, particularly the Over-the-Counter (OTC) segment. These reforms have driven the market towards greater standardisation, increased transparency, and more robust regulation. Key regulations like the Markets in Financial Instruments Directive (MiFID) II aim to enhance investor protection and manage the risk of mis-selling, which is crucial for trading ESG financial products. The EU has also implemented comprehensive disclosure regimes, including the EU Taxonomy, the Sustainable Finance Disclosure Regulation (SFDR), the Central Securities Depositories Regulation (CSRD), European Sustainability Reporting Standards (ESRS), and the proposed Corporate Sustainability Due Diligence Directive (CSDDD). These frameworks provide clarity on the disclosure and classification of ESG investments, helping to establish a distinct treatment for green assets under the revised Capital Requirements Regulation (CRR) II and Capital Requirements Directive (CRD) V packages. The European Securities and Markets Authority (ESMA) has also called for the integration of sustainability assessments and product governance processes within firms’ prudential measures.
In the UK, the regulatory framework for ESG derivatives is extensive, drawing from both domestic and EU regulations. This framework includes corporate governance and company law regulations, such as the UK Corporate Governance Code (UKCGC) and the Companies Act of 2006, as well as Listing Rules and Disclosure Guidance and Transparency Rules (DTRs) for publicly traded companies. The UK has emphasised stewardship practices through the UK Supreme Court (UKSC) 2020, which guides asset owners and managers in their ESG-related interactions with companies.
In contrast, the US has historically relied on voluntary, market-led initiatives to address ESG concerns. However, recent years have seen significant regulatory developments, beginning with the Securities and Exchange Commission’s (SEC’s) rules on climate-related risk disclosure. These regulations mandate the reporting of greenhouse gas (GHG) emissions reductions, with specific requirements for Scope 1 and Scope 2 emissions, and Scope 3 emissions when material. The Commodities and Futures Trading Commission’s (CFTC’s) Climate Risk Unit has also promoted new financial instruments like water derivatives and voluntary carbon offset markets to support sustainability objectives.
Overall, while the EU and UK have established more structured and mandatory ESG regulations, the US has adopted a more flexible, market-driven approach. As the ESG derivatives market continues to grow, it is likely that regulators across these regions will increasingly recognise the potential of these instruments in promoting sustainability goals, leading to further harmonisation and refinement of regulatory frameworks.
Q: What are the challenges with the use of ESG derivatives today as part of a sustainable investment strategy including optimal risk management?
A: The use of ESG derivatives in sustainable investment strategies, including optimal risk management, faces several significant challenges.
Inconsistent regulation across jurisdictions and lack of standardisation
One of the primary challenges is the lack of uniform regulation across different jurisdictions. The treatment of ESG derivatives is not consistent among the EU, UK, and US. This regulatory fragmentation creates uncertainty for market participants and complicates the development of standardised ESG derivatives products. While the EU has a robust framework with specific regulations like the EU Taxonomy and SFDR, the US relies more on voluntary initiatives, and the UK has its own distinct set of rules. This inconsistency makes it difficult for global investors to navigate the regulatory landscape effectively.
Although regulatory reforms are pushing for greater standardisation and transparency, ESG derivatives still face issues in these areas. The market for these products is relatively new, and there is a lack of standardised metrics and benchmarks for evaluating ESG performance. This makes it challenging to compare products and assess their alignment with sustainability goals accurately. Enhanced transparency is needed to build trust and ensure that ESG claims are credible and verifiable.
Data challenges and performance measurement
High-quality, reliable data is crucial for the effective use of ESG derivatives. However, obtaining accurate and comprehensive ESG data remains a significant challenge. Inconsistent reporting standards and the voluntary nature of some disclosures can result in data gaps and discrepancies. This lack of reliable data hinders effective risk management and the accurate pricing of ESG derivatives.
Measuring the actual impact of ESG derivatives on sustainability objectives is complex. Unlike traditional financial instruments, the success of ESG derivatives depends on achieving specific ESG outcomes, which can be difficult to quantify. Investors need robust methodologies and tools to evaluate the environmental, social, and governance impact of these instruments accurately.
Liquidity constraints and greenwashing
The market for ESG derivatives is still developing, and liquidity can be an issue. Limited market depth can lead to higher transaction costs and increased volatility, making it more challenging to execute large trades or manage positions effectively. As the market matures, increased participation and product innovation will be necessary to improve liquidity.
There is a risk that ESG derivatives could be used to create a false impression of sustainability, known as greenwashing. Without stringent standards and oversight, companies and financial institutions might use these products to appear more environmentally or socially responsible than they are. This undermines the credibility of ESG investing and poses a reputational risk for investors.
Resources required for incorporating ESG derivatives into traditional frameworks
Incorporating ESG derivatives into traditional risk management frameworks requires significant adjustments. Risk managers need to understand how ESG factors influence financial performance and develop new models to integrate these considerations. This can be resource-intensive and requires specialised knowledge and skills.
Addressing these challenges will be crucial for the effective use of ESG derivatives in sustainable investment strategies and achieving optimal risk management. Enhanced regulatory coherence, improved data quality, market development, and robust impact measurement frameworks will be key to overcoming these obstacles.
Q: What role does ESG derivatives play in addressing market failures affecting sustainable finance?
A: ESG derivatives play a crucial role in addressing market failures affecting sustainable finance, an aspect often overlooked by regulators. These instruments primarily facilitate effective risk management, which is essential for integrating sustainability into financial strategies. The introduction of traditional derivatives with specific ESG KPIs, such as credit default swaps (CDS), futures, options, and catastrophe weather derivatives, highlights their core function of risk management in sustainability. However, the poor quality of ESG data and issues of endogeneity (omitted variable bias) must be addressed, particularly for CDSs, to ensure these derivatives can reliably support corporate sustainability aligned with the United Nations Sustainable Development Goals (SDGs).
Home bias
One significant challenge in the use of ESG derivatives is the potential presence of home bias, particularly in options and futures linked to underlying ESG targets. The availability of ESG data varies across jurisdictions, with developed economies having a clear advantage over emerging markets. This discrepancy can exacerbate home bias, further excluding developing markets from participating in ESG futures and options markets. This exclusion deprives these markets of the opportunity to engage in and benefit from sustainable finance practices.
Sustainability-linked derivatives
Sustainability-linked derivatives (SLDs) exemplify the significant potential of financial derivatives in advancing well-defined ESG objectives. These transactions are constructed with specific KPIs integrated into each counterparty’s sustainability strategy, ensuring consistency and systematic progress towards sustainability goals. The International Swaps and Derivatives Association (ISDA) recommendations on key provisions for drafting KPIs help ensure that SLDs achieve desired outcomes. A key characteristic of SLDs is their adaptability, allowing contracts to be tailored to a wide range of ESG-related objectives, thus addressing the market’s need for flexibility and customisability.
Carbon markets
Carbon markets, particularly voluntary carbon markets (VCMs), have seen significant growth but still have untapped potential. To fully realise this potential, the market needs to scale up by increasing demand, enhancing transparency, and streamlining certification processes. Governments, businesses, and civil society must collaborate to create an enabling environment that encourages participation and drives market expansion. VCMs address climate change and contribute to the SDGs by supporting offset projects with co-benefits such as poverty alleviation, biodiversity conservation, and clean energy access. However, challenges related to additionality, standardisation, and double counting must be addressed through collaborative efforts to enhance market transparency and harmonised standards.
The regulation of carbon markets is crucial for driving climate action, fostering sustainable development, and transitioning to a low-carbon economy. Effective market regulations and standardised practices ensure market integrity, facilitate emission reductions, and provide price signals to guide investment decisions. By continually adapting and improving the design of carbon credit derivatives, carbon markets can play a transformative role in mitigating climate change and building a sustainable future.
“In summary, ESG derivatives address market failures in sustainable finance by enhancing risk management, improving price discovery, and facilitating capital allocation towards sustainable projects. They also promote transparency and accountability, encourage financial innovation, and send important market signals that influence corporate behaviour.”
In summary, ESG derivatives address market failures in sustainable finance by enhancing risk management, improving price discovery, and facilitating capital allocation towards sustainable projects. They also promote transparency and accountability, encourage financial innovation, and send important market signals that influence corporate behaviour. Recognising and leveraging the potential of ESG derivatives can significantly advance sustainable finance goals, a critical aspect that regulators in the EU, the UK, and the US should prioritise.
Q: What are the ways in which the industry can better utilise ESG derivatives in the future?
A: The industry can better utilise ESG derivatives through strategic advancements that anticipate significant evolution in these financial instruments. Firstly, improving data quality and transparency is paramount. Standardising ESG reporting frameworks will enhance the reliability and consistency of ESG data, facilitating more accurate pricing of ESG risks and opportunities. Advanced analytics, including artificial intelligence (AI) and blockchain technology, will further bolster data collection, verification, and transparency, crucial for fostering trust and credibility in ESG markets.
Regulatory harmonisation
Regulatory harmonisation stands out as a critical imperative. Streamlining regulatory frameworks across jurisdictions will reduce fragmentation and uncertainty, fostering a cohesive global approach to ESG derivatives. Aligning regulations among the EU, UK, and US can create a more predictable environment for market participants. Governments and regulators can also incentivise the development and adoption of ESG derivatives through mechanisms like tax incentives or grants for green financial products.
Product innovation and market adoption
Ongoing product innovation will drive the future adoption of ESG derivatives. Introducing new types of derivatives tailored to specific sustainability goals—such as biodiversity futures or water rights derivatives—will cater to niche areas within ESG investing. Customising these instruments to align with precise ESG KPIs will enhance their effectiveness in meeting investor and corporate sustainability objectives.
Educational initiatives will be pivotal in broadening market adoption. Educating investors about the benefits and applications of ESG derivatives through targeted programs and awareness campaigns will cultivate a knowledgeable and engaged investor base. Similarly, providing training for corporate treasurers and risk managers on integrating ESG derivatives into overall risk management strategies will facilitate their broader acceptance and utilisation.
Integration with traditional finance will play a transformative role. Blending ESG derivatives with conventional financial instruments to create diversified finance solutions will attract a wider spectrum of investors, including those new to ESG investing. This integration will effectively manage both financial and ESG-related risks, enhancing the attractiveness of ESG derivatives as investment tools.
Collaboration and partnerships across sectors will be instrumental. Promoting collaboration among financial institutions, regulatory bodies, and industry groups will drive the development of best practices and standards for ESG derivatives. Public-private partnerships that support initiatives promoting ESG derivatives in achieving sustainability goals will further enhance their adoption and efficacy.
“The future use of ESG derivatives can be seen through a transformative lens that connects financial innovation with societal impact. These derivatives, often overlooked in traditional financial perspectives, hold the potential to redefine the social licence of finance. By integrating ESG criteria into derivatives markets, there is an opportunity to shift from merely attributing value to capital at risk towards generating social wealth. This evolution suggests that ESG derivatives can be reimagined to harness wealth creation for socially productive purposes, thereby broadening the scope of what constitutes value in financial markets.”
In the book I also bring what I see as a controversial argument. The future use of ESG derivatives can be seen through a transformative lens that connects financial innovation with societal impact. These derivatives, often overlooked in traditional financial perspectives, hold the potential to redefine the social licence of finance. By integrating ESG criteria into derivatives markets, there is an opportunity to shift from merely attributing value to capital at risk towards generating social wealth. This evolution suggests that ESG derivatives can be reimagined to harness wealth creation for socially productive purposes, thereby broadening the scope of what constitutes value in financial markets. Embracing this perspective entails constructing a framework where derivatives not only manage financial risks but also contribute positively to broader social and environmental goals.
Q: How do you see ESG derivatives evolving?
A: Looking forward, ESG derivatives are poised to evolve with increased standardisation and regulatory clarity. As data quality improves and regulatory uncertainties diminish, broader adoption across various sectors will enhance market maturity, leading to greater liquidity and more sophisticated product offerings. Technological advancements, such as blockchain for transparent reporting and AI for enhanced risk assessment, will play pivotal roles in this evolution, boosting efficiency, transparency, and trust in ESG markets.
The focus of ESG derivatives will shift towards achieving tangible sustainability outcomes. Future contracts will be designed not only to manage financial risks but also to drive specific environmental, social, and governance impacts. Emerging markets for ESG derivatives, particularly in carbon trading, biodiversity conservation, and social impact investing, will foster innovative financial products tailored to address specific ESG challenges.
Global collaboration will be essential for addressing cross-border ESG issues effectively. International organisations and coalitions will play pivotal roles in harmonising standards and promoting best practices in the use of ESG derivatives worldwide. This evolution will enhance their effectiveness in achieving sustainability goals and managing ESG-related risks, ultimately contributing to a more sustainable and resilient global economy.
Related Reading:
More on the book – https://www.routledge.com/The-Law-of-ESG-Derivatives-Risk-Uncertainty-and-Sustainable-Finance/AriasBarrera/p/book/9781032429953
Attend the book launch June 24th in London: https://www.qmul.ac.uk/law/events/items/the-law-of-esg-derivatives-risk-uncertainty-and-sustainable-finance.html
