The role of derivatives in sustainable finance

Three recent developments have made it clearer how the derivatives market is likely to contribute to sustainable finance goals moving forward:

1. the publication and coming into effect of the EU Taxonomy Regulation (EU) 2020/852);
2. a study by the European Capital Markets Institute (ECMI), which highlights the links between derivatives and sustainable finance; and
3. the publication by the European Supervisory Authorities (ESAs) of draft regulatory technical standards on ESG disclosures under the sustainability-related disclosures in financial services sector regulation (SFDR) (EU) 2019/2088).

We will discuss each development in more detail below.

Top-down and bottom-up drivers of change

Change in the financial services sector towards sustainable finance is being imposed from both the top down and the bottom up. This is true for derivatives too. At one end, regulator action and legislation are forcing change on the financial sector, for example, environmental, social and governance (ESG) disclosure required under the SFDR from 2021.

At the other end, investors are demanding product development and innovation to meet their ESG agendas. This is not just driven by requirements on firms such as asset managers but is also at the request of end investors who want to factor these goals into their investment strategies.

How is COVID-19 driving change?

COVID-19 may have an impact on bottom-up pressure for more sustainable finance, including derivatives. The COVID-19 pandemic has highlighted existing social issues in our communities, as well as the vulnerability of businesses to world-wide systemic shocks. There are signs that this focus may lead to an increase in investor demand for products that have a strong ESG focus.

COVID-19 has made it more challenging for EU legislators to progress sustainability goals over the past months. However, it has also highlighted the need for top-down factors to drive change in sustainable finance, particularly with respect to the EU’s focus on making sustainable finance mainstream. The Taxonomy (discussed below) has been years in the making and eagerly awaited by the market for some time. Although the European legislation is regionally focused, there is a need for consistency and standards at a global level and the EU is leading in this area. ISDA, as a global industry body, is also focused on this need for consistency and has been actively engaging with various regulators on sustainability issues, including how to build on the Taxonomy.  

Top-down: The EU has an action plan

As part of the top-down approach by regulators, the EU’s 2018 Action Plan on Financing Sustainable Growth aims to:

1. reorient capital flows towards sustainable investment to achieve sustainable and inclusive growth;
2. manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues; and
3. foster transparency and long-termism in financial and economic activity.

The Action Plan forms part of the EU’s framework to meet the United Nation's Sustainable Development Goals and the targets under the Paris Agreement to reduce greenhouse gas emissions. The most important and urgent action envisaged by the Action Plan was to establish a system for classifying sustainable activities, i.e., a taxonomy.  

The Taxonomy will clarify what activities are sustainable

A key issue that has been holding back financial markets from pursuing more sustainable investment is the lack of clarity around the meaning of sustainability. Inconsistent standards fragment the market and allow for greenwashing. Clear definitions are needed to create transparency and to give investors confidence in the quality of the products they are buying. Building this confidence, and demand, will be a key factor in building a liquid and stable market for sustainable investment.

The EU Taxonomy framework, for sustainable finance, set out in the Taxonomy Regulation has been years in the making and is a good first step toward setting definitional standards, although much of the detail will be developed over the years to come. The Taxonomy creates a framework for a classification system that defines 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 latter is still far more common. A derivative can play its traditional role by helping manage risks in a more complex transaction that has a sustainability agenda. These types of transactions allow capital to flow more easily into companies and projects that have clear sustainability goals.

However, we are starting to see derivatives with a more direct sustainability agenda being offered in the marketplace. Although weather derivatives that allow businesses to hedge against the risk of extreme weather have been around for twenty years, this is nonetheless an emerging area. Leading the charge, ING traded an ESG-linked interest rate swap last year, despite the lack of formal definitions around sustainability.  This type of trade is, however, still rare. Once the EU fills in more of the details of the Taxonomy with secondary legislation, it’s likely that the volume of derivatives with a direct sustainability link will increase as products linked to the Taxonomy are created, for example, performance swaps or total return swaps.

But things are not going quite to plan

Despite these steps, the EU is not quite on track to meet its sustainability targets. The gap between their goals and the current public and private investment in sustainable projects is trillions of euros. As a result, the EU adopted the European Green Deal in December 2019 to build on its 2018 Action Plan. The European Green Deal includes a goal to make Europe the first climate-neutral continent by 2050 and the European Commission has proposed the European climate law (EU 2018/1999) to implement this strategy.

The European Green Deal also includes a proposed sustainable finance strategy, which aims to embed sustainability in the EU’s corporate governance requirements. Consultation on the sustainable finance strategy closed mid-July. The strategy aims to reflect the heightened ambition of the Green Deal, i.e., to promote investment in sustainable projects and manage and integrate climate and environmental risks into the financial system. The EU recognises that sustainable finance needs to become mainstream if it has any chance of achieving this strategy. Derivatives have the potential to be a key tool in making these sustainability goals a reality.

Derivatives in Sustainable Finance

A July study published by ECMI on “Derivatives in Sustainable Finance” aims to make the link between derivatives and sustainable finance more evident. The study identifies four ways in which derivatives are well-suited to help the transition to a sustainable economy:

1. 1. 1. Derivatives allow capital to be channelled into sustainable investments.

A key challenge in meeting sustainability goals is the volume of funds that need to be redirected into sustainable projects. The use of derivatives to promote this agenda has been limited to date although derivatives could be used to tap into additional funding sources by modifying the risk profile of an investment. This could allow two parties with different risk tolerances and differing assessments of ESG risks to transact with each other. It would also be possible to structure derivatives to incentivise a customer to invest in sustainable finance, e.g. a customer may be offered better pricing on a derivative if it met certain criteria.

1. 1. 2. Derivatives hedge risks associated with sustainable investments.

Until now, firms have relied much more heavily on insurance than derivatives to manage the risks associated with climate change. However, derivatives take a pre-emptive approach and so could minimise the downside of insurance (including the requirement to show evidence of loss) when managing risks associated with ESG issues. Derivatives can also transform erratic cashflows into more predicable returns and hedge against the likelihood of losses if a significant event occurs.

1. 1. 3. Derivatives enhance transparency.

Derivatives are tightly regulated, particularly since the 2008 global financial crisis. The ECMI study suggests that this regulation makes derivatives safer and more transparent. The introduction of mandatory clearing and reporting, for example, has greatly increased the transparency of the derivatives markets. The vast majority of interest rate swaps and credit default swaps are now cleared.

The derivatives market has also shown its resilience during the COVID-19 pandemic, with financial markets remaining largely stable and banks able to rely on their capital reserves. At its heart, transparency helps investors to assess risk more effectively, which is a key challenge of the climate crisis.

1. 1. 4. Derivatives enable long-termism.

A downside of the regulation coming out of the global finance crisis is that it has encouraged investors to invest primarily in assets of short-term duration. The transition to a more sustainable economy requires fundamental structural, technological and societal change, which requires long-term investment. It is in this space that the traditional role of derivatives is critical. Long-term investments bring risks, which derivatives are uniquely placed to price and manage. For example, changing supply chains is likely to create foreign exchange risk, which can be hedged. It is important that liquid and transparent markets are created for these longer-term investments, so that investors can enter and exit transactions as needed.

Mandatory ESG disclosure is coming

SFDR aims to harmonise ESG disclosure standards across different financial products and financial market participants. Under the SFDR, which applies from 10 March 2021, financial market participants will need to report the extent to which their products are consistent with, and how their activities align with, the Taxonomy for sustainable finance.

The European Supervisory Authorities have launched a consultation on draft regulatory technical standards (RTS) for ESG disclosures under the SFDR. The consultation suggests that firms will need to comply with the proposed disclosure requirements for all investment products, including derivatives, that it markets after the SFDR applies.

The draft RTS include the requirements for:

• an entity to include a statement on its website of its due diligence policy on the adverse impact of investment decisions on sustainability factors, and social and employee matters, respect for human rights, anti-corruption and anti-bribery matters;
• information on an entity’s website to describe the environmental or social characteristics of financial products, including derivatives, or any sustainable investment; the methodologies used; required pre-contractual information and periodic reports;
• pre-contractual information to show how a product, including a derivative, is to meet its sustainable investment objectives or its environmental and social characteristics. If that product has a designated index as a reference benchmark, this information includes how that index is aligned with the sustainable investment objective or social characteristics and why that index differs from a broad market index; and
• information in periodic reports to specify how products meet environmental or social characteristics or the overall sustainability-related impact of a product that has sustainability objectives.

As part of the consultation, the ESAs are considering whether pre-contractual information on ESG characteristics and sustainable investment objective products should be included in a separate section or as part of the general graphical and narrative explanations. ISDA has been seeking feedback on the views of market participants on this point. Either way, this additional disclosure is likely to enhance the transparency of sustainable financing in the market.  

Next steps

Derivatives have a key role to play in the market’s continued, and accelerating, transition to sustainable finance. We can provide practical guidance on market standards for investing in ESG-related products, as well as implementation of the new ESG-related disclosures. Please contact us for more information on how we can help.

Authored by Jennifer O'Connell and Emma Burrell