ESG derivatives once seemed like the next big thing in sustainable finance. Two years on, momentum has slowed in this renowned and innovative sector of investment banking, leaving a question mark as to whether these markets are simply suffering from growing pains or are facing bigger problems. fundamentals that hinder widespread adoption.
Firms announced a flurry of sustainability-related derivatives transactions in 2019 and 2020, resulting in cost savings on interest rate and currency hedging provided they met certain ESG targets. Bankers say there has been a slow but steady trickle of such deals since then, while acknowledging they remain a niche product that is time-consuming and complex to set up.
For this to change, experts agree on the need for greater standardization of corporate sustainability goals and the creation of sufficiently robust key performance indicators across different sectors – an issue that continues to hamper the development of ESG financial products more broadly. But despite the slow progress of recent times, many still expect sustainable derivatives to grow to complement the expected increase in sustainability-related finance in the coming years.
“Derivatives can be an important part of the financing solutions toolkit when they all point in the same direction, complementing what is being done in the area of sustainable bonds and loans,” said Constance Chalchat, Director Sustainability for Global Markets at BNP Paribas.
“It’s a nascent product and there’s a lot of heavy work involved; there is a lot of structure. It took three to four years for the industry to industrialize sustainability-related loans and bonds. What’s great is that we’re learning from these experiences as we seek to industrialize the market and connect it to a broader sustainable finance framework,” she said.
Sustainable finance has grown rapidly in recent years as investors and companies seek to reshape their businesses in more ESG-friendly ways. Assets in global sustainable funds nearly quadrupled from mid-2019 to $2.9 trillion at the end of last year, according to Morningstar, before declining slightly in the first quarter of this year.
ESG derivatives have also grown and now cover a range of asset classes that have been more or less successful. Products providing exposure to ESG-friendly stocks have grown in popularity, with the Stoxx Europe 600 ESG-X index futures market now representing around one-fifth the size of index futures. usual European benchmark, according to data from Refinitiv, although the outstanding amount of these contracts have fallen by 46% since their peak in November.
In credit markets, there have been just a handful of trades on IHS Markit’s flagship ESG credit default swap index since its launch in 2020, according to data from Depository Trust and Clearing Corporation.
Sustainability-linked interest rate and currency hedges are more bespoke contracts that seek to replicate the success of ESG bond and loan markets, where it is becoming increasingly common for companies to link their costs borrowing to ESG objectives. Standard Chartered expects green, social, sustainable and sustainability-linked bond issuance to reach $1.7 billion this year, representing 18% of total debt sales compared to 11% in 2021 – and that share is expected to reach one-third by 2025.
ING negotiated the first known sustainability-linked swap in 2019 when it structured a deal for Dutch company SBM Offshore that allowed it to hedge interest rate risk on a revolving credit facility. Although subsequent transaction designs have differed, these structures tend to save a company money on the cost of interest rate or currency hedging provided it meets certain defined sustainability targets. in the key performance indicators, or that it pays a penalty if it misses these objectives. Many of these transactions have accompanied sustainable bond or loan financings, although some hedging programs, particularly in foreign exchange markets, have stood alone.
“When it comes to KPIs, companies tend to align their funding with their coverage. If we see the funding part of the spectrum increase, that could impact derivatives,” said Neven Graillat, Global Division Head. by JP Morgan. market sustainability center.
“On the derivatives side, what the market wants is standardization around material KPIs, audited and with ambitious objectives. We spend a lot of time working on this.”
Slow but steady
Geraud Redor, head of EMEA private-side structuring for global markets at BNP Paribas, said the market for sustainability-related derivatives has expanded beyond Europe to include Asia, the United States and Latin America. He also pointed to smaller companies considering ESG derivatives, as well as developing a wider range of asset classes and products such as options. “The market is much larger than it was a few years ago,” he said. “It’s still a niche product – the market doesn’t double in size every year, but we see it growing steadily.”
Jonathan Gilmour, head of derivatives and structured products at law firm Travers Smith, pointed to three areas that are holding back growth. Without standardization, it is very difficult for banks to clear their transactions with other participants in a liquid market. Some banks, meanwhile, are waiting to see whether regulators will relax capital rules for sustainability-related instruments.
There are also “concerns about whether sustainability KPIs are robust enough to guard against accusations of greenwashing,” he said.
These concerns have created an inherent tension in ESG finance more broadly that has hampered the development of these markets since their inception: how to establish standards that can be applied industry-wide, while ensuring that individual companies commit to achieving sufficiently stringent targets in exchange for better funding conditions. Sustainability-related derivatives are no different: a cut-and-paste approach to designing transactions simply doesn’t work for most companies.
“There is no market standard right now,” said Vanessa Battaglia, senior counsel at Travers Smith. “The KPIs we’ve seen for these products are very personalized. They can vary depending on a number of factors, including specific counterparty requirements and objectives, as well as the industries and jurisdictions in which they operate. This means that it is difficult to achieve standardization of KPIs in the field of derivatives.”
Development of standards
This has made creating these trades extremely labor intensive for all parties involved, especially for companies that have to develop KPIs from scratch. These can vary greatly depending on the type of business and the markets in which it operates, not to mention how far it has already progressed in its transition to a more sustainable footing.
“It’s a structured product with only flow income,” said a senior trader at an ESG-conscious investment bank. “I think it’s worth it for the brand image and to move the industry forward, but there’s a lot of work to be done.”
Some are simply skeptical of the whole company. “It seems to be a bit of a flag exercise rather than something systemic,” said a senior executive at an international bank.
Proponents of ESG derivatives remain unfazed, while mindful of the challenges ahead. The International Swaps and Derivatives Association is working to develop best practices for trading sustainability-related derivatives and is examining how KPI frameworks used in the bond and loan markets can be included in such contracts. The ISDA has also launched a survey to determine if there is enough appetite to consider standardizing certain contract terms.
At the corporate level, it will inevitably take time for individual companies to develop appropriate targets for their financing or hedging operations. Associated British Ports completed its first sustainability-related derivative last year in what group treasurer Shaun Kennedy described as something of a “trial”.
The company is currently working a lot on its sustainable development strategy. Once completed, ABP will consider how it can incorporate this into its funding plans. “It makes sense for us to align all aspects of our funding with our Sustainable Development Goals,” Kennedy said.
Kristell Herbault, sustainable finance specialist at Societe Generale, noted that the market for sustainability-related derivatives is still very new. “One of the toughest obstacles to market growth is the difficulty for clients to build credible sustainability strategies: set relevant KPIs and ambitious goals,” she said.