Podcast: Hedging with a Purpose: An Overview of Derivatives in Sustainable Finance
In this Ropes & Gray podcast, asset management partner Isabel Dische and associate Andy Des Rault discuss the role of derivatives in ESG investing and risk management, and some considerations that asset managers and asset owners will want to keep in mind.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on ESG, impact investing and corporate social responsibility. I’m Isabel Dische, an asset management partner based in our New York office and co-head of our institutional investor practice. Joining me today is Andy Des Rault, an associate in our derivatives & commodities practice based in New York. Today, we’ll be discussing the role of derivatives in ESG investing. Andy, would you like to get us started?
Andrew Des Rault: Sure, Isabel. It’s helpful to think of derivatives as being useful in two ways in ESG investing and sustainable finance. On the one hand, “conventional” derivatives, such as interest rate swaps or credit default swaps, can be used to help market participants in the ESG space hedge various risks and facilitate investment much as they can be used to help any other market participant do the same thing. For instance, a borrower—whether or not pursuing ESG goals—may want to convert its obligation to pay a floating interest rate under a loan to a fixed interest rate using an interest rate swap. Similarly, an investor wishing to “go long” a bond it can’t physically obtain due to liquidity constraints or otherwise can do so by selling a credit default swap as any other fixed income investor might do, whether or not the underlying bond is a green bond.
On the other hand, derivatives can be structured specifically to direct investment towards ESG-related goals or hedge risks that are unique to sustainable enterprises or activities. In a research paper published last month, the International Swaps and Derivatives Association (“ISDA”) describes the range of “ESG derivatives” currently offered in the marketplace and makes a strong case that they will be an essential part of sustainable finance going forward. Not only can derivatives be used to channel capital towards ESG investments, but they are uniquely suited to hedge the risks associated with ESG investments and, to be clear, this is perhaps where derivatives can play the biggest role in ESG investing: Because they provide a way for ESG investors to offlay risks over extended periods of time, they encourage investing over the longer time horizon that is generally needed to achieve ESG goals. In the process, hedging leads to better price discovery and greater liquidity in the market for ESG assets. Isabel, would you like to describe some of these derivatives to our listeners?
Isabel Dische: I’d be happy to. Perhaps the easiest to explain are derivatives whose value is based on the share price of a company pursuing ESG goals. These derivatives could theoretically take many forms and be structured as swaps, forwards, etc., but the ISDA research paper focuses specifically on the rapidly growing number of equity index futures and options that have been launched by global exchanges, including Eurex, the Intercontinental Exchange, the CME and the Chicago Board of Trade, to name a few. These futures and options contracts, like any other based on an equity index, provide a convenient and cash-efficient way to invest in a basket of underlying shares meeting certain criteria without having to purchase each share individually and with the added benefit of leverage. What’s different, of course, is that the equity indices underlying these futures and options are specifically constructed to either exclude issuers that don’t meet certain ESG standards or to include those which do meet certain sustainability criteria.
Pivoting from the world of exchange-traded derivatives, bilaterally negotiated, “over-the counter derivatives” can be tailored to meet the parties’ particular sustainability goals. The ISDA paper provides several examples of such “sustainability-linked derivatives,” which are typically structured such that the party “buying” the derivative will obtain better pricing if it achieves a pre-agreed sustainability goal or target, or instead, if it refrains from a disfavored activity. Under the terms of one interest rate swap summarized in the paper, the fixed rate payer receives a “discount” of 5 to 10 basis points of the fixed rate if the prescribed ESG target is met and would have to pay a penalty of 5 to 10 basis points if the target is not met. It is worth noting that this is an idea we’ve also seen parties incorporate into other types of agreements – such as a credit agreement where the underlying terms depend on whether the borrower achieves certain agreed-upon ESG metrics.
There are many other ways derivatives can be used in ESG investing and risk management. Weather swaps and purchase power agreements are routinely used to smooth the volatility in market prices for renewable energy generated by wind or solar sources. Additionally, the derivatives markets play a critical role in “cap and trade” regulatory schemes, a market-based approach to reducing pollution under which businesses generating higher carbon emissions can purchase carbon allowances or offsets from those generating lower emissions to stay under the applicable emissions cap. But, before we get ahead of ourselves, it is important to mention that there are headwinds in the market that could slow the growth of sustainable finance, and by extension, ESG derivatives.
Andrew Des Rault: That’s right. As ISDA mentions briefly in its paper, one of the key challenges in ESG finance has been the lack of a standardized taxonomy for describing what qualifies as a “sustainable” goal and how progress towards these goals can be measured. At its best, the lack of standardization between ESG investment products and the language used to describe ESG goals can lead to confusion and serve as a damper on market activity. At its worst, however, less scrupulous or well-intentioned issuers or market participants can use vague claims of having achieved “ESG goals” to attract capital or sell a financial product – something known as “greenwashing.”
To some extent, private actors have addressed these concerns by including objective ESG screening criteria in their product offerings or by pushing for the adoption of standard terms. We briefly touched upon this earlier in our discussion of equity indices, but the S&P 500 ESG Index is a perfect example: It starts with the S&P 500 index and screens out any issuers that derive more than a specified percentage of their revenues from producing controversial weapons, tobacco or coal-based power. Additionally, much like it does for other product classes, ISDA has provided standard forms and definitions for those wishing to trade emissions derivatives in the U.S. and in Europe.
But, as we’ve learned, private actors can only do so much when a market-wide response is needed to promote the growth and integrity of a particular financial market. This is when regulators typically step in. The EU has already issued rules governing ESG disclosures and setting forth an approved taxonomy for ESG investments, which are set to come into effect over the next couple of years. In the U.S., some have predicted that that the Securities and Exchange Commission under the Biden-Harris administration will make a push for a more robust ESG disclosure regime. This would undoubtedly impact the market for derivatives referencing issuers or instruments subject to the new disclosure regime or traded by market participants subject to it. But “how” exactly it will impact the derivative market remains to be seen, and is something our clients pursuing ESG investment strategies should actively be monitoring.
Isabel Dische: Thank you, Andy. As we’ve seen, derivatives can play a central role in ESG investing and risk management. That said, we’ll have to keep a close eye on how this space develops over time and especially on regulatory developments. We’d also like to thank our listeners for joining us today. For more information on ESG derivatives, and other topics of interest to the ESG and impact investing community, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please do not hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.