[Snigdha is a student at NALSAR University of Law.]
Derivatives are financial contracts that derive their value from the performance of an underlying asset, such as equities, currencies, or commodities, and are primarily used for hedging risks. Environmental, social and governance (ESG) criteria focus on sustainable and socially responsible investing, assessing companies' performance based on these parameters. ESG derivatives combine these concepts to support sustainability while managing financial risks incentivizing funding into energy transition which is currently is estimated to require around USD 110 trillion is needed to achieve net-zero emissions by 2050. Hence, it is pertinent to understand innovative ways to fund and incentivize funding to the requirements of energy transition.
Basics on Derivatives
One common feature of both capital markets and commodity markets is risk. Derivatives are financial contracts which derive their value off a spot price of an underlying asset, which can be anything ranging from equities, currency, credit, interest rates, carbon, weather or any other commodity.
Derivatives developed as contractual mechanisms to manage financial risks. Risk is transferred to the party that can best handle such risk. Other features of a derivatives contract include not just hedging risks but also speculation, yield enhancement, to avail arbitrage opportunities, etc.
What is ESG?
The answer to what ESG is precedes the concept of ESG derivatives that can promote ESG objectives.
ESG, rooted in sustainability and socially responsible investing, initially focused on excluding companies with environmental, social, or governance concerns. However, it has evolved to emphasize companies making positive ESG contributions, integrating environmental and social issues into strategic positioning. Amid the climate crisis and social justice movements, ESG reporting criteria have gained significant importance for businesses worldwide across sectors and regions. ESG key performance indicators (KPIs) are crucial performance metrics that evaluate a company's environmental, social, and governance practices while promoting transparency, responsible stakeholder consideration, and long-term risk assessment.
Sustainability and Derivatives
Studies have shown that climate change creates physical and transition risks to the financial markets. Physical risks stem from various weather and climate-related factors or hazards such as flash floods or severe droughts, necessitating urgent emissions reduction measures to mitigate severe outcomes in the long-run. Physical risks not only depend on the hazards themselves but also on entities' exposure to such hazards, vulnerability, and risk mitigation measures against such hazards, including insurance coverage. For example, banks may experience increased credit and market risks, while insurers face challenges in assessing and pricing natural catastrophe risks.
Coming to transition risks, they refer to the financial risks associated with the transition towards a low-carbon economy, primarily driven by climate change mitigation efforts through public and private initiatives and technological advancements. For example, in the banking sector, transition risk arises from exposure to firms undergoing significant changes in their business models or operations to adapt to climate-related policies and regulations. This exposure can lead to credit and market risks, impacting banks' solvency, liquidity, and financial stability. Both physical and transition risk do not create any kind of new forms of risk. However, they might exacerbate market risk, credit risk, liquidity risks and operational risks for financial markets and its participants.
EGS derivatives encompass plain vanilla derivatives, like interest rate swaps, ensuring stable financing for sustainable projects, and green derivatives tailored to environmental goals. Together, they promote sustainable hedging encouraging investment in eco-friendly projects and fostering a low-carbon economy.
ESG Derivatives and Its Types
ESG derivatives play a dual role in managing risks related to sustainable investments. Firstly, they act as shields against market uncertainties, reducing the costs for investors or borrowers involved. Secondly, this encourages more sustainable investments by making investments financially more attractive. ESG derivatives, specifically, offer a win-win situation for both the lender and the borrower.
Let us take a hypothetical example. Consider a renewable energy company planning to build a wind farm. To secure financing for the project, the company enters into an interest rate swap derivative contract with a bank. Here, the company agrees to pay a fixed interest rate to the bank in exchange for a floating interest rate linked to a benchmark. By doing so, the company can effectively hedge against the risk of rising interest rates, ensuring predictable financing costs throughout the construction and operation of the wind farm, a long term project. This allows the company to attract investors and lenders more easily, thereby facilitating capital flow.
The bank gains from the interest rate swap by earning a steady fixed income despite market rate fluctuations. This boosts profitability and aligns with environmental goals, attracting eco-conscious investors and broadening the bank's clientele.
ESG derivatives go beyond merely promoting sustainability by directing capital to environmental investments; these instruments also mitigate ESG-related risks, improve market transparency and efficiency, and cultivate a long-term outlook among market participants.
Various types of ESG derivatives, spanning 6 broad categories, have emerged as innovative solutions.
Sustainability linked derivatives
Sustainability-linked derivatives (SLDs) are innovative financial instruments that incorporate sustainability objectives into derivative transactions. They are generally bilateral and bespoke contracts conducted over the counter. SLDs, unlike sustainability-linked loans or bonds, are derivative transactions without inherent funding. However, they hold the potential to incentivize funding in certain sectors where SLDs are prevalent and aid risk mitigation in high-risk projects in energy sector.
The ESG overlay can be done in various ways and is very adaptable to the needs of the derivative transaction which makes it more lucrative. SLDs utilize KPIs as benchmarks to monitor compliance with ESG targets. SLDs can take various forms, such as plain vanilla derivative transactions like interest rate swaps or cross-currency swaps, with an added ESG pricing component linked to specific KPIs. They incentivize ESG performance and support sustainable projects by adding an ESG pricing component to conventional hedging instruments.
Failure to meet KPI targets results in consequences like payment adjustments, donations to charitable organizations or other causes that lead to ESG compliance. Hence, it is significantly important to have clear and objectively verifiable KPIs.
For example, we look at Siemens Gamesa, a company that provides wind power solutions, worked with HSBC to set up an interest rate swap (IRS) in March 2020. This swap converted a portion of a loan Siemens Gamesa had taken out in December 2019 from a floating interest rate to a fixed interest rate. The unique aspect of this IRS is that the fixed interest rate will not change based on Siemens Gamesa's ESG rating.
However, if Siemens Gamesa's ESG rating improves during the life of the swap, HSBC will donate money annually to non-profit organization projects. On the other hand, if Siemens Gamesa's ESG rating declines, they will make the donations instead. This incentive structure encourages Siemens Gamesa to focus on improving its ESG performance, This is how individual client financial relationship can be leveraged to encourages sustainability goals using SLDs.
ESG related credit default swaps
Firstly, we will look into what a credit default swap (CDS) is. A CDS is a derivative contract that shifts the risk of default by a specific borrower, from the buyer of the CDS to the seller of the CDS. In this arrangement, the buyer makes regular payments to the seller and, in exchange, receives compensation if the reference entity defaults on its debt obligations, known as a credit event. Such financial products are very similar to insurance, but they do not have the requirement of insurable interest in the credit quality of the underlying asset to hedge or speculate.
Now, coming to ESG related CDS contracts are used to manage credit risk for counterparties whose financial performance may be influenced by climate change or shifts in consumer preferences towards sustainable alternatives. These instruments are increasingly sought after due to the belief that companies with strong ESG ratings pose lower credit risks. By screening companies based on ESG factors, many indicies provides a macro instrument for exposure to hedging of ESG business risk in Europe. For example, the iTraxx MSCI ESG Screened Europe Index is a broad European corporate CDS index created using ESG criteria.
ESG related exchange traded derivatives
ESG related exchange traded derivatives play a crucial role in promoting ESG investment by expanding the range of ESG-related investment options and offering insights into market demand and transparency. These derivatives are linked to specific ESG indices, providing exposure for investors looking to hedge, invest, or fulfil ESG investment mandates. ESG indices track the performance of listed companies based on their ESG practices, with over a thousand such indices currently available, including in India. These derivatives enable fund managers to manage cash flows and allocations more effectively compared to direct investments in underlying stocks.
Derivatives in carbon market (emission allowances)
Carbon markets, both mandatory and voluntary, aim to regulate and reduce carbon dioxide (CO2) emissions. Derivatives based on emissions allowances are traded on major exchanges, as well as in OTC markets, both having advantages in their own realms. These derivatives do not directly decrease emissions but play a crucial role in hedging price risks in the underlying carbon market and providing vital price signals for emissions-related programs. For instance, CME offers futures and options on CO2 allowances.
These derivatives assist companies subject to carbon cap-and-trade programs in meeting their obligations and managing risks effectively. Additionally, they contribute to the development of nascent voluntary carbon markets by offering standardized contracts on CO2 emissions allowances and offsets. Major exchanges like ICE, EEX, Nodal Exchange, Nasdaq, and CME offer a variety of futures and options contracts on emissions allowances from different regions, enhancing liquidity and price transparency. Such derivatives can motivate ESG-driven firms to join voluntary carbon markets, while helping mandatory participants hedge and manage risk effectively.
Renewable energy and renewable fuels
These derivative contracts include renewable energy certificates futures, wind index futures, renewable identification numbers futures, and low carbon fuel standard futures, offer tools for hedging price risks in renewable energy production and compliance with regulatory standards. They facilitate investment in renewable energy projects and support the transition to cleaner energy sources.
Weather derivatives
Weather derivatives are financial tools that allow individuals and businesses to protect themselves from financial losses caused by unpredictable weather conditions. These derivatives work by basing their value on specific weather-related variables, such as temperature or rainfall, and pay out based on whether certain weather conditions occur. For example, a farmer might purchase a weather derivative that pays out if temperatures drop below a certain level during the growing season, helping them mitigate the risk of crop damage due to frost. These derivatives can be traded on exchanges or customized through over-the-counter transactions to meet the specific needs of different users.
Conclusion
ESG derivatives serve dual purposes: they mitigate risks associated with sustainable investments and encourage eco-friendly projects by making them financially attractive. By incorporating sustainability objectives into financial instruments, these derivatives promote transparency, efficiency and a long-term outlook in the market, driving the transition towards a low-carbon economy. Additionally, considering the importance of risk management in today’s time, capitalizing on such innovative market instruments becomes necessary.
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