The number ESG-linked derivatives on offer are growing in Europe. Despite sparse liquidity, the future outlook looks promising. Lynn Strongin Dodds explores.
Despite the reams of regulation emanating from Europe on sustainability, derivatives are not yet in the main frame, but they are certainly on the fringes. This is not stopping exchanges and index providers from exploring or developing new, innovative products for hedging and exposure. Liquidity may be sparse today but in time the outlook is for healthy activity.
Regulation – ESG-linked derivatives minor role for now
Currently, the Environmental, Social and Governance (ESG) spotlight is turned onto equities and fixed income in the form of sustainable bonds. Both have pulled in record amounts although equities have dominated with GBP33.5billion of inflows last year, according to research from Refinitiv Lipper in their Everything Green Flows 2021 report. Bonds are making their mark with assets more than doubling from GBP3.2 billion between January and September to GBP6.8billionn by year end.
This may explain why ESG was not in the newly revised European Market Infrastructure Review (EMIR), or explicitly in European Union Sustainable Finance Disclosure Regulation (SFDR), which came into effect last year. However, a closer look at SFDR reveals that counterparties who use derivatives as part of their wider investment strategy will now be required to disclose their use of the instruments and explain how they have helped in achieving their objectives, whether it be to hedge their positions and gain exposures.
Market participation believes derivatives will fall under the regulators’ remit, but it will not happen overnight. Stevi Iosif, senior advisor for Public Policy, International Swaps and Derivatives Association (ISDA) thinks derivatives can play an important role in supporting price discovery, transparency and effectiveness of the ESG market. “There might be a re-assessment in terms of EU regulation but at the moment, the ESG regulatory framework of derivatives will be in flux for several years,” she says. “Derivatives can facilitate the raising and allocation of green capital towards sustainable investments at scale, as well as helping firms to hedge risks related to ESG factors. They can also enable longer-term ESG investments via the efficient hedging of investment risks.”
ISDA has lent a guiding hand to its members and wider community by publishing key performance indicators (KPIs) for sustainability-linked derivatives which have been gaining traction. They serve as hedges for ESG transactions by linking cashflows on a conventional hedging instrument, such as interest rate swaps, cross-currency swaps or forwards. These transactions are bespoke and use various KPIs to determine sustainability goals.
The race is on, and the climate front is centre stage
The other products that are gaining traction are the equity index futures and options tied to one of the ESG benchmarks, particularly on the climate front. In the past two years, EU Benchmark regulation reform has seen the introduction of an EU Climate Transition Index whereby assets are selected, weighted or excluded in accordance with the objective of carbon neutrality and an EU Paris-Aligned Benchmark. This is aligned with the Paris Agreement goal of limiting temperature increases to below 2°C. and their minimum requirements to facilitate the move to a low carbon economy.
“We are definitely seeing an increase in demand for listed derivatives, and we expect that to accelerate,” says George Harrington, global head of listed derivatives, OTC and structured Products at MSCI. “One reason is the switch from market cap to climate change benchmarks and the need to reflect these new investment objectives. This is fairly common with new benchmarks and products. Investors will leg in with a future to build an exposure as they adjust their equity portfolios.”
ESG-linked derivatives with various uses
Caterina Caramaschi, global head of Equity Derivatives at the Intercontinental Exchange (ICE) stated that, to date, customers are using ESG futures for a variety of use cases including to hedge, implement investors’ ESG investment strategies and mandates, cash equitization and portfolio overlays.
Jan Thorwirth, head of Asia Derivatives and Partnerships, FTSE Russell, adds, “These derivatives contracts allow investors to further adapt their investment and trading strategies to fulfil ESG mandates and optimally manage the risk of ESG-driven portfolios. In addition, margin offsets against traditional index derivatives allow for capital efficiencies across the portfolios.” In Asia, FTSE Russell offers ESG contracts listed on SGX (Blossom Japan Index, FTSE Asia ex-Japan Index, FTSE Emerging Asia ESG Index, FTSE Emerging ESG Index) as well as TAIFEX (FTSE4Good TIP Taiwan ESG Index). Not surprisingly, global exchanges, including Eurex, ICE, CME Group, Nasdaq, Chicago Board Options Exchange (CBOE), Euronext and Japan Exchange Group, have launched a series of new contracts, according to a report last year from ISDA. This is year is also expected to be a hive of activity especially with a broader reach to the S and G components of ESG.
Eurex is a good example of how the market is developing. Last year, it reported ESG segment futures & options traded volume of over €49.7 million.
Zubin Ramdarshan, head of Equity & Index Product Design for Eurex, explains that so far there have been three phases to their development. The first focused on negative screening or norms-based screening which were typical exclusions based on controversial weapons, tobacco, and the UN Global Compact principles. This led to its most successful product to date, the STOXX Europe 600 ESG-X Futures.
He said 2021 saw the launch of five new futures contracts that track companies in the MSCI ESG Enhanced Focus Indexes which are weighted by companies that can help drive a 30% reduction in exposure to carbon dioxide and other greenhouse gases. “This year, the aim is to look at (Socially Responsible Investing (SRI) as well as climate transition benchmarks, Paris-aligned benchmarks. However, these are more complex and will require more data inputs.”
Climate has also been firmly on ICE’s agenda and in November last year it announced plans to debut four new index futures contracts based on the MSCI Climate PAI, which were launched in February this year. The indices covered were the MSCI World Climate Paris Aligned Index, MSCI USA Climate Paris Aligned Index, MSCI Europe Climate Paris Aligned Index and MSCI Emerging Market Climate Paris Aligned Index.
“The main reason for listing the MSCI Climate PAI futures contracts is client demand,” says Caramaschi. “Our customers want a product that will enable them to hedge their climate related risks as well as be able to synthetically align their portfolio with the Paris agreement requirements. The feedback we have received has been very positive.”
As for Euronext, its Eurozone ESG Large 80 future came onto the scene in June 2020 and tracks the index of the same name. Designed with Vigeo Eiris Moody’s, the benchmark follows the eurozone’s 80 best-performing large cap companies that are strong on social and governance criteria and leading the transition to a low carbon economy. It excludes companies facing critical controversies with regards to the United National Global Compact or those involved in sectors such as coal, tobacco or weapons.
“We believe that we have established a futures contract with the most competitive pricing,” says Charlotte Alliot, head of institutional derivatives at Euronext. “The index and future were based on client demand for a product in the eurozone and we wanted to have a truly ESG focus that looked at energy transition but also the social and governance components. We plan to launch other products this year.”
Benefits clear but there are also challenges
While the benefits are clearly outlined, there are of course challenges and market participants will have to be patient. Like any new investment strategy or product, ironing out the kinks will take time. One of the big questions being asked is whether the trade-off between the liquid contracts and highly tailored versions can drive capital towards sustainability.
“It is early days for listed ESG and climate index derivatives and the liquidity are not yet the same, for example, as in the more established MSCI Index Futures, like our MSCI Emerging Market Future and our MSCI EAFE Future,” says Caramaschi. “However, there is a huge potential for these products because of increasing regulation and changing investor behaviour. Investors are much more aware of climate as well as social and governance risks in their portfolios.”
Euronext’s Alliot agrees, adding that indices will be part of the transition to a low carbon environment and reallocation of capital to sustainable investment. She believes that greater transparency and regulatory convergence will be important drivers. “ESG derivatives are still very new, and development will be progressive but there is no way going back,” she adds.
Standardisation will also be a key determinant. As FTSE Russell’s Thorwith notes, “We see this trend growing and moving into further SI areas such as climate and carbon related derivatives as well as ESG fixed income instruments. However, to further drive the ESG agenda, regulators, governments and organisations need to work together to frame standardised criteria which will allow the segment to further gain traction and grow over time.”
©Markets Media Europe 2022
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