ESG derivatives: Weapons of green distraction?
Derivatives could turbocharge environmental, social and governance markets, with a related boost to bank revenues. However, they could also make it harder to monitor exposure.
Warren Buffett famously described derivatives as “financial weapons of mass destruction” in 2003. This did not mean that the legendary investor was swearing off the use of swaps and options. He actually made his biggest personal derivatives trades in the years after this quip, including a multi-billion dollar bet on the long-term price of equity indices that was placed via put option sales.
Buffett was instead concerned that derivatives could be deployed to mask exposure, adding in 2007 that: “More and more imaginative ways of using them are introducing more and more leverage.”
Derivatives are now being used to speed the development of the environmental, social and governance (ESG) markets – also in increasingly imaginative ways. New uses of derivatives are helping to tailor ESG exposure and hedges, in order to broaden green and socially responsible trades from equity investments to the entire fixed income product suite.
One potential effect of this trend could be to accelerate a pace of growth in ESG-branded financial products that is already worrying regulators. On September 20 two economists from the Bank for International Settlements drew an explicit parallel between the current growth in ESG products and the increase in private mortgage-backed securities in the approach to the global financial crisis of 2008.
As a company and a bank you need a transition plan, but you have to get out of fossil fuels – that’s the most important thing
Derivatives did not cause the growth in mortgage exposure that was the single biggest cause of the 2008 financial crisis, but they both exacerbated the risk and made it harder to monitor.
So could ESG derivatives play a distorting role in a coming green valuation bubble or enable cynical actors to engage in greenwashing?
“I struggle with derivatives because it is difficult enough to know what a physical asset means in terms of being green or not green. When you get into derivatives it’s even more difficult,” says Wolfgang Kuhn, a former head of pan-European fixed income at Aberdeen Asset Management who has in recent years worked with responsible investment group ShareAction.
Evangelists for ESG derivatives believe that new instruments can instead bring greater clarity to the sector and insist that they will not enable companies and investors to exaggerate their progress towards responsible goals.
The clients we engage with have a holistic approach
“This market will not survive if there is greenwashing going on,” said Scott O’Malia, chief executive of the International Swaps and Derivatives Association (Isda), soon after the September launch by the trade group of guidelines for the use of key performance indicators (KPIs) in sustainability-linked derivatives.
Bankers who are already active in structuring ESG derivatives hope that the guidelines will help to bring rigour and accountability to the market.
“Having the Isda sustainability-linked derivatives guidelines is very helpful,” says Isabelle Millat, head of sustainability for global markets at Societe Generale. “It is going to create a first set of quality standards, then case by case – with energy majors for example – we are going to need to make sure KPIs are really meaningful and ambitious and externally verified standards for the transition. That’s where everyone – corporations, the financial industry, regulators and also civil society – have a role to play to be a spur to set ambitious goals.”
Broadening the tools
ESG derivatives were initially used mainly to create equity structured products, but in the last two years they have moved into the fixed income space with corporate hedging trades.
In August 2019, ING structured the first sustainability improvement derivative to hedge the interest rate risk of a $1 billion five-year floating rate revolving credit facility for Dutch offshore energy firm SBM.
There are opportunities to overlay ESG in what should be almost all fixed income products
If SBM meets its target ESG score, as assessed by Sustainalytics, a discount of five to 10 basis points is applied to the annual fixed rate it pays on the swap, while a penalty of the same size is levied for each year it misses the ESG target.
ESG interest rate derivatives to hedge loan exposure have since been structured by banks including Credit Agricole, DBS, HSBC and Natixis, while ESG FX derivatives have been done by firms such as BNP Paribas, Deutsche Bank, JPMorgan and Societe Generale.
Broadening the tools that are available for ESG purposes is an important step for corporates, according to bankers.
“The clients we engage with have a holistic approach and this is a way for them to reinforce sustainability commitments and increase their sustainable debt exposure without issuing more debt, and to do it synthetically via derivatives – it is a way to show that they are aligning their sustainability targets across all their financial instruments,” says Delphine Queniart, head of sustainable finance and solutions for global markets at BNP Paribas.
The expansion of ESG solutions into fixed income is also important for banks that want to play to their strengths, such as Deutsche Bank, which pulled out of equity sales and trading in 2019.
“One of the first things we looked at was what is happening in the ESG bond and loan markets, then how can we apply that across the entire fixed income product suite,” says Claire Coustar, global head of ESG for the fixed income and currencies business at Deutsche Bank. “We have a significant presence in FX so we looked at how we could engage clients there with ESG ambitions, including companies without the ability or need to fund themselves.”
The most important thing for a company to avoid greenwashing is to start with a plan
Deutsche Bank recently structured what it billed as the first green repo financing in Europe (BNP Paribas had done a similar trade in Asia), in a deal that involves transferring securities to M&G Investments and receiving cash to fund Deutsche’s green asset pool, including renewable energy projects.
“If I look at the repo space I can certainly see this growing,” says Coustar. “There are opportunities to overlay ESG in what should be almost all fixed income products.”
There are still gaps, however.
“The main area where the market is nascent and should get bigger is on the fixed income investing side – in fixed income indices,” says Patrick Kondarjian, global co-head of ESG sales for markets and securities services at HSBC.
As demand for ESG products and solutions increases, the European banks that pioneered the market are inevitably facing their own greatest threat to sustainable growth – competition from bigger US firms.
US market share
US banks – like other American companies – were slow to embrace ESG principles, but they are now rushing to adapt to sustainable finance goals and the related revenue opportunities. JPMorgan is already the leading investment bank in Europe by revenue and the top global dealer in derivatives, so it is logical to assume that its current ESG marketing push will eventually deliver substantial market share.
JPMorgan will face some hurdles, however, chiefly in squaring its sustainable finance ambitions with the fact that it remains the biggest provider of finance to the fossil fuel industry.
My number one wish is to have comprehensive standardized reporting by companies
“I wouldn’t say it means they can’t do anything, but it rings a little bit hollow,” says Kuhn, referring to the current ESG push by JPMorgan and other big US banks. “As a company and a bank you need a transition plan, but you have to get out of fossil fuels. That’s the most important thing.”
Some European bankers try to appear unruffled by the ESG derivatives threat from the US banks that dominate other markets. “Competition is good as it is a factor for emulation and promoting transparency and visibility,” says Ghyslain Ladret, head of corporate and capital management structuring at Crédit Agricole CIB.
Others seem to hope that clients will take the ESG scorecards for their dealers seriously enough for this to become an issue for any banks that are perceived to be lagging in their own efforts to reduce funding of harmful projects.
“We see more engagement from our clients at the time of broker reviews on the investor side – or the corporate side – trying to understand what exactly is our involvement,” says Queniart.
However, there are already signs that US banks are muscling their way into ESG markets that had been largely the preserve of European firms. In October 2020, Italian energy company Enel issued £500 million of sustainability-linked bonds with an accompanying sustainability-linked cross-currency swap with JPMorgan.
And when Enel this July issued a record $4 billion sustainability-linked bond, it appointed four banks to handle the related cross-currency swap to euros, including JPMorgan along with European firms such as Societe Generale.
This derivative contract featured a commitment by the bank counterparties to meet their own sustainability performance targets, with a discount or penalty in the cost of the transaction based on achieving the goals.
Call to arms
Constance Chalchat, head of change management for BNP Paribas corporate and investment banking, believes that companies need to take a fundamental approach to ESG goals that they can apply to all forms of financing.
“The most important thing for a company to avoid greenwashing is to start with a plan, ideally with real materiality, a positive impact and sufficient level of ambition, then to enable it with sustainable financing,” she says.
The move towards what is in effect syndication of debt-related ESG derivatives trades indicates that borrowers are taking steps to ensure that as many banks as possible will be able to quote on deals.
“We understand that clients may want to have a framework that works with most of their banks and we work alongside them in that effort,” says Credit Agricole’s Ghyslain Ladret, although he believes that there is still plenty of scope for new structuring ideas to be developed before product standardization gives an advantage to the banks with the greatest scale.
“We are not at the point where all ideas and concepts have been tested. There is still a lot of room for innovation in this field,” says Ladret.
Some standardization is nevertheless inevitable for derivatives linked to an ESG market that is taking a growing share of most forms of financing. Green bonds already account for around a quarter of the European debt issued this year, for example, and estimates of the ultimate share of products with an ESG angle range from a third to more than half for some investment types.
Standardization and the involvement of new entrants chasing market share creates the obvious risk that some banks will offer clients structures that are not ambitious in their ESG targets.
Bankers who are already active in the market maintain that ESG derivatives will not suffer erosion in standards comparable to the undercutting on prices or collateral demands that is often seen in established markets.
“It is inevitable when you have new markets and new products that you have the potential for different levels of standards – for private markets even more so – but we are not just working on trades, we are working on industry standards,” says BNP Paribas's Delphine Queniart. “We are not trying to mass produce something without looking at what we are doing – we really want to do things properly.”
Isabelle Millat at Societe Generale argues that any loosening of standards by banks looking to win market share would be unwise.
“That would be a short-term view. I think I welcome the heightened scrutiny of these deals – you might get away with it once, but there would be a backlash and people wouldn’t work with you anymore,” she says.
“That would be detrimental to the industry and for the credibility of these products,” adds HSBC’s Patrick Kondarjian.
One way to maintain standards and prevent trades that flirt with greenwashing would be to have consistency in the KPIs that are used to monitor progress for ESG derivatives. There are some steps towards KPI consistency within sectors, but there are also formidable barriers to the easy comparison of deals.
“You have more commonality across a sector – the first element where you can standardize is sectoral – but KPIs themselves can change depending on how long you have been making the transition; and that’s where it can become quite bespoke in terms of transactions,” says Kondarjian.
Societe Generale’s Millat adds that improved corporate ESG reporting standards would be an important advance.
“What will help on all fronts – hedging, financing and investing – is standards set for corporate reporting. All of what we do depends on consistent, reliable data put out by corporations. My number one wish is to have comprehensive standardized reporting by companies,” she says.
Banks can help in the push to improve ESG data quality.
“I consider us an activist in ESG data because we are working with others to make ESG data standardized, easily accessible and comparable, for example through OS-Climate,” says Chalchat, referring to an open-source ESG initiative that also features Goldman Sachs and the Linux Foundation in offering a software platform designed to boost global capital flows into climate change mitigation and resilience.
Banks can also expect to be called to arms for a role in activism designed to force change on companies, however. Kuhn thinks that the fixed income markets are well suited to an activist approach that presses corporations to move faster towards their ESG goals.
“There is no question that bondholders and banks hold power,” he says, adding that bond-based activism is the best route to exercising that power. “You need to sell the bonds, you need to engage with the company and you also want to make sure the spread goes out” to have an impact, he says.
Kuhn believes that some of the structures that are currently popular in the ESG bond and derivatives markets instead effectively endorse a gradualist approach to change.
“It is not that anyone is trying to deceive, instead it’s a question of ambition and unfortunately in most of these things the ambition is not good enough,” he says.
“When it comes to embellishing hedging with options like a step-up or step-down, I’m sceptical. It is not wrong in principle, the problem is what is the scale of this and what does it actually do to motivate the company?” Kuhn asks.
The development of ESG credit derivatives could in theory add to the toolbox of future activist campaigners, although there is limited liquidity in specialized default swaps for now.
Volatility in any asset class is generally viewed as a revenue opportunity for bank traders and for their counterparts on the buy side with a focus on active dealing, such as hedge funds.
ESG products are likely to become increasingly politicized as they take a bigger share of the overall financial markets and to receive greater scrutiny by environmental activists for potential greenwashing.
That in turn exposes banks and funds to reputational risk if they are accused of manipulating prices to boost their own bottom lines or are perceived to be helping clients to exaggerate their own progress towards sustainable goals.
Derivatives will play a key role in helping banks and their clients to achieve ESG targets, but they are also likely to bring problems with implementation as their uses become more and more imaginative.
Building the derivative infrastructure
In May 2020, IHS Markit launched the iTraxx MSCI ESG screened Europe index, which is a five-year European corporate default swap index using ESG criteria.
The index includes a basket of default swaps on companies that meet various sectoral, controversy and ESG risk criteria, with a three-step methodology based on MSCI ESG research, including a value-based screen, a controversy-based screen and an ESG ratings-based screen.
IHS Markit billed the index as a macro instrument to gain exposure to or hedge ESG European corporate risk. It also pointed out that it could be an effective hedge for bond portfolios tracking forthcoming iBoxx MSCI ESG indices.
The index can be used by buy-side firms to gain long exposure as default swap protection sellers on ESG companies. And a high correlation with the benchmark iTraxx Europe index theoretically allows sell-side trading counterparties to use the ESG index to hedge their protection buyer positions.
Low trading volumes in this product indicate limited demand for targeted ESG credit derivatives, but bankers hope to develop activity as they structure deals that involve credit exposure.
The growing market for ESG cross-currency swaps brings considerable credit risk to bank counterparties, especially when they are done for emerging market clients, for example. Banks need to hedge that exposure, which could lead them to set up offsetting trades.
“To the extent that we are creating green credit risk, over time that should help to create a new market” in ESG credit derivatives, says Deutsche Bank’s Claire Coustar.
The plumbing of the market for ESG derivatives is improving, which should boost activity. LCH offers clearing for the iTraxx ESG index; and on September 19 CME Group launched what it billed as the first sustainable derivatives clearing service for listed contracts.
“This new framework for clearing sustainable derivatives will make it easier for our clients to measure the impact of their support for sustainable activities and can be part of the solution to encourage further growth in this key sector as the economy transitions to net-zero emissions,” said Julie Winkler, the CME’s chief commercial officer.
Participating futures commission merchants will be provided with sustainable clearing eligibility criteria to identify and tag their sustainable trades. The eligibility criteria will be aligned to external standards, such as the International Capital Market Association’s social and green bond principles, and CME Group said it will be “criteria neutral” in ensuring that only independent third-party standards are applied.
A liquid carbon trading market would also help to boost activity in ESG derivatives and could provide an opportunity for banks that are still active in commodity derivatives trading – including Goldman Sachs, JPMorgan and Morgan Stanley – to win market share by offering holistic solutions to clients such as energy majors that are trying to demonstrate progress towards their transition goals.
The recent surge in core energy prices in Europe and volatility in earlier incarnations of a carbon emissions trading market highlight some risks for bank dealers.