The role of ESG derivatives in hedging and pricing

As environmental, social and governance (ESG) issues grow in importance, the derivatives markets can play a key role in the transition to a sustainable economy, according to a new paper – Overview of ESG-related Derivatives Products and Transactions – by the International Swaps and Derivatives Association (ISDA).

The aim to categorise ESG derivatives and to help market participants further understand the potential role of derivatives in sustainable finance.

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“As the costs and challenges of climate change continue to mount, so too has the need to mobilise capital to drive climate innovation,” the paper said.

It added, “the financial services sector will be an essential partner in meeting this need, by providing funding and managing the risks associated with sustainable investments, including project risk and interest rate and currency risks.”

The paper noted that derivatives not only provide a hedge but also promote transparency, price discovery, market efficiency and long-termism.

The paper focuses on product structures and transaction types that comprise the universe of ESG-related derivatives. These include sustainability-linked derivatives which have been issued over the past several years.

They add an ESG pricing component to conventional hedging instruments, such as interest rate swaps cross-currency swaps or forwards. These transactions are highly customisable and use various key performance indicators (KPIs) to determine sustainability goals.

Some of the transactions can reduce one counterparty’s payment in the event it achieves some pre-agreed sustainability performance target.

This mechanism provides market participants with a financial incentive for improved ESG performance.

The paper also mentions ESG-related credit derivatives which manage the credit risk of a counterparty or credit where its financial results may suffer because of climate change or where its viability might be threatened.

Also on the list are ESG futures and options which enable institutional managers to better hedge their ESG investments, more efficiently implement their strategies, as well as manage cash inflows and outflows of their ESG funds.

The paper does not cover traditional IRS, which are used by market participants to hedge the risk arising from green bonds, or conventional credit default swaps (CDS).

Although they play an important part in the transition to a sustainable economy, they are no different from a product standpoint than other IRS or CDS transactions, according to the paper.

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