Commentary

Innovating in ESG Derivatives

Olga Roman, Head of Research at ISDA, provides a guide to the growing range of standardised and bespoke derivatives used to manage ESG-related risks.

As the costs and challenges of climate change continue to mount, so too has the need to mobilise capital to drive climate innovation. The financial services sector will be an essential partner in meeting this need by providing funding and managing the risks associated with sustainable investments.

Derivatives markets can play an important role in facilitating the transition to a sustainable economy by enabling more capital to be channelled towards sustainable investments, helping market participants hedge risk related to environmental, social and governance (ESG) factors and facilitating transparency, price discovery and market efficiency. A variety of derivatives structures and transaction types have already emerged, including sustainability-linked derivatives, ESG-related credit default swap (CDS) indices, exchange-traded derivatives on listed ESG-related equity indices, emissions trading derivatives, renewable energy and renewable fuels derivatives, and catastrophe and weather derivatives.

Sustainability-linked derivatives

Sustainability-linked derivatives typically 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 transactions can reduce one counterparty’s payment in the event it achieves a certain pre-agreed sustainability target, providing a financial incentive for improved ESG performance. Other transactions facilitate a user’s ability to support sustainability outcomes through derivatives transaction. If a company cannot meet its ESG target, it will have to compensate by supporting climate action sustainability projects.

The table below provides examples of recently issued sustainability-linked derivatives, which focus on individual client approaches to sustainability.

ESG-related credit derivatives

Market participants can use CDS to manage the credit risk of a counterparty’s financial results or viability being threatened by climate change. In that respect, CDS can serve two different purposes: to hedge future potential losses that would be realised following a catastrophic event that leads to bankruptcies or defaults; and to hedge the risk of changes in the market value of ESG/sustainability-linked bonds or loans resulting from market expectations of future potential losses or damages and other market factors.

ESG screening can be applied to the reference entities of CDS contracts. In May 2020, IHS Markit launched the iTraxx MSCI ESG Screened Europe Index, which is a broad European corporate CDS index derived using ESG criteria. The index includes a basket of CDS contracts on companies that meet various sectoral, controversy and ESG risk criteria.

ESG-related exchange-trade derivatives

With more capital flowing into ESG strategies, global exchanges have launched a series of new equity index futures and options contracts tied to ESG benchmarks. ESG futures and options enable institutional managers to hedge their ESG investments, implement ESG investment strategies efficiently, and manage cash inflows and outflows of their ESG funds. Using ESG futures and options also allows funds to meet target allocation in a more cash- efficient way than investing directly in the underlying stocks.

ESG index derivatives reference ESG indices, which are based on parent benchmarks that define the universe of companies from which the constituents of an ESG index are selected. ESG indices can be based on an exclusion methodology that allows investors to eliminate certain types of exposures, while retaining similar risk-return characteristics to the parent benchmark. Some examples of exclusions are companies considered to be non- compliant with certain ESG standards or organisations involved in controversial business lines. Alternatively, ESG indices can be constructed to gain exposure to high ESG ratings, a specific ESG theme, or to generate a positive environmental or social impact.

Emissions trading

Emissions trading is a market-based approach to reducing pollution, designed to set a geographic limit on the amount of (primarily) carbon dioxide that can be emitted into the atmosphere by specific sectors of the economy.

Emissions trading includes two key components: a limit (or cap) on pollution and tradable allowances that authorise allowance holders to emit a specific quantity of the pollutant. The limit declines on an annual basis, with the intention of reducing the overall amount of emissions.

Market participants can trade emission allowances (including offset credits) and derivatives based on emission allowances. Emission allowances can be purchased through centrally organised auctions or from other companies that have more than they need for compliance. Secondary trading can be executed on exchanges or in over-the- counter (OTC) markets.

Derivatives based on carbon allowances and carbon offsets enable companies subject to carbon cap-and-trade programmes to meet obligations and manage their risk in a cost-effective way. Policy-makers rely on price signals from these instruments to gauge the effectiveness of their programmes and ensure desired outcomes.

Market participants use ISDA templates for emission allowances (ie, the ISDA US Emissions Annex and the ISDA EU Emissions Annex) to trade swaps, options and forwards. ISDA also offers EU emissions forms for the trading of carbon dioxide allowances. The ISDA US Emissions Annex covers sulphur dioxide and nitrogen oxide emissions (under the federal scheme) and carbon dioxide (under the Regional Greenhouse Gas Initiative).

Renewable energy and renewable fuels

Renewable energy and renewable fuel derivatives support the transition to a sustainable economy by enabling market participants to hedge against the risks associated with fluctuations in renewable energy production and encouraging more capital to be directed to sustainable projects.

Various derivatives instruments have been created to trade renewable energy and renewable fuels, including power purchase agreements (PPAs), renewable energy certificates (RECs) futures, wind index futures, renewable identification numbers (RINs) futures and low carbon fuel standard (LCFS) futures.

PPAs are legal contracts for the purchase of power and associated RECs between a specific renewable energy generator (the seller) and a purchaser of renewable electricity (the buyer). The renewable electricity is mainly generated by solar and wind sources.

PPAs can be used to reduce market price volatility for buyers. At the same time, they provide a guarantee to developers that the buyer will purchase power generated from renewable energy assets and, therefore, enable new renewable electricity projects to be developed. Even though PPAs do not require companies to reduce their overall greenhouse gas emissions, these instruments can help catalyse a shift to clean energy sources by financing projects.

RECs are market-based instruments that represent the property rights to the environmental, social and other non-power attributes of renewable electricity generation. They are issued when one megawatt hour of electricity is generated and delivered to the electricity grid from a renewable energy resource.

RECs are traded on the REC spot or futures markets, and are used to ‘green’ a specific buyer’s electricity consumption – ie, a buyer consumes grid electricity made up of various sources (natural gas, coal, nuclear and/or renewable) and covers the non-renewable elements of this consumption with an equivalent amount of RECs. ISDA has published a template for trading in a wide range of US RECs as a supplement to the existing ISDA North American Power Annex.

Wind index futures are financial instruments that enable trading firms and companies operating in the energy industry to hedge against the risks associated with fluctuations in wind energy production.

RINs are credits that are used for compliance in the renewable fuel standard (RFS) programme in the US, which sets renewable fuel blending standards for fuel producers. Obligated parties under the RFS must comply with the programme by producing and blending the minimum percentage of renewable fuels into their transportation fuels, or by purchasing enough RINs to equal their obligation.

The LCFS is a greenhouse gas reduction programme focusing on the transportation sector in California that incentivises low-carbon fuels and other alternative transportation methods. Each year, different fuel types are given carbon intensity (CI) scores. Fuel producers that are below their annual CI benchmark are awarded credits, while producers that are above the benchmark must procure LCFS credits to remain in compliance.

Catastrophe and weather derivatives

Catastrophe derivatives are financial instruments through which natural disaster risk can be transferred between counterparties. Catastrophe swaps are customisable OTC derivatives that enable a bearer of risk to obtain protection from massive potential losses resulting from a major natural disaster, such as a hurricane or earthquake, by transferring some of its catastrophe exposure to investors in return for a premium payment. It can therefore be thought of as the financial equivalent of a reinsurance contract or securitisation, but it avoids the structural complexities and costs associated with facultative agreements or full catastrophe bond issuance.

Catastrophe swaps allow countries to transfer some of their disaster risk exposure to insurance and capital markets without increasing their sovereign debt. A country pays a premium and in return receives a payout if a specified disaster event occurs. These instruments are pre-arranged in advance of a disaster happening and can be designed to provide a quick payout within days or weeks of an event occurring.

Weather derivatives are financial products that derive their values from weather-related variables such as temperature, precipitation, wind and stream flow. Weather derivatives are typically used by market participants to hedge or mitigate the risks associated with adverse or unexpected weather conditions. The main players in these derivatives, apart from farmers, are utilities, insurance companies and some banks.

The payout on a weather derivatives contract is typically based on an index that measures a particular aspect of weather. For example, temperature-related derivatives are usually based on the number of heating degree days or cooling degree days over the contract period (typically a month or a winter or summer season) at a specified location.

Precipitation-related weather derivatives are based on the number of critical precipitation days (those during which precipitation exceeds a specified reference level) that occur during the contract period. Hurricane derivatives are based on factors such as the number of named hurricanes, wind speed and hurricane radius.

This market is a mix of insurance-linked products, some hybrid solutions, exchange-traded derivatives and bespoke OTC transactions. Customised OTC derivatives allow market participants, such as holiday resorts or ice cream manufacturers, to structure transactions that suit their specific needs. OTC weather derivatives have become more complex as they combine several variables, such as weather and commodities.

ISDA offers templates for weather swaps, which specifically cover temperature transactions (cooling/ heating degree days). A separate ISDA template covers US wind events for the purposes of natural catastrophe trading.

Table: Sustainability-linked IRS and FX Derivatives
IssuerDeal InformationSustainability-linked Characteristics
Interest Rate Derivatives
SBM Offshore, a global supplier of floating production solutions
to the offshore energy industry
In August 2019, ING executed the world’s first sustainability improvement derivative (SID), designed to hedge the interest rate risk of SBM’s $1 billion five- year floating rate revolving credit facility. SBM pays a fixed rate on the swap and receives a floating rate.The SID adds a positive or negative spread to the fixed rate set at the inception of the swap based on SBM’s environmental, social and governance (ESG) performance, which is scored by Sustainalytics.

At the beginning of every year during the life of the swap, ING sets a target ESG score for SBM. If this score has been met, a discount of 5-10 basis points (bp) is applied to the fixed rate paid by SBM. If SBM hasn’t met its targeted ESG score, it has to pay a 5-10bp penalty.
Italo - Nuovo Trasporto Viaggiatori, a private rail operatorIn January 2020, Natixis structured a €1.1 billion sustainability-linked syndicated loan. The loan comprised a €200 million revolving credit facility to provide general corporate funding and a €900 million green loan to finance and refinance the company’s low-carbon rolling stock.As part of the loan transaction, the company also executed a sustainability-linked interest rate swap (IRS) that included an incentive mechanism aligned with the sustainable performance indicators outlined in the financing agreement.
Siemens Gamesa, a supplier of wind power solutionsIn March 2020, HSBC executed an IRS that converted a €250 million tranche of a floating-rate syndicated loan, which was arranged in December 2019, into fixed-rate funding.The fixed rate of the swap will not vary if Siemens Gamesa’s ESG rating changes, but any change during the life of the swap will prompt charitable giving. If Siemens Gamesa’s ESG rating improves, HSBC will donate annually to projects of non-profit organisations. If the rating declines, Siemens Gamesa will donate. This incentive structure differs from some other ESG-linked derivatives hedges where the ESG target impacts the cost of the hedge.
Goodman Interlink Limited, a global logistics property groupIn November 2020, Credit Agricole CIB executed a green IRS, totalling HK$590 million.A preferential fixed rate paid by the borrower was linked to the underlying facility’s green classification. The company’s fixed rate steps up to non-preferential if the green condition fails.

The green condition is satisfied if the company maintains two requirements: (1) silver certification from the US Leadership in Energy and Environmental Design, the most widely used green building rating system in the world; and (2) gold certification of the building environmental assessment method (BEAM) from the BEAM Society Limited, an organisation specialising in green certification for Hong Kong buildings.
New World Development, a
real-estate owner and
developer
In November 2020, DBS Hong Kong completed an IRS linked to the United
Nations Sustainable Development Goals(UNSDGs). This derivative transaction is designed to provide a hedge against the interest rate risk related to the New World Development (NWD) five-year HK$1 billion sustainability-linked loan from DBS, which closed in November 2019.
If the company successfully generates at least eight business-to-business integration opportunities that contribute to the UNSDGs adopted by the New World Sustainability Vision 2030, it is eligible to receive sponsorship from DBS to support social innovation projects. NWD’s social innovation initiatives include Impact Kommons, a UNSDG-focused start-up accelerator and business-integration programme, of which DBS is a social impact partner.
FX Derivatives
Enel, an Italian power and gas companyIn September 2019, Société Générale executed a sustainable-development- goal-linked cross-currency swap tied to a €1.5 billion bond. The swap enables Enel to hedge its exposure against the euro/dollar exchange rate and interest rate risk created by the different denomination of the bond
repayments (US dollars) and the source of repayments (euros).
As part of the transaction, Enel received a discounted rate based on its commitment to sustainability performance. Société Générale provided the discount as part of its commitment to positive impact finance and based on Enel’s positive contribution to one of the pillars of sustainable development (economic, environmental and social) and mitigation of any potential negative impacts to any of the pillars.

Enel’s bond is linked to the company’s ability to increase its installed renewable electricity generation capacity from 45.9% to 55% by December 2021. Should Enel not be able to achieve this objective, the interest on the bond will rise by 25bp to 2.9%. This will be carried over to the accompanying cross-currency swap, which will be rebooked if the bond coupon changes.
Siemens Gamesa, a supplier of wind power solutionsIn October 2019, BNP Paribas executed a €174 million foreign exchange (FX) hedging contract. The transaction aims to hedge Siemens Gamesa’s FX exposure from selling offshore wind turbines in Taiwan and to contribute to the UNSDG targets related to climate action and affordable and clean energy.Depending on whether Siemens Gamesa reaches its sustainability targets, BNP Paribas will reinvest any premium into reforestation projects.

If Siemens Gamesa misses its annual minimum ESG score, it must pay a sustainability premium, which BNP Paribas will reinvest in reforestation projects. The premium is calculated using a metric assigned by third-party sustainable finance specialists RobecoSAM.
Olam International, a major food and agri- business companyIn June 2020, Deutsche Bank executed an FX derivative linked to ESG key performance indicators (KPIs). A one- year US dollar/Thai baht FX forward enables Olam to hedge its FX risk arising from exporting agriculture products from farms in Thailand to the rest of world.The transaction allows Olam International to lock in a discount when it meets pre- defined ESG targets, which support the UNSDGs.

The transaction KPIs will contribute to 10 of the 17 UNSDGs, including alleviating poverty (UNSDG 1); alleviating hunger (UNSDG 2); improving gender quality (UNSDG 5); improving clean water and sanitation (UNSDG 6); reducing inequalities (UNSDG 10); increasing responsible consumption and production (UNSDG 12); contributing to climate action (UNSDG 13); protecting life below water (UNSDG 14); protecting life on land (UNSDG 15); and increasing partnerships for the goals (UNSDG 17).
Primetals Technologies, an engineering and plant construction companyIn October 2020, Deutsche Bank entered into an FX transaction that links currency options to sustainability goals. This agreement enables Primetals Technologies to hedge its currency risk with FX options over a four-year period.If Primetals Technologies fails to meet the agreed sustainability targets, it must pay a predefined sum to a contractually defined non-governmental organisation.

The currency hedge is linked to several sustainability targets, including the proportion of total sales of projects that aim to reduce greenhouse gas emissions for customers, and revenues relative to research and development expenditure that result in improved resource efficiency. Another metric is the promotion of a safe and healthy work environment for all staff at Primetals Technologies.

Independent consultants will monitor and certify whether the targets are adhered to for the entire life of the option.
Hysan Development, a Hong Kong property developerIn October 2020, BNP Paribas executed a $125 million approximately15-year sustainability-linked hedge.Under the terms of the transaction, Hysan commits to remain as a constituent member of the Hang Seng Corporate Sustainability Benchmark Index, which ranks the top 20% of Hong Kong companies based on their sustainability performance on broad metrics, for the period between 2021-2024. The company also commits to reduce its energy consumption by 20% by December 31, 2024.

If Hysan is not successful in reaching the two goals, it will contribute to an impact- driven charity approved by BNP Paribas.
Enel, an Italian power and gas companyIn October 2020, Enel issued £500 million of sustainability-linked bonds. Along with this issuance, Enel also executed a sustainability-linked cross- currency swap with JP Morgan Chase to hedge against the sterling/euro exchange rate and interest rate risk.The bonds are linked to the company’s ability to reach at least 60% renewable generation within its total installed capacity by December 31, 2022. The achievement of the target will be certified by an auditor’s specific assurance report. The interest rate on the bonds will remain unchanged to maturity, unless Enel fails to achieve the sustainability performance target. If the target is not achieved, a step-up mechanism will be applied, increasing the rate by 25bp as of the first interest period after publication of the assurance report of the auditor.

Enel and JPMorgan will pay interest to each other on the borrowed money every six months on the cross-currency swap. That interest cost can rise if either side does not keep to its environmentally friendly targets.

JP Morgan has pledged to help arrange $200 billion of funding this year for climate-change action and the UNSDGs, which include activities such as underwriting green bonds.

This article was originally published in the Q1 2021 edition of IQ, the official publication of ISDA.

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