As organisations seek to manage their ESG1 impact and risks more effectively, we’re starting to see sustainability innovation amongst non-cash instruments.
While “green derivatives” raise a plethora of questions – operational, accounting, reporting and otherwise – they are likely to become more commonplace in a “mainstream” ESG capital market.
Some of the new formats that have been introduced include:
Project level: Green certificates
If you have no desire to issue a green bond and you still want to exhibit greenness then you could issue certificates. This is in line with the model being explored currently by the Kingdom of Denmark. Several market participants have pointed out that such a certificate could create a more efficient price for incremental CO2 impact.
Company level: Sustainability-linked hedge
With sustainability pricing components now a typical feature in the lending markets, we have started to see such structures arise amongst conventional hedging instruments, such as interest rate or cross-currency products. This could incentivise companies with limited outstanding debt to still put in adequate efforts to meet ESG targets. Or indeed create a synthetic sustainability loan by adding the derivative to a conventional loan product.
Company level: ESG counterparty assessment
The most straightforward form of applying ESG in derivative investments lies in the counterparty – i.e. only putting in place new derivatives with organisations that meet the investor’s minimum ESG requirements. We’re already seeing a growing number of sizeable investors and companies proactively introducing such screening.
Sector level: CDS/iTraxx with ESG assessments
Screening can also be applied to the reference entity of the contract. This is core to the structure of the new iTraxx MSCI ESG Screened Europe Index, which includes a basket of companies that meet various sectoral, controversy and ESG risk criteria. This allows investors to more easily take a directional view on the performance of high-ESG scoring companies as well as more tactical relative value trades (ESG cash index vs CDS index).