Environmental, social and governance ("ESG") concerns are fast becoming a major driver of investment flows. Investors are increasingly seeking out and prioritising ESG investment opportunities, while many corporates strive to align their business models with ESG principles. In the middle sit the banks and broker-dealers who are scrambling to meet the sky-rocketing demand for ESG-driven financing solutions. At the EU level, authorities are keen to both promote and regulate this emerging area, in an effort to ensure that socially responsible economic activity is adequately financed while also protecting investors. Initiatives like the Sustainable Finance Disclosure Regulation ("SFDR")1 seek to prevent "greenwashing" in the financial sector, while the Taxonomy Regulation2 aims to establish a common language to facilitate ESG-related discourse and disclosure. Matheson's ESG Advisory Group has previously issued a number of publications in relation to these important pieces of regulation.3
Derivatives play an important role in financing economic activity and managing investment risk, so it is to be expected that their use will influence, and be influenced by, trends in the broader finance sector such as the focus on ESG. Furthermore, the flexibility afforded by derivatives means that they can be (and increasingly are being) used to pursue and promote ESG objectives in various ways. Industry bodies, such as the International Swaps and Derivatives Association ("ISDA") and the International Emissions Trading Association ("IETA"), have been pro-active and enthusiastic in fostering the growth of ESG-related derivatives, both by engaging with regulators and by developing standardised template documents to allow parties to trade these instruments efficiently. ESG themes dominated the discussion at ISDA's European Annual Legal Forum in March, for example, and more recently ISDA has published a new US Renewable Energy Certificate (REC) Annex to its flagship ISDA Master Agreement, allowing market participants to more easily trade in renewable energy certificates.4
In this briefing note we will look at how derivatives can be used to promote ESG objectives – and, conversely, how this new focus on ESG concerns might impact on the use and regulation of derivatives.
2. Some examples of ESG derivatives
In some areas – such as the green energy sector – derivatives have played a central role in the ESG story for some time. In addition, "vanilla" derivatives such as credit default swaps and interest rate swaps are commonly used to hedge the risk arising from ESG activities (such as green bonds, ESG-focused investment funds, etc). Increasingly, however, market participants are employing derivatives that have ESG components built in. ISDA recently published a report outlining several examples of this innovation.5 Below we discuss some of the main categories of ESG derivatives that are emerging.
(a) Virtual PPAs
A power purchase agreement ("PPA") is an agreement for the purchase of renewable energy from a specific seller. The energy is usually generated by solar and wind sources. PPAs are an important way for sellers of renewable energy to finance new projects and hedge the risks associated with market price volatility. They also allow energy purchasers to hedge market price risk, making green energy a more attractive proposition.
PPAs can be settled physically (resulting in the actual delivery of electricity) or "virtually" ("Virtual PPAs"). Upon the settlement of a Virtual PPA, a cash payment will be made by one party to the other based on the difference between the strike price specified in the Virtual PPA and the wholesale market price of the energy. A Virtual PPA is a derivative instrument, described by ISDA as a cash-settled fixed-for-floating commodity swap. Matheson's ESG Advisory Group is seeing an increasing preference from both corporate buyers and renewable generators for Virtual PPAs in the Irish market. We have been at the forefront of the corporate PPA market in Ireland over the past 5 years and have advised on all but one of the corporate PPAs which have been entered into to date in Ireland.
(b) Emission allowances
Many jurisdictions, including the EU, operate emissions trading schemes ("ETS"), which (i) limit the amount of pollutants that companies can emit, and (ii) allow companies to trade the unused portion of their emission allowances. ETS are a cornerstone of the global fight against pollution and climate change. Derivatives play a key role in facilitating the trading of emissions allowances. The IETA has worked with ISDA and other industry bodies to create the International Emissions Trading Master Agreement, a standard form template document that allows market participants to enter into forwards, swaps and options (among others) relating to emissions allowances. ISDA has also published the ISDA EU Emissions Allowance Transaction documents, which supplement the ISDA Master Agreements and allow market participants to trade swaps, options and forwards on EU emission allowances.
(c) Sustainability-linked interest rate swaps and foreign exchange derivatives
These instruments are similar to the "vanilla" interest rate swaps ("IRS") and foreign exchange ("FX") derivatives that are often used by corporates to hedge their interest rate or currency risk. However, these instruments include additional terms which alter the payment and other obligations of the parties based on the ESG performance of one or both of the parties. For example, an IRS might contain a provision that increases or decreases the effective rate payable by or to a company based on that company's future performance against ESG metrics. Other examples include FX hedging agreements that oblige counterparties to donate to charities or invest in reforestation projects when certain events occur. There has also been some discussion in the market recently about potentially including additional termination events linked to ESG-related performance metrics in derivatives documentation. These instruments, and others like them, are now embedding ESG related criteria and performance in traditional hedging strategies.
(d) Exposure to ESG-focused corporates through derivatives
Increasingly, derivatives are being used to provide investors with an efficient and convenient way to gain exposure to baskets of corporates which are considered to be strong ESG performers. For example, the iTraxx MSCI ESG Screened Europe Index is a credit default swap ("CDS") index tracking European corporates screened based on ESG factors. The CDS markets play an important role in the pricing of corporate credit risk, and a growing body of research suggests that ESG-related risks – and the disclosure of those risks – can impact on a corporate's risk profile.6 Many of the major exchanges have also launched exchange-traded futures and options which track ESG indexes, such as CBOE S&P 500 ESG Index options or EURO STOXX ® 50 Low Carbon Index futures.
(e) Catastrophe derivatives
Catastrophe bonds – debt instruments which have a reduced payment (or no payment) where a specified catastrophe occurs – have been much discussed in the media, but less has been said about the increasing use of catastrophe derivatives, either in conjunction with or as an alternative to catastrophe bonds. In 2017, for example, the World Bank issued $105 million in swaps, alongside $320 million in bonds, as part of its Pandemic Emergency Financing Facility ("PEF"). Catastrophe swaps have also been used as part of facilities to protect against the risks posed by hurricanes and earthquakes.7
3. Regulatory impact
(a) Recent regulatory developments
ESG considerations are now relevant to virtually all areas of economic activity, and the EU's regulatory response is similarly broad and multi-faceted. Derivatives have not yet been the direct target of ESG-driven regulatory changes. For example, the European Market Infrastructure Regulation ("EMIR") – the primary EU regulation governing the use of OTC derivatives – is not among the various regulations that have been (or are being) amended to incorporate ESG considerations. However, due to the widespread use of derivatives in the financial sector, there are various other legislative developments that will be of relevance to counterparties.
A prime example is the SFDR – arguably the cornerstone of the EU's regulatory response to the rise of ESG investing. While the SFDR does not directly regulate derivatives or their use, it may nevertheless be relevant to counterparties. Market participants who use derivatives as part of their broader investment, financing or portfolio management activities may be subject to the disclosure requirements of SFDR by virtue of those activities. Where market participants use derivatives to pursue sustainable investment objectives, they may be required to disclose on their use of derivatives and to explain how those derivatives attain their objectives.8
The EU's approach to ESG investing is to facilitate, as well as to regulate. For example, the Benchmarks Regulation9 was revised in 2019 in order to provide for two new categories of ESG benchmarks. An "EU Climate Transition Benchmark" is linked to assets which are selected, weighted or excluded in in accordance with the objective of carbon neutrality. An "EU Paris-Aligned Benchmark" is a benchmark which is aligned with the Paris Agreement goal of limiting temperature increases to below 2°C. The introduction of these new benchmark categories potentially opens the door to a new asset class of carbon- or climate change-linked derivative products.
The EU and global ESG regulatory framework is still very much in its infancy. As further regulatory developments are implemented in the coming years, it will be important for market participants to be aware of how those developments could directly or indirectly impact on the use and users of derivatives.
(b) ESG derivatives and the "traditional" regulatory framework
While counterparties to derivatives should be mindful of new ESG-driven regulations, it is equally important for financial market participants in the ESG space to be aware of the existing regulatory framework for OTC derivatives, given the important role that OTC derivatives are coming to play in ESG financing. For example, green energy market participants will have seen EMIR provisions (including EMIR reporting requirements) being included in their Virtual PPAs and financially settled corporate PPAs.
Even seasoned users of derivatives will need to reflect on the potential legal and regulatory implications of including ESG-related terms in their trading documents. For example, introducing ESG-linked payments into traditional hedging instruments such as IRS or FX swaps could complicate the valuation of those instruments, which could have knock-on effects on parties' portfolio reconciliation, dispute resolution, margining and other risk mitigation procedures. These risk mitigation procedures, as well as being commercially important to counterparties, are also required and regulated by EMIR, meaning that the challenges posed by ESG derivatives have a legal as well as a commercial dimension.
Counterparties should also carefully consider how any ESG-related payments will be handled, and how this may impact on the legal or regulatory analysis of their derivatives. For example, where ESG-linked payments are introduced into hedging derivatives, counterparties may need to assess whether such instruments can still be considered to be entered into for hedging purposes. OTC derivatives entered into for hedging purposes are treated differently for certain purposes under EMIR (for example, a non-financial counterparty is not required to count those derivatives when determining whether it exceeds the clearing threshold under EMIR). In addition, where one party to a derivative is obliged to make payments to a third party (such as a charity or conservation project), this may impact on the netting enforceability analysis. While the introduction of ESG-linked payment obligations into OTC derivatives can be a powerful tool in aligning parties' commercial incentives with ESG objectives, they must be carefully scrutinised to ensure that they do not alter the legal or regulatory treatment of contracts in an unforeseen or unintended way.
It is clear that derivatives have an important role to play in the growth of ESG investing. While "conventional" derivatives are increasingly being used to manage the risks associated with ESG-related economic activity, we are also seeing the emergence of innovative new types of derivative contract, which are tailored to the needs of ESG-conscious investors and corporates. These developments bring with them many opportunities, and some challenges. Market participants dealing in ESG-linked financial instruments should be mindful of their legal and regulatory obligations under both the new, ESG-driven regulatory framework and, where applicable, the traditional regulatory framework for derivatives.
1 Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector.
2 Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088.
3 [Links to Matheson pieces]
6 https://www.unpri.org/pri-blog/how-disclosing-transition-and-physical-climate-risks-affects-credit-default-swaps/7418.articleOpens in new window; https://www.msci.com/documents/10199/19248715/Foundations-of-ESG-Investing-in-Corporate-Bonds-How-ESG-Affects-Corporate-Credit-Risk-and-Performance+(002).pdfOpens in new window
8 Final Report on draft Regulatory Technical Standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a(3), Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088.
9 Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014
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