ESG derivatives: Weapons of green distraction?

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.

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.

“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.”

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.

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.”

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 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.

“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.

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.

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.