The emergence of derivatives linked to sustainability
To encourage the financial system to participate in the transition to climate neutrality in 2050, the European regulation known as the “taxonomy regulation” establishes a classification common to all Member States to help investors identify ecologically sustainable economic activities. It also promotes cross-border investment and prevents market fragmentation.
The taxonomy regulation will apply from January 1, 2022. It was retained as EU law within the UK after Brexit, meaning the UK retains the framework, including high-level environmental goals.
However, more detailed rules regarding these objectives, in particular delegated acts setting the criteria for technical standards (TSAs), have not yet been published by the European Commission and, therefore, there is still an element of uncertainty as to the extent to which the UK aligns with the EU on this TSC.
In addition, the European regulation known as the “Disclosure Regulation” or “SFDR Regulation” – which entered into force in March – created new sustainability transparency obligations for credit institutions and investment firms. .
These obligations are broadly defined and should be followed in the pre-contractual phase of investments, in periodic reports and be presented on the websites of the entities affected by these requirements.
Since the SFDR regulation entered into force after the expiration of the Brexit transition period, the UK did not adopt the SFDR regulation. However, the UK has charted a path to make climate-related disclosures fully mandatory and which would be more stringent than the requirements of the SFDR Regulation.
It is in this regulatory context that environmental, social and governance (ESG) derivatives have developed in recent years, in particular CO2 derivatives.
Companies struggling to reduce their carbon emissions can enter into futures contracts, which allow them to buy allowances at the current price that will be delivered in the future.
They thus protect themselves against an increase in the price of allowances. To optimize their stock of quotas, they can also agree to a call option or put option or a swap contract.
The renewable electricity market is also experiencing the development of financial power purchase contracts (PPAs). Financial PPA – also known as virtual or synthetic PPA – takes the form of a contract for difference or a fixed-to-float swap that guarantees the buyer of electricity a fixed price and provides the seller with long-term income, allowing it to develop and finance its renewable electricity infrastructure (wind and solar).
Derivatives linked to sustainable development have also appeared. They integrate or create a sustainable development cash flow using key performance indicators (KPIs), designed to monitor compliance with ESG objectives.
In practice, a bank may, for example, enter into a sustainability-linked interest rate swap with its counterparty, in which it sets an ESG target. If the objective is reached, the bank commits to a reduction in the fixed swap rate paid by the counterparty.
Companies that use derivatives can also use ESG credit derivatives to hedge against the risks of a potential natural disaster or to hedge against changes in the market value of sustainability-related loans or issues.
As new ESG derivatives begin to emerge, harmonizing the data on which the market relies and standardizing reporting standards will be crucial for the development of the ESG derivatives market. This is expected to be partly resolved through the implementation of EU initiatives which should be widely followed in ESG derivatives.
However, it is likely that it will take five to 10 years before the reporting requirements and the processing of this information are sufficiently developed to process this information directly and transparently.
Standardization of vocabulary (especially consistent and transparent drafting of KPIs) across ESG derivatives will also play a role in providing greater certainty.
The ESG derivatives market is expected to grow exponentially in the years to come as new opportunities arise and solutions to these early stage issues are found.
Chris Clark is Capital Markets and Derivatives Partner at CMS Law Firm