The Role of Derivatives in ESG



ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

There is no doubt that sustainable finance and environmental, social and governance (ESG) products are becoming increasingly important to policy-makers and financial market participants all around the world. Earlier this week, ISDA hosted a virtual conference on ESG and derivatives, which highlighted the very important role the derivatives market has to play in the transition to a sustainable economy.

Sustainable finance is set to be at the heart of the recovery from the coronavirus pandemic in Europe. On September 16, European Commission president Ursula von der Leyen announced that 30% of the €750 billion recovery fund will be raised through green bonds. This will equate to a huge amount of new financing in this area, and both issuers and investors will be looking to the derivatives market to hedge their exposures. Product innovation is already developing rapidly to support the hedging needs of participants in this nascent market.

Other jurisdictions are also discussing and developing policy in this area. In the US, the market risk advisory committee of the Commodity Futures Trading Commission, sponsored by Commissioner Rostin Behnam, published a major report on climate risk management on September 9. Meanwhile, we at ISDA cooperated with the Centre for European Policy Studies (CEPS) on a paper that was published in July on the role of derivatives in sustainable finance.

First and foremost, the derivatives market will be the means by which participants are able to hedge their exposure to ESG assets, but its role extends further. Derivatives play an important role in facilitating price discovery and fostering greater market transparency. They contribute to the establishment of a market price and thereby enable better assessments of risk.

Alongside the development of ESG derivatives products, work will be needed to promote standardization across jurisdictions and market segments in order to ensure efficiency while reducing risk and cost and also supporting digitization. At ISDA, we have always been strong proponents of standardization in documentation, market practices, operational processes, and wherever else it might make economic sense. This is just as important in a relatively new area like ESG as it is in more established markets.

ISDA documentation and definitions are already being used to document ESG transactions. For example, swaps that are linked to a client’s performance against a set of sustainability targets have been documented under the 2006 ISDA Definitions. We have also started to expand the range of ISDA templates for environmental trading to include renewable energy certificates.

If needed in the future, we will amend the existing ISDA templates for transactions with particular relevance to ESG and sustainable finance, such as emissions allowances, weather and other commodities. We have also convened the ISDA Sustainable Finance Working Group to discuss how ISDA can ensure better alignment with cash products and identify areas where the development of standard terms and definitions for ESG derivatives may be necessary.

The growth of ESG finance will be a major trend in financial markets in the years to come, and the derivatives industry can be a powerful force in mitigating the associated risks and developing standards. We will continue to work closely with policy-makers and market participants to support risk mitigation, product innovation and the development of robust product standards, with an eye towards aligning the work to suit a global derivatives market.

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