Coming Together on Climate Risk

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.

When trade associations work together to address areas of common concern, it highlights the importance of a particular issue and can lead to very positive outcomes. That is why I am so encouraged by the publication today of a landmark set of principles on financing the US transition to a sustainable low-carbon economy. These principles are the work of 11 organizations, including ISDA, and reflect the aligned views of banks, asset managers, insurers, investment funds, pension funds and other financial intermediaries on this pressing topic.

The principles come at an opportune moment. Recognizing the urgency of addressing climate change, governments around the world have set ambitious targets to reduce carbon emissions, with a widespread objective of reaching net-zero emissions by 2050. The EU has led the way in developing the European Green Deal, while the new Biden administration has made clear that addressing climate change is a priority in the US.

However, the transition to a green economy cannot be achieved without the financial industry, which will facilitate the financing of trillions of dollars in green investments that will be needed, as well as providing hedging tools to manage the associated risks. The US Climate Finance Working Group’s 10 principles set out a pragmatic approach to the transition to a low-carbon economy, providing practical guidance to financial market participants and policy-makers.

A key recommendation is the development and harmonization of taxonomies, data standards and metrics, which will support sound risk assessment and disclosure and enhance the comparability and alignment of product labelling and corporate reporting. These new taxonomies should provide the necessary clarity and verification to enable investors to access the growing class of environmental, social and governance (ESG) products through existing platforms and infrastructures and better understand and manage their exposure. Establishing a price on carbon will also spur development of climate-related financial products and provide more transparent pricing of climate-related financial risks – vitally important in driving investments towards new low-carbon technologies.

Another key principle is for any climate-related financial regulation to be risk-based to avoid creating perverse incentives, ensure firms can appropriately manage their exposures and promote the development of new ESG risk management products. To help firms price climate-related risks, the paper recommends further work and international coordination on the development of climate risk modelling and scenario analysis. The principles also call for the strengthening of post-disaster recovery, risk mitigation and adaptation, recognizing that appropriately structured ESG derivatives contracts will enable better hedging of climate-related risks.

Together, these principles set the foundations for further development of innovative ESG-related investment products and derivatives, enabling firms to efficiently invest in this sector and/or hedge their risks as trillions of dollars of green bonds and other instruments are issued to finance the transition. This hedging will be achieved through conventional derivatives, but we are also seeing the growth of more bespoke sustainability-linked derivatives and exchange-traded instruments. As a global derivatives association, our focus will be on ensuring these instruments can continue to be used effectively as a risk-mitigation tool. Last month, ISDA published a research report that gives a valuable overview of ESG-related derivatives products and transactions.

As ESG gains momentum, standardization will be more important than ever because it is only through robust standards that products and markets can scale efficiently. In late 2020, we surveyed the ISDA membership to identify their priorities in this area. Their responses indicated the widespread expectation of growth in ESG derivatives and a strong desire for standardization. Work is well advanced on expanding our suite of documentation templates to include renewable energy certificates and other contracts. We will continue to work on standardization of documentation, market practices and operational process in line with member demand.

As we advance these efforts in the derivatives market, the newly published principles give us confidence that our work is in line with the broader direction of the financial sector. With a challenge as complex and global as climate change, it is only through collaboration that real progress will be made.

Read the latest edition of IQ magazine, which carries a series of articles on derivatives and sustainable finance, here.

Listen to episode 6 of ISDA’s podcast, The Swap, featuring Bob Litterman, founder of Kepos Capital and chair of the Commodity Futures Trading Commission’s climate-related market risk subcommittee, here.

Download ISDA’s research report, Overview of ESG-related Derivatives Products and Transactions, here.

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