How green are your hedges?

In brief…

What ESG-related derivatives are available in the market? Why they are helpful in a sustainable finance context? And how can your ESG-related goals be more efficiently achieved via ESG derivative products?

One silver lining to come out of the COVID-19 pandemic has been the sharp reduction in carbon emissions over the last 12 months. As governments set out their roadmaps out of lockdown, they have a rare opportunity to completely reshape large sections of global economies going forward. Derivatives as an essential part of sustainable finance and investment will have an important role in supporting governments and businesses in building back a better and a more sustainable future.In the same way as market participants incorporate green and sustainability-linked loan principles for loans and green and sustainability-linked bond principles for debts in capital markets, players in the derivatives market have also been actively engaged in “greening” their derivatives trades. We consider the key developments in this area with respect to sustainability-linked derivatives, ESG-related credit default swaps and indices, exchange-traded derivatives on listed ESG-related equity indices, renewable energy and fuel transactions, emissions trading derivatives and catastrophe and weather related products. We also discuss potential development of these products in the future and explore how clients may use these traditional financing tools to achieve their sustainable development goals.

Sustainability-linked derivatives

Derivatives products assist and facilitate sustainable investment in different ways. We have seen businesses and new projects continue to use conventional derivatives in connection with a growing amount of green and sustainability-linked loans or bonds. Interest rate or currency hedging and credit default swaps enable companies to effectively manage risks as well as expand their funding sources. These products will contribute to the expansion of green and sustainability-linked financing and play an important role in the transition of many businesses to sustainability.

At the same time, there have been innovative examples of bespoke derivative transactions where the economic terms of the derivative trade itself is linked to ESG or sustainability-linked targets of the counterparties involved. In the Overview of the ESG-related Derivatives Products and Transactions¹ (the ESG Products Overview), the International Swaps and Derivatives Association (ISDA) introduced a number of recent transactions which incorporate ESG targets into pricing of the transactions or impose obligations on one party to make charitable donations when another party meets ESG targets.

One example is a EUR1.1 billion sustainability-linked syndicated loan for Italo – Nuovo Trasporto Viaggiatori, a private rail operator, structured by Natixis in January 2020. The company entered into a sustainability-linked interest rate swap to hedge interest rate under the loan with a EUR900 million green loan to finance the company’s low-carbon rolling stock. The interest rate swap contained an incentive mechanism aligned with the sustainable performance indicators set out in the loan agreement. Another example is a one year USD/THB FX forward linked with ESG performance targets entered into by Olam International, a major food and agri-business company with Deutsche Bank in June 2020. Olam International uses the FX forward to hedge currency risk in connection with the export of its products. The transaction allows Olam International a discount when it meets agreed ESG targets which supports the United Nations Sustainable Development Goals. Other notable examples include preferential pricing for interest rate hedges for property developers when their buildings are certified to meet green or energy efficiency standards, and discounted pricing for FX transactions for power and gas companies when they meet renewable electricity generation targets. Due to the flexible nature of derivative contracts, we expect to see market participants devising more and more highly customised derivatives transactions to incentivise companies in meeting their individual ESG performance targets.

ESG-related credit default swap (CDS) index

Market participants use CDS to manage credit risks of a counterparty where such counterparty’s credit risk may be adversely affected by climate change. Generally speaking, CDS can help either (i) hedge future potential losses that would be realised following a catastrophic event, or (ii) hedge the risk of changes in the market value of catastrophe-linked bonds/loans.

In May 2020, HIS Markit launched the iTraxx MSCI ESG Screened Europe Index (the ESG Screened Index), a broad European corporate CDS index derived after screening companies against a set of ESG criteria. The ESG Screened Index can be used as a macro instrument by investors to gain exposure to ESG companies as well as to hedge broad ESG European risk. The ESG Screened Index is cleared through LCH CDSClear from September 2020 and therefore will become increasingly liquid and easier to invest in.

Exchange-traded derivatives on listed ESG-related equity indices

Many global exchanges (including ICE, Euronext, CME Group and Nasdaq) have launched equity index futures and options contracts tied to ESG benchmarks. Asset managers can use ESG futures and options to allocate their target ESG investment more efficiently without directly investing in underlying stocks. They can also hedge their ESG investments better and implement their ESG investment strategies in a more efficient and cost-effective manner.

ESG index derivatives reference ESG indices. ESG indices can be based on exclusion methodology, allowing market participants to invest in underlying benchmarks but eliminating certain non-compliant companies based on certain ESG standards (eg excluding companies linked with fossil fuels or tobacco products). Conversely, ESG indices can also be based on positive inclusive methods, including companies with high ESG ratings, a certain specific ESG theme, and/or having a particular positive ESG impact. The ESG Product Overview listed more than ten examples of ESG index derivatives offered by different exchanges.

Renewable energy and corporate power purchase agreements

In a world where many countries have reduced or withdrawn subsidies for renewable energy, renewable energy derivatives contracts are increasing important in supporting the development of new renewable energy projects.

We have seen various derivatives instruments being created to purchase or trade renewable energy, the most significant development in recent years are the corporate synthetic power purchase agreements (PPAs), also called financial PPAs.

Financial PPAs of renewable energy are entered into between a renewable power generator, often from solar and wind sources (the seller) and a purchaser of renewable energy (the buyer), often a financially strong corporate entity. Under such financial PPAs, no power is physically traded. Instead, the agreement functions as a financially settled fixed-for-floating commodity swap where the buyer and seller agree a defined “strike price” for power generated by a renewable energy facility. Each party will then enter into separate agreements with their electricity supplier/utility to sell or acquire (as applicable) electricity at the spot price. The financial PPA then works as a financial hedge: the monetary difference between the spot price and the strike price in successive settlement periods are settled between the parties periodically, so the seller always receives the net strike price throughout the duration of the PPA. The certainty in electricity sale price achieved through these financial PPAs will provide much needed “bankability” support for renewable energy projects, enabling more new renewable projects to be financed and built.

Many large corporates in the US and UK have entered into financial PPAs. DLA Piper has a market-leading practice on corporate PPAs and has in-depth first-hand experience in this area.² We have advised lenders, developers and corporate purchasers on their PPAs - from generators and their funders to the corporate end users and their licensed electricity suppliers – we have acted on many of the largest European corporate PPAs in recent years.

Emissions trading

Emissions trading is a market-based solution to reducing pollution (mainly CO2 emissions). Companies in specific industry sectors are subject to a capped limit for their CO2 emissions within a specified geographic area. These capped annual emission allowances are either allocated to each of the companies within an industry for free or through purchase at auctions, and they will be reduced annually, thus incentivising companies to reduce emissions year on year. Companies that emit more pollutant than their allocated allowance will have to purchase additional allowance in the market, or face substantial fines for non-compliance with the capped amount.

Market participates use derivatives contracts (based on ISDA template for emission allowances) to trade swaps, options and forwards in secondary markets. These derivatives products, based on carbon allowances and carbon offsets, enable companies that are subject to compulsory cap-and-trade programs to meet their emission reduction obligations and manage risks in a cost efficient way. In this regard, both the liquid exchange-traded products and the flexible, customisable over-the-counter (OTC) products are needed to meet the varying demands of companies in their respective risk management strategies.

In addition to the mandatory compliance market scheme which existed in different geographic regions for many years, there is also a voluntary carbon emission trading market. The voluntary market enables individuals, companies and government entities to purchase carbon offsets on a voluntary basis, typically driven by ESG and corporate responsibility goals and undertakings.

Emissions trading has significant growth potential in Asia, particularly in view of China’s commitment to meet the targets of carbon emission peak by 2030 and carbon neutrality by 2060. China has issued new trial carbon emission trading rules (Trial Rules), effective February 2021, pursuant to which a new national emissions trading system (ETS) is expected to be launched by the middle of 2021. The Trial Rules apply to companies in specific sectors with more than 26,000 mt/year of CO2 equivalent emissions, but will start with 2,225 coal-fired power plants initially, which last year accounted for about 40% of China’s total emissions, making it the world’s largest carbon market for the power sector. Entities registered under the ETS will also be allowed to use voluntary Chinese Certified Emissions Reduction to meet up to 5% of their compliance obligations, which would be a significant boost to the voluntary market. In addition, observers believe that the new national ETS would lay the foundation for the development of China’s first carbon emission futures on the new Guangzhou Futures Exchange.

Catastrophe and weather derivatives

Catastrophe derivatives are flexible and customisable financial instruments to transfer losses connected with natural disasters between counterparties. Market participants can enter into OTC swap contracts where one party seeks protection by transferring part or full losses caused by natural disasters (such as earthquakes, hurricanes or pandemics) to the other party, while the other party takes on such risks in return for premium payments, similar to an insurance contract or securitisation. Parties seeking protection through catastrophe derivatives may be countries or insurance or reinsurance companies, and catastrophe swaps allow them to transfer disaster risk to the financial market without increasing their debt liabilities.

The World Bank has organised several successful catastrophe swaps including one USD206 million 2017 swap issued for the Philippines (the World Bank acted as an intermediary and transferred risk outside the Philippines to international investors).

There have been some very significant developments in Asia in the last few years in the area of Catastrophe financial instruments, including insurance-linked securities (ILS). Singapore led the region by adopting legislations to facilitate the issuance of catastrophe ILS and has seen nine ILS issuances since 2018 covering risks such as earthquake, typhoon and flood, all of which DLA Piper’s teams in Asia have advised on together with our US teams. At the same time, legislative initiatives for ILS are underway in Hong Kong aiming to create the legal framework for ILS in Hong Kong.³

The focus in Asia on catastrophe loss transfer is not surprising given Asia has the lowest loss coverage rate for natural disasters compared with elsewhere in the world. The COVID-19 pandemic has further increased the urgency of such endeavour. As a result, there is potential for catastrophe derivatives products to play a role in Asian markets. Compared with ILS, catastrophe derivatives offer more flexible and bespoke solutions to meet an individual party’s needs while at the same time avoid the structural complexities and associated costs of ILS. Established financial hubs in Asia, such as Singapore and Hong Kong, can play a leading role in the newly established Guangdong-Hong Kong-Macau Greater Bay Area and elsewhere in Asia by offering Catastrophe derivatives products alongside ILS to insurance/reinsurance companies and governments in the area, to assist their efforts in managing risks and, more importantly, in bridging the huge gap in uninsured economic losses resulting from significant natural disasters in China and other countries in Asia.

Weather derivatives are financial contracts that derive value from weather-related variables, typically including precipitation and temperature. Parties to weather derivatives transactions hedge and mitigate risks associated with adverse weather conditions affecting their business. Payments on weather derivatives are generally based on an index that measures particular weather factors, e.g. amount of rainfall during a specific period, or number of days on which the temperature is above or below a certain threshold. While this appeals in particular to the agricultural sector, it can also be used by wider sectors such as holiday resorts, manufacturers of ice creams or electric fans or air conditioning units. Transaction parties typically enter into transactions on the basis of ISDA produced weather derivatives template agreements.

Future outlook

Derivatives as a core component of financial markets can play a significant role in the global transition towards a low-carbon and sustainable economy. They facilitate sustainable investment by hedging risks associated with various financing. They also contribute to pricing transparency and help channel more investments into ESG compliant companies, renewable energy projects, or those achieving sustainable development goals. Market participants have so far been very innovative in creating tailor-made products for specific ESG-linked objectives. To move to the next stage of the development and scale up the adoption of ESG-related derivatives, market participates should strive to develop common taxonomy in definition of sustainability, disclosure requirements as well as standard measurement metrics. Meanwhile, now is the time for companies and organisations to familiarise themselves with the increasingly versatile derivatives tools available and build them into their overall long-term strategy for future sustainable business.