Exotic World of ESG Derivatives Triggers Warning From Regulator

(Bloomberg) -- As some of the world’s biggest banks start experimenting with complex ESG derivatives, Europe’s markets regulator says it’s time to impose new rules to protect investors from greenwashing.

The European Securities and Markets Authority says it’s hard to verify the positive impact of derivatives sold under environmental, social and governance labels. The watchdog says standardized criteria should be met before firms can add ESG tags to products such as forwards, options and swaps.

The term ESG derivative “captures very different products, and each market participant seems to have their own view as to the reasons why their product is ‘ESG’,” ESMA told Bloomberg News in a written response. “The absence of disclosure requirements or recognized labels with minimum sustainability criteria implies that claims as to the impact of these instruments cannot be substantiated.”

The ESG market has enjoyed almost unfettered growth in recent years, mushrooming into a $35 trillion hodge podge of products that have reshaped the financial industry. The more recent spread of ESG into the world of derivatives is being led by a small group of Wall Street and European banks including JPMorgan Chase & Co., ING Groep NV and Deutsche Bank AG.

While the over-the-counter nature of such transactions makes it difficult to estimate the exact size of the ESG derivatives market, its rapid growth has caught the attention of regulators. That’s amid growing concern that the ESG label is being too liberally applied in general. 

In Europe, the financial industry is already being forced to rein in its ESG business as a new framework for sustainable investing, banking and business goes into force. Asset managers have started scaling back earlier ESG claims as an anti-greenwash rule book -- the Sustainable Finance Disclosure Regulation -- forces transparency on the industry. And the European Central Bank just published details on climate stress tests that will require banks to calculate how resilient their business really is to the fallout from global warming.

Proponents of ESG derivatives argue that an expansion of the market will help channel much needed private finance into green activities. That’s as the European Union estimates it will require an extra 350 billion euros ($405 billion) a year to pay for infrastructure and clean energy production. And expanding the pool of financing for green projects will be a key focus of United Nations climate talks next month in Glasgow, Scotland.

ESMA says it hasn’t yet developed a “focused view” on ESG derivatives, because it needs more time to study the market. Even at this early stage, though, the regulator says the absence of standardized definitions is grounds for concern.

What’s Out There?

A first step will be defining the size and scope of the market. The International Swaps and Derivatives Association says the sheer speed with which the ESG derivatives market has mushroomed makes compiling a list of the different types of structures “very challenging.” Its current tally of ESG derivatives includes sustainability-linked derivatives (SLDs), credit-default-swap indexes, exchange-traded derivatives on listed ESG-related equity indexes and emissions-trading derivatives.

ISDA published a set of guidelines last month on appropriate sustainability goals for SLDs. But for many of the other variants of ESG derivatives, no common standards exist. Meanwhile, banks are signaling they have big plans to continue expanding in this market. JPMorgan has gone so far as to say it wants to attach the ESG label to all corners of its business as part of a plan to make sustainable finance ubiquitous across products.

This year, Deutsche Bank sold what it said was the world’s first green hedge, in the form of a derivative that hedges the currency exposure of renewable energy company Continuum Energy Levanter Pte.’s green U.S. dollar bond. The product is not to be confused with sustainability-linked derivatives such as the cross-currency swap JPMorgan created for Italian energy company Enel SpA, where the pricing of the product was tied to both counterparties meeting sustainability goals.

For ESMA, the concern is that the plethora of labels makes it hard to hold the market to account. The authority warns that a term like green hedge “could mislead investors into thinking that the green bond is somehow hedged against potential environmental risk, which is not the case since the underlying [asset] is just a currency.”

“Similar to ‘ESG derivatives’, new expressions such as ‘green hedge’ are primarily intended for marketing purposes without any legal meaning,” ESMA said. “This contributes to investor confusion and greenwashing risks.”

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