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Derivatives markets eager for sustainable finance opportunities

FIA Asia panelists stress ESG-related products can generate real profits as well as protect the planet

5 December 2019

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Leaders across the global derivatives industry agree: Doing the right thing is important, but the path to a sustainable future for the global economy depends on following the money, too.

Representatives across exchanges, index providers and banks participating in a panel discussion on environmental, sustainability and governance (ESG) issues at the FIA Asia conference in Singapore on Dec. 5 agreed that the world collectively needs to address the problem of climate change with a sense of urgency. However, they were realistic about the financial industry's role in that transition -- and the importance of presenting solutions that make sense monetarily as well as morally.

A key challenge is the perception "that sustainability is all about doing good," said Stefan Ullrich, a director of sustainable finance at Paia Consulting with two decades prior experience working at derivatives exchanges. "Don't get me wrong, I'm all in favor of doing good and there are impact investors and philanthropy investors out there that are doing an awful lot of good in the world and I'm hoping that will continue. But the fact is that the financial industry at large is never going to work under those parameters, to do what needs to be done on climate change."

Fortunately, he said, the hard numbers that matter to financial industry professionals tell a compelling story. Ullrich noted that last year, renewable energy investment topped $270 billion—three times that of investment in fossil fuel projects—and that the United Nations-supported Principles for Responsible Investment now boasts an international network of 2,500 signatories putting key principles such as sustainability into practice through their collective $82 trillion in assets under management.

Michael Tang, the head of listing policy and product admission for Singapore Exchange Regulation, agreed that it is crucial for exchanges to provide these kinds of hard numbers to allow investors to allocate capital wisely.

"There's a huge amount of capital looking for sustainable investments, and what investors want is good data," Tang said. "That is the traditional strength of exchanges. We promote the disclosure of useful information so investors can make informed decisions."

At SGX, Tang said the listing group has created a framework around environmental, social and governance issues that have "financial materiality" and requires listed firms to follow a structure that "will allow for comparability to other companies that are also reporting."

Representing the bank perspective was Frederick Shen, senior vice president and head of business management, global treasury, at Singapore-based OCBC Group. He said that OCBC staff looks carefully at ESG-related issues in every transaction it enters into.

"I'm from the Treasury and market side, and there we prohibit our dealers from participating in IPOs, syndicated bond issuances or other loans from entities that are not ESG friendly," Shen said. "We analyze the information and do not allow our dealers to buy or trade those products" because of the possible financial risk as much as the environmental implications. He noted one high profile example of OCBC recently pulling out of a multibillion-dollar financing project for a Vietnam coal-fired plant because of these concerns.

It is the obligation of derivatives exchanges to develop the right products that help banks like OCBC manage their risk in a changing global economy, said Michael Peters, deputy chief executive officer for Eurex Frankfurt. Earlier this year Eurex launched three new equity futures contracts with an ESG focus, and on Dec. 5 the exchange announced another batch of ESG contracts will be listed in March.

"What we can offer from a derivatives point of view is solutions and instruments to manage sustainable risk and transition risk. So then the question we have to answer is, what are the right instruments and what are the right parameters for those products," Peters said. "There have to be standardized parameters for both the buyside and sellside" that provide a shared understanding of how risk is being transferred, and support liquid markets.

George Harrington, global head of futures and options licensing at index provider MSCI, said his firm is focused on "creating the raw materials" for exchanges to offer ESG-related products with transparency and standardization.

"We are a ratings agency, and currently rate over 8,000 companies and growing on ESG issues," Harrington said. "We publicly put ratings on our website for all the companies we rate, and it's now to the point where if your company is not being rated or rated poorly that you want to know why."

MSCI's ESG indexes are currently being used by major exchanges including ICE and SGX, and "we are seeing a very real switch in terms of the benchmarking strategy from an ACWI or all-world or emerging market benchmark to the ESG alternative," Harrington said.  And even in the U.S., which is alone among major national economies in its absence from the Paris climate accord, "there is a real wake-up moment going on" with a switch to MSCI's ESG indexes versus traditional benchmarks across both individual and institutional investors.

There is clearly real money behind the ESG movement, and a real opportunity for derivatives markets to develop new products and meet this growing investment need. However, there remain challenges to developing these products and winning capital from institutional investors because of a lack of transparency and standardization, said Franc Sportiello, head of business development, financial derivatives, Asia-Pacific, at Intercontinental Exchange.

"What's surprising is that in terms of raw materials (for ESG indexes), only about 40% of the information is from mandatory disclosure. You have that lack of standardization across the board," Sportiello said. The rest comes from areas like non-financial data and potential "negative externalities."

"It's not just the cost of external goods. At some point, somebody out there, whether it's from regulation or because the public is pushing you in that direction, these factors will need to be taken into account," he said. That demands index providers, exchanges and other participants to acknowledge a broader set of risks when building ESG-related products.

The good news, Sportiello added, is that this gap has created an exciting opportunity for those interested in creating the next generation of sustainable finance products for derivatives markets

"Some of these things may not immediately appear to be natural choices at first," Sportiello said. "But they are very compatible with how the financial industry functions, and it's exciting times for those who deal in the data and the tools."

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