ESG Investing: Derivatives

Derivatives are financial contracts whose value is tied to an underlying asset, group of assets, or benchmark.  Derivatives can trade on an exchange (like the Chicago Mercantile Exchange) or over-the-counter.  Examples of derivatives include:  (1) futures (contracts for the purchase and delivery of an asset at a specific price at future date that trade on exchanges), (2) forwards (which are similar to futures, but are privately negotiated and trade OTC); (3) options (which are like futures, but don’t obligate the holder to buy or sell the asset), and (4) swaps (used to exchange on type of cash flow with another – e.g., exchanging a variable rate loan to a fixed rate loan).

The ISDA (International Swaps and Derivatives Association) as published a comprehensive overview of ESG-relative derivative products and transactions, which include:

  • Sustainability-Linked Derivatives: Derivative that add an ESG pricing component to swaps and forwards.

  • ESG-Related Credit Derivatives: Credit Default Swaps (CDS) that can hedge against losses resulting from either climate change, or changes in the market value of sustainability-linked bonds and loans due to market factors.

  • ESG-Related Exchange-Traded Derivatives:  Equities index futures and options contacts linked to ESG benchmarks (which can include indices that use positive or negative screening).

  • Emissions Trading: Also referred to cap & trade –a system that caps the amount of emissions a holder can generate and allows holders to trade emissions allowances (primarily through futures and options).

  • Renewable Energy and Fuels:  Renewable energy come from sources (like solar, wind, and water) that are naturally replenishing, while renewable fuel includes hydrogen fuel, biofuel, and other fuels produced from renewables.  A number of derivatives have been created to trade renewable energy and fuels, including renewable energy certificates (RECs) (rights to the environmental, social, and non-power based attributes of renewable energy), renewable identification numbers (RINs) (credits used for compliance with the US renewable standard program), and power purchase agreements (PPAs) (contracts for the purchase of power and associated RECs).

  • Catastrophe and Weather Derivatives:  Derivatives (including swaps, insurance linked products, and exchange traded derivatives) that allow parties to transfer the risk of natural disasters or extreme weather events.