When the Paris Agreement was finalised in 2015, it was determined that, countries would submit a new action plan to reduce their emissions every five years. The aim was to ratchet up the deliverables over time with financing underpinning these ambitions.
At the end of COP 26 in November 2021, the emphasis on the colossal financing needs of global sustainable development remains, even if the political will varies across nation states.
To achieve the climate ambitions set by national, regional, and international initiatives, massive investment is needed. By way of example, in 2019 the European Commission estimated that achieving European climate and energy targets required €260 billion of additional annual investment.
The derivatives market has a fundamental role to play in this and is a critical component of the successful transition to a greener economy.
Derivatives in a Green Economy
In order to help market participants further understand the potential role of derivatives in sustainable finance, the International Swaps and Derivatives Association (ISDA) published an overview of ESG-related Derivatives Products and Transactions.
“Conventional” derivatives transactions are already used by market participants:
- A “classic” interest rate swap may be used to hedge the risk arising from green bonds;
- Credit default swaps may be used to hedge future potential losses that would be realized following the occurrence of a catastrophic event.
Customized derivatives may be used to hedge climate risks such as catastrophe derivatives or weather derivatives:
- Catastrophe derivatives are used to transfer a natural disaster risk where massive potential losses could result from a natural disaster;
- Weather Derivatives derive their values from weather-related variables such as temperature, precipitation, wind, and other stream flow (typically limited to a specified location).
Carbon certificates and related derivatives are also an important steppingstone on the road to decarbonizing the global economy. With the development of the carbon market, a variety of new sustainability linked derivatives have emerged. Usually market participants use dedicated annexes, such as the ISDA US Emissions Annex and the ISDA EU Emissions Annex, to cover such products.
In September 2021, ISDA published a research note entitled “Role of Derivatives in Carbon Markets”, outlining how carbon derivatives are a critical component of a successful transition to a green economy by the development of a transparent and resilient carbon market and an effective price on carbon certificates.
Renewable energy and fuels derivatives
Various derivative instruments (usually futures) have been created in relation to renewable energy and renewable fuels, including:
Through a Power Purchase Agreement, a legal contract is created for the purchase of power and associated renewable energy certificates (that represent the property rights to the environmental, social and other non-power attributes of renewable electricity generation) between a renewable energy seller and a renewable electricity buyer.
Such renewable electricity is mainly generated by solar and wind sources. ISDA has published a template for trading in a wide range of US renewable energy certificates (as a supplement to the existing ISDA North American Power Annex).
The Wind Index, which is based on the wind power production over a given geographic area always the creation of a derivative instrument. Derivatives on this Index may be used by entities operating in the energy industry to hedge against the risks associated with inherent fluctuations in wind energy production. For example, the Nasdaq German Wind Index Futures allows producers and other stakeholders to hedge the production of German wind power.
Renewable Fuel – Renewable Identification Numbers (RINs)
These are credits that are used by rimporters of gasoline or diesel fuel for compliance with the renewable fuel standard (RFS) program in the USA. Obligated parties under the RFS must produce and blend a minimum percentage of renewable fuels into their transportation fuels or purchase enough RINs to reach their obligation.
There are also local innovations in relation to derivatives aimed at reducing greenhouse gas emissions. For example, the California Low Carbon Fuel Standard Credit (OPIS) Future) or in solar energy the New Jersey Solar Renewable Energy Certificate Futures.
As these financial instruments involve assessing environmental, social and/or governance (ESG) criteria, accordingly an ESG derivative is a transaction measuring certain ESG components (e.g. sustainability targets, ESG-oriented investments or ESG criteria or ratings). Key performance indicators (KPI) are used to monitor compliance with such ESG targets.
However, ESG related regulations (and event terminology) are not uniform. Due to the lack of common standards to measure such ESG performance, both KPIs and corresponding cashflows can take several forms. As emphasized by ISDA, KPIs, what they measure and how they are verified are critically important to the effectiveness and integrity of the related derivative.
In recognition of the wider impact that derivatives will have on the green agenda, ISDA published the “Sustainability-linked Derivatives: KPI Guidelines” on 7 September 2021.
According to these ISDA Guidelines, the KPIs commonly seen can be classified into the following categories:
Reducing behavior that negatively impacts the environment
This includes KPIs that are linked to reducing greenhouse gas emissions, lowering the quantity of waste sent to landfills or incinerator, reducing water consumption or any other forms of pollution.
Encouraging behavior that is beneficial for the environment
This includes KPIs that are linked to improving energy efficiency, renewable energy production or use, increasing recycling or contributing to biodiversity.
Tracking a counterparty’s general ESG performance
This is by reference to a rating issued by a specific third party or a supranational, regional or local rating system.
In any event, the chosen KPIs must be credible and counterparties should ensure they are specific, measurable, verifiable, transparent, and suitable.
Further standardization is likely as the number of such “Sustainability-linked Derivatives” increases, and these market standards can be used as a further means of benchmarking a counterparty’s performance.
ISDA proposed and analyzed five overarching principles in relation to KPIs.
Specificity – Clear and Precise Definition
KPIs should be as clearly and precisely defined as possible. General concepts of “reasonableness” or “materiality” should be avoided. Targets should ideally be described by reference to percentages or specific numbers with specific scope and parameters.
- The scope should be clear and delimited (entity, activity, country, etc.) to minimize the possibility of the counterparties reaching different interpretations, especially for entities with international operations.
- The period covered by the target should be clearly identified.
- The reference point or source should be clearly established and ideally based on publicly available information to enable verification.
- The KPI methodology calculation should be included in all documentation (wherever possible in full and with the relevant mathematic formula).
- Fallbacks should be included where relevant to allow for situations in which the KPI cannot be calculated in a satisfactory manner in accordance with the stated methodology. The economic impact of achieving – or failing – the KPI should be clearly stated in the documentation.
A KPI should be measurable by reference to applicable scientific measures to ensure there is no ambiguity in establishing whether or not a KPI has been met. Wherever possible, this should be by benchmarking it against a global, regional, local or industry standard.
Each party (or an independent third party) should be able to verify if the other party has met the relevant KPI within the applicable period (ideally by publicly available information). As such, parties should consider the availability and transparency of the information necessary for verification. In addition, the use an independent third-party verifier (i.e. an auditor, environmental consultant, or expert) should ideally be defined. The parties should establish a dispute resolution mechanism including how a replacement third-party verifier may be appointed.
The counterparties should establish a process for related information to be made available to other parties – i.e. what information, which parties should receive it, frequency of the discussion and management of market sensitive information.
Parties should avoid greenwashing i.e. claims relating to sustainability performance or impact that are inaccurate, misleading, or inflated. ISDA highlights that greenwashing undermines trust and threatens the credibility of the product and, if sufficiently widespread, the entire industry.
Counterparties should ensure they choose KPIs that are appropriate and meaningful for their business, size, geographical location, activity sector and any existing ESG commitments.
Green finance derivatives are innovative financial products aimed at environmental protection and a sustainable utilization of resources. It is important to understand and anticipate the potential use of these derivatives, as they not only allow an efficient way of hedging but are increasingly necessary to make the energy transition a viable and tangible reality.
- Including the United Nations resolution adopted by the General Assembly on 25 September 2015, the European Climate Law – Regulation (EU) 2021/1119 and the Paris Agreement.