In December 2020, in a true sign of the times, water entered Wall Street. Just like oil, it is now a rare commodity. It is now possible to hedge against a water shortage by entering into futures contracts on the Chicago Mercantile Exchange.
Faced with the ravages of pollution on the environment and the climate, the international community has taken on the issue of preserving our vital resources by initiating a large-scale ecological transition. This includes transforming our economic activities into environmentally sustainable activities, i.e. activities that meet environmental, social and governance (“ESG”) criteria. As state budgets alone cannot bear the cost of such a transformation, many green tools have emerged in financial markets. Green bonds and social bonds raise funds that are used exclusively for environmental or social projects. Sustainability-linked bonds provide financial benefits to the issuer if it succeeds in achieving the ambitious sustainability goals to which it has committed. Alongside these products, green derivatives are being developed to hedge against environmental risk, offset greenhouse gas emissions or finance renewable energy infrastructure.
Genesis of a wealth of regulations
These sustainable finance instruments are taking off in a context where international and European standards in favor of climate transition are proliferating.
Reduction of greenhouse gas emissions
The Kyoto Protocol, the first international treaty for the reduction of greenhouse gas emissions, was signed in 1997. By ratifying the protocol, the signatory parties, including the European Union (the “EU”), committed themselves to respecting CO2 emission quotas. The United Kingdom remains a party to the Kyoto Protocol notwithstanding that it is no longer a member of the EU.
In October 2003, the EU adopted Directive 2003/87/EC, which is the legal translation of the EU's commitment under the Kyoto Protocol. This text established an EU Emissions Trading Scheme (the “EU ETS”). Each year, the EU ETS allocates a certain number of emission certificates (or allowances) to companies. At the end of the year, each company must surrender the same number of certificates it was allocated, and if necessary, a company may buy additional certificates on the carbon market from a less polluting company in order to satisfy such obligation. If it fails to do so, it risks a fine of EUR 100 per additional ton of CO2 emitted.
As early as 2005, in order to encourage companies to reduce their emissions, the EU introduced a timetable for the gradual reduction of the number of certificates allocated. During phase 3 (2013-2020), the number of allowances fell by 1.74% per year. The current phase 4 (2021-2030) foresees a decrease of 2.2% per year. This decrease in quotas necessarily leads to an increase in the price of certificates.
Similarly, the UK Emissions Trading Scheme (the “UK ETS”), established through the Greenhouse Gas Emissions Trading Scheme Order 2020, replaced the UK’s participation in the EU ETS on 1 January 2021. The introduction of the UK ETS allows for a continuity of emissions trading for UK businesses post-Brexit. The UK ETS is seen as a crucial step towards achieving the UK’s target for net zero carbon emissions by 2050 (as recommended by the UK’s independent climate advisory body, the UK’s Committee on Climate Change), and it plans to reduce the existing emissions cap by 5%, attempting to go further than the timetable outlined above under the EU ETS. Phase 1 of the UK ETS is planned to run from 2021 – 2030, with three in-phase reviews.
Adopted by 195 countries, the Paris Agreement on global warming is the result of international negotiations that took place at the Paris Climate Change Conference (COP21) in December 2015. The main objective of the Paris Agreement is to achieve the goal of keeping the global temperature increase below 2°C and, as far as possible, below 1.5°C.
In 2019, the European Commission launched its Green Deal – a set of initiatives to make Europe carbon neutral by 2050. For the duration of her mandate at the head of the Commission, Ursula von der Leyen has made the reduction of greenhouse gas emissions her hobbyhorse, involving the transformation of certain sectors and notably finance, with a legislative project underway relating to climate change.
To encourage the financial system to participate in the transition to climate neutrality in 2050, the European Regulation (EU) 2020/852, known as the "Taxonomy Regulation", establishes a common classification for all Member States, in order to help investors identify environmentally sustainable economic activities,to promote cross-border investments and prevent market fragmentation. The Taxonomy Regulation, which will apply from 1 January 2022 in several phases, aims to protect the market against the risks of greenwashing by prohibiting the marketing of falsely ecological financial products. Failure to comply with the rules prescribed by the Taxonomy Regulation will result in sanctions. The performance indicators that companies will have to meet are to be specified by delegated acts.
The Taxonomy Regulation has been retained as EU law within the UK post-Brexit, meaning that the UK retains the framework, including the high-level environmental objectives, as set out in the Taxonomy Regulation. However, more detailed rules about these objectives, specifically the delegated acts setting out the technical standards criteria (“TSC”) are yet to be published by the European Commission, and, therefore, there is still an element of uncertainty as to the extent by which the UK will align with the EU on such TSC.
In addition, the European Regulation (EU) 2019/2088, known as the "Disclosure Regulation" or "SFDR Regulation", which came into force on 10 March 2021, created new sustainability transparency obligations for credit institutions and investment firms. These obligations are broadly defined and will have to be followed in the pre-contractual phase of investments, in periodic reports and be set out on websites of entities caught by such requirements.
Given that the SFDR Regulation came into force following the expiry of the Brexit transition period, the UK has not onshored the SFDR Regulation. However, the UK has set out a path towards making climate-related disclosures fully mandatory, aligned with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD) which, if so implemented, would be stricter than the requirements in the SFDR Regulation.
Regulation (EU) 2016/1011 (the "Benchmarks Regulation") on benchmarks was revised in 2019 to include a sustainable finance component. As amended, the Benchmark Regulation now enshrines two categories of benchmarks: (i) a "EU Climate Transition Benchmark" , which makes it possible to compose a portfolio of underlying assets in line with the objective of carbon neutrality and (ii) a "EU Paris-Aligned Benchmark" which is aligned with the climate objectives of the Paris Agreement on limiting temperature increases to below 2°C. These new benchmarks make it possible to exclude underlying assets that do not comply with certain ESG criteria. Post-Brexit, the UK has onshored an equivalent form of the Benchmarks Regulation, with the Retained Regulation (EU) 2016/1011 (the UK Benchmarks Regulation) applying in the UK.
Finally, on 29 January 2021, ESMA called on the European Commission for a legislative framework for ESG ratings and other assessment tools, which are currently not regulated.
The rise of ESG derivatives
It is in this regulatory context that ESG derivatives have developed in recent years – particularly CO2 derivatives. As mentioned above, the EU grants a certain number of emission certificates to companies each year. Companies that are struggling to reduce their carbon emissions can enter into forward contracts, which allow them to buy allowances at the current price that will be delivered in the future. In this way, they hedge against a rise in the price of allowances. To optimize their stock of allowances, they can also enter into an option to buy (call) or sell (put) allowances or a swap contract. The International Swaps and Derivatives Association (“ISDA”) has published annexes for Phase 3 and Phase 4 CO2 derivatives, which complement the ISDA Master Agreements. Companies are also increasingly using voluntary carbon offsets. This consists of "buying" carbon credits on the market and/or financing ESG projects (such as reforestation).
The renewable electricity market is also seeing the development of Financial Power Purchase Agreements. The financial PPA, also known as a virtual or synthetic PPA, takes the form of a Contract for Difference (CFD) or a fixed-to-floating swap that guarantees the electricity buyer a fixed price and provides the seller with long-term revenues, enabling it to develop and finance its renewable electricity infrastructure (wind and solar).
Sustainability-linked derivatives have also recently appeared. They provide a counterparty with financial incentives if sustainable objectives are met. In practice, a bank can, for example, conclude a sustainability-linked interest rate swap with its counterparty, in which it sets an ESG target. If the target is met, the bank commits to a reduction in the fixed swap rate.
Companies that use derivatives may also use ESG-related credit derivatives to hedge against the risks of a potential natural disaster or to hedge against changes in the market value of sustainability-related loans or issues. Finally, companies can enter into derivatives referencing ESG indices, such as those introduced in the Benchmarks Regulation.
Development of the ESG derivatives market
As new ESG derivatives products start to emerge, harmonization of the data on which the market relies and the standardization of reporting standards shall be crucial for the development of the ESG derivatives market. It is expected that this will be partly resolved through the implementation of the aforementioned EU initiatives which we expect will be largely followed in ESG derivatives. However, it is still expected that it will take five to ten years before reporting requirements and the processing of such information is developed enough to process this information directly and seamlessly. Standardisation of vocabulary across ESG derivatives will also play a role in providing greater certainty.
It is fully expected that the ESG derivatives market will grow exponentially in the coming years and months as new opportunities arise and solutions to these teething issues are found. ISDA is also working closely with market participants to develop the ESG derivatives markets following the publication of its ESG Members Survey in November 2020 so we are expecting further guidance and standard form documents to be available in due course.