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Derivative Markets and Sustainability

Our September 2020 article introduced concepts that trustees should be aware of when assessing the sustainability implications of their scheme’s investments in derivatives.

To recap, these considerations for trustees fall into three broad categories:

  • ESG risks and opportunities relating to underlying investments.
  • Operational factors such as including sustainability as a criteria in the selection of counterparties.
  • The wider potential of derivative markets to manage ESG risks and opportunities.

This article further explores these themes. We believe that to fully address the sustainability of a pension fund’s assets, we must also address the sustainability of derivatives.

Investment Toolkit

First, we would assert that the existence of derivative markets is a societal good. Derivatives can help us match a pension fund’s assets with liabilities in a cost effective and capital efficient way. That is why derivatives are an essential part of the investment toolkit and that will not change.

Derivative markets:

  • deepen liquidity and support efficient capital allocation.
  • lower transaction costs.
  • broaden market access. For instance, participation in diversified strategies for small investors would not be possible without derivatives.
  • facilitate cost-effective risk management, for example, by allowing liability driven investing.

Integration and Reporting

There is not yet a robust consensus on the integration and reporting of ESG risks and opportunities in the most vanilla of investments, let alone derivatives.

Derivatives appear, so far, to have been relegated to the ‘too hard to deal with’ box, and their treatment is characterised more by questions than answers, including:

  • Does it make sense to assess a derivative position according to its underlying constituents? In a cash investment, the direct link between a company and an investor is clear. In the case of derivatives the link is not so clear. The disclosing entity is a third-party, distinct from the two derivative counterparties. We favour sustainability disclosures irrespective of the instrument.
  • Is netting exposure of ‘longs’ and ‘shorts’ a defendable approach (which, of course, would sum to zero)? Being short a company that has a deteriorating record on climate change is not removing carbon emissions from the atmosphere, but it may help a portfolio manage its climate change exposures. Can shorts also play an environmentally useful role?
  • Can derivative positions be ignored when the underlying is not a corporate security, for example, commodity futures or inflation swaps? On this, we think not.

Stewardship

Stewardship considerations also prompt further questions:

  • Can engagement be made effective without voting rights? We believe derivative counterparties should also actively engage with the entities that represent their underlying investments, with collective actions far more powerful than individual initiatives.
  • What is the value of stewardship rights? Can value be created by separating voting rights from ownership to form a new asset class that better matches the sustainability objectives of investors independent from the instruments that they choose to represent their investments?

Counterparty Engagement

More straightforward is the interface between a bank and investor in a derivative investment. Much more effectively than a depositor, a bond holder, or even a small shareholder, a counterparty has the ability to engage with the bank on sustainability issues and escalate concerns, in a manner that is analogous to the influence that a major shareholder would have.

Counterparties do not have voting rights but banks are sensitive to changes in sentiment amongst their counterparties. Preserving unfettered market access is a commercial priority for the bank so counterparty confidence and support is critically important to them. We believe it’s important to engage our counterparties on sustainability issues.

Innovation

There have also been examples of linking derivative contracts to the achievement of real-world impact metrics, such as carbon emissions reductions by the underlying entity. This could potentially open up new avenues for risk management and incentivisation.

Next steps

Working out what would make sense is going to be hard but we know that it needs to be done. It is encouraging that IIGCC is working on the development of methodologies in other hard to reach asset classes; private equity and infrastructure for example.

Within the recently published IIGCC consultation response on the Net Zero Investment Framework the majority of industry participants expressed the view that all asset classes be substantively included within the scope of further initiatives.

Cardano is a market leader in the provision of specialised services to private-sector and collective pension schemes in the UK and the Netherlands. We are widely recognised as a financial pioneer, as an innovator and as a risk manager using derivatives. Accordingly, we welcome the commitment shared by our peers in the investment industry to progress the development of wider methodologies and reporting protocols. This should include derivatives.

We recognise that there is a gap in the industry for this development work. Over the coming months Cardano will be working on the formulation of methodologies for our own clients’ portfolios. But, we want to make progress in collaboration with the wider investment community.

Cardano has the knowledge, experience and expertise within derivative markets to spearhead the industry’s thinking on this subject. We look forward to shaping the next stages of how to apply sustainability to the derivatives markets.

Please contact us for further details:

Will Martindale, Group Head of Sustainability
w.martindale@cardano.com