How should pension funds be applying ESG in derivatives?
Despite the prominence of derivatives across UK pension scheme portfolios, the assessment of ESG factors in derivatives remains relatively nascent.
ESG has become a mainstream feature of institutional investment, yet the integration of ESG has not been applied equally across portfolios. To date, integration efforts have been very much focused on direct ownership in equity and fixed income, with alternative assets like property and private equity lagging, but starting to catch up.
The question of how trustees – and investors more broadly – should approach ESG in derivatives remains relatively poorly treated. This is surely a serious omission, given that pension funds are significant users of derivatives. According to a recent survey conducted by the Pensions Regulator, DB pension schemes have notional derivative exposure equal to around 75% of their asset value. 
In the context of derivatives, ESG integration comprises two key components, namely, in relation to the underlying asset or variable being referenced, and the operational structure that the derivative uses.
ESG exposure of the underlying
As the name implies, all derivatives reference an underlying asset or variable, i.e. the derivative (which is just a financial contract) always links to something tangible in the ‘real world’. For example, an option contract on BP plc, will link to the share price of BP.
As a result, the ESG factors impacting the underlying security should also be taken into account in appraising the derivative. In some situations, this may be obvious; any investor using derivatives to gain exposure to equities ought to take account of ESG factors affecting those companies in the same way as a direct equity investment. In certain cases, the derivative may imply greater ESG responsibility. For example, commodity futures are often used as an essential commercial tool by commodity producing companies. Investment in oil or metal futures contracts therefore provides important liquidity to oil and mining companies, which are frequently the ultimate counterparty to these transactions.
In LDI Portfolios, consideration of ESG raises questions about governance.
Applying ESG to interest rate and inflation swaps, two of the most frequently used derivatives by DB pension funds in constructing liability hedges, is more complex. For interest rate swaps, the underlying is, broadly speaking, the expected future path of the Bank of England’s (BoE) base rate and for inflation swaps, it is the expected future path of RPI (ultimately CPI, assuming that reform takes place). Integrating ESG considerations into this analysis is challenging and remains a focus for the industry. Clearly, climate-related factors will have a bearing on future inflation, and by extension, on future BoE base rates. It may currently suffice for trustees to argue that their LDI hedge simply “reflects their liabilities”, but this will change going forward, as all assets, even those held to match liabilities, will need to be subject to ESG considerations.
In LDI portfolios, consideration of ESG raises questions about governance. Good governance in the corporate equity world implies active shareholders challenging and monitoring boards. The equivalent in the LDI space implies active engagement with the Treasury and Debt Management Office – around the sustainability of debt issuance – as well as active participation in topics like RPI reform.
Operational ESG factors in derivatives
All derivatives require banking counterparties, and, increasingly, central clearing counterparties (CCP) and/or exchanges. These counterparties are relied upon to ensure delivery of the derivatives and maintenance of their liquidity.
Pension funds should be applying ESG criteria to the selection and monitoring of their derivative counterparties, in the same way that they apply these considerations when appointing fund managers. The industry is still at a nascent stage in determining which criteria matter most. How exactly should an ESG standing be assessed alongside a credit rating to produce a single view on whether the counterparty is acceptable or not?
Derivatives supporting sustainability
Finally, and perhaps most relevant for the future, it is worth considering how derivatives will evolve over time – and the essential role they will play in supporting the transition to a net zero world through initiatives such as the European Green Deal and Sustainable Finance Action Plan. A recent paper published by the European Capital Markets Institute highlights several fascinating areas of development.
Derivatives have become so prolific (with global notional exposure running at a staggering £550tr) because they enable efficient use of capital and management of risk. As institutional investors look to manage environmental risks, derivatives present a wealth of untapped potential.
Weather derivatives could be used to protect funds from the negative impact of unhelpful climatic conditions (such as drought and temperature rises); carbon credit derivatives could offset high greenhouse gas exposure elsewhere in the portfolio; while derivatives linked to green energy factors could provide exposure to solar, wind and hydrogen output.
Given the scale of derivative use across UK scheme portfolios, ESG assessment in this arena not only presents a huge opportunity to mitigate risk, but a crucial support to the raising of debt financing the transition to a greener economy.
 DB Pension Scheme Leverage and liquidity Survey, December 2019. The survey covered 137 of the largest 400 pension schemes with combined assets of £697bn.