As some of the world s biggest banks start to experiment with complex ESG derivatives, Europe s markets regulator says it s time to impose new rules to protect investors from greenwashing.
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The European Securities and Markets Authority says it is hard to verify the positive impact of derivatives sold under environmental, social and governance labels. The watchdog says that standardized criteria must be met before firms can add ESG tags to products such as forwards, options and swaps.
The term ESG derivative captures very different products and each market participant seems to have their own view on the reasons why their product is ESG ESMA said Bloomberg News in a written response. The absence of disclosure requirements or recognized labels with minimal sustainability criteria implies that claims as to the impact of these instruments cannot be substantiated. The ESG market has experienced almost unfettered growth in recent years, mushrooming into a $35 trillion hodge podge of products that have reshaped the financial industry. The more recent spreading of ESG into the world of derivatives is being led by a smaller group of European banks including JPMorgan Chase Co. ING Groep NV and Deutsche Bank AG.
Although the over-the-counter nature of such transactions makes it difficult to estimate the size of the ESG derivatives market, its rapid growth has caught regulators' attention. That s amid growing concern that ESG label is being too liberally applied in general.
In Europe, the financial industry is already forced to rein in its ESG business as a new framework for sustainable investing, banking and business goes into force. Asset managers have been scaling back earlier ESG claims as an anti-greenwash rule book - the Sustainable Finance Disclosure Regulation forces transparency on the industry. And the European Central Bank just published details on climate stress tests that will require banks to calculate how resilient their business really is against global warming.
Proponents of ESG derivatives argue that an expansion will help channel much needed private finance into green activities. That s as the European Union estimates it will require an extra 350 billion Euros $405 billion a year to pay for infrastructure and clean energy production. And funding for green projects will be a key priority in next month United Nations climate talks in Glasgow, Scotland.
ESMA says it hasn't yet developed a focused view on ESG derivatives because it needs more time to study the market. However, even at this early stage, the regulator says the lack of standard definitions is grounds for concern.
A first step will be defining the size and scope of the market. The International Swaps and Derivatives Association says the sheer speed with which the ESG derivative market mushroomed makes compiling a list of the different types of structures very difficult. Its current tally of ESG derivatives includes sustainability-linked derivatives SLDs credit-default swap indexes, exchange traded derivatives on listed ESG-related equity indexes and emissions-trading derivatives.
An ISDA post-mortem published a set of guidelines to SLDs on appropriate sustainability goals last month. Most other variants of ESG derivatives have no common standard, but some exist. Meanwhile, banks are signaling they have big plans to keep expanding in this market. JPMorgan has gone so far as to say it wants to be part of a plan to transform sustainable finance to all sectors as part of a plan to make sustainable finance ubiquitous across products.
This year, Deutsche Bank sold what it claimed was the world s first green hedge, in the form of a derivative that hedges the currency exposure of renewable energy company Continuum Energy Levanter Pte. The product is not to be confused with sustainability - linked derivatives such as the cross-currency swap JPMorgan created for Enel SpA in Italy, where the pricing of the product was tied to both counterparties meeting sustainability goals.
For ESMA, the concern is that the plethora of labels makes it difficult to hold the market to account. The authority warns that a term like green hedge could mislead investors into thinking that the green bond is somehow hedged against potential environmental risk, which is not the case since the underlying asset is just a currency. Similar to ESG derivatives, new expressions such as green hedge are primarily intended for marketing purposes without any legal meaning, ESMA said. This contributes to investor confusion and greenwashing risks. How do we Short-Circuit our ability to think rationally?
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