The next boom in sustainable finance: ESG derivatives

IFR 2321 - 22 Feb 2020 - 28 Feb 2020
6 min read
Christopher Whittall, Tessa Walsh

Last year, BNP Paribas began pitching a new type of structured note to private banking clients, with a twist: it would plant a tree for every thousand euros of these ESG-friendly products sold. So far the French bank has planted one million trees after selling €1bn of the notes.

Seeding tracts of woodland twice the size of Manhattan’s Central Park to sweeten sales of derivatives products is a novel approach even in this famously creative corner of investment banking. The broader takeaway is clear, though: sustainable derivatives are fast becoming big business for the finance industry.

After making promising inroads in 2019, banks are now targeting ESG-linked derivatives as one of the greatest potential growth areas this year, tapping into the burgeoning demand for channelling money towards companies focused on environmental, social and governance issues.

ESG experts broadly welcome such developments, while warning against any loosening of standards that could undermine the wider sustainable finance industry.

“Investors are very eager to invest in ESG-linked solutions,” said Delphine Queniart, global head of sustainable finance and solutions at BNP Paribas.

“For us it’s not about painting every derivative into a green or rainbow colour one. We need to ensure rigour and go back to the fundamentals of what clients are trying to achieve. That’s the only way this market will evolve. If it’s superficial, it’s going to stagnate quickly.”

Sustainable investing has been one of the fastest-growing areas in finance. Assets in European sustainable funds increased 56% in 2019 to €668bn, according to Morningstar, while sales of green, social and sustainable bonds rose 43% to US$222bn, according to Refinitiv data.


Ever ones for homing in on a popular marketing angle, investment bankers are translating this budding interest into derivatives sales. Equities have been at the centre of this expansion, with banks already selling billions of euros-worth of structured notes based on ESG indices, according to industry executives, and ESG futures volumes rising steeply.

Elsewhere, banks sold the first ESG-friendly derivatives designed to hedge against moves in interest rates and currencies last year. There is also an ongoing industry consultation over the development of ESG-friendly credit derivatives, IFR has reported.

"Every participant in the market – companies, bankers, investors, issuers – see this whole ESG movement in genuine, sincere ways, but also in opportunistic ways," said Mitch Reznick, head of research and sustainable fixed income at Federated Hermes.

"Bankers will naturally come up with new derivatives and products. That's not necessarily a bad thing as long as they're well understood and don't serve to undermine or dilute the overall positive process."

European sustainable fund assets


The mainstay investment banking activity of selling structured notes to retail investors has proven particularly well-suited to ESG. These notes typically provide investors with an annual payout depending on the performance of a basket of stocks, allowing banks to insert an ESG-friendly index in the product instead of a major benchmark like the Euro Stoxx 50.

“We have definitely noticed a strong acceleration in the appetite for ESG-branded indices in retail structured products,” said Arnaud Jobert, head of equity derivatives structuring for EMEA at JP Morgan.

Jobert said JP Morgan has rebuilt a number of its multi-asset indices to incorporate ESG building blocks and also launched new ones, such as products referencing ESG-focused mutual funds. It has even built an ESG-friendly equity long-short strategy to sell to institutional clients.

“We’ve spent a lot of time investing in data. Data remains a key challenge for ESG, as we need a high level of granularity to see if a product is ESG compliant,” said Jobert.

ESG futures markets are also on the up, with bankers pointing to a broader range of investors, including hedge funds, using the products. German exchange Eurex said earlier this month that more than 700,000 contracts of its Stoxx Europe 600 ESG-X Index futures had traded with a notional value in excess of €10bn since launch a year ago.

"We're seeing more investors looking to switch large amounts of exposure to ESG futures. It's not just traditional ESG funds," said Isabelle Millat, head of sustainable investment solutions at Societe Generale.


Bankers have also been busy pitching ESG derivatives that allow companies to shield themselves against moves in interest rates and currencies.

Take the cross-currency swap that SG provided for Enel, for example, when the Italian energy company hedged currency and interest-rate risk stemming from a US$1.5bn sustainable bond it sold last year. Like the bond it hedged, the swap will become more expensive if Enel fails to reach its sustainability target.

“We're keen on developing this business. But it's not a cookie cutter type of solution. You have to define with each client relevant and ambitious ESG goals,” said Millat.

Others agree banks need to be careful about not copy and pasting deals, but instead focusing on individual clients’ approach to sustainability and ensuring the derivatives contract is appropriate. That could mean uptake of ESG products in these markets will be more gradual.

"It's not something that should become too commoditised,” said BNPP’s Queniart.