Trading ESG Risk
Deep and liquid traded markets
Many financial risks can be acquired or modified through trading of securities and/or derivatives. For example, derivative products related to interest rates have been traded for many years and has seen the considerable growth of markets to shift risk from firm to firm. An active market to trade the risk has enhanced the ability of investors and borrowers to settle on the type and amount of risk best suited to their needs.
Another example is equity risk which also have deep and tradable markets. In this case, derivatives often reference an index such as Dow, S&P500 and NASDAQ which allow participants to trade the general direction of the market or alternatively trade sectors or even individual names. In each case, the underlying floating rate or index is clear and readily referenced to benchmark the trade.
Markets depend on a level of benchmark standardisation that makes each dealer and end-user confident of the performance and valuation of each product. Even the much-maligned LIBOR played a pivotal part in the development of traded interest rate markets. Without a standardised measure for risk setting such as LIBOR, derivative markets, for example, would have been impossible to trade in such a simple and definable way. And as LIBOR was replaced by Risk Free Rates such as SOFR and SONIA, the traded markets have adapted and continued to grow.
Likewise, equity markets have developed effective benchmarks for pricing in markets and allow for efficient risk transfer.
Most deep and liquid markets depend on a standard benchmark for risk resetting which is widely available and used in the majority of traded products.
The ESG markets – the next frontier
The ESG markets do not, at present, have the ability to trade the ESG risk in an equivalent way to interest rate or equity risk. There is no inter-dealer ESG derivative market and no standardised rate or benchmark to reference in a similar way to interest rates or equities.
A few firms do produce ‘ESG Scores’ which are not, technically, benchmarks. These include:
rating agencies such as S&P, Moody’s and Fitch;
Data providers such as Bloomberg and Refinitiv; and
Others such as ISS, MSCI, Datalytics etc.
While these agencies and vendors produce a ‘score’ from publicly available data (such as annual reports from companies) they are quite clear that these are not independently verified. In this sense, they are not benchmarks and could not be used under the regulatory requirements of many jurisdictions for the purposes of a benchmark, I.e., typically defined as refixing a variable rate or valuing a security.
So, there is no existing robust and standardised measure of ESG which captures a wide range of inputs and could be classified as a financial benchmark.
Why does the lack of a benchmark matter
If you have a risk or a desire to trade a financial product, you usually look at a screen where the bids and offers are posted for the products in which you have an interest. The products have standards and definitions which are supported by contracts and documentation such as that provided by ISDA for derivatives.
Whether it is a swap for fixed against floating or a fixed rate security, there is a need for an index or benchmark to provide the floating side of the trade and/or the valuation of a security. This is at the very heart of ‘price discovery;’ itself an important efficiency-driver.
It is particularly useful to use a standardised benchmark for obvious reasons. Once the benchmark is defined and readily available then there is a consequent reduction in the complexity of the trading because everyone is referencing the same rate or index.
Without a standardised benchmark, ESG products are difficult (I.e., near impossible) to trade in the inter-dealer market which means everyone simply builds up risk with no effective way to trade this into a market where the other side may be found.
One-sided or two-sided markets if an ESG benchmark can be developed
There is a market view that any ESG market would only be a one-sided (i.e., everyone wants to receive ‘fixed’ and pay ‘floating’ ESG). It is likely the result of the rush into ESG exposure and the perceived lack of floating rate investments that seems to drive this argument.
However, I take a slightly different view. Let’s take the example of a company with a debt linked to ESG performance. These have been transacted where the margins on the fixed or floating debt reduces as ESG performance improves (however that is measured!).
In this case, if the company had assets with fixed returns, then they may be a natural fixed rate payer of the derivative to match the asset risk to the liability risk. So why have ESG linked debt? Well, investor demand may be such that ESG debt represents cheaper funding, but it needs to be swapped for better risk management.
The investor argument is also important. Not every fund is ESG focussed, and some investors may actually need additional non-ESG exposure if they can only acquire assets with ESG links in the names they need for diversification.
I am a believer in traded market efficiency. If there is a market which is clear and standardised, a basis may form but equally the arbitrageurs will move in if that basis is unfounded. Price discovery is fundamental to their work.
Summary
The ESG market is growing and evolving as borrowers and investors respond to changes in demand. The current products are generally customised and structured for individual needs and are therefore not easily tradeable.
For deep and liquid markets to develop, there will need to be considerable development of standards and documentation for products (see ISDA survey) and credible benchmarks to support the products. While there are some ‘scores’ available there are no robust benchmarks to apply to products.
Along with the products for borrowers and investors, a supporting derivative market is essential to allow firms an efficient way to move and diversify the risk. A derivatives market needs a benchmark, and this is one of the major components of the market yet to develop.