Report: Sustainability Risk within Financial Derivatives

Authors:

Harry Tong - Senior Associate, Totem Product Development, Derivatives Data & Valuation Services

Greg Wallace - Managing Director, Head of ESG Research, Sustainable Finance

The Sustainable Finance Disclosure Regulation (SFDR) from the EU requires financial markets participants and financial advisors to disclose information at an entity, a service, and a financial product level to help answer several key questions:

1. How can Principal Adverse Impact be identified, measured, and prioritised, so it can be incorporated into investment decisions and disclosed to investors?
2. When Principal Adverse Impact and Sustainability Risk is identified, how does the relevant party engage with the underlying party?
3. How does Sustainability Risk affect returns for investors and how do sustainability branded products compare to their vanilla counterparts? Where this is not relevant, why not?
4. More specifically, does the product aim to reduce carbon emissions?
5. How are considerations of Sustainability Risk monitored and disclosures kept up to date?
6. For the disclosing Firm, how do sustainable business codes and standards align with the Paris Agreement and how is renumeration kept consistent with Sustainability Risks? The requirements of the regulations are relatively high level, and as such the three European Supervisory Authorities (ESAs) have released an RTS2 to incorporate feedback and clarify expectations.

Key Insights from the Report

Under the EU's SFDR regulation, since 10 March 2021, Fund Managers are required to make pre-contractual disclosures on Sustainability Risk at both an entity and product level.

• Product level disclosures apply to all in-scope ESG products. The European Supervisory Authorities (ESAs) have indicated a minimum set of disclosures. These requirements apply to a broad range of products, including derivatives.
• A key concept within SFDR is the micro-economic concept of the "Principal-Agent Problem". This frames Sustainability Risk in two ways:
  1. The Principal Adverse Impact that the investor may have on the underlying
  2. Sustainability Risk and the impact this may have on returns for the investor
• Sustainability Risk can be explicitly hedged within the contract of an OTC derivative contract, aligning the goals of the investor and the underlying. However, Sustainability Risk can also manifest itself in derivatives without an intrinsic ESG component, whether they be vanilla or exotics, or traded via OTC or on the exchange.
• A simple set of rules combined with more complex financial risk indicators can help to effectively explain the Sustainability Risk of derivatives, and ultimately the potential impact it has on returns for investors.

Download our full report.