Navigating the next steps in ESG

Navigating the next steps in ESG

Given the fast-growing global demand for environmental, social and governance (ESG) investing, it is easy to forget just how new the sector is.

Nasdaq Nordic launched its ESG compliant index futures contract in October of last year.

Since then Deutsche Boerse-owned exchange Eurex also delved into ESG derivatives, launching three derivatives products in February, as well as ESG-X indices in May.

One thing that Nasdaq’s index and all but one of Eurex’s products have in common is that they rely on negative screening.

Negative screening applies a filter to remove companies involved in certain activities. This helps to standardise contracts and makes them easier for asset managers to understand and trade.

Nasdaq’s ESG index future traded 91,000 contracts in May, rising to 108,500 in June, according to the US exchange group.

Eurex saw a total of 24,750 contracts trade between its three screened contracts in May, jumping to 137,000 lots in June, according to the German exchange group.

However, there is a dilemma; whilst Nasdaq and Eurex are seeing liquidity in their ESG contracts grow, they are both aware that products which rely on negative screening are only the first steps in the ESG journey.

Willem Keogh, STOXX’s head of ESG, thematic and factor solutions, said developing “super green indices” straight away does not always work because it is not always easy for the market to switch overnight to a benchmark that differs significantly from the current benchmark.

Similarly, Alessandro Romani, head of derivatives products and vice president of Nasdaq Europe, said it becomes more difficult to provide a standardised product once asset managers start offering more complex ESG strategies.

Therefore, as datasets evolve in the coming years, exchanges will be expected to walk the tightrope in providing ESG indices that allow greater customisation whilst retaining the benefits associated with offering a standardised contract.

Next Steps

STOXX is already seeing demand for derivatives on its ESG-X indices referencing the US and Europe.

The index provider also plans to launch highly specialised ESG indices in future, but the timing remains uncertain.

Meanwhile Nasdaq said it plans to adopt a basket approach to ESG in September this year.  

The basket approach would enable customers to design their own custom baskets based on a selection of global stocks before Nasdaq lists the forward on its exchange for trading and clearing.

“It is a product that combines the advantage of a standardised and centrally cleared derivative contract with the flexibility of designing your own baskets of stocks,” Romani said.

Rather than relying on ESG demand, Romani said the basket approach was originally designed to be an alternative to over-the-counter (OTC) equity swaps.

Complementing, not replacing

Nasdaq’s upcoming basket approach highlights that the success of ESG in the future might rely on its synergies with other markets. 

Speaking at the Futures Industry Association’s IDX conference in London in June on the sourcing of ESG compliant resources, Georgina Hallett, chief of staff at the London Metal Exchange, said the exchange has been wary of disenfranchising non-ESG compliant producers.

“We were clear from the very start that we didn’t want to disenfranchise anyone,” Hallett said.

She explained that the easy option for participants has been to move out of non-ESG compliant markets entirely and source from somewhere else.

“There are resources that are found in their (producer's) country, and they have the right to take advantage of that.

“It is up to us to find a way to allow the rest of the world to do that, while appropriately mitigating the associated risks,” Hallett said.

Nature of the demand

Pauline Engelberts, global chief operations officer at ABN AMRO clearing bank said she sees a larger industry change where participant demand is falling broadly into three levels (varying between companies).

“The first one is if participants are just looking to grow their revenue and reduce their costs. The next level is stakeholder legitimacy, which is if you are involved in ESG because society and institutions expects you to. And the third level would be more intrinsically, for moral and ethical reasons,” she said.

The nature of the demand for ESG products could also determine how they are designed.

For example, ESG products with a greater sustainability focus might rely on demand that is more ethical in nature rather than economic necessity.

Nandini Sukumar, chief executive officer of the World Federation of Exchanges, said the introduction of new products will also depend on what constitutes a “sustainable investment”.

“The introduction of widely-used, standardised ESG products will probably depend on greater standardisation of, and agreement around, what constitutes a sustainable investment (or an unsustainable one),” she said.

 

Meanwhile she said work on developing an EU taxonomy to determine whether an economic activity is environmentally sustainable “is a step in this direction”.

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