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Report: Sustainability Risk within Financial Derivatives
25 August 2021
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:
How can Principal Adverse Impact be identified, measured, and
prioritised, so it can be incorporated into investment decisions
and disclosed to investors?
When Principal Adverse Impact and Sustainability Risk is
identified, how does the relevant party engage with the underlying
party?
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?
More specifically, does the product aim to reduce carbon
emissions?
How are considerations of Sustainability Risk monitored and
disclosures kept up to date?
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.