Risk, reward and sustainability – sustaining the ESG economy

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As sustainable investments grow, the need for risk management solutions specifically tailored to ESG criteria also increases. Although approaches to sustainability are many and varied, the investment industry will need to come together around a few basic benchmarks capable of attracting sufficient liquidity to make risk management simple and economical. They must also correspond to the ESG references required from regulators and investors.

The obvious place the market needs to turn are the specialized ESG versions of existing, high performing and highly liquid benchmarks. For example, the S&P 500 Index may be the most widely traded index in the world. Its ESG version – the S&P 500 ESG Index – has a five-year tracking error compared to the S&P 500 Index of just 1.06%. As a result, the S&P 500 ESG Index has become a prime candidate to provide a broad benchmark for the ESG investment industry, supported by a deep and liquid futures market.

The cutting-edge methodology has also been used in the recently launched S&P Europe 350 ESG Index and provides a template for a more standardized and holistic approach to ESG investing across the world.

This will not be enough, however.

New regulations, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) and EU taxonomies, are creating demand for more products and prompting asset managers to take a closer look at investment criteria to ensure that it is both beneficial to the portfolios and sustainable.

For fund managers, derivatives will continue to play a role in financial transactions by reducing credit and market risks, which will not change with the new ESG principles. Derivatives can support the management of climate change risks and this trend will only continue as the underlying markets develop.

The prudent use of derivatives allows companies to manage specific risks related to ESG factors. They allow funds to reach the target allocation in a more liquidity-efficient manner than by investing directly in the underlying stocks, potentially allowing more capital to be channeled into sustainable investments.

Greenwashing is at the forefront of investor concerns about ESG

Having a few core benchmark products around indices that meet SFDR requirements and comply with Article 8 should attract sufficient liquidity pools and create price transparency, which in turn will help to ensure effectively implement ESG strategies, which will facilitate the transition to a more sustainable environment. economy.

With concerns about greenwashing, best expressed by regulatory developments such as SFDR, it is crucial to have a market for liquid instruments that meet the most stringent requirements of ESG investments.

As private capital will need to be mobilized to meet the needs of the various global green initiatives, the 2030 Agenda, the European Green Deal or the Ten Point Plan for the Industrial Green Revolution in the UK, and new regulations, such as SFDR and EU Taxonomies, ESG derivatives are expected to play a larger role in the years to come. It is now essential that the market mobilizes around basic liquid products with high ESG standards to avoid the devaluation of a pivotal sector of the markets and the future of the economy.

Payal Shah is Director of Equity Research and Product Development at CME Group


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