A Linklaters client update notes an increasing public awareness of climate change along with the realisation that government action alone will be insufficient to tackle the climate crisis has led to a growing focus around the world on mobilising private finance to effect climate action with structured products taking centre stage.
The green and sustainable finance market expanded considerably during 2019, with industry bodies such as the International Swaps and Derivatives Association (Isda) and the Association for Financial Markets in Europe (AFME) setting up specific working groups to focus on sustainable finance and the first legislative measures in the European Commission’s sustainable finance action plan being agreed and adopted.
The client update (Derivatives and Structured Products Horizon Scanning 2020 - Sustainable Finance) by Linklaters, however, reads that significant financing is still required to meet the UN’s Sustainable Development Goals and that there will be increased pressure in 2020 for private capital to be used for sustainable investments.
“We expect to see these types of products rise in popularity during 2020 as investors seek greater exposure to sustainable transactions,” said Leanne Banfield (pictured), counsel at Linklaters. “We are already seeing a huge increase in demand for sustainable finance products. This is not just in the green bond and green/sustainable loan space, but also in the derivatives and structured products world.”
There is increased pressure to be investing in more sustainable products and there is undoubtedly more demand than supply at the moment
There remains a concern that there are not enough sustainable investment opportunities compared to the increasing demand. As a result, there has beena rise in sustainable derivatives and structured products, including green regulatory capital transactions and synthetic securitisations, repackagings of sustainable commodities such as carbon credits, repackagings of green and blue bonds and structured notes with payouts linked to green benchmarks and funds.
Investors are seeking structured notes with payouts linked to green funds and benchmarks, repackagings of green and blue bonds and sustainable commodities as well as exposure to “sustainable” securitisations and regulatory capital transactions, according to Banfield.
“There is increased pressure to be investing in more sustainable products and there is undoubtedly more demand than supply at the moment,” Banfield said. “As such, we expect issuers and banks to prioritise their ESG offerings this year.”
To deal with the expected demand in sustainable finance products, the market has seen increased regulation and industry led recommendations at a global, European and UK level intended to create a level playing field for these products, give companies and financial instruments easily comparable suitability credentials and clarify ESG disclosure requirements for investors and asset managers.
The first legislative measures in the European Commission’s sustainable finance action plan have now entered into force, comprising two regulations, one establishing regulated categories of low carbon indices to help investors compare the carbon footprint of their investments and the other setting out ESG disclosure requirements for regulated firms.
Regulatory framework
The much awaited taxonomy regulation establishing a framework to determine whether a particular economic activity can be considered environmentally sustainable is expected to be published in early 2020.
One of the biggest obstacles facing the industry is the lack of clear guidance on the definition of ‘green’
“A clear regulatory framework is essential to developing a solid sustainable finance offering,” said Banfield. “But one of the biggest obstacles facing the industry is the lack of clear guidance on the definition of ‘green’.”
“It is very difficult to be sure what a product is really doing,” she said. “The taxonomy seeks to target greenwashing and provide guidance on what is environmentally sustainable. For now, it is very ‘dark green’ and products will likely struggle to fulfil the relevant criteria, but along with the Sustainable Finance Disclosures Regulation and the Sustainable Finance Benchmark Regulation it will be key in developing and shaping the market.”
It is expected that the quantity and quality of climate-related disclosures will continue to increase as consideration of climate risk becomes embedded in financial decision making. Even where the regulations comprising the EU action plan do not directly apply to financial institutions (for example, where they are arranging structured products), they will be subject to the usual obligation to be “fair, clear and not misleading” and the regulators will likely be looking at any sustainable products with increased scrutiny.
Financial institutions should therefore pay particular attention to how they are marketing and disclosing risks for sustainable structured products, according to Banfield.
“I personally think we will see a whole new market of instruments to transfer ESG risk emerge, so watch this space,” Banfield said.
Recent regulatory updates around sustainable and ESG structured products include the French Autorité des marchés financiers (AMF) move to clarify exemption criteria around ESG strategies used in structured products in late 2018, while the Hong Kong Securities and Futures Commission (SFC) introduced new requirements for new investment products to be classified as green or ESG.
At a European level, although finalising the Priips RTS review is a priority for 2020, the application of ESG labels for structured products, such as the quality standard for sustainable and socially responsible financial products introduced by the Belgian federation of the financial sector Febelfin, will be a major point of discussion at both national and EU levels, Thomas Wulf, secretary general at the European Structured Investments Association (Eusipa) told SRP in a recent interview.
Click in the link to read Linklaters’ New EU ESG rules for asset managers and financial advisers client note on the EU sustainable finance action plan.