Risk, Reward and Sustainability: Future Proofing the ESG Economy

In the aftermath of the crucial COP26 climate talks and with key sustainability targets becoming more of a priority, Environment, Social and Governance (ESG) criteria have moved to the forefront of fund managers’ decisions, meaning that risk, reward and sustainability are now the three key considerations for fund managers.

As sustainable investments grow, so too does the need for risk management solutions that are specifically tailored to ESG criteria. Although approaches to sustainability are many and varied, the investment industry will need to coalesce around a few core benchmarks that are capable of attracting sufficient liquidity to make risk management straightforward and economic. They will also need to fit with the required ESG credentials of regulators and investors.

The obvious place for the market to turn to is specialised ESG versions of existing, highly successful and highly liquid benchmarks. For example, the S&P 500 index is perhaps the world’s most widely quoted index. Its ESG version – the S&P 500 ESG index – has a 5-year tracking error against the S&P 500 index of just 1.06%. As a result, the S&P 500 ESG index has emerged as a leading candidate to provide a general benchmark for the ESG investment sector that is backed by a deep, liquid futures market. The leading methodology has also been used in the recently launched S&P Europe 350 ESG Index and provides a template for a more standardized, holistic approach to ESG investing across the globe.

ESG investment accelerated in 2020. Even during the initial COVID-driven equity sell off, sustainable based funds saw record amounts of inflows while nearly all other asset classes saw significant outflows.

This won’t be enough though. New regulations, such as the EU Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomies, are creating demand for more products and driving asset managers to consider investment criteria in more detail to ensure it’s both beneficial to portfolios and suitably sustainable.

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

The careful use of derivatives allows firms to manage specific risks related to ESG factors. They allow funds to meet target allocation in a more cash efficient way than investing directly in the underlying stocks - potentially enabling more capital to be channelled towards sustainable investments.