07 Mar 2023

Eurex Exchange

The role of ESG ratings for collateral

Ahead of Derivatives Forum Frankfurt, Eurex spoke with Pauline Engelberts, Global Chief Operating Officer at ABN AMRO Clearing on the role ESG ratings play for collateral and the challenges of making derivatives more sustainable.

How much of a discrepancy is there between public ESG data and firms’ private ESG data?  

Even between the ESG rating agencies there is a big discrepancy in data. Some jurisdictions, like France, have mandated that ESG rating agencies discuss and make transparent how they actually come to their ratings. The classic example is Tesla shares, which can have a really good score from one rating agency and then a really bad one from another. As long as you are aware of that then you are fine to operate. But we’ve got to really understand what the differences are. That is an area where you can add value.  

There is a big discrepancy between the rating agencies and therefore also in firms’ portfolios and the measurements that they use for those portfolios. 

What data do you use to assess portfolios for ESG factors? 

Financing in clearing is really short term, it's not on our balance sheet. We do not assess fund portfolios for ESG factors. As a clearer, we assess our own securities borrowing and lending portfolios. To do that, we take the stocks that we are financing and put them through our chosen rating agency, to see what their average rating is to get a view of the ESG scores that we are using for security financing   

We also use the same methodology with our clients to start a conversation. We have three different types of clients: the proprietary trading groups, the prime clients and the commodity traders. We can look at their portfolio, every trade they have done with us for the last year and tell them how their ESG rating compares to an average benchmark rate for their group of peers or client type. Then we can engage with them and start a general conversation, which for many is the first time they have regarded their portfolios through that lens.  

The only problem we find is that the coverage of futures and other derivatives data is much lighter than equities. The derivatives world is very complex, with so many different varieties of products that it's hard to get a really good picture. At this point though, it’s just good to start the conversation, because there are no golden tools out there right now.  

What are the main issues with making derivatives more sustainable?  

The most important thing with futures and derivatives in general is looking at the underlying sector and the tenor. So, if you have an option on oil then the underlying should be considered in the risk assessment. But then you can also look at the tenor - if it's longer then it has a higher risk factor than for a shorter period of time perhaps. Derivatives are hard for the ESG rating agencies to understand.  

There are also ideas around the intent of the derivative. If you trade a pure FX or interest rate derivative and are using it because you're buying solar panels and want to hedge your currency or interest rate risk. Can that then make a derivative automatically green? That wouldn’t work for firms that are just trading spreads – then there is not a real economy perspective, or intent, for the derivative.  

It also means that somehow every derivative that is linked to a green project has to be given that label. That would involve a lot of information gathering from clients and it is not going to work at the moment if we have to do that ourselves. Ideally the information is tagged to the trade so we can identify it easier throughout the whole value chain. 

How can derivatives be used to further the goals of sustainable finance? 

The whole derivatives space is really important for ESG. It means we can be better at bringing flows to where they need to be and promoting long-termism as opposed to short-termism. Derivatives have a really important function and role in the whole sustainability transition.  

Derivatives’ use in price formation is also important. You are promoting transparency of pricing, which is the general reason why we use derivatives. You also make it possible for companies to actually get the liquidity or get the money that they need, to be able to make investments in sustainability.  

With an industry standard still not yet established for reporting GHG emissions for derivatives, which method do you believe should be used?  

We have been providing a lot of feedback in consultations about this, for example to IOSCO and the FIA. As an industry, we're all trying to find solutions for integrity and transparency of carbon credits, carbon trading and how to price derivatives.  The next step is understanding the true GHG impact of these products and reporting them in a transparent and standard way.  

But at the moment, ESG factors aren't really priced into derivatives. But as soon as we make that link to the underlying motivation of the derivative and how long it is, then we can start looking into proper pricing. 

What are the main benefits of an exchange or clearing house with regards to furthering ESG goals? 

This takes us back to the issue of long-termism. Clearing is basically your risk management function. It provides stability and access within the financial markets’ infrastructure. That is a role that it can play that pertains to non ESG and ESG financing. That's really, really important.  

But also, more and more people are asking for ESG products and liquidity. Clearing manages the risk, but it also opens an opportunity for more liquidity to be created, especially in the areas where it's needed most.  

What role will ESG ratings play for collateral?  

Ultimately, we will get to a stage where if you have collateral with a really good ESG rating, then it will probably be deemed less risky. That should make highly-rated ESG stocks or collateral stronger, because it will be more desirable and liquid. Whereas if you have collateral that's really bad, then it's going to be hard to get it back into the market – be less liquid possibly - and that collateral is going to be worthless.  

So, ESG should determine the value of the collateral in the future. That means we then need to know what the ESG rating of the collateral is and be able to link it to an ISIN, as opposed to us having to spend time finding out what it is. So, we really need a more granular information flow, better data, than we have now. 

What factors will be used to differentiate ESG securities used for collateral in the next five years? 

Climate and environmental factors seem to weigh more than the social factors. You could question that with commodities and some other sectors though and I think there should be more attention given to social factors. In the whole ESG discussion, we're focusing mostly on the degradation of nature and not enough on unequal wealth distribution. But at the moment, the liquidity impact is probably stronger if it's on the environmental side than if it's on the social side. 

To go back to commodities, there are social factors to consider, like human rights and labour.  

We must realize that talking about sustainability is also a privilege. How cannot you be angry with the use of plastic in communities with no clean or running water - how else are people going to drink?  

The environment is important. But if we really want to get moving with ESG, we have to start focusing on the social impact too. Only when people have their basic level of needs met, will they be able to focus on environmental impact. We have to price that in. 

It must be very hard to kind of quantify social factors?  

It's just as hard as carbon. For example, if a commodity trader is buying product from the Congo, he would have to factor in data such as the country’s GDP but also average life expectancy. Funnily enough, countries that are being led by women are looking at more measures other than just GDP, such as healthcare and education to determine the health of their country. Maybe we as an industry should start taking that into consideration too, do we have to factor in pricing when we take collateral from a country with a bad track record. We're not even having that discussion yet though.