Demand for investments – including structured products – linked to environmental, social and governance criteria is one of finance’s virtuous cycles. But, as Danielle Myles reports, a more sophisticated market comes with more challenges.

Isabelle Millat

Isabelle Millat

Investors have been a driving force behind sustainable finance’s march towards the mainstream. Some started their environmental, social and governance (ESG) journey after recognising they have a fiduciary duty to integrate such criteria into their investment analysis.

For others, the motivation was the growing body of research suggesting that climate change and inequality could damage the value of their investments. “Most investors measure their financial performance, so a way to begin incorporating ESG is to incorporate ESG factors in their risk analysis,” explains Heike Reichelt, head of investor relations and new products at the World Bank. “Then, if their stakeholders are interested in impact, they can look at various products that enable them to report on this.”

Coming of age

The ESG movement is, of course, propelled by more than just investors. Credit rating agencies now include ESG in their risk analysis frameworks, more sustainability-focused research firms are cropping up, and buy-side firms in countries such as France are legally required to report on how they integrate ESG into their investment policies.

But the overriding reason why ESG will soon become an ordinary investment factor is the proof of its correlation with financial performance. “Five to 10 years ago it was more theoretical, but the real game-changer has been the ability to demonstrate value creation – and not just via back-testing, but live performance,” says Yannick Ouaknine, head of sustainability research at Société Générale Corporate & Investment Banking (SG CIB).

For example, the bank’s SGI European ESG Champions Index, which replicates the performance of a basket of stocks whose ESG rating is the best in their sector, has outperformed the Europe-wide Stoxx 600 index by 28% over the past five years. Numbers such as this are evidence that sustainable criteria can help investors reach their financial targets. “ESG should be part of risk analysis. It should not mean giving up any financial returns,” says Ms Reichelt, who adds that there are long-term gains from having a better understanding of ESG risks.

Another recent development that supports the market’s expansion is EU authorities outlining an ESG finance strategy for the bloc. “We are at a watershed moment in terms of regulation, with the European Commission delivering a fully fledged action plan to support sustainable growth via the financial sector,” says Isabelle Millat, SG CIB head of sustainable investment solutions. “If you combine that with the appeal of financial performance and clients’ overall interest in sustainable development, we really have the three key factors to continue the market’s growth.”

The case for...

The ESG revolution has led to a proliferation of asset classes designed to satisfy socially responsible investing (SRI). Structured products are a relatively new entrant, but investors are quickly realising they provide benefits not offered by other instruments. By combining ESG metrics with financial engineering, banks can create custom solutions that offer a yield pick-up. At SG CIB, this means Ms Millat’s sustainable investment solutions team build products by leveraging both their structuring capabilities and independent ESG research provided by Mr Ouaknine’s team.

It’s very useful having sovereigns entering the green bond market as it creates liquid instruments with big nominal value

Isabelle Millat

The buy-side’s holistic approach to sustainability is another reason these instruments are gaining traction. “The trend we have seen among investors – especially insurers, which are among structured products’ biggest institutional clients – is a top-down, cross-asset class commitment to ESG and/or green,” says Orith Azoulay, global head of Natixis’s green and sustainability hub. “It means that at some point, pretty much every one of their teams, including structured products specialists, are expected to contribute to these commitments.”

An investor workshop recently conducted by the World Bank and Japan’s Government Pension Investment Fund (GPIF) found that asset managers are receiving more requests for customised investment approaches that consider their clients’ expectations and values. This could increase demand for tailored investment mandates, for which structured products are a good match.

Product mix

Another advantage of derivatives-based instruments is that they open the door to ESG for different types of investors. A good example is positive impact structured notes (PISNs). Pioneered by SG CIB, PISNs can make use of the full range of underlyings used in conventional structured products. What sets them apart is that for the life of the investment product, SG CIB commits to provide – and hold on its books – funding that equals (or exceeds) the PISN principal. Combining financial performance and ESG performance within a custom-made PISN extends the sustainable finance market to investors who would not otherwise be able access it. SG CIB recently started trading PISNs which support small and medium-sized enterprises that align with the positive impact finance principles adhered to by the bank.

Another relatively recent innovation is green bond repacks. At its simplest, the structure sees the investor sell green bonds off its balance sheet to a bank, which places the bonds into a separate vehicle. The client then invests in a structured note issued by the vehicle, which pays an index-linked return rather than the underlying’s fixed coupon. The credit risk is the same, but by adding certain features the return can be increased. SG CIB (among others) has structured a repack of the €7bn green bond sold by the French government in 2017. “It’s very useful having sovereigns entering the green bond market as it creates liquid instruments with big nominal value – they are ideal for repack structures,” says Ms Millat.

Equity-linked solutions, where the pay-off is based on the performance of a basket or index of stocks, were the first ESG structured products to hit the market and are still among the most popular. Ms Millat says a topic trending among institutional investors is how to combine ESG and equity risk premia factors. Indeed, SG CIB has launched seven European and seven US indices that combine equity risk premia strategies with an ESG filter. Structured products can be based on custom versions of these benchmarks to satisfy a client’s preference for a heavier weighting on, for example, the ESG filter or certain risk premia factors.

The real game-changer [for ESG] has been the ability to demonstrate value creation – and not just via back-testing, but live performance

Yannick Ouaknine

Research challenges

The popularity of ESG indices and structured products, plus the buy-side’s increasing sophistication regarding sustainability, is prompting questions from investors about how to fit socially aware investing into their portfolios. Many US investors use a process known as integration, whereby they add some ESG criteria across each of their funds. Meanwhile in Europe, investors typically engage in negative screening to exclude controversial sectors from dedicated funds. European funds marketed as ESG-compliant grew 49% in 2017, far outpacing the 12% growth posted by the region’s entire fund universe.

Irrespective of the investor’s strategy, new data and research challenges continue to surface. For example, the lack of research regarding ESG’s impact on credit risk creates hurdles for the adoption of products with fixed-income underlyings. “So far most of the [ESG] research has been in the equity space,” says Ms Millat. “A lot of it can be reused in the credit space, but there is a need to enhance research to address specificities of ESG and credit risk.” For products with emerging markets underlyings, it can be difficult to find sufficient – and granular enough – information to back-test the structure. “These companies disclose less than in other regions, and even for those that disclose a lot now it can be hard to find historical data,” says Ms Millat.

The green bond market’s focus on transparency regarding use of proceeds and impact reporting has spread to the broader SRI universe. When buying ESG instruments, including structured products, investors are demanding more from borrowers. The World Bank and GPIF’s investor workshop found that investors want data to be more easily accessible, reliable and timely. “A key outcome was the recognition that data and technology will revolutionise ESG investing,” says Ms Reichelt. “This is where the market is moving. Investors will be asking for more information and issuers should have the data available to meet their requests.”

The path to consensus

A lack of a framework or guidelines akin to the Green Bond Principles also creates challenges for structured products. Today, investors use their own ESG criteria and, according to Mr Ouaknine, many are uncertain which criteria are most relevant or how to combine them with financial recommendations. However, he expects a market standard to emerge soon. “Most asset managers have their own approach to evaluating and comparing ESG metrics, but with more help from the corporates, I believe there will be more transparency,” he says. “I think a kind of consensus will appear in the next few years.”

A certification system could also improve structured products’ standing within the broader ESG community. Ms Azoulay believes derivative strategies have sometimes been met with reluctance by sustainability experts. “They are more complicated than other asset classes, and sometimes they lack the familiarity needed to understand the structures, [and] the market has not defined per se what a green structured product is and how to assess its greenness,” she says. For these reasons, a common definition and framework would be welcome.


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