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SUSTAINABLE DERIVATIVES: THE “GIVING TREE”

Jennifer Kafcas, Lauren Blaber, Alvino Van Schalkwyk and Harry Polan

 

Momentum continues to gather pace towards building a sustainable economy, especially since the start of the pandemic. As a result, financial markets have seen a considerable increase in the focus on, and deal volume with respect to, sustainability-linked loans and bonds.  It has been a logical progression that the sustainability tree sprouts a new leaf with the development of environmental, social and governance (ESG) linked derivatives.  These products enable, among other things, firms and companies to hedge risks associated with sustainable investments including project risk, interest rate and currency risks.  This will be all the more important given the need to hedge risks from any underlying loan and its related sustainability criteria.

While ISDA has outlined the broad range of derivatives in sustainable finance, furthering the development of this product type (including, among others, sustainability-linked derivatives, ESG-related credit default swaps, exchange-traded derivatives on listed ESG-related equity indices, emissions trading derivatives, renewable energy and renewable fuels derivatives, and catastrophe and weather derivatives), this article focuses on more conventional derivatives transactions, such as interest rate swaps (IRS) and Foreign Exchange (FX) transactions used by market participants to hedge the risk arising from green bonds and loans. Though these transactions are no different conceptually from a product standpoint than any other IRS or FX transaction, it is important to understand the inherent structural and deal term differences.

 

Finance-linked sustainable derivatives (OTC)

A number of sustainability-linked derivatives have been issued in recent years, which add an ESG pricing component to conventional IRS and FX hedging instruments. The table below provides examples of recently issued sustainability-linked derivatives. As this is a developing market, the transaction volume has been very low, but uptake is expected to increase over coming years.

 

PartiesDeal Information
BNP Paribas & Siemens Gamesa€174 million FX forward, under which Siemens Gamesa will pay a premium on their forward if they do not meet certain ESG targets. If paid, that premium shall be used to finance local reforestation projects in Spain. The premium shall be calculated using a metric assigned by a third-party sustainable finance specialist.
Société Générale & EnelCross currency swap, by which Enel hedged their euro-dollar exchange rate and interest rate risk under a $1.5 billion sustainability-linked bond. If Enel does not meet certain renewable energy targets, the swap will be re-priced to their detriment.
New World Development (NWD) & DBS Hong KongInterest rate swap linked to the United Nations Sustainable Development Goals, hedging interest rate risk under NWD’s HK$1 billion sustainability-linked loan. If NWD generates at least eight business-to-business opportunities that contribute to the Sustainable Development Goals, DBS will sponsor certain NWD social innovation projects.

 

As evidenced above, ESG-linked derivatives can take on a number of characteristics and structures, including:

  • Derivative pricing. One counterparty having a number of prescribed ESG targets which, if met, will lead to a downwards ratchet in the pricing of the derivative (with such pricing often increasing if the targets are not met).
  • Fixed payments. If ESG targets are not met by the corporate, a fixed payment can be required to the issuing bank, which will be put towards a green project.
  • Triggers linked to a company’s ESG rating. If the ESG rating of the corporate increases, a benefit can be awarded to them (e.g. interest rate discount).
  • Both parties having ESG targets papered into their derivatives contracts. Corporates can receive a discount on the interest rate under the derivative if they meet their ESG targets, with that discount increasing if the issuing bank fails to meet its own ESG targets.
  • Charitable giving requirements. A failure by the corporate to comply with its ESG targets can lead to it being required to make contributions to non-profit organisations, with the bank having to make such contributions if the corporate’s ESG targets are met.

As sustainability-linked products gain traction, a degree of care will be required to ensure ESG targets are finely balanced and verifiable. Verification is essential for market transparency, for ESG products to be considered credible and for lenders and corporates alike to avoid reputational risks. Furthermore, the ability of a corporate to verify reliable compliance with ESG targets could provide a significantly smoother path through their lender’s credit approval process and in turn the lender’s ability to verify will enable it to better monitor the performance matrix set by the underlying loan or bond.

 

Renewable Energy and Renewable Fuels

In addition to the above OTCs, renewable energy hedging transactions (including power hedge transactions) are important for market participants to hedge the risk associated with fluctuations in renewable energy production, and in doing so, encourage more capital to be contributed to renewable energy projects.

Typical documentation with respect to the above type of trades are Power Purchase Agreements (PPAs) which document the purchase of power and associated renewable energy certificates between a renewable energy generator (the seller) and a purchaser of renewable electricity (the buyer). PPAs do not require companies to contribute directly to enhanced ESG standards, however they can help catalyse a shift to clean energy sources as they reduce market price volatility for buyers, and reassure sellers that a buyer will purchase power generated from renewable energy assets, thus encouraging the financing of such projects.  In an ESG-linked transaction, these types of arrangements can be replicated by covering the credit risk element in the intercreditor terms.  As an alternative the market may develop such that in lieu of these structures the underlying risk with respect to market price volatility is documented under an ISDA and secured under the financing and intercreditor documentation. This structure is fast approaching.

 

Expected developments in 2021

Climate change and, therefore, a sustainable economy remain front and centre for governments and regulators worldwide.  In 2020,countries like Japan, China, South Korea, Hong Kong and the UK set net carbon neutrality objectives and most recently the USA, following the inauguration of President Biden, announced plans to spend $2 trillion over four years to aid in the fight against climate change, all following the commitment already set by the EU.

Whilst the need for banks and corporates to develop and consider bespoke products to promote true progress in ESG compliance may hinder any radical uplift in ESG-linked derivatives volumes over the course of 2021, we anticipate that as banks and corporates continue to familiarise themselves with the requirements of such products, integrating ESG elements into derivatives trades will begin to be common practice.

In view of this, derivatives market participants will be eager to continue to drive ESG-linked derivatives volumes and to develop new and innovative ESG products facilitating the mobilisation of capital towards sustainable investments to ensure that they continue to significantly improve ESG standards, and to strengthen their contribution to the green finance drive.

 

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FINANCIAL SERVICES MUST FIX THEIR MISSED OPPORTUNITY AS CONSUMERS DEMAND MORE ENGAGING DIGITAL EXPERIENCES

  • Less than one-third (30%) of consumers believe the Financial Services firms they interact with now deliver a better digital experience than before the pandemic
  • Over half (51%) of consumers are prepared to switch to a competitor if their digital experience does not live up to their expectations

Time is finally up for Financial Services firms failing to create the engaging digital experiences that consumers have been crying out for. Almost half of UK consumers (45%) prefer to engage with banks via apps rather than in person with members of staff, while two-fifths (39%) believe their smartphone is more important than their wallet in powering financial transactions (rising to 51% amongst 18-35 year olds).

These are the stark findings from a new study from VMware of more than 2,000 UK consumers, exposing the extent to which the digital-first, customer-obsessed mantra that was ushered in by the FinTechs and Challenger Banks, has transformed the customer battleground.

However, while most industries underwent a seismic digital switch as a result of the pandemic, the Financial Services industry has not matched the level of innovation. Less than one-third (30%) of consumers believe the Financial Services firms they interact with now deliver an improved digital experience compared to before the pandemic.

In a market beset with challenger brands looking for ways to uproot the incumbent providers, this research should serve as a wake-up call to Financial Services firms looking at ways to install brand loyalty. Over half (51%) of consumers would switch to a competitor if their digital experience doesn’t live up to expectations – just 10% would remain loyal.

The areas of investment that will best serve both traditional and challenger firms alike are clear. While there remains an insatiable appetite for better digital services in Financial Services, the absolute priority for three-quarters (74%) of customers when choosing a new provider is security. This unsurprisingly is played back when customers reveal what more they want from their digital interactions, which include:

  • a high level of security and protection of their data (70%)
  • simple and effective applications (47%)
  • and ease of use across all their devices (40%)

The Financial Services firms that will thrive in this new customer battleground will ultimately be those that can establish themselves as a trusted, digital partner. It will also prove a key success factor in the roll out of more innovative products and “smart” services. For instance, while today, if customers had money to invest, just 12% would allow an app to make the investment decisions over an individual that works for the bank, It is those firms that can put trust and transparency front and centre of their offering, that will have the opportunity to capture this lucrative opportunity.

 

Matthew O’Neill, Industry Managing Director, Advanced Technology Group, VMware said: “After the unprecedented but overdue ‘digital switch’ of last year, consumers are rightly demanding more from an industry where the battle for the best customer experience means success or failure to businesses in the Financial Services sector. In this new battleground, the most successful firms will be the ones that are becoming digital at the core – where they can adapt and innovate faster to create better user experiences, without compromising security, in the process. Those firms who have a digital-first posture, have everything to play for with today’s consumers and not just those that are growing up digitally native.”

 

Methodology

This research was conducted by an online survey, commissioned by VMware, of 4,102 EMEA consumers across 3 countries – UK (2,069), France (1,028), Germany (1,005). In this online survey, consumers were asked to rate their digital experiences across five sectors – Retail, Healthcare, Financial Services, Education and Government (local and national). YouGov conducted the survey in November 2020.

 

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VIRGIN MONEY EXPANDS PARTNERSHIP WITH FINTECH LIFE MOMENTS

Virgin Money is expanding its partnership with FinTech data expert company, Life Moments, to focus on the development of the sustainability elements of the Virgin Money offer to its business banking customers.

 

The agreement is the latest partnership from Virgin Money as it continues to develop its working capital health proposition, which will be launched in the Autumn.  This will transform the Bank’s existing business current account and forms part of its commitment relating to the recent £35m award from the Banking Competition Remedies (BCR) Capability and Innovation Fund.

 

Life Moments is a leading provider of platforms and tools to improve customer experience and generate data insight. The company has worked with the Bank since early 2020, developing and launching Virgin Money’s Home Buying Coach app, designed to simplify the home purchase process and help first time buyers on to the property ladder. The company will now work on digitising and capturing customer responses to an ESG benchmarking tool, developed by the Bank in conjunction with Future-Fit Business, as well as integrating the results and data into the Bank’s new Business Current Account Wellness Tracker, providing tailored digital coaching for businesses.

 

Virgin Money, which joined the Future-Fit Development Council last year, is the first company in the financial services industry to use the Future-Fit Benchmark for commercial banking. The tool, which can be used by any business of any size, whether they are a Virgin Money customer or not, has a user-friendly set of questions to help a company understand its current position, via both an ESG score and guidance on the steps that could be taken to create a more sustainable model.

 

The agreement is also expected to contribute towards Virgin Money’s recently launched ESG commitments and aspirations, including at least halving its carbon emissions across everything it finances by 2030. Within business banking, and part of its BCR commitments, it will increase lending by an extra £2.2Bn by the end 2025 (£0.5Bn by end of 2022), with more than £100M of new lending going to clients pursuing environmental, social and governance aims.

 

Gavin Opperman, Group Business Director at Virgin Money, said: “Sustainability is a key element of our new working capital health proposition. Life Moments has brought exciting innovation into our mortgage business, so it was a natural progression to invite them to collaborate on enhancing our Benchmarking Tool and support our ambition to help our customers on all aspects of their ESG journey. We have created a strong base but there is more to do, which is why this partnership with Life Moments is so important the development of our new business current account.”

 

Ben Leonard, CEO and Co-founder of Life Moments, said: We are delighted to have the opportunity to extend our partnership with Virgin Money and apply digital coaching to business banking. We see many similarities between the support & nurturing we have developed with Virgin Money for first time buyers and how to help small business owners so are confident this will enhance the business banking proposition. Being able to apply our platform technology to helping businesses embed sustainability is extremely exciting for us and aligns perfectly with our profit & purpose mission.”

 

Graeme Sands, Corporate and Mid-Market Director at Virgin Money, said: “All businesses, whatever their size or industry, should be thinking about their approach to sustainability, ensuring that any future growth strategy takes into consideration the ESG impact of their operations. This isn’t an easy task, but those that do so often find new opportunities and we are committed to working with our customers and partners, like Life Moments, to provide the support and insight that allows them to work towards becoming a more sustainable business.”

 

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