Around the world, investing strategies based on environmental, social and governance criteria (ESG) have become increasingly popular. For example, Japan’s Government Pension Investment Fund, the world’s largest with $1.48 trillion in assets, Norway’s Government Pension Fund with $1.11 trillion in assets, and the California Public Employees' Retirement System, the largest public pension fund in the U.S. with $382 billion in assets, have all embraced using ESG criteria for at least some part of their investment approach.
Exchanges have responding by introducing a host of derivatives based on ESG indices, with roughly a dozen now on offer and more on the way in 2020.
There is no clear consensus, however, when it comes to defining just what environmental, social and governance criteria matter in building an ecosystem of ESG investment products that include cleared derivatives.
Over the next two years, the European Union hopes to deploy a series of new laws requiring financial firms to take climate risk into their investment strategies or disclose a lack of compliance to their shareholders. The EU also is trying to standardize ESG terminology by developing "taxonomy" for ESG definitions. In June 2019, a group of experts appointed by the European Commission released a 400-page report that sets out the basis for a future EU taxonomy, but the Commission has not yet decided how to implement its recommendations. As a result, those standards remain a long way off, and regulators in Asia and the Americas remain even farther behind.
At present, then, exchanges largely look to index providers to structure ESG products. In some cases, the index providers do their own analysis. In other cases, they rely on specialist firms with expertise in measuring corporate performance on environmental, social and governance standards.
Sometimes this means formulating an index through exclusion of certain types of companies that fall well short of ESG standards, such as weapons producers, tobacco companies or coal miners. Other times, the indexes are thematic with a focus on a specific sector of the economy such as firms that have substantial revenue from clean energy businesses. There are also hybrid approaches, which can involve a custom methodology to rank potential constituents on hand-picked criteria and then formulate the index based on the results.
One of the top index providers in Europe is Stoxx, a subsidiary of Deutsche Börse. When Stoxx decided to create a set of ESG indices, it turned to Sustainalytics, a research firm based in Amsterdam that advises on ESG and compliance issues. According to Alexandra Reed, a spokesperson at Deutsche Börse, Sustainalytics helped Stoxx create the ESG version of the Stoxx 600 index by screening out certain undesireable companies. One of the screens used by Sustainalytics is the United Nations Global Compact, a non-binding but widely accepted framework for corporate sustainability.
"The screens are based on the responsible policies of leading asset owners and aim to reduce reputational and idiosyncratic risks," Reed said. "Stoxx will exclude companies that Sustainalytics considers to be non-compliant with the UN Global Compact Principles, are involved in controversial weapons, are tobacco producers and either derive revenues from thermal coal extraction or exploration or have power generation capacity that utilizes thermal coal."
Eurex introduced futures on the ESG version of the Stoxx 600 index in February 2019, and it has quickly gained traction on the exchange. The total number of contracts traded last year was 667,802, with a total value of 9.75 billion euros ($10.8 billion).
Eurex also offers futures on the Euro Stoxx 50 Low Carbon Index. This index takes a different approach by focusing on just the environmental dimension of ESG. The index is based on the Euro Stoxx 50, with overweighting of companies that emit relatively low amounts of carbon and underweighting of companies with high carbon emissions. To determine the weightings, Stoxx relies on carbon emission data supplied by CDP, a non-profit that runs a global environmental disclosure system, and the climate solutions arm of Institutional Shareholder Services, a leading shareholder advisory firm.
The Stoxx Europe ESG Leaders Select 30 Index offers yet another approach. The index is designed to replicate a widely used stock selection strategy based on research showing that a portfolio consisting of stocks with low volatility and high dividend yields will generate better risk-adjusted returns than the benchmark indices. The ESG version of this index combines this investment strategy with an ESG screen based on the Global Compact Principles. It is already in use in the European structured products market, with banks such as J.P. Morgan and Société Générale selling funds and notes based on this index directly to their customers.
CME Group introduced its first ESG future in November. The contract is based on the S&P 500 index, a leading benchmark for the U.S. stock market. Like Eurex, CME does not choose which companies to exclude. Instead that analysis is conducted by the index provider, S&P Global. The ESG version of the S&P 500 index screens for the usual weapons and tobacco companies but also excludes firms that fail to score well on a proprietary S&P Dow Jones ESG ranking. That eliminates such companies as retailer Macys, movie streaming business Netflix, and the restaurant chain Chipotle Mexican Grill.
To identify the companies that fail to score well on S&P's ESG ranking, the index provider relies on data gathered by RobecoSAM, a Swiss investment company focused on sustainable investing. SAM administers an annual evaluation of sustainability practices at more than 4700 companies around the world.
Tim McCourt, CME’s global head of equity index products and alternative investments, said S&P uses a "fairly intense screening process" to construct the S&P 500 ESG index. He added that the index is constructed in such a way that it covers 75% of the market capitalization for each industry group within the S&P 500. This construction allows the index to maintain "very close proximity" to the performance of the parent index, he said, with a variation of only 75 basis points over the last five years.
Intercontinental Exchange also entered the ESG derivatives market in November, launching a suite of futures products referencing indices provided by MSCI. According to MSCI, more than $180 billion of assets have been allocated to its ESG indices since 2014, including a family of "ESG Leaders" indices that focus on companies with high environmental, social and governance performance relative to their sector peers.
MSCI identifies these companies based on its own screening methodology. This includes a global team of nearly 200 research analysts assessing data for each potential component stock across nearly 40 key Issues and then ranking them accordingly.
Each index and related family of derivative products comes with its own unique characteristics. And as capital increasingly is flowing into ESG strategies where there is no clear leader and no public-sector guidance on standards, it remains likely that the fragmented landscape of different index providers with different ESG standards will remain as major index providers such as S&P Global and MSCI rush to meet demand with new benchmarks.
Jeff Reeves contributed to this report.