As the concept of responsible investing rises in popularity, the derivatives industry is responding. The most recent examples are in Europe, where two leading exchanges have launched futures on stock market indices that meet environmental, social and governance standards.
While definitions of ESG investing vary, the adoption of this approach is spreading rapidly and increasing amounts of money are flowing into funds that consider ESG factors in their investment process. Morningstar estimates that €34.4 billion flowed into European ESG funds in 2018, bringing the total assets under management to €684 billion at year-end.
What is ESG investing?
An ESG investing index requires that any corporations within the benchmark meet certain standards for environmental, social and governance of their business.
Some methodologies for ESG indexes include:
- "Best-in-class" screening, with companies or projects selected for positive ESG performance relative to industry peers.
- Exclusionary screening, where certain sectors or companies involved in controversial activities are omitted
- Impact investing, where corporations included are those that commit to targeted investments aimed at solving social or environmental problems that may not be directly related to their business.
- Active integration, via systematic and explicit inclusion by investment managers of ESG factors into their financial analysis and index construction.
Index providers also have joined the trend, creating versions of popular stock market benchmarks that have been adjusted to filter out companies that do not meet ESG standards. Now the exchanges are using these ESG indices for a new class of stock index futures.
At the Forefront of the Trend
Nasdaq was the first exchange to move into this new sector. In October 2018, the exchange launched futures on a version of the OMX Stockholm 30, the main benchmark for Swedish stocks, that excludes companies that fail to meet ESG standards.
The OMXS30 ESG Responsible futures have performed well, having traded 436,000 contracts in less than six months since launch. Plans for corresponding ESG indices for two of Nasdaq’s other Nordic benchmarks, the OMXC25 in Denmark and the OMXH25 in Finland are underway; those additional indices are expected to launch soon.
The exchange developed the index in cooperation with several Nordic asset managers and designed it to be used not only for standardized futures but also for structured products such as warrants, index bonds, and exchange traded funds. is part of a broader strategy to make it easier for investors to pursue sustainable investment strategies.
"In recent years we have seen institutions increase efforts to integrate sustainability into their investment strategies, with the Nordic region being in the forefront of this trend," Alessandro Romani, head of European equity derivatives at Nasdaq, said in a press release when the new futures were launched. "Those looking to invest in a more sustainable way need more investment products based on established and liquid indexes. Our existing OMXS30 index future contract is among the most traded in Europe and we expect to see the same interest for the ESG version."
Eurex, Europe's largest derivatives exchange, joined the trend in February, launching three new futures contracts that are tied to European stock indices with an ESG focus:
- The Stoxx Europe 600 ESG-X Index, a version of the large-cap Stoxx Europe 600 that screens out companies with low ESG rankings. For instance, the ESG-X index has removed 20 companies such as British American Tobacco and Airbus.
- The Euro Stoxx 50 Low Carbon Index offers a play on the Euro Stoxx 50, the leading benchmark for continental European stock markets, but with a focus on companies with the lowest “carbon intensity” scores.
- The Stoxx Europe Climate Impact Index, a group of about 260 European corporations that includes companies that disclose the environmental impact of their businesses and excludes those in industries such as coal.
The exchange has lined up a long list of banks and trading firms to provide liquidity for the new contracts. The exchange also is working to get approval from the Commodity Futures Trading Commission to offer the contracts directly to U.S. customers, said Grit Beecken, a spokesperson for the exchange.
"Sustainable investing is no longer a niche, but rather an increasingly essential investing practice," Beecken said. "More investors are convinced that investing in sustainable businesses is good from an ethical and moral perspective as well as for risk adjusted performance."
The Eurex ESG futures got off to a fast start, with nearly 20,000 contracts traded in the first six weeks. To build on that initial movement, Eurex plans to continue with “stepwise extension to complementary sustainability offerings, further regions, and options,” Beecken said.
Eurex also has lined up support from institutional investors such as BNP Paribas Asset Management and Swedbank Robur that incorporate ESG factors into their investment strategies. These firms are familiar with using index futures to manage their market exposures, and the ESG futures will offer an important addition to their ESG investment tools.