Environmental, social and governance (ESG)

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Environmental, social and governance, or ESG, is a term used to describe an investing strategy, or screening process, that incorporates factors pertaining to sustainability, social responsibility and corporate management.[1]

The term originates from a 2004 United Nations publication called "Who Cares Wins." [2] In its early days, it mostly meant avoiding companies like those engaged in the production and/or sale of tobacco, alcohol or firearms, but has since grown to encompass investing in companies that include, promote and/or focus on issues like workplace diversity and low emissions. ESG builds upon a pre-existing trend of socially responsible investing, or SRI.[3][4]

Difference between ESG and sustainability[edit]

Important differences between ESG and sustainability have emerged. Seeing this difference requires a shift in perspective: ESG looks at how the world impacts a company as an investment, whereas sustainability focuses on how a company (or investment) impacts the world. [5]

ESG is typically used to describe an investment framework that helps investors assess company performance and risk. The need for the ESG investment framework in the financial world arises from evidence that current economic pathways are unsustainable.[6]. Investors are increasingly analyzing these non-financial factors to identify material risks and growth opportunities. ESG metrics are not commonly part of mandatory financial reporting, but companies are increasingly presenting these factors in their annual reports or developing a standalone sustainability report.[7]

Challenges of ESG classifications[edit]

The CFA Institute, which awards the professional designation of Chartered Financial Analyst, points out the lack of definitive taxonomy, or classification, of ESG factors. Because ESG factors might be interlinked, classification of an issue as being solely an environmental, social, or governance issue, can be difficult. For instance, it might be easy to measure employee turnover at a company, but challenging to assign a monetary value to the cost of the turnover. This is true for each of the ESG categories.[8]

Environmental[edit]

In the environmental realm, climate change is causing heat waves, rising sea levels, forest fires, hurricanes and other calamities. The environmental portion of ESG considers a business’s performance as a steward of the physical environment. The CFA Institute categorizes "Environmental" as being: Conservation of the natural world

  • Climate change and carbon emissions
  • Air and water pollution
  • Biodiversity
  • Deforestation
  • Energy efficiency
  • Waste management
  • Water scarcity [9]

Social[edit]

In the social realms, a business that falls short on standards related to human rights, gender diversity and labor needs faces protests that will capture the attention of investors and the general public. The social part of ESG, therefore, looks at the behavior of the business as a global citizen. The CF Institute categorizes "Social" as being: Consideration of people and relationships

  • Customer satisfaction
  • Data protection and privacy
  • Gender and diversity
  • Employee engagement
  • Community relations
  • Human rights
  • Labor standards [10]

Governance[edit]

Governance looks at the way businesses govern themselves – everything from board composition to executive compensation to lobbying. The CF Institute categorizes "Governance" as being: Standards for running a company

  • Board composition
  • Audit committee structure
  • Bribery and corruption
  • Executive compensation
  • Lobbying
  • Political contributions
  • Whistleblower schemes [11]

Role of regulation in ESG[edit]

One important distinction between ESG and sustainability frameworks is that ESG frameworks are based on standards set by lawmakers, investors, and reporting organizations while sustainability standards are usually science-based. The goal of ESG standards is to encourage businesses to transition into models that operate sustainably, are socially responsible, and are managed in an inclusive and honest manner. The challenge in this transition is to understand how to encourage the players in the financial systems to adapt more sustainable and just business models while fostering continued economic growth.

Emerging to address this challenge are governmental regulations and standards-setting groups.

Regulation in the United States[edit]

The U.S. Securities and Exchange Commission (SEC) created the Climate and ESG Task Force on March 4, 2021 to identify ESG related misconduct. [12]

In 2022, the SEC proposed two sets of ESG rules. The first, proposed on March 21, 2022, would require mandatory climate risk disclosures by all public companies in their SEC filings. The second set, which was announced on May 25, 2022, would curb the practice of "greenwashing," and would add amendments to rules and reporting forms that apply to registered investment companies and advisers, advisers exempt from registration, and business development companies. These rules could possibly be finalized in 2022. [13]

A special role in carbon markets[edit]

In September 2020, the Commodity Futures Trading Commission released a report, “Managing Climate Risk in the US Financial System.[14].” In this, the CFTC notes the key role of the derivatives markets in providing risk mitigation instruments. Non-binding recommendations include:

  • That the US establish a price on carbon;
  • That financial regulators should include climate-related risks in their monitoring and oversight activities;
  • That regulators pilot climate-risk stress-testing; and
  • That material climate risks be disclosed.

Enforcement actions by the SEC[edit]

In early 2022, the SEC took two enforcement actions related to ESG disclosure. On April 28, 2022, the SEC’s action against Vale S.A., a Brazilian mining company, alleged that Vale made false and misleading claims about the safety of its dams before its Brumadinho dam collapsed, killing 270 people and causing more than a $40 billion loss in Vale's market capitalization. [15] On May 23, 2022, SEC took enforcement action against BNY Mellon Investment Advisors, finding that company statements implied funds had undergone an ESG quality review, even though that was not always the case. BNY Mellon agreed to pay a $1.5 million penalty.[16]

EU and global regulations[edit]

In March 2021, the European Union instituted rules known as the Sustainable Finance Disclosure Regulation (SFDR) that require more stringent ESG disclosure and reporting requirements for financial services participants, including investment firms and fund managers.

The new ESG rules apply to all asset managers that raise money in the EU, wherever their companies are based, from March 10, 2021. According to an analysis published by the National Law Review, the SFDR has significance at both the firm and product level. The rules require asset managers to disclose how sustainability risks are incorporated in their decision making, disclose the "principal adverse impact" of investments on external sustainability factors, and make product-level disclosures when they have ESG as a stated objective. [17] [18]

On 25 July, 2022, Regulatory Technical Standards (RTS) were published in the Official Journal with no material changes. This means from 1 January 2023 onward, financial market participants will be subject to the provisions under the SFDR and Taxonomy Regulation which are already in force. [19]

On July 28, 2022, the Joint Committee of the three European supervisory authorities (EBA, EIOPA and ESMA – ESAs) published its first annual report on the extent of voluntary disclosure of principal adverse impact under the Sustainable Finance Disclosure Regulation. The report found that compliance with voluntary disclosures varied significantly and in general the first disclosurees were not very detailed. There was a low level of disclosure related to alignment with the Paris Agreement and when offered, disclosure was vague. Financial market participants in general did not disclose details required to explain why they did not take into account the adverse impact of their investment decisions.[20]

Evolution of standards[edit]

As clear laws and regulatory requirements are emerging, third party standards bodies provide recommendations, frameworks, and suggested metrics for reporting and disclosure. In 2020, major players came together to create a unified framework and prototype for global financial reporting, and in turn the Value Reporting Foundation(VRF) was created. The VRF, which includes the boards for the International Integrated Reporting Framework and the Sustainability Accounting Standards Board, was consolidated into the IFRS Foundation August 1, 2022. The IFRS Foundation is now charged with developing IFRS Sustainability Disclosure Standards.

Stock exchanges and ESG[edit]

Stock exchanges have an important role in promoting the transition of businesses into models that operate sustainably, are socially responsible, and are managed in an inclusive and honest manner. Research by United Nations Conference on Trade and Development UNCTAD and World Federation of ExchangesWFE identified main mechanisms through which stock exchanges can contribute to development. Two of these are mobilizing resources for sustainable economic growth and development and promoting good governance in business practices. Chief among these is offering small and medium companies access to finance.[21]

To facilitate an active role for stock exchanges in the ESG transition, the UN Sustainable Stock Exchange (SSE) initiative was created in November 2009. A UN Partnership with several organizations, the SSE initiative provides a global platform for exploring how exchanges, in collaboration with investors, companies, regulators, policymakers and international organizations can encourage sustainable investment. As of July 2022, 116 stock exchanges belonged to the UN SSE.[22]

Derivative exchanges and ESG[edit]

The role of derivative exchanges in this complex financial landscape is just emerging. The risk management products and forward price discovery that derivative exchanges bring to the table could allow cost efficiencies and facilitate greater ease into this transition to a more sustainable future.


The paper,"How derivative exchanges can promote sustainable development," was published in 2021 by the SSE. [23] Julie Winkler, Chief Commercial Officer, CME Group, and Owain Johnson, Global Head of Research, CME Group and Vice-Chair of the WFE’s Sustainability Working Group, chaired the Derivatives Advisory Group that included derivative exchanges around the globe and the World Federation of Exchanges (WFE).

Derivative exchanges are part of a broader ecosystem that makes the market function. The participants in this ecosystem are: the central counterparty (CCP), the brokers, and the clearing members. When discussing commodities markets, warehouse operators are essential. Price reporting agencies (PRAs), index operators, independent software vendors (ISVs) and data providers round out the ecosystem. [24]. All these participants could have a role to play in the derivative market transition to ESG.

Sustainable Trading, a membership group dedicated to transforming ESG practices within the financial services industry, launched on Feb. 22, 2022. Those engaged in trading or providing trading-related services can join as members.[25]

Exchange-traded ESG market[edit]

It is challenging to estimate the scope of the ESG market. In 2022, Bloomberg Intelligence and GSIA estimate the global ESG market for all ESG assets at around $40 trillion, and see it rising to $50 trillion by 2025. Investment research firm Morningstar says the figure for ESG funds is just $2.7 trillion. [26] The number of financial products tied to ESG investment strategies has grown steadily in recent years.

The sustainable funds landscape in the United States grew in 2021, Morningstar research found. At year end 2021, investors added nearly $70 billion into open-end and exchange-traded funds. During the same period, the number of sustainable open-end funds and ETFs available to U.S. investors had risen to 534, with more than $350 billion in assets. In 2021, 121 new funds launched and 26 existing funds took on a sustainable investment mandate. At year-end 2021, U.S. investors had 5 times as many sustainable funds available to choose from vs. a decade ago, and 3 times more than five years ago.[27]

While ESG investments took hold in Europe earlier than in the United States, in part because of the EU's goal to be carbon neutral by 2050 ("The European Green Deal"), ESG-related investing had gained ground in the U.S. at year end 2020. That year, the number of sustainable open-end funds and ETFs available to U.S. investors rose to 392, up 30 percent from 2019 and nearly a fourfold increase over the past 10 years, Morningstar said. [28] [29]

ESG Index derivatives[edit]

Institutional investors hedge price risks in their equity portfolios using index derivatives. ESG index derivatives are used in the same way but they are tied to an ESG index, targeting investors who have an ESG mandate or preference. The first ESG index was the Domini 400 Social Index created in 1990. Now the number of ESG Indexes has grown to more than 1000.[30].

How exchanges are addressing ESG[edit]

In the listed derivatives space, Eurex was the first exchange to establish a successful suite of ESG futures contracts, STOXX® Europe 600 ESG-X Index Futures (FSEG), EURO STOXX 50® Low Carbon Index Futures (FSLC) and STOXX® Europe Climate Impact Index Futures (FSCI). Introduced in February 2019, its ESG Index futures track a group of companies that are filtered to meet ESG criteria. The STOXX® Europe 600 ESG-X Index Futures, is based on socially responsible investment criteria. The EURO STOXX 50® Low Carbon Index Futures is based on a benchmark index which includes lower carbon emitting companies. And the STOXX® Europe Climate Impact Index Futures is based on a index of companies adhering to Climate Disclosure Project guidelines and excludes companies in tobacco and weapons manufacturing. In its first six months of trading, the ESG futures suite traded 243,000 contracts with an open interest value of EUR 786 million. [31] [32][33]

In 2022, Eurex ESG derivatives offered 34 ESG products, of which 32 cover equity indices. Total volume of Eurex's ESG derivatives across equity index and fixed income totals exceeded 35 EUR billion in 2022. At the end of July 2022, total open interest stood at 4 billion EUR and 1.2 billion EUR, respectively. Traded contracts in 2022 reached over 1.6 million contracts. This amounts to an overall Average Daily Volume (ADV) of EUR 237 million. Eurex most successful segment remains the STOXX Europe ESG-X Index family, reaching a combined ADV of 8k lots in 2022, equivalent to 123 million EUR notional. ESG exclusionary methodologies have dominated the segment. [34]

References[edit]

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  2. Who cares wins in the brave world of ESG. Financial Times.
  3. A Better Approach to ESG?. Barron's.
  4. The Remarkable Rise Of ESG. Forbes.
  5. Is ESG the same as sustainability. Brightest.
  6. How Derivatives Exchanges can Promote Sustainable Development – An Action Menu. Sustainable Stock Exchanges.
  7. What is ESG investing?. CFA Institute.
  8. Key ESG factors. CFA Institute.
  9. Environmental. CFA Institute.
  10. Social. CFA Institute.
  11. Governance. CFA Institute.
  12. SEC Announces Enforcement Task Force Focused on Climate and ESG Issues. SEC.
  13. FAQ: The SEC's Proposed Rule on the Enhancement and Standardization of Climate Related-Disclosures. Baker Donelson.
  14. Managing Climate Risk In The U.S. Financial System. CFTC.
  15. SEC Charges Brazilian Mining Company with Misleading Investors about Safety Prior to Deadly Dam Collapse. SEC.
  16. SEC Charges BNY Mellon Investment Adviser for Misstatements and Omissions Concerning ESG Considerations. SEC.
  17. Breaking Down the New EU ESG Disclosure Regulation: One Month to Go. National Law Review.
  18. EU to Make Fund Managers Back Up Sustainability Claims. WSJ.com.
  19. ESG Regulation Monthly Round-Up: Looking back through July. JD Supra.
  20. Esas Issue Report On The Extent Of Voluntary Disclosure Of Principal Adverse Impact Under The Sustainable Finance Disclosure Regulation. ESMA Europa.
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  22. Stock Exchange Sustainability Activities. SSE Initiative.
  23. How Derivatives Exchanges can Promote Sustainable Development – An Action Menu. SSE Initiative.
  24. How Derivatives Exchanges can Promote Sustainable Development – An Action Menu. Sustainable Stock Exchanges.
  25. Press Release: Sustainable Trading launches non-profit membership network to drive ESG change across financial markets. Sustainable Trading.
  26. ESG Funds Managing $1 Trillion Are Stripped of Sustainable Tag by Morningstar. Bloomberg.
  27. Sustainable Funds Landscape - Highlights and Observations; Let's try for greater transparency in 2022.. {{{org}}}.
  28. A European Green Deal: Striving to be the first climate-neutral continent. European Commission.
  29. U.S. Sustainable Funds Continued to Break Records in 2020. Morningstar.com.
  30. ESG Index derivatives. Sustainable Stock Exchanges.
  31. EURO STOXX® 50 Low Carbon. STOXX.
  32. EURO STOXX® 50 Low Carbon. STOXX.
  33. Eurex Group sees 235,000 ESG futures traded since launch. The Trade.
  34. ESG Equity Index Derivatives Update. EUREX.