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    ISDA Report Examines Role of Derivatives in Sustainable Finance in EU

    July 16, 2020

    ISDA published a report that discusses the role of derivatives in sustainable finance in EU. The report highlights how derivatives markets can contribute by enabling EU to raise and channel the necessary capital toward sustainable investments. The derivatives markets can also help firms hedge risks related to environment, social and governance (ESG) factors; facilitate transparency, price discovery, and market efficiency; and contribute to "long-termism." This report is the result of an effort by the Center for European Policy Studies (CEPS) in Brussels, which manages the European Capital Markets Institute (ECMI).

    In this report, the use of derivatives by market participants is being examined in the context of the EU sustainable regulatory framework that is being developed. The report also examines the EU Sustainable Finance Action Plan and the most relevant policy initiatives from a derivatives’ perspective. The report calls EU Taxonomy the flagship project of the Sustainable Finance Action Plan. The EU Taxonomy sets the framework for what is regarded as sustainable, while the disclosures framework will enhance the transparency surrounding sustainable investments. Derivatives will be developed to reference these new measurements and metrics with a view to contributing to the financing of projects and funding of companies in the transition to a sustainable future. Another important aspect of the Sustainable Finance Action Plan is the development of an EU Ecolabel framework for certain financial products to be applied once the EU sustainability taxonomy is adopted. The EU draft Ecolabel for retail financial products proposes requirements for the use of derivatives by retail investment funds. The EU Ecolabel defines the minimum environmental performance of such products by defining green thresholds on portfolio level for funds, and by defining whether companies’ green economic activities fulfill thresholds.

    The report also discusses how supervisors are calling for an alignment of the prudential treatment of greens assets with the current credit risk framework. The revised Capital Requirements Regulation (CRR) 2/Capital Requirements Directive (CRD) 5 package includes a mandate (Article 501c of CRR 2) for EBA to assess, by June 2025, whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and social objectives would be justified (as a component of Pillar 1 capital requirements). In particular, it should determine the effective riskiness of exposures related to assets and activities associated with environmental and social objectives compared with the riskiness of other exposures; the appropriate criteria for the assessment of physical risks and transition risks and how to develop them; and the potential effects of a dedicated prudential treatment of exposures associated with environmental and social objectives and activities on financial stability and bank lending in EU. In addition, the Renewed Sustainable Finance Strategy is consulting on whether the current macro-prudential policy toolbox for the financial sector in EU is fit for purpose to identify and address potential systemic financial stability risks related to climate change. 

    The report emphasizes that European Green Deal is the cornerstone of EU response to the COVID-19 pandemic, given the massive amounts required for a sustainable and green recovery. Derivatives markets can play a significant role in the context of the European Green Deal and the transition toward a low-carbon economy. They facilitate capital raising via the hedging of risks related to sustainable investments. Moreover, they enhance the transparency and the price formation process of the underlying securities and, thus, foster long-termism. Overall, ESG products have demonstrated their resilience during the market decline caused by the pandemic and will play a pivotal role in accelerating the transition to a sustainable economy. 

     

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    Keywords: International, Europe, EU, Banking, Insurance, Securities, Sustainable Finance, COVID-19, Derivatives, ESG, Climate Change Risk, CRR/CRD, Basel, Credit Risk, Disclosures, ISDA

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