In early May 2021, the World Federation of Exchanges ("WFE"), along with the United Nations Sustainable Stock Exchanges Initiative ("SSE"), and the International Swap Dealers Association ("ISDA") took significant steps towards incorporating sustainability in derivatives. On May 6, 2021, ISDA published a new US Renewable Energy Certificate ("REC") Annex.1 RECs represent one megawatt hour of electricity generated by a renewable energy source. Firms without a direct connection to a renewable energy producer may buy RECs to support green energy and meet their sustainability goals. ISDA’s REC Annex streamlines the over-the-counter trading of RECs by enabling market participants to trade them using the standardized definitions and terms in a ISDA Master Agreement that the counterparties may already have in place for the trading of other products. The REC Annex follows ISDA’s previous trading templates to enable the trading of other environmental derivatives, including EU emissions and temperature-related weather transactions.2
On May 5, 2021, the WFE published a joint paper with the SSE entitled How Derivatives Exchanges Can Promote Sustainable Development – An Action Menu (the "Paper").3 The Paper discusses in depth sustainable commodity derivatives – a topic not as well discussed as environmental, social and corporate governance ("ESG") in stock investing and equity index derivatives. Although the Paper addresses ESG equity index derivatives, here we will focus on the Paper’s review of currently traded sustainable commodity derivatives and recommendations to expand such products.
The Paper analyzes the existing sustainability derivatives and draws lessons from them for the creation of additional products. It cites the 2019 introduction by the London Metals Exchange ("LME") of a responsible sourcing requirement for metals to be eligible for delivery through an LME contract. To be "responsibly sourced," the metal has to be produced by manufacturers that commit to abide by certain standards on the sourcing of raw materials for the production of metal. The LME explained that the new requirement was the result of "ethical, commercial and leadership imperatives."4 Part of the commercial imperative was that if buyers were forced to accept delivery of non-responsibly sourced metals, LME metal contracts could trade at a discount.5
Similarly, the Paper points to the Bursa Malaysia ("BM") Crude Palm Oil futures contract for which BM introduced a traceability requirement in 2018. Sellers delivering crude palm oil under BM’s futures contract must present a traceability document showing what mill the crude palm oil was processed at. In the meantime, Malaysian crude oil mills are being certified under various sustainability regimes such as the Malaysian Sustainable Palm Oil ("MPSO"), the Marine Stewardship Council ("MSC"), and the Forest Stewardship Council ("FSC") initiatives. By October 2020, the vast majority of mills processing crude palm oil in Malaysia (94%) have been certified under one of these initiatives. As a result, BM was able to phase in the delivery of sustainable crude palm oil over a two-year period without listing a separate futures contract or taking other actions that could have been disruptive to the market.6
The Paper also notes that the launch of new contracts can be an alternative method for embedding sustainability in derivatives contracts. It notes as examples the launches by both ICE and CME of reduced sulphur fuel oil futures contracts after the International Maritime Organization set an upper limit on sulphur content for fuel used in the shipping industry with an aim to reduce the sulphur dioxide released into the atmosphere by the shipping industry.7
Based on these and other currently trading sustainable commodity futures contracts, the Paper suggests exchanges should incorporate sustainability and social elements to existing contracts. For physically-delivered contracts, the exchange could require that the seller produce exchange-approved evidence of compliance with the sustainability or other requirements (e.g., child labor was not used in the processing or production of the commodity).8 The sustainability requirement could be encompassed within approved brands – at least where the number of producers are relatively limited. As potential challenges, the Paper notes the following:
- lack of consensus around appropriate standards;
- verifying compliance with standards;
- insufficient demand or supply;
- risk of excluding producers who cannot afford to meet standards; and
- the potential lack of price premiums.
The Paper notes in the case of competing standards, an exchange could accept a range of industry standards similar to BM’s approach to acceptable crude palm oil by including the standards required under the MPSO, MSC, and FSC initiatives. Compliance issues, the Paper suggests, could be addressed through requiring chain of custody documentation showing a commodity originated with an approved producer, again similar to BM’s traceability requirements for crude palm oil.
The Paper also suggests the "more straightforward" approach of exchanges simply listing new contracts "that respond to growing demand driven by the transition to a low carbon future."9 It notes examples of exchanges listing new contracts to help risk manage the supply chains necessary for greener products. One example is the LME’s development of derivative contracts that could be a tool for risk management for battery manufacturers and the electric car industry.10 Another example is the CME’s listing of Used Cooking Oil ("UCO") and Used Cooking Oil Methyl Ester ("UCOME") futures contracts in September 2020. UCO is used as a feedstock for UCOME which, in turn, is a lower carbon ingredient for biodiesel fuels.
Of course, listing a new futures contract involves more than drafting the contract specifications and adding some code to an exchange’s systems. The exchange has to identify a sufficient pool of hedgers that can use the contract for risk management for their business and attract a sufficient number of speculators willing to take on risk for the commodity involved. In addition, an exchange must recruit market-makers so that there is a continuous competitive market during the trading day.11 Accordingly, it is not clear that the Paper’s assertion that launching new contracts are necessarily the "more straightforward" approach to embedding sustainability elements to derivatives. That said, for the exchange that anticipates a hedging need in the greener economy just over the horizon, there may be monetary green to be made.
1 Available at: https://www.isda.org/2021/05/06/isda-publishes-us-renewable-energy-certificate-annex/
3 Available at: https://www.world-exchanges.org/storage/app/media/uploaded-files/SSE-WFE-Derivatives-Exchanges-Guidance.pdf
4 Paper at 16.
5 Id. at 15-16.
6 Id. at 16.
7 Id. at 18.
8 Id. at 20 (citing steps LME took in light of human rights abuses in the excavation of cobalt ore processed into cobalt traded on the LME uncovered by Amnesty International in its 2016 report Democratic Republic of Congo: "This is what we die for": Human rights abuses in the Democratic Republic of Congo power the global trade in cobalt, available at: https://www.amnesty.org/en/documents/afr62/3183/2016/en/).
9 Id. at 23.
11 See generally, H. Till, Case Studies on the Success or Failure of Futures Contracts, 4 J.Gov. & Reg. 30 (June 2015).