Despite their central role in portfolio and risk management, accounting for the carbon footprint of derivatives has proved to be a challenge for investors and other capital-markets participants.

While calculating the financed emissions of assets such as stocks and corporate bonds follows well-established industry frameworks, the indirect ownership implicit in derivatives and a dearth of guidance for their handling has raised more questions than answers about both their treatment in climate reporting and their role in driving decarbonization.

Those questions — and some possible answers — were the focus of discussion at a roundtable in April hosted by the MSCI Sustainability Institute, which convened practitioners, policymakers and standards-setters in London to examine whether (and how) derivatives should be captured in climate disclosure.

Discussion centered on whether climate reporting should include derivatives and, if so, how investors might approach such reporting given both the variety of investors’ motives for using them and a desire for transparency.

Below are the biggest takeaways from the discussion, which with the exception of the three presentations and remarks of public officials was governed by Chatham House rule. The public officials stressed that the views they shared were their own.

Guidance emerging

While guidance is emerging, a series of presentations and discussion that ensued showed that standards-setters themselves continue to grapple with the difficulty of carbon accounting for derivatives and suggested that clarity may, for now at least, continue to elude investors.

Proposed guidance from the Institutional Investors Group on Climate Change (IIGCC) recommends that investors who are aligning their portfolios with net-zero disclose how they use derivatives and how actions they are taking drive real decarbonization.

• That means investors should disclose how their investments in derivatives and hedge funds impact real-economy emissions and explain actions they are taking through their investments that are designed to reduce emissions in the real economy, they said.
• Rather than netting long and short positions, “report the emissions separately,” they suggested. “That maximizes transparency.”

“The question is how investors can drive real-world decarbonization,” agreed a representative of the Standards Board for Alternative Investments, which has developed principles for accounting for alternative strategies that assesses net exposure to carbon.

• Derivatives matter in carbon accounting because net exposure to them impacts demand for stocks in the real world, where that demand impacts companies’ cost of capital, Deinet observed.
• “If we care about the carbon associated with exposure and think there’s impact by owning or selling something to others, than ultimately it makes no difference whether that’s through an equity or through a derivative,” he added.

“We look at this from the perspective of investors,” said Yuliya Plyakha Ferenc, vice president of equity solutions research at MSCI Research, which in consultation with clients has proposed a framework for derivatives that looks through to the sustainability and climate characteristics of the underlying asset as a starting point.

• “Investors hold derivatives for a variety of reasons that differ dramatically and influence your choice of aggregate scheme,” observed Ferenc, who noted that a diversity of opinions notwithstanding, inclusion of derivatives in reporting regardless of their intended use could maximize transparency for investors.

Regulatory views

A senior representative from European Securities and Markets Authority (ESMA), observed that both the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and Taxonomy Regulation require financial market participants to disclose their use of derivatives but leave the details to their discretion.

• Though the SFDR “encompasses any asset, investment or exposure, and hence, derivatives, a lot of our focus was on long-only exposures, so we included derivatives without much detail of how to do it.” they noted ,
• The European Commission, they added, “focuses on investments’ real-world impacts, which we’re trying to measure.”

“We are seeing an explosion of interest in derivatives across different areas,” reported a senior representative from  the U.S. Commodity Futures Trading Commission.

• Apart from their use in hedging interest-rate risk, derivatives are fueling development of a spot market, they explained, noting that U.S. commodities exchanges are seeing an uptick in trading of contracts for cobalt and nickel while investors are using exchanges’ reporting of such contracts to discover prices for both metals.
• “The intention for holding derivative varies,” they observed. “Investors are using them for price discovery and for uses that go hand in hand with the Inflation Reduction Act and infrastructure law.”

Identifying impact

The focus of reporting should be on impact, whether that flows through equities or derivatives, stressed the head of sustainability at a Paris-based hedge fund. “You emit when you hold a long or short security,” he stressed. “The derivative needs to be accounted for, otherwise you don’t measure impact properly.”

• “How can we not treat derivatives as absolutely equal to equity investments when the only difference between a stock and a derivative is that I have voting rights,” suggested the manager, who stressed the need for carbon accounting that captures financed emissions in a linear fashion.
• “Just because carbon accounting for derivatives isn’t easy is not a reason not to regulate their reporting,” he added.
• Several others agreed. “For accounting purposes, let’s stick with things where we can be linear and mathematical,” suggested one asset manager.

“Derivatives create the same demand in the market as if you’re buying and selling a security,” concurred the head of sustainability at a London-based asset manager, who distinguished between risk and impact.

• At the level of an individual security, “it matters whether you are long or short,” he observed, differentiating between hedging investment risk and driving decarbonization in the real world.
• “Let’s think about how to measure impact in the real world that is easy to compute,” agreed a London-based asset manager. “The rest should not be called financed emissions but de-risking activities, which include derivatives or any security that has economic exposure.”

“We should accept that derivatives are as powerful in impact as physical securities,” suggested a manager from a U.K.-based hedge fund who said his firm does “a ton of futures trading” and who cautioned against netting emissions.

• “If we were to net our emissions, we’d be at net-zero but we could not say mission accomplished,” he added. “It’s greenwashing if portfolio cosmetics become the game in town.”

“We will only solve this with a system of carbon accounting that’s linear,” echoed a professor of operational risk, banking and finance at University College in Dublin, who also called for rigor in emissions accounting.

• Financing Scope 3 emissions that are miscounted or that focus on emissions other than those that are financially relevant misdirects impact and undermines trust, he said. “I think we need to generate sufficient trust in the estimates so that we don’t get criticized for putting a derivative on a poor estimate.”

Transparency

The cares of clients should factor into thinking about accounting for derivatives, suggested a senior executive from the UK Sustainable Finance and Investment Association.

• The anti-greenwashing rule for finance adopted by the U.K. Financial Conduct Authority and set to take effect at month’s end “covers everybody in the system and changes then conversation around greenwashing when it comes to derivatives,” he added.

“We are being asked to report on derivatives in climate investing, so by definition our clients are asking us to report,” noted the head of a London-based pension consultant, stressing the need for guidance.

• “If the big investors are not reporting, it’s because that until there are clear standards, there is a risk to reporting inconsistently,” he added.

Still, reporting frameworks should distinguish between owning shares and owning them synthetically said a U.K. based commodities trader.

• “The market isn’t currently pricing the value of that distinction and will continue to be agnostic until there is a price on carbon,” he stressed.
• A key characteristic of the frameworks discussed today is “symmetry of impact,” suggested by the SBAI. “Record the long, record the sort, show the net, so that investors can assess the impact.”

Clarity of objectives matters for investors in this context, stressed a London-based asset manager. “I would like to see more on how investors with physical positions in companies are using their positions to influence corporate behavior.

• There can be greenwashing in engagement too, he added. “So investors should look clearly at what is being accomplished.”
• Though ownership of a shares should hold more value (and hence cost more) for asset owners, pension plans continue to focus on the return. “Most investors will take the return over the opportunity to engage,” he added.

Navigating complexity

Derivatives are complex, and the debate on the treatment of carbon accounting should be expanded from equities to credit and sovereign exposure, in the context of investors and asset owners with asset allocation strategies that span across multiple corners of the financial markets, suggested the ESG researcher for a U.S. asset manager.

• “Climate itself has complexity; accounting for derivatives should be detailed enough to let people calculate what they want, but it should also be simple and practical,” urged the head of sustainable finance at leading global lender.
• “There are a number of things that can fit in the framework, so let’s define what we mean by climate derivatives,” he added, noting the growing use of derivatives for hedging interest-rate risk and price discovery.
• “There’s a lot of innovation coming into this,” agreed the representative from the CFTC. “We want transparent, open, fair and competitive markets.”

For their part, ESMA’s representative stressed the value of practicability.

• “For most of us devising the rules, opening them up for derivatives is good, but the fear is that in trying to develop something practical, you realize how complex it is,” they noted.
• “It’s difficult to avoid complexity” they added, saying he remained hopeful that with continued engagement and healthy debate between regulators and practitioners, workable standards will soon emerge.