The influence of ESG on the valuation of derivatives

ESG criteria are becoming increasingly important when analysing the risk/reward profile of a company or market. As they can have a direct impact on performance and risk, they are relevant for the pricing of derivatives. For this reason, it may be necessary to adjust traditional models or their inputs in order to adequately take ESG-related opportunities and risks into account.

ESG derivatives are financial instruments that enable investors to engage with ESG criteria and manage ESG risks. They enable hedging against ESG risks, promote sustainable investments, help with portfolio diversification and meet growing regulatory requirements. They also help to make capital markets more sustainable and promote ESG practices in the corporate world. The demand for ESG derivatives has risen sharply in recent years due to the growing awareness of sustainable investing. There are currently hardly any specific guidelines for the valuation of ESG derivatives. The existing principles must therefore be used as guidance.

The valuation of ESG derivatives refers to financial instruments that are structured based on ESG criteria. These derivatives reflect, for example, the ESG performance (e.g. ESG score, CO₂ emissions) of an underlying asset. For example, there are products such as 

In order to value ESG derivatives, the traditional methods can be used, adjusted by ESG components. Derivatives can generally be divided into contingent claim and forward commitment derivatives. In the case of contingent claim derivatives such as options, the buyer has the right but not an obligation to execute a transaction on contractually agreed terms or to forego it. In contrast, in the case of forward commitment derivatives such as swaps, futures and forwards, both contracting parties are obliged to fulfill the contract on maturity.

The following provides an overview of how ESG factors can be taken into account in the valuation of derivatives:

Regardless of the valuation model selected, volatility is a key input parameter in option valuations. It describes the expected fluctuation in the price of the underlying asset. High volatility is associated with greater uncertainty and therefore a higher probability of stronger price movements, which in turn increases the chance of profitable movements in the underlying asset. This is due to the limited downside but unlimited upside potential. Consequently, high volatility leads to a higher option value for both call options (the right to buy a specific asset at a specific price) and put options (the right to sell a specific asset at a specific price). Companies that are heavily involved in ESG-critical sectors such as fossil fuels often exhibit higher volatility, which is reflected in a higher option price. Volatility is therefore directly influenced by ESG risks:

Among other things, these factors imply that historical volatilities can only be extrapolated into the future to a limited extent. For listed companies, it may be advisable to focus on implied volatility. This is a measure of the expected future volatility of the underlying asset and influences the market price of the option. A high implied volatility means that market participants expect a higher volatility of the underlying asset, which increases the price of the corresponding option. For non-listed companies, volatility can be adjusted on the basis of ESG scores. Companies with higher ESG ratings are often considered less volatile as they are seen as more stable in the long term.

In the case of options, the possibility of early exercise can be particularly relevant if companies are subject to rapid ESG change (e.g. in the event of sudden regulatory changes in the environmental sector). In such a case, it could make sense for investors to exercise an option early before ESG risks materialise. However, call options should never be exercised prematurely, as the holder loses the remaining time value of the option by exercising it prematurely. A longer term increases the time value and thus the option price, as there is more time for profitable price movements in the underlying asset.

Monte Carlo simulations can be used to incorporate ESG risks, such as the introduction of new environmental regulations, CO₂ price increases, climate risks or social risks (e.g. labour disputes), into the valuation. Monte Carlo simulations are a common method for valuing complex derivatives in which several uncertainty factors can be taken into account. One can simulate different scenarios based on ESG-related uncertainties and analyse their impact on the price of the derivative. In addition, Monte Carlo simulations can be used to take extreme ESG risks, such as natural disasters or regulatory shocks, into account using so-called “fat-tail” distributions. Fat-tail distributions describe a statistical distribution in which the extreme values (i.e. very large or very small events) occur more frequently than in a normal distribution. In contrast to a normal distribution, fat-tail distributions have a slower downward slope, which means that unusually large events occur more frequently.

In ESG swaps, two parties swap the risk or performance of an ESG index or ESG portfolio. As with conventional swaps, the valuation is based on the present value of the expected cash flows. An ESG index or portfolio with high ESG performance can have a more stable and less risky cash flow profile, which can lead to a lower risk premium and therefore a lower discount rate.

CO₂ derivatives are financial instruments based on the price of CO₂ certificates or climate certificates. The value of these derivatives depends heavily on price developments in CO₂ emissions trading. The current and future CO₂ price is influenced by regulatory developments, such as the introduction or tightening of emissions trading programmes, as well as supply and demand for emission allowances, which can cause prices to fluctuate significantly. Various CO₂ price developments can also be modeled using Monte Carlo simulations.

When valuing futures and forwards, the underlying asset can also be influenced by ESG criteria. For example, commodity derivatives, particularly derivatives of energy or agricultural commodities, are affected by environmental factors such as climate change, environmental disasters or strict environmental protection requirements, which can have a significant impact on the price of the underlying goods and their availability. In addition, changes in working conditions, human rights issues or demographic trends can influence the production of or demand for certain goods and services. 

The article makes it clear that ESG criteria are increasingly influencing the valuation of financial instruments. As these factors influence both the opportunities and risks of a company or market, it may be necessary to take these special features into account in the valuation. In practice, however, there is uncertainty as to how exactly ESG factors should be included in the valuation. There are currently few specific guidelines for the valuation of ESG derivatives. However, conventional methods, supplemented by ESG components, can provide guidance.