Over the recent years, more and more investors and traders have decided to put their money where their mouth is. Instead of just simply believing or supporting certain values, they now choose to take action. As a result, brokerage firms have started offering financial products that follow Environmental, Social, and Governance (ESG) investing strategies.
ESG investing is used to monitor investments based on corporate policies and to encourage companies to act responsibly. ESG investing can also help portfolios embrace ethical companies and avoid holding companies that are involved in risky or bad practices. ESG investing is also described as sustainable, responsible investing, or socially responsible investing (SRI). Traders who consider ESG factors before they make trading decisions tend to look at and assess a wide range of policies and behaviours shown by the companies they want to invest in.
ESG in forex
ESG integration is noticeable across different asset classes, and it is especially evident in equities, index funds, and sustainable bonds. In other markets such as the global foreign exchange (FX) market, ESG processes have been more difficult to integrate. But first let’s look more closely at what ESG really involves.
ESG refers to three different types of factors:
- Environmental impact: Climate change policies, natural resources, water scarcity, pollution and waste, treatment of animals.
- Social aims: Diversity, inclusion, social justice, human rights, LGBTQ+ rights, product liability, labour, health and safety and GDP indicators.
- Governance factors: Corporate transparency, Diversity on board of directors, company audits, executive pay alignment, leadership and shareholder rights.
Incorporation of ESG into trading
A younger generation of traders are interested in ESG issues and incorporate ESG into their trading approach. By taking ESG into consideration, traders put their money in companies that comply with ESG standards. Traders can do their research and analysis, and develop a portfolio that integrates ESG through exclusionary screening. If a company is involved in harmful sectors or products, such as weapons, tobacco, or alcohol, then the investor or trader will decide to exclude them.
Forex and ESG
Forex market articipants follow and adhere to the Global FX Code. The FX Global Code July 2021 (Global Code) was developed by a partnership between central banks and market participants from 20 jurisdictions around the globe. It includes a series of principles of good practice for the effective functioning of n the foreign exchange market. The Global Code promotes a fair, liquid, open, and transparent market in which different market participants can participate and transact at competitive prices.
When it comes to ESG, for most asset classes, environmental factors have been the focus. With FX, adherence to the Global FX Code (the Code) can be regarded as a form of ESG, as it connects social and governance aspects and creates a mechanism that market participants can rely on for strong governance and transparent practices.
The PRI is a global leading advocate of responsible investment. It focuses on understanding the investment implications of environmental, social and governance (ESG) factors and supporting its international network of investors in integrating these factors into their investment decisions. The Securities and Exchange Commission has proposed new climate disclosure rules that would require publicly traded companies to disclose how climate risks impact on their businesses and report on their own climate goals and greenhouse gas emissions.
ESG-linked derivatives
Companies have also signed up to ESG-linked derivatives whose price could depend on reducing greenhouse gas emissions or boosting labour force diversity. Banks selling the derivatives want to promote their own sustainability promises and offer forward contracts (locking in favourable exchange rates for future purchases).
ESG-linked FX transactions
With ESG continuing to grow, such FX transactions will become more mainstream. At the moment, with FX being neutral, it is difficult to develop FX products that are “green” or “social.” The current ESG-linked FX transactions are KPI-based. Here are a few examples:
- Energy firm Siemens Gamesa signed an FX transaction agreement with BNP in 2019 linking its FX hedging rate to a third party sustainability rating.
- In 2020, JP Morgan and Enel SpA entered a EURGBP XCCY swap agreement in which both have to meet specific ESG targets or incur extra costs.
- Deutsche Bank and Olam International executed a 1y USDTHB FX forward, which gives Olam a discount if it meets pre-agreed targets that support the UN’s SDGs. Otherwise, if it fails, it has to pay a specific sum to an NGO.
Currency pairs and climate change
Currency pairs can be allocated depending on each country’s climate change issues or their commitment to climate change mitigation and adaption. GDP stats, economic indicators and political influence can affect social strategy, while governance factors can be assessed for risk reward opportunities in currencies. For example, Scandinavian countries score the highest in terms of ESG rankings. Sweden and Finland are among the top when it comes to education, healthcare and social security infrastructure.
Future considerations
ESG is becoming more central in finance and is anticipated to have a bigger influence on regulators and policy makers, as well as companies and investors who will become more interested in incorporating ESG factors in their trading activities. While the impact of ESG on FX markets is not yet pronounced, this will continue to evolve and may have more influence in the future, as well as on other asset classes.
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