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I read with interest news about Netherlands bank trading several novel products in which a counterparty pays floating cash flows linked to the counterparty's ESG (environment, social, governance) score from an external rating agency. The worse the rating, the higher the payments. Thus, the corporation is incentivized to improve its ESG rating in order to pay less. It's been done in the format of loan interest and floating swap leg:

https://www.ing.com/Newsroom/All-news/Introducing-the-worlds-first-sustainability-improvement-derivative.htm https://www.ing.com/Newsroom/All-news/ING-structures-and-coordinates-largest-ever-sustainability-improvement-loan-in-commodity-trading.htm

I'm curious, how would a bank mark to market such receivables? Could they assume that the ESG score would not improve, but take negative PL if the score did improve? Could the bank conservatively assume that the score might improve and then recognize more PL once the score did not improve? Also I'm curious, how could the bank hedge the possibility that the score would improve and the bank would receive less? Could they assume some relationship between ESG score and counterparty's equity price and/or CDS spread?

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It doesn't say exactly how it's structured, but does say the 'floating leg' of the swap is determined by an ESG score provided by Sustainalytics. Having worked with their data, their scores run from 0 to 100, so the mechanics would likely operate a bit like a commodity swap.

As to hedging, in this case, as the underlying isn't traded, there isn't a clear hedge aside from a proxy (eg, carbon credits, certain commodities, equity baskets etc). It's also not entirely clear the motivation for the product; the MM/bank only makes money when the counterparty's ESG score deteriorates, which is at odds with the product's purpose, so not itrinsically desirable. There's obvious incentive for the counterparties who decided to enter in to agreements like these.

It seems progressive governments would have greater incentive to sell products like these than banks attempting to make a profit would.

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I do not have direct knowledge to be completely clear, but I'm pretty certain that banks do not hedge these. I think if the bank loses money, they consider it a 'green investment' so they can claim they are doing their part for the environment. This is especially true for European banks that are under pressure from politicians. And if the bank makes money, then they just keep quiet. That's an educated guess at what's going on right now.

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    $\begingroup$ "And if the bank makes money, then they just keep quiet. That's an educated guess at what's going on right now." --> I think that is indeed a good guess :) $\endgroup$
    – user34971
    Apr 23, 2020 at 6:59
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These kind of swaps are not hedged. They usually are priced incorp with the ESG linked Loans or Bonds. These types of Swaps usually have bonus and malus. IF the ESG rating is hit the loans are a little bit cheaper and the swap is negative for the bank but the green asset ratio for the loans are beneficial. The swap is often similarly priced as a non ESG Swap. IF the ESG rating is not hit the loan get a bit more expensive for the company and the swap is positive for the bank. Usually these benefits from the swap are getting donated to Offsetting projects.

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