West Yorkshire Pension Fund to use derivatives ESG risk framework

West Yorkshire Pension Fund (WYPF), the £16.3bn (€19.2bn) UK local government pension scheme (LGPS), has asked investment management boutique WieldMore Investment Management and the Wheeler Institute for Business and Development, part of the London Business School (LBS), to design a framework for assessing the ESG risks and impact of derivative instruments.

The framework, originally proposed by London-based WieldMore IM, will be used by WYPF to build an ESG-aware derivatives overlay as the fund gradually builds its portfolio of illiquid, alternative assets.

WPYF, WieldMore IM and the LBS hope the project will produce the first comprehensive framework for scoring derivatives according to ESG principles.

The project is being financed by the LBS as part of its research activities. As well as WieldMore IM staff, the project team comprises researchers from LBS and the University of Bath. SustainAdvisory and compliance specialist Laven will also be providing support.

Ola Ajala, head of finance at WYPF, said: “Our intention is to grow our portfolio of alternative assets. In order to do that, we are planning to hedge part of our equity assets using options, so that when the opportunity comes to pick up attractive opportunities in alternatives, we do not divest from our equity portfolios at the wrong time.”

The fund already invests in infrastructure through GLIL, the £3.6bn infrastructure investment vehicle launched by WYPF, Lancashire County Pension Fund (LCPF) and Merseyside Pension Fund (MPF), which has now raised capital by several LGPS.

However, Ajala said WYPF aims to expand its portfolio of infrastructure assets and other alternatives. Hedging the equity assets would allow the scheme to be more selective and gradual in its push to acquire further alternative assets, he added.

“At the same time, we are continuously engaged in finding facts and data to support our understanding of the true degree of sustainability of our core assets. Because we also intend to build exposure to derivatives, understanding the ESG risks and impact of derivatives will be a key step in assessing the sustainability of our whole portfolio. WieldMore has convinced us that it is possible to construct a comprehensive framework with indicative ESG exposure”, said Ajala.

The framework will leverage a combination of quantitative and qualitative information to assign a score to each derivative position. The UN’s Sustainable Development Goals (SDGs) will form part of the basis for the scoring system, while climate-specific risks will be quantified and assessed using the Task Force on Climate-related Financial Disclosures (TCFD) framework.

WYPF has provided the research team with the full list of portfolio holdings. Work on the project begun earlier this month and the first set of results is expected to be available in three months’ time.

“We aim to be the first to create a model that quantitively defines the ESG-impact of derivatives”

Giuseppe Amitrano, founder and CEO of WieldMore IM

Giuseppe Amitrano, founder and chief executive officer of WieldMore IM, an expert in derivatives structuring and trading and a former director at Scotiabank, Royal Bank of Scotland and UBS, said: “As a UN PRI signatory, being ESG-conscious constitutes one of our core beliefs. However, applying our expertise to use listed derivatives for the purposes of portfolio hedging and stabilising returns means that we need to compromise on our ESG-conscious principles since we have no ways of measuring the ESG-impact of such products on an investment portfolio. Sadly, no one in the world does. Solutions are yet to be developed for this problem.”

According to WieldMore’s analysis, no derivative ESG screening tool currently exists, particularly for non-native ESG products comprising of securities not created for the primary objective of ESG.

This equates to around €244trn in derivatives in the EU that are not being utilised for ESG scoring and risk management. The figure is based on 2021 data from the European Securities and Markets Authority (ESMA).

“We aim to be the first to create a model that quantitively defines the ESG-impact of derivatives. Our goal is to empower all investors with the ability to analyse ESG-risks, implement more ESG-conscious investment decisions and successively disclose their ESG-impact to relevant stakeholders. We seek to use the derivatives’ correlation to the underlying portfolio constituents, combined with established ESG data and screening providers, to devise a scoring mechanism”, Amitrano added.

The LBS team members said: “The project represents an exciting opportunity to enable asset management firms to track ESG impact, comply with regulations and pave the way towards more transparent and sustainable finance.”

The use of derivatives as part of sustainable portfolios has been the subject of speculation and controversy in the industry but relatively limited research.

However, a technical standards document published by the European Commission in April this year in relation to the Sustainable Finance Disclosure Regulation (SFDR), the EC said:

“Financial market participants should explain how the use of derivatives is compatible with the environmental or social characteristics that the financial product promotes or with the objective of sustainable investment.”

Amitrano added: “It is more crucial than it has ever been for investment professionals to be able to measure and report the ESG related risk of their portfolios, including derivatives.”

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