In remarks before the "Derivatives Trading Forum: Trading ESG Products," ISDA Chief Executive Scott O'Malia urged regulatory action to address Basel III market risk rules for carbon certificates. He asserted that the proposed rules would set capital requirements that are disproportionately high. Mr. O'Malia said that action must be taken before the Fundamental Review of the Trading Book is due to be implemented in 2023.

In his address, Mr. O'Malia warned that it is difficult to assess performance across different sustainability-linked derivatives due to the lack of standards for compliance with environmental, social and governance goals. He went on to discuss the importance of creating a voluntary carbon trading market and outlined ISDA's efforts to develop related standards.

In a related white paper, ISDA described the role of derivatives in carbon markets" and reviewed exchange-traded and OTC carbon derivatives. ISDA explained that carbon markets can operate through mandatory schemes, such as cap-and-trade programs, and through voluntary programs, which typically involve private companies attempting to reach corporate social responsibility goals.

ISDA stated that derivatives can be used by companies with mandatory carbon compliance programs to achieve their goals and manage risk in the most economical way.

ISDA highlighted that companies can use derivatives to:

  • either "bank allowances" or hedge future production-related emissions costs, if they have concerns regarding the volatility of carbon allowance costs; or
  • purchase allowances and sell forward futures or options contracts at the same time to avoid carbon price risk exposure.

ISDA also noted that derivatives markets are critical to improving transparency with respect to carbon because they provide "forward information," which (i) aids firms in managing their long-term sustainability goals, (ii) assists regulators in their regulation of carbon prices and (iii) helps investors determine their portfolios' climate transition risks.

ISDA described exchange-traded and OTC carbon derivatives as (i) offering more liquidity, increased price transparency and reduced counterparty risk and (ii) with OTC derivatives, enabling market participants to better tailor their contracts to achieve specific risk management goals. ISDA stated that exchange-traded spot and futures contracts and OTC markets are instrumental to ensure that carbon markets are functional and carbon contracts are effective for hedging purposes.

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