What is ESG and how is it incorporated into the investment process?

Over the last two years, investor concerns about climate change, natural resource depletion, supply chain management and corporate governance have caused record inflows to funds focused on environment, social and governance (ESG) issues.

ESG refers to three categories of factors:

  • Environmental impact – Climate change risks, natural resources, water scarcity, pollution and waste
  • Social aims – Human rights, product liability, labor, health and safety and GDP indicators
  • Governance factors – Company audits, executive pay alignment, leadership and shareholder rights

A growing number of investors and funds now incorporate ESG into their investing approach, and ratings companies such as MSCI and Sustainalytics provide over 4000 corporate ESG ratings. ESG investing is a strategy that directs money to companies that meet rigorous ESG standards to enable companies to show support for responsible corporate behavior without sacrificing performance or incurring excessive fees. Companies engage in ESG investing via ESG-related mutual funds, index funds and indices such as the S&P 500 ESG and S&P 350 ESG on which CME Group also offer futures and exchange-traded funds. It can be specifically incorporated into the investment process by research, analysis and portfolio construction, which can be assisted by investor and company engagement processes. Exclusionary screening is the most widely used ESG integration technique, whereby companies or countries that conduct business in harmful sectors or into harmful products are not considered for investment – they are screened out. This mainly includes products such as weapons, tobacco, alcohol and gambling.

ESG integration is prevalent across asset classes – it is most common in equities through index funds, followed by fixed income through issuance of green/sustainable bonds. However, ESG processes have been somewhat harder to incorporate in other markets such as the global foreign exchange (FX) market.

Aligning Corporate ESG Goals to Performance

Companies can integrate elements of ESG into their day-to-day activities and relationships by considering their FX trading counterparties, as well as their service providers and vendors. ESG review as part of the selection process for products and liquidity providers is relevant to FX in terms of end users seeking out good ESG performers. FX market infrastructure providers are also increasingly likely to be expected to show attestation to commendable ESG practices. A potential knock-on effect will mean FX businesses will not only be judged on their own adherence to ESG commitments but also those of their client bases.

Regulation and Industry Best Practice for FX Participants

Not only do FX market participants have a set of best practice principles to adhere to, such as the Global FX Code, but there are also ESG-related recommended practices that companies are being encouraged and expected to sign up to. For most asset classes, ESG has traditionally focused on the environmental aspects; however, within FX adherence to the Global FX Code (the Code) links both the social and governance aspects and is a pronounced mechanism by which FX market participants can demonstrate strong governance and manage practices in their FX activities. The 2021 report by the GFXC highlights this connection, citing support by a number of FX buy-side firms for a linkage between the Code and ESG, suggesting that Code adherence plays a role in boosting a firm’s reputation giving the growing focus on responsible investing, particularly on the buy-side.

The U.N. Sustainable Development Goals (SDGs) focus on fair and regulated financial markets. The SDGs include targets to improve the regulation and monitoring of global financial markets and institutions, and strengthen the implementation of such regulations, as well as developing effective, accountable and transparent institutions at all levels. The Principles for Responsible Investing (PRIs) provide further Code adherence by signatories – many asset managers and institutions have signed up, committing to incorporate ESG into policies and practices. These codes and principles evidence a growing support for ESG goals and are an indicator of action to develop impressive ESG credentials. In the FX market, adhering to best practice Codes is an integral part of an FX participants’ commitment to corporate social responsibility and governance.

Regarding the emphasis on climate change and environmental issues, ESG taxonomies and reporting/disclosure mandates could have an indirect impact on the FX market. ESG disclosures have the potential to impact how all business lines, including the FX business, are viewed and evaluated by clients, investors and counterparties. ESG measures for greater transparency could also be a component to product innovation and help avoid the risk of greenwashing.

In addition, the Securities and Exchange Commission has recently proposed new climate disclosure rules that would require publicly traded companies to provide more information on how climate risks affect their businesses and report on their own greenhouse gas emissions, climate-related targets, and goals.

ESG-linked FX hedges – Will it Become Common Practice?

FX hedges can be used as a way for companies to promote themselves as cleaner and greener. They receive a more favorable rate if they hit environmental targets and receive a penalty if they do not; this could also be used in the same way for a social goal. Over the last couple of years there have been various banks and asset managers that have entered into sustainability-linked transactions. However, these transactions can also face hurdles to overcome, such ensuring the environmental target is finely balanced and achievable, in which some cases a third party is needed to adjudicate. As more participants enter the ESG sphere, it is likely these practices will become more common. ESG indexes can be hedged with FX overlay using a total return swap.

Example 1

In 2021, HSBC executed the first FX hedge linked to the global MSCI ESG index by creating the MSCI world ESG leaders 100% hedged to sterling (GBP) based on the performance of the MSCI index. It gets rebalanced monthly by MSCI and includes 12 current currencies of its constituent stocks that are hedged by HSBC to GBP using one-month rolling forward exchange rates. The client of this total return swap will pay HSBC the compounded daily SONIA rate at maturity of the swap in one years’ time, in exchange for the price return of the index.

Firms have also signed up to ESG-linked derivatives, the price of which depends on anything from cutting greenhouse gas emissions to improving workforce diversity. Banks selling the derivatives are eager to promote their own sustainability pledges and offer a lock-in future exchange rate. This market is soaring in popularity to boost sustainably prudent reputations.

Example 2

In 2021, Olam, a major food and agricultural business, bought a U.S. Dollar/Thai Baht forward contract at a discount to the conventional forward price, on the condition it meets a target to cut its carbon emissions.

How a value is assigned to an ESG goal, and therefore how a product is priced, remains between the bank and the client for now.

Commodity hedges linked to ESG benchmarks have also taken place in markets, whereby the transaction combines derivatives risk management with sustainability-linked key performance indicators that are linked to reducing greenhouse gas emissions and to sustainable sourcing in the base metals business.

Incorporating ESG into systematic FX strategies is also possible. Algorithms dynamically allocate higher weights to ESG indicators that are more compatible to the current state of the FX market and lower weights to the less compatible components. Back-test data has shown that incorporating ESG data as part of a systematic FX strategy can generate uncorrelated signals, which can be used as a complementary source next to other types of economic data.

ESG-linked FX transactions are a relatively new phenomenon in the FX market, but as ESG continues to grow and sustainable finance is no longer just a buzz phrase, these types of FX transactions are likely to become more common.

Embedding ESG Factors into Buy-side Currency Strategy

An original and effective approach to active currency management using ESG factors, ratings and analysis could provide a source of value and differentiation in terms of product offerings. Country sustainability scores could provide a forward-looking piece of scenario analysis through the construction of indices to reflect country-level performance in each ESG factor and link the country to the currency. Incorporating this into a qualitative FX strategy could also provide an outlook on the long-term performance of the currency, which could be particularly useful in an emerging markets currency strategy.

In terms of environmental aspects, currency pairs can be allocated according to the country’s vulnerability to climate change or their commitment to climate change mitigation and adaption. Social factors such as GDP stats, economic indicators and political influence can also play a part in adopting a social strategy, whereas governance factors can be assessed for risk premia opportunities in currencies.

Scandinavia – the ESG Master?

Scandinavian countries score the highest in terms of ESG rankings. Among the best-performing countries, Sweden and Finland particularly score high on education, healthcare and social security infrastructures. These two countries have great performance in the rating area of Climate Change and Energy along with Norway and Iceland.

At the corporate level, issuers in those countries usually have high rankings in terms of sustainability scores. According to the Morningstar Sustainability Atlas, Finland, Sweden and Denmark rank among the top five at the company level.

CME Group’s highly liquid marketplace allows participants to manage their FX exposure using cleared and listed NOK and SEK futures and options, benefitting from transparent pricing and efficient alternatives to forwards and swaps.

Sustainable Clearing – The New Kid on the Block

The emergence of sustainable clearing allows firms to credibly measure their risk management activities that are used to finance ESG initiatives. This can include a variety of products such as carbon offsets, bioenergy, S&P ESG 500 futures and hedging activity that is supporting sustainable businesses. CME Group launched the first ever sustainable derivatives clearing service in September 2021, on the back of increasing client prioritisation to expand their green businesses. This service provides high transparency on ESG reporting, does not increase costs as there are no additional fees or margins to use the service. Sustainable clearing integrates seamlessly into existing workflows, offers independent oversight from the CME Group Benchmark Administration, and helps to avoid greenwashing. The eligibility criteria are aligned to external standards already published, such as ICMA's Social & Green Bond Principles, helping to ensure consistency across ESG practices.

ESG Integration Challenges – Lack of Consistency?

AAlthough ESG integration is becoming a lot more prevalent in the investment process and markets in general, there are some challenges that may need to be overcome. The main issue facing the materiality of ESG factors is the inconsistency of ESG rating agencies and ESG scores. Differing methodologies used among rating agencies can provide varying results making it hard to compare performance. This ties into the challenge of aligning materiality with performance, as well as the transparency of ESG products alignment with investors sustainable finance objectives. There are a variety of frameworks investors can follow, such as the Sustainability Accounting Standards Board (SASB) guidance that sets standards for the disclosure of financially material sustainability information by companies to their investors, but these types of frameworks are adopted on a voluntary basis, so disclosure can become an issue.

There is evidence that high-ESG indices and portfolios can outperform the market; however, the same is also true for low-ESG portfolios, so some investors are not entirely convinced that ESG integration contributes positively toward risk-adjusted return.


The guidance and influence that has begun to be exerted by regulators and policy makers, as well as the interest by companies and investors to incorporate ESG factors in their trading and investment activities, is likely to mean that ESG and financial markets will only become more intertwined and important over the next few years.

The impact of ESG on the FX markets will clearly continue to evolve over time, having either direct or indirect impacts on FX as an asset class.

Having a clear understanding of where ESG can be incorporated into FX markets and how it will impact the FX business is important, not only to help mitigate any challenges but also to take advantage of any opportunities for the FX industry.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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