9 High-Impact Strategies to Uncover Profitable ESG Derivatives in 2025

Wall Street finally woke up to what crypto traders knew all along—sustainability pays. ESG derivatives are exploding, and these nine methods separate the real opportunities from the greenwashed garbage.

Leverage AI-driven sentiment analysis

Track regulatory tailwinds across jurisdictions

Monitor carbon credit price correlations

Analyze institutional flow patterns

Scrutinize underlying asset verification

Identify liquidity arbitrage opportunities

Track ESG rating agency momentum

Monitor corporate bond conversion triggers

Capitalize on volatility around sustainability reports

Because nothing says 'ethical investing' like complex financial instruments that would make your ESG-loving grandma's head spin—but hey, profits are sustainable too.

The 9 High-Impact Ways to Identify Lucrative ESG Derivatives

To successfully navigate this evolving market, a strategic approach is essential. The following table provides a quick-reference guide to the nine high-impact strategies that can help identify and leverage lucrative opportunities in ESG derivatives.

#

Strategy

Description

1

Mastering ESG Quantitative Analysis

Deconstructing ESG performance through verifiable metrics and data, moving beyond subjective claims.

2

Harnessing ESG Index Products

Gaining exposure to and hedging against the most liquid ESG strategies through standardized futures and options.

3

Uncovering Value in Incentivized Structures

Analyzing sustainability-linked derivatives (SLDs) to find financial value tied directly to a company’s ESG performance.

4

Following the Signals of Market Growth

Identifying new and bespoke ESG derivatives by tracking key drivers such as evolving regulations and investor demand.

5

Decoding Investor Sentiment

Understanding the dual motivation of investors—balancing sustainability goals with a demand for strong financial returns.

6

Analyzing Corporate Hedging

Pinpointing opportunities by observing how companies in high-impact sectors are using these instruments to reduce risk and lower capital costs.

7

Navigating the Evolving Regulatory Environment

Capitalizing on the market’s fragmented regulatory landscape by anticipating future compliance and disclosure demands.

8

Mitigating Risks for Maximum Impact

Protecting investments by identifying and avoiding greenwashing, and mitigating the risks associated with ESG rating divergence.

9

Analyzing Notable Transactions

Learning from the pioneers of the ESG derivatives market to create a blueprint for future investment opportunities.

The Expert’s Playbook: Detailed Analysis of Each Strategy

Chapter 1: The Foundation: Deconstructing the ESG Derivatives Landscape

Defining the Core: What Are ESG Derivatives?

ESG derivatives are financial contracts whose value is derived from an underlying ESG asset or performance metric. A derivative, by its nature, is a contract between two parties whose value changes in response to an underlying variable, such as an asset, index, or rate. In the context of ESG, this variable is a non-monetary criterion related to environmental, social, and/or governance performance. The terminology in this space is not uniform, which makes precise definitions critical for any investor.

It is important to distinguish between two main types of ESG derivatives:

• Traditional “ESG-linked” derivatives: These are products that have long existed in the market and typically involve an environment-linked commodity, such as carbon credits. Their value is tied to the price of a tangible, tradable commodity, but they do not directly incentivize a counterparty’s sustainability performance.
• Modern “Sustainability-Linked Derivatives” (SLDs): These are a much newer and more sophisticated creation, with the first such transaction occurring in 2019. Unlike their predecessors, SLDs are not tied to a commodity. Instead, they add an ESG “overlay” to a conventional derivative (e.g., an interest rate or foreign exchange swap) and tie a financial consequence to the achievement of a company’s ESG targets, typically measured by Key Performance Indicators (KPIs).

This evolution from commodity-based to performance-based products signals a maturation of the market. The early products were about trading a tangible asset. The new generation of SLDs represents a shift toward a direct financial incentive model that aims to influence and monetize a company’s internal behavior. A skilled investor understands this critical distinction, as it reveals the market’s deepening integration of ESG principles into CORE financial strategy.

Why They Matter: Risk Hedging, Incentives, and Capital Allocation

ESG derivatives are not just an alternative investment; they are powerful tools for achieving a dual objective: managing risk and encouraging sustainable behavior. Their primary function is risk management, a core role of derivatives in modern finance. These products offer parties a mechanism to manage the financial risks related to ESG, such as those sensitive to climate change. For instance, a bank can use a credit default swap to protect itself against a counterparty whose creditworthiness is impacted by climate-related risks.

Beyond risk, these derivatives act as a powerful catalyst for sustainable action. They are intrinsically designed to incorporate new features that address the needs of sustainable finance, allowing them to easily be used in various financing structures. By linking a company’s cost of capital to its ESG performance, these instruments create a direct financial incentive to meet pre-agreed targets. For example, a counterparty may receive a discount or a preferential rate for meeting a target or face a premium or a higher rate if they miss it. This market-based mechanism converts a company’s ethical commitment into a quantifiable financial outcome, solving the problem of aligning long-term, abstract sustainability goals with short-term, concrete financial performance.

Chapter 2: Strategy One: Mastering the Art of ESG Quantitative Analysis

Leveraging Key Performance Indicators (KPIs)

The bedrock of any sustainability-linked derivative is the use of Key Performance Indicators (KPIs). These indicators serve as objective, verifiable measures for monitoring compliance with ESG targets. The effectiveness and credibility of an SLD are directly tied to the integrity of its KPIs, which must be clearly and accurately defined to have legal certainty over their operation and impact on cash flows. The International Swaps and Derivatives Association (ISDA) has provided guidelines that recommend five core principles for credible KPIs: they must be specific, measurable, verifiable, suitable, and transparent. These guidelines promote market standardization and reduce the risk of disputes and greenwashing. A key feature of these products is the use of “unilateral KPIs,” which typically measure only the performance of the non-financial counterparty, placing the responsibility—and the financial incentive—squarely on the corporation to improve its ESG profile.

Measuring Impact: Common Quantitative Metrics

To identify truly impactful and lucrative opportunities, a DEEP understanding of the metrics used to measure ESG performance is required. These metrics can be both quantitative and qualitative but must provide specific, verifiable information.

• Environmental (E) Metrics: These include tangible data points related to a company’s impact on the planet. Examples are greenhouse gas (GHG) emissions (both direct Scope 1 and 2 emissions), energy and water consumption, waste output, and land use. The efficacy of an environmental KPI often lies in its direct link to a company’s core operations.
• Social (S) Metrics: These metrics measure a company’s relationship with its employees, communities, and stakeholders. Examples include workforce diversity percentages, human rights policies, and labor conditions.
• Governance (G) Metrics: This category focuses on a company’s leadership and internal controls. Key indicators include board composition, executive compensation, anti-corruption policies, and shareholder rights.

These metrics translate the abstract concepts of ESG into tangible, measurable data points that can be integrated into financial models, providing a concrete basis for valuation and trade structure.

ESG Pillar

Metric

Description

Environmental (E)

GHG Emissions

The total volume of greenhouse gases produced by a company, measured in tons of carbon dioxide equivalent (CO2​e).

 

Energy Consumption

The amount of energy consumed, often measured in kilowatt-hours (kWh).

 

Waste Output

The volume of solid, hazardous, or wastewater produced, measured in kilograms, tons, or cubic meters.

 

Water Consumption

The amount of fresh water used in operations, measured in liters or cubic meters.

Social (S)

Workforce Diversity

The percentage of the workforce from underrepresented groups, including gender, race, and ethnicity.

 

Labor Rights

The presence of policies protecting labor rights and ensuring fair working conditions.

 

Community Relations

Policies related to charitable contributions or community engagement.

Governance (G)

Board Composition

The structure of a company’s board, including the percentage of independent directors and diversity.

 

Executive Compensation

The alignment of executive pay with long-term company performance and ESG goals.

 

Anti-Corruption

The presence of policies and controls to prevent bribery and corruption.

The Role of Third-Party Ratings and ESG Scores

Third-party ratings and ESG scores are a significant component of this market, with data providers like MSCI and LSEG offering transparent, data-driven assessments of companies’ relative ESG performance. These scores are calculated based on publicly reported data and account for industry materiality and company size. However, a key issue in the market is the lack of a single, uniform standard for ESG measurement, which is the root cause of “ESG rating divergence”. When a company receives conflicting ratings from different agencies, it creates information asymmetry and volatility in the market. This divergence can erode investor confidence and hinder decision-making, leading to market inefficiencies. For a sophisticated investor, this inefficiency is a potential source of significant alpha. By developing a proprietary, robust internal ESG analysis framework, an investor can identify opportunities that are mispriced by the broader, confused market, turning a market flaw into a competitive advantage.

Chapter 3: Strategy Two: Harnessing the Power of ESG Index Products

ESG Futures and Options: Gaining Exposure to ESG Outperformers

While sustainability-linked derivatives are primarily bespoke, over-the-counter (OTC) instruments, the market is maturing with the emergence of more liquid and standardized exchange-traded products. Futures and options on ESG indices offer a transparent and efficient way to gain exposure to ESG-focused strategies or hedge against risks. These products track equity indices where companies are weighted and evaluated based on various ESG standards. Examples include the E-mini S&P 500 ESG Future, Cboe S&P 500 ESG Index Options, and various futures and options on MSCI and STOXX indices traded on platforms like Eurex. These products provide capital efficiency, as they are eligible for portfolio margin offsets against other index derivatives.

The Benefit of Transparency and Liquidity

The proliferation of these exchange-traded products provides a crucial market signal. The initial phase of the market was dominated by private, bilateral transactions that, while highly customizable, lacked transparency and liquidity. The move of ESG products to centralized exchanges indicates a maturation of the market and sufficient demand and liquidity to support standardization. This shift enhances transparency and price discovery for the underlying ESG strategies, which, in turn, helps to enhance capital flows toward sustainable objectives and make these strategies more accessible to a broader range of financial market participants. The ability to replace risk on the market is the equivalent of tradability, and this shift to exchange-traded products further legitimizes ESG as a mainstream asset class.

Chapter 4: Strategy Three: Uncovering Value in Incentivized Structures

Analyzing Sustainability-Linked Derivatives (SLDs)

The core appeal of sustainability-linked derivatives for a profit-driven investor lies in their incentivized structure. These derivatives are not just for managing risk; they are designed to provide a financial consequence for a company’s ESG performance. ISDA distinguishes between two main types of SLDs based on how the incentives are structured:

• Category 1 SLDs: The KPIs and their related financial consequences (e.g., adjustments to cash flows, margins, or spreads) are embedded directly within the derivative transaction itself. In this structure, the outcome of the ESG KPI has a direct, immediate bearing on the derivative’s cash flows.
• Category 2 SLDs: The KPIs and financial consequences are documented in a separate agreement from the underlying derivative. The derivative serves as a reference for calculating a separate KPI-based payment, but its own terms and cash flows are not affected by the ESG performance.

The financial consequences for meeting or missing an ESG target are diverse and customizable. A company might receive a discount or preferential rate for meeting a target or, conversely, have to pay a premium or a higher spread if it fails to meet its goal. In some cases, a penalty for a missed target may even take the FORM of a charitable payment to a third party.

The financial incentive embedded in SLDs solves a classic agency problem: aligning a company’s long-term sustainability goals with its short-term financial performance. Without a direct financial incentive, a company’s public commitments, such as reducing emissions, can be treated as a “nice-to-have” secondary to its core financial priorities. By directly linking a company’s cost of capital to the achievement of a sustainability target, an SLD makes ESG performance a line item on the financial ledger. This forces the company’s treasury and management to actively manage ESG risks, just as they WOULD any other financial risk. This creates a market-based mechanism that enforces an ethical commitment, making the company’s ESG strategy a financially motivated one.

Chapter 5: Strategy Four: Following the Signals of Market Growth and Innovation

Identifying Key Market Drivers and Trends

The growth of the ESG derivatives market is not accidental; it is driven by a powerful confluence of political, legislative, and investor forces. Political and legislative pushes, such as the EU’s Sustainable Finance Action Plan and the UK’s Green Finance Strategy, are creating the necessary regulatory frameworks to support this growth. This is happening alongside a dramatic increase in investor demand for sustainable investment opportunities. The market, while still considered nascent, is experiencing rapid growth, with major investment banks increasingly incorporating these products into their portfolios. The volume of transactions is expected to increase “dramatically,” showing no signs of slowing down.

This growth is driven by a positive feedback loop. Regulatory clarity reduces uncertainty for market participants and encourages the use of derivatives to hedge climate and ESG-related risks. As more companies and investors enter the market, it increases liquidity and pushes for standardization , which in turn attracts even more capital. The trend towards increased disclosure, such as the SEC’s proposed climate rules, will provide more data, making these derivatives more viable and the market more efficient.

Emerging Products: VIRTUAL PPAs and Other Bespoke Instruments

Beyond the more common sustainability-linked swaps, the market is seeing innovation in other bespoke and specialized instruments. Savvy investors can find opportunities by understanding the mechanics of these emerging products:

• Virtual Power Purchase Agreements (VPPAs): Defined by ISDA as cash-settled fixed-for-floating commodity swaps, VPPAs allow energy purchasers to hedge against market price risk. This makes green energy a more attractive proposition by reducing a key uncertainty.
• Catastrophe Derivatives: These are used in conjunction with or as an alternative to catastrophe bonds to manage financial risks stemming from climate-related disasters and extreme weather events.
• Credit Default Swaps (CDS): This established instrument is being repurposed to hedge against the creditworthiness of a counterparty whose financial results are sensitive to climate change risk.

Chapter 6: Strategy Five: Decoding Investor Sentiment and Demand

The Shifting Mindset of Institutional Investors

Investor sentiment is a critical signal for identifying lucrative opportunities in this market. Recent surveys show a profound shift in the mindset of institutional investors. An overwhelming 88% of institutional investors believe that ESG factors are more important than traditional financial metrics when evaluating a company’s long-term attractiveness. Furthermore, 79% believe that companies with ESG failings should be avoided, even if they could offer attractive short-term returns.

Despite this strong sentiment, there is a fundamental tension in investor motivation. The vast majority of investors (81%) are unwilling to accept more than a one-percentage-point reduction in investment returns for the pursuit of ESG goals. This paradoxical demand for ESG performance that does not compromise financial returns is a direct catalyst for the development of new, sophisticated financial instruments like ESG derivatives. These products are perfectly positioned to meet this demand by allowing investors to manage a new LAYER of ESG-related risks while still pursuing a profit-driven mandate.

Understanding the Retail Investor’s Role and Motivations

Retail investors are also playing an increasingly important role, with their trading activity increasing significantly around ESG news events. A recent study found that retail investors are primarily motivated by financial gain rather than non-pecuniary preferences, trading in the direction of financial performance even when it conflicts with a company’s ESG performance. This shows that they are not investing out of purely ethical concerns but rather for the pecuniary implications of ESG news. A plurality of retail investors (41%) believes that ESG investments will perform in line with the market, not worse, while a smaller portion (14%) expects them to outperform. This belief system provides a strong foundation for the continued growth and legitimization of the market.

The Balance Between ESG Goals and Financial Returns

The analysis debunks the myth that sustainable investing leads to lower returns. In fact, the evidence suggests that focusing on material ESG issues can lead to lower investment risk and, in some cases, superior returns. This performance dynamic provides the fundamental rationale for the “lucrative” aspect of ESG derivatives, as they are a tool to capitalize on this LINK between sustainable practice and financial value.

Chapter 7: Strategy Six: Analyzing Corporate Hedging and Value Creation

How Companies Use ESG Derivatives to Manage Risk

Corporations are increasingly using ESG derivatives as a serious, financially motivated strategy to reduce risk and cost of capital, rather than just as a public relations tool. These products allow them to hedge against standard market risks—such as interest rate, currency, and commodity price volatility—in a manner that is consistent with their sustainability commitments. For example, an interest rate swap can adjust its rate based on a company’s ESG performance, providing a direct financial incentive to meet specific targets like reducing GHG emissions or increasing renewable energy use.

This approach is particularly relevant for companies in sectors with substantial ESG-related pressures, such as energy, construction, agriculture, and transport. These companies are on the front lines of climate and social change, facing risks like potential legal liabilities, reputational damage, and supply chain disruptions. By using ESG derivatives, they can monetize their sustainability efforts and reduce their cost of capital, which makes managing ESG a smart financial decision. This alignment of the financial and sustainability departments creates a more resilient and cohesive corporate strategy.

Real-World Examples of Corporate Adoption

Analyzing pioneering transactions provides a blueprint for identifying future opportunities. The use of these instruments is not theoretical; several notable deals have already been executed:

• SBM Offshore and ING: The first sustainability-linked derivative transaction was executed in August 2019, an interest rate derivative used to hedge the interest rate risk of SBM’s $1 billion five-year floating rate revolving credit facility. This pioneering deal demonstrated the dual purpose of hedging traditional financial risk while incentivizing ESG performance.
• Enel and Société Générale/J.P. Morgan: In two separate transactions, Enel used sustainability-linked cross-currency swaps tied to a bond issuance to hedge against exchange rate and interest rate risk, with the bond rate linked to the company’s ability to reach a specific renewable energy generation target.
• Hysan Development and BNP Paribas: This transaction involved a sustainability-linked hedge tied to Hysan’s inclusion in a public ESG index and its energy consumption reduction targets.

Parties

Type of Derivative

Purpose

Key ESG KPI

SBM Offshore & ING

Interest Rate Derivative

Hedge interest rate risk on a $1 billion revolving credit facility

Unspecified ESG target (unilateral)

Enel & Société Générale/J.P. Morgan

Cross-Currency Swap

Hedge against exchange rate and interest rate risk on bond issuance

Reaching at least 60% renewable generation within total installed capacity

Hysan Development & BNP Paribas

Sustainability-Linked Hedge

Link a hedge to ESG commitments

Constituent member of Hang Seng Corporate Sustainability Benchmark Index & a 20% reduction in energy consumption

Siemens Gamesa & HSBC

Interest Rate Swap

Convert a floating-rate loan to fixed-rate funding

Unspecified ESG target

Chapter 8: Strategy Seven: Navigating the Evolving Regulatory Environment

Major Global Regulations (EU, US, UK) Shaping the Market

The rapid development of ESG derivatives is outpacing the regulatory landscape, which is still fragmented and evolving. This creates both risk and opportunity for investors. Regulators, particularly in Europe, have been proactive in fostering sustainable finance through initiatives like the EU Sustainable Finance Action Plan and the UK Green Finance Strategy. The Sustainable Finance Disclosure Regulation (SFDR) in Europe, for instance, requires financial companies to provide pre-contractual disclosures on their use of sustainability-linked derivatives. In the US, the landscape is shifting with the CFTC’s recent withdrawal of guidance on voluntary carbon credit derivatives, citing a disproportionate focus that could lead to confusion. Similarly, the SEC has introduced rules for mandatory climate-related disclosures, though their implementation has been legally challenged. Understanding this regulatory divergence is a high-impact strategy. The absence of a fixed legal definition for ESG in the US and the lack of a uniform global standard create a vacuum that is being filled by a patchwork of rules and guidelines.

The Role of Regulatory Bodies (CFTC, SEC, ISDA)

Industry bodies like ISDA are crucial in this environment, proactively developing standardized documentation and publishing KPI guidelines to enhance market credibility and efficiency. However, a key focus for regulators like the SEC remains the prevention of fraud. The SEC is actively pursuing enforcement actions for ESG greenwashing when it constitutes a violation of securities laws. These actions underscore the regulatory shift from voluntary to mandatory and auditable disclosures.

Chapter 9: Strategy Eight: Mitigating Risks for Maximum Impact

The Threat of Greenwashing: Legal, Financial, and Reputational Risks

As the market for ESG-related products grows, so too does the risk of “greenwashing,” where companies misrepresent their commitment to ESG factors to attract investors. For an asset manager, greenwashing presents three main types of risks :

• Compliance and Regulatory Risks: This includes providing incomplete or inaccurate information to regulators and missing reporting deadlines, which can lead to investigations, penalties, and legal action.
• Financial Risks: If a firm is found to have greenwashed its products, it can face significant financial penalties and legal costs. The value of investments in the exposed company may also be negatively impacted.
• Reputational Risks: Greenwashing claims can severely damage a company’s brand, erode consumer and client trust, and lead to a loss of market share.

Recent enforcement actions demonstrate the severity of these risks. The multi-billion dollar penalties against Volkswagen and Toyota for misrepresenting emissions , and the multi-million dollar fines against investment advisors for failing to implement ESG policies they publicly claimed to follow , serve as stark warnings.

Company/Parties

Penalty

Accuser

Nature of Greenwashing

Volkswagen

> $34.6 billion

US EPA, DOJ, multiple international authorities

Using software to deceive regulators about vehicle emissions

Toyota

$180 million

US Department of Justice

Failing to report defects in vehicle tailpipe emissions

DIMA (DWS)

$19 million

SEC

Misleading investors about the controls used for incorporating ESG factors into research and investment recommendations

Kohl’s & Walmart

$5.5 million (total)

FTC

Labeling products as “environmentally friendly bamboo” when they were made of other materials

The Challenge of ESG Rating Divergence

The lack of a standardized measurement for ESG success has led to significant discrepancies in ratings among different agencies. This divergence creates a significant challenge for investors, as it diminishes the value of ESG ratings as a reliable reference for decision-making. Conflicting ratings can lead to greater information asymmetry and market volatility. This highlights the need for a disciplined, analytical approach rather than a reliance on a single, external rating.

Practical Steps for Due Diligence

To mitigate these risks and identify authentic opportunities, investors must perform rigorous due diligence. This involves:

• Seeking verifiable data: Prioritizing quantitative and objective metrics that are within a company’s control and can be benchmarked against publicly recognized standards like the UN’s SDGs.
• Looking for third-party verification: Relying on companies that have their ESG reports and data verified by independent auditors to enhance credibility and reduce the risk of moral hazard.
• Analyzing legal documentation: Scrutinizing the legal and contractual language of the derivatives to ensure KPIs are clear and well-defined, and that a clear dispute resolution mechanism is in place.

Chapter 10: Strategy Nine: Analyzing Notable Transactions and Case Studies

The market for sustainability-linked derivatives is still young, but pioneering transactions provide a clear roadmap for future opportunities. By analyzing these deals, an investor can understand the structural and strategic elements that make these products successful.

A Detailed Look at Pioneering ESG Derivative Trades

• SBM Offshore & ING: The first ever sustainability-linked derivative, a hedging of an interest rate risk for a floating rate revolving credit facility. This transaction established the template for using an ESG derivative as a dual-purpose tool for both hedging and incentivizing.
• Enel & Société Générale/J.P. Morgan: A cross-currency swap tied to a bond issuance, where the interest rate was subject to a step-up mechanism if Enel failed to meet its renewable energy generation targets. This deal demonstrates how derivatives can be used to hedge a primary financing instrument while enforcing a sustainability commitment.
• Hysan Development & BNP Paribas: A sustainability-linked hedge that tied a company’s financial terms to its membership in a public ESG index and a reduction in energy consumption. This example highlights the use of a public benchmark as a verifiable KPI.

Key Takeaways from Successful Engagements

An analysis of these deals reveals key trends and strategic commonalities. The transactions tend to occur between financial institutions and non-financial companies, particularly those in sectors with significant ESG-related pressures, such as energy, construction, and transport. These deals often utilize a “unilateral KPI” model, where the financial consequences only apply to the non-financial institution, which serves to incentivize their performance. The products are highly customizable and are used to incentivize ESG performance rather than to dictate the use of proceeds, which is a key distinction from instruments like green bonds.

Lessons for Future Opportunities

Studying these transactions provides a clear blueprint for identifying future opportunities. By observing which sectors are under the most pressure and which companies are actively seeking to monetize their sustainability efforts, an investor can predict where the next “lucrative” transaction will emerge. The strategic use of these derivatives to reduce the cost of capital, manage risk, and align with investor demands will continue to be a powerful driver of innovation in the market.

Conclusion: The Path Forward for Smart Capital

The ESG derivatives market is a rapidly evolving frontier in finance. It is a space where the traditional laws of risk and return are being rewritten by the non-financial principles of environmental stewardship and social accountability. Identifying lucrative opportunities in this market requires a sophisticated approach that moves beyond superficial ESG claims and dives into the quantifiable details of a company’s performance. The nine high-impact strategies presented in this report—from mastering quantitative analysis to navigating regulatory complexities and analyzing real-world transactions—provide a comprehensive framework for success.

The market’s current state, characterized by fragmented regulation and a lack of uniform standards, presents both challenges and unparalleled opportunities for those who can navigate its complexities. As global drivers continue to push capital toward a more sustainable economy, ESG derivatives are proving to be a critical mechanism for this transition. For the prepared investor, this market is not just about risk mitigation; it is a fertile ground for a new era of value creation.

Frequently Asked Questions (FAQ)

An “ESG-linked” derivative typically involves an environmental-linked commodity like carbon credits. A “Sustainability-Linked Derivative” (SLD) is a newer, more customizable instrument that adds an ESG “overlay” to a conventional derivative and ties a financial consequence to a company’s performance against specific ESG targets.

A company can make money by receiving a financial incentive for meeting a pre-agreed ESG target. This can take the form of a discount on a derivative’s rate, a payment of a rebate, or a decrease in a premium. If a company fails to meet its target, it may have to pay a penalty, which can sometimes be a charitable payment.

The main risks include greenwashing, where a company misrepresents its ESG claims, which can lead to legal, financial, and reputational penalties. Another key risk is ESG rating divergence, where different rating agencies provide inconsistent scores, which can create information asymmetry and market volatility.

Investors should seek clear, quantifiable, and verifiable Key Performance Indicators (KPIs) and look for a clear dispute resolution mechanism. Relying on third-party verification of a company’s ESG reports can also enhance credibility and reduce the risk of misleading claims.

The evidence suggests that ESG is not a fad. Data indicates that institutional and retail investors are increasingly incorporating ESG into their decision-making. Furthermore, focusing on material ESG issues has been shown to potentially lower investment risk and, in some cases, lead to better returns.