Creating, Pricing, and Modeling ESG Derivatives

Regulations and pressure from society have led to new ESG policies for businesses. Banks play a significant role in the ESG transformation because they are at the center of the economy. Banks have constructed ESG-linked products that stimulate companies to improve ESG-related KPIs within their organization. However, the range of the products currently offered by banks is still limited. Therefore, we researched how we can create, price, and model new ESG-related products. There are different guidelines for setting up KPIs for ESG-linked products. However, there are no general restrictions that hold for every company. Therefore, we created a general ESG KPI framework that every business can use. Furthermore, we found that all the current ESG-linked products are constructed in the same way. There is a base financial product with on top of it a bonus/malus KPI structure. We tried to model the KPI structure as an option, using the binomial tree model and the binary model as the foundation. Our KPI option models are based on the company’s historical volatility of a KPI, or that of a company of a similar size and sector. This way of pricing the KPI gives banks a viable model.