Heating up

Structured products

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The earth is undergoing rapid change: it is already in the grip of water shortages, coastal flooding and storms; the Amazon rainforest is severely damaged; and the Greenland and West Antarctic ice sheets are melting at a rate of knots. And, according to a report published last October on climate change commissioned by the UK Treasury and written by former World Bank economist Nicholas Stern, carbon dioxide emissions could reach 550 parts per million by 2035 if current trends were to continue - a level at which there is at least a 77% chance that global temperatures could rise by 2%. This would be sufficient to cause a significant rise in the number of people at risk from famine, and could send the world economy spiralling into recession.

No wonder people are taking it seriously. First came the Kyoto Protocol, which requires those developed countries that have ratified the agreement to cut their greenhouse gas emissions to at least 5% from 1990 levels by 2012. Then came the European Union's emissions trading system, which allows market participants to buy and sell carbon credits, as well as an EU agreement to ensure 20% of energy is generated from renewable sources by 2020. Meanwhile, various governments are pushing the development of alternative energy through offering subsidies to biofuels, egged on by greater awareness of the issue by voters who fear the world's leaders are doing too little, too late.

This increased awareness is even now filtering down to the investment community. In particular, investors are waking up to the fact that the devastating scenario outlined in Stern's report could actually present opportunities to those companies and industrial sectors focused on developing solutions to offset and overcome the effects of climate change. There's the obvious (alternative energy and carbon trading), but also the not quite so obvious (waste management, recycling and building insulation). In fact, the Stern report estimates that low-carbon technologies could be worth at least $500 billion by 2050.

It has prompted a handful of financial institutions, including ABN Amro, Credit Suisse and HSBC, to launch so-called climate change or global warming indexes to track these sectors. And banks are planning to launch various structured products linked to these indexes to retail, high-net-worth and institutional clients.

"We expect an unprecedented twofold reallocation of capital investment - first towards low-carbon solutions and second to enable economies to adapt to the physical impacts of a changing climate," says Joaquim De Lima, head of quant research for HSBC in London.

HSBC launched its family of climate change indexes in September, designed to reflect the stock market performance of companies likely to profit from global warming. The suite of indexes comprises a benchmark and four investable indexes: the HSBC Investable Climate Change Index, the HSBC Investable Low Carbon Energy Index, the HSBC Investable Energy Efficiency and Energy Management Index and the HSBC Investable water, Waste and Pollution Control Index.

The benchmark comprises 300 stocks that generate a minimum of 10% of their overall revenues from climate change-related activities, have a minimum market capitalisation of $500 million and a minimum average daily trading turnover of 0.02% of full market capitalisation. Those stocks included in the investable indexes, however, must derive more than 50% of their revenues from climate change, have a market capitalisation of $1 billion and a six-month average daily turnover of at least 0.5% of the minimum market capitalisation threshold.

The Investable Climate Change Index comprises 50 stocks covering solar, nuclear, wind, biofuels, building insulation water and waste. On a back-tested basis, it has returned 125% since 2004 with a Sharpe ratio of 1.49. The low-carbon energy production index comprises 27 stocks and has returned 205% since 2004; the energy efficient index is made up of 10 stocks with a return of 129% over the same period; while the water index consists of 13 companies with a return of 94%.

The bank believes these indexes represent good underlyings for structured products and exchange-traded funds. In particular, it plans to launch capital-protected notes, certificates and funds referenced to the indexes globally, targeting retail, high-net-worth and institutional investors. HSBC declined to comment on when these products would launch.

"We created these indexes and structured products to capture potential returns from the challenges presented by climate change. We have seen a lot of demand for these types of products," says Kevin Bourne, head of equities at HSBC in London.

ABN Amro has also jumped into the climate change market, having previously been active in various alternative energy and water products (Risk January 2007, pages 83-85).1 The bank launched its Climate Change and Environmental Index in March, designed to track those businesses tackling climate change.

The product is a market capitalisation-weighted total return index initially composed of 30 stocks split between eight sub-sectors that include geothermal and alternative fuels, hydroelectric power, water and wind power. Each constituent stock must have a market capitalisation of greater than EUR600 million, a daily liquidity of EUR1 million and derive more than 25% of its revenues from one or more of the sectors. A maximum of four stocks from each sector can be included. The index is rebalanced twice-yearly, while the sector weightings are reweighted on an annual basis - meaning more emphasis is given to the renewable energy sectors that perform the best.

"Businesses that benefit resolving environmental issues are a fast-growing segment and this is what we wanted the index to reflect, as opposed to exposure to mainstream large capitalisation companies that others have focused on," explains Shahzad Ahmad, head of equity structuring at ABN Amro in London.

The bank launched capital-protected notes and certificates linked to the index in the second quarter of 2007, and has even mooted the potential for a collateralised debt obligation based on the credit ratings of the index constituents.

The capital-protected note was a five-year, dollar-denominated product comprising two tranches: one offering 100% capital protection and 100% participation in the index; and the other offering 80% capital protection and a participation rate of 200%. At maturity, investors participate in any positive performance of the index (based on the average of a series of closing levels taken at pre-specified observation dates during the life of the product), with unlimited upside. The product was offered to private banking and retail investors, with hundreds of millions of dollars sold so far.

"When we issue our capital-protected notes linked to the index, our risk management system will tell us our delta exposure. We then either hedge with a replicating portfolio of the stocks from the index, or manage the exposure across the wider portfolio of issued products," says Ahmad.

Similarly, Credit Suisse launched its Global Warming Index in August. Like the ABN Amro and HSBC indexes, the priduct tracks some key sectors: companies that provide solutions for more efficient energy consumption; emissions limitation; renewable energy; and renewable fuels.

The index is chosen from 269 stocks, which are narrowed down to those with sufficient liquidity. The bank's corporate and valuation tool, Holt, is then used to narrow the universe down according to operational performance, cashflow valuation and momentum. The 40 stocks with the highest Holt scores (five from each sector plus another 20) are then chosen for the index, which is rebalanced twice a year. It is calculated as a synthetic price-return index, and offered in dollars, euros and Swiss francs.

Like its rivals, Credit Suisse plans to launch a range of structured products referenced to the index, including certificates and capital-protected notes, and has also licensed the index for funds to be based on it.

One product available in the market at the moment is a three-year equity-linked deposit with an Asian call embedded in it. Norway's DnB Nor started selling the deposit to retail investors in August. It has 100% capital protection and offers investors 72% participation in the Global Warming Index with unlimited upside. The observation points for the deposit are monthly for the last year of the product's life. There are no floors for the observation points, but investors are guaranteed to receive their money back if all observations fall below the index's initial value.

To hedge the bank's delta exposure, it uses a replicated portfolio of the index's underlying stocks; and to hedge its vega exposure - the risk from selling options on the index - it buys a portfolio of options on liquid indexes that most resembles the underlying vega risk of the Global Warming Index.

"We use options on the main traded indexes, such as the S&P 500 and Dow Jones Euro Stoxx 50, because they are very liquid and relatively cheap to trade," says Ed Leech, part of the European equity exotics trading team at Credit Suisse in London. "We still have basis risk between the positions we have in those indexes and the underlying position of our structured products."

As with most structured products, the pricing of options the banks sells reflects the expected cost of hedging. Leech says Credit Suisse is always looking at ways to minimise the basis risk and improve its hedging, such as through trading new indexes.

Other banks have launched rival indexes, while more are preparing to follow. All see increasing investor concern about climate change as an important area of growth, and are competing in their ability to identify those companies that can best respond to the need to develop new energy sources, conserve existing energy reserves, help ease pollution and manage waste. With so many indexes vying for attention, the world of structured products is sure to hot up.

1 www.risk.net/public/showPage.html?page=359562

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