Published: Friday 25 November 2022

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Introduction

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The transition to a net zero and sustainable economy is an urgent challenge, and the focus on environmental, social and governance (ESG) activities is increasing across the global markets.

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Over the past few years, the market has seen the development of green and sustainable financing products which allow market participants to demonstrate their commitment to a sustainable future. Derivatives markets have begun to play a key role in this transition to a more sustainable economy, as investors look for ways to meet their sustainability goals. As well as conventional over the counter (OTC) derivatives providing hedging solutions for sustainable finance products, a number of innovative OTC derivatives have developed, with the use of sustainability-linked derivatives (SLDs) in particular seeing an increase in growth in the EU, UK and US in recent years since the first SLD was executed in August 2019. 

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ISDA have published research papers relevant to SLDs[1] which discuss some of the key considerations, including guidelines on key performance indicators (KPIs) linked to SLDs, as well as the regulatory landscape surrounding SLDs. In addition, a recent white paper published by the ISDA Future Leaders in Derivatives (IFLD)[2] reviewed some of the key considerations that market participants may need to think about from a legal, commercial, regulatory, data management and documentation perspective when trading SLDs.

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It is clear that derivatives markets can play an essential role in managing the risks associated with sustainable investments. As the SLD market evolves, Regulators and key industry bodies are committed to increasing transparency, standardisation and market efficiency to encourage growth of this market. This article will summarise what SLDs are and will provide an overview of some of the considerations identified by ISDA surrounding the SLD market.

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What are SLDs and what attracts market participants?

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SLDs have a key role to play in helping the world transition to a more sustainable economy and assisting individual and institutional investors with furthering their ESG objectives. SLDs are relatively new to the derivatives market and trading volumes are still currently much smaller than those of more traditional ESG-related derivatives, such as derivatives that typically involve an environmental-linked commodity e.g. carbon credits or allowances.

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SLDs are customizable transactions that use KPIs to set sustainability targets. The first SLD was executed in August 2019 between SBM Offshore and ING to hedge the interest rate risk of SBM’s $1 billion, five-year floating rate credit facility. Unlike green bonds, SLDs are generally used to incentivize ESG performance or to support sustainable projects, rather than being products or instruments that focus on the use of proceeds.

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SLDs typically involve adding an ESG overlay to a conventional OTC derivative such as an interest rate or cross-currency swap. This ESG overlay usually takes the form of an ESG target that is applied to one or both parties to the transaction, typically measured using KPIs that monitor performance against certain ESG metrics. KPIs are therefore a crucial part of the transaction and need to be carefully drafted to ensure they can be effectively measured. An ESG overlay can be constructed in several different ways; for example, an adjustment to cashflows depending on whether the agreed ESG target(s) are met, so that one party to the transaction pays more if it fails to meet the agreed ESG target(s) and pays less if it meets the agreed target(s).

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There are several reasons why SLDs may be attractive for both buy-side and sell-side counterparties. SLDs can allow an entity to hold itself accountable for its ESG targets by providing financial incentives to meet those targets (this could be both internal ESG targets and those set by external stakeholders and investors). By participating in the SLD market, it also allows an entity to demonstrate to its stakeholders its commitment to its ESG objectives. Offering SLDs may allow banks and other financial institutions to support their buy-side clients with ESG targets, as well as achieving their own ESG-linked commitments[3].

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Regulatory landscape surrounding SLDs

 

As mentioned above, SLDs are typically structured as an OTC derivative with an ESG overlay, therefore, from a regulatory perspective, are likely to be classified as OTC derivatives. This means that the existing regulatory requirements that apply to OTC derivatives would be considered when trading SLDs, including but not limited to:

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• Mandatory trade reporting;

• Margin requirements;

• Risk mitigation requirements (including portfolio reconciliation, dispute resolution and confirmations);

• Disclosure and pre- and post-trade transparency requirements when dealing with certain counterparties

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ISDA’s paper, Regulatory Considerations for Sustainability-linked Derivatives[4], explores how current regulatory frameworks apply to SLDs in the EU, UK and US and covers, among other things, whether SLDs would be considered swaps under US, EU and/or UK regulations, the impact SLDs may have on other derivatives cashflows that are not included in certain regulations, and compliance issues that may arise.

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Despite existing OTC regulatory requirements being relevant to SLDs, Regulators across the globe have increased their focus on ESG-specific issues, with the goal of improving transparency and standardisation for ESG products. The EU is seen as being at the forefront in developing ESG-specific regulations compared to other jurisdictions, so far mainly focusing on green bonds with the EU Taxonomy Regulation[5] and EU Green Bond Standard[6], and asset managers with the Sustainable Finance Disclosure Regulation[7].  The IFLD paper Sustainability-linked Derivatives: Where to Begin [8] further explores ESG regulatory developments in the EU and other jurisdictions.

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Greenwashing

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One risk factor for market participants when transacting in SLDs is that of claims of ‘Greenwashing’[9]. Greenwashing is when misleading or unsubstantiated claims about environmental performance are made by business or investment funds about their products or activities[10]. Should such claims of greenwashing be made against a business or investment vehicle, this could lead to reputational and/or financial damage to its business. Therefore, as the SLD market grows, it will be important for Regulators and markets to support the credibility and integrity of ESG products, to help avoid the risk of greenwashing claims against market participants.

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Regulators are committed to addressing the concerns around greenwashing. In the UK, the FCA chief executive Nikhil Rathi said in a speech at COP26 in November 2021 that greenwashing cannot be allowed to persist[11]. Implementation of robust regulations and standardisation of ESG overlays will help to build trust in the market for sustainable investment products.

Other ways that greenwashing concerns may be reduced include the use of ESG labels for financial products, having robust ESG targets, market participants having clearly defined and relevant KPIs and the importance of rigorous monitoring of KPIs[12].

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Documenting SLDs

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SLDs use KPIs to set sustainable targets, therefore it is important that the KPIs and consequences of meeting or failing to meet the KPIs are clearly and accurately documented to ensure they can be tracked and monitored. There is currently no standardised approach for documenting SLDs, and they are typically traded on bespoke terms that may differ depending on:

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• what type of SLD is being traded;[13]

• the sector to which the SLD relates (e.g., commodities, manufacturing);

• the geographical location of the counterparties;

• the regulatory framework applicable in the jurisdiction and/or

• whether the SLD relates to, or is a hedging transaction for, an underlying ESG-linked debt instrument

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If SLDs and the corresponding KPIs are not clearly and accurately documented there is a risk for potential disputes between the parties, including disputes around disclosure and verification of the KPIs or indeed disputes around the impacts of meeting, or failing to meet, the KPIs and ESG targets, which will likely have pricing implications for the parties.

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ISDA’s paper, Sustainability-linked Derivatives: KPI Guidelines[14], provides a comprehensive overview of key considerations when drafting KPIs, to help market participants when documenting these bespoke transactions.

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As well as the documentation and drafting of the KPIs associated with the trade there are a number of other documentation considerations that market participants may need to consider, including but not limited to:

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• documenting fallbacks for determining whether a KPI has been met in the event the initially agreed method cannot be used;

• how disclosure and verification of the KPIs will take place;

• any additional termination events linked to ESG factors, such as failure to meet ESG targets or where ESG targets are misrepresented or, indeed, where a corporate event may influence a counterparty’s overall ESG strategy[15] 

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Documentation standardisation may be difficult to achieve for SLDs, as they are often traded on bespoke terms and the use of SLDs varies by jurisdiction. As discussed in the IFLD paper Sustainability-linked Derivatives: Where to Begin [16], as with most derivatives, there are benefits to standardising documentation. Having a common starting point would help to harmonise the SLD market and may lower the barriers of entry to this market for new market participants. A standardised approach would also help to combat some of the regulatory and risk factors associated with trading SLDs. Standardised guidance, ESG definitions and/or template confirmations are just some of the ways that standardisation could be achieved as this market grows in size and sophistication. 

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Conclusion

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As the volume of SLD transactions continues to increase globally, so does the focus from regulators and key market bodies such as ISDA on increasing transparency and making SLDs and other ESG related products more readily available to market participants. It is evident that areas such as regulation, documentation and data management are still developing globally with respect to ESG products, but it is certainly clear that the financial services industry will be an essential partner in the transition to a more sustainable economy.

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Disclaimer

This article does not constitute legal, accounting, regulatory, financial, or other professional advice. This article is not intended to specify or recommend any particular approach to transacting in ESG derivatives and/or SLDs, and parties should therefore consult with their own legal advisors or any other advisor they deem appropriate prior to entering into any ESG or SLD transaction.

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Notes

The author of this article also participated in the inaugural ISDA Future Leaders in Derivatives (IFLD) program in 2021/2022 and co-authored the whitepaper “Sustainability-linked Derivatives: Where to Begin” with the IFLD ESG working group;  Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf

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[1] Sustainability -linked Derivatives: KPI Guidelines, ISDA, September 2021, https://www.isda.org/a/xvTgE/Sustainability-linked-Derivatives-KPI-Guidelines-Sept-2021.pdf; Regulatory-Considerations-for-Sustainability-linked-Derivatives, ISDA, December 2021, https://www.isda.org/a/58ngE/Regulatory-Considerations-for-Sustainability-linked-Derivatives.pdf

[2] Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

[3] Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

The IFLD white paper explores further reasons why both buy-side and sell-side counterparties may participate in the SLD market.

[4] Regulatory-Considerations-for-Sustainability-linked-Derivatives, ISDA, December 2021, Regulatory-Considerations-for-Sustainability-linked-Derivatives.pdf (isda.org)

[5] EU Taxonomy Regulation, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32020R0852

[6] EU Green Bond Standard, https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/european-green-bond-standard_en

[7] EU Sustainable Finance Disclosure Regulation, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32019R2088

[8] Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

[9] Other risk considerations are explored further in the IFLD paper Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

[10] Greening Finance: A Roadmap to Sustainable Investing, HM Government, October 2021, https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1031805/CCS0821102722-006_Green_Finance_Paper_2021_v6_Web_Accessible.pdf

[11] A strategy for positive sustainable change, Nikhil Rathi, UK FCA, November 3, 2021, www.fca.org.uk/news/speeches/strategy-positive-sustainable-change

[12] Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

[13] ISDA have identified two broad categories of SLD discussed further in Sustainability-linked Derivatives: KPI Guidelines, ISDA, September 2021, https://www.isda.org/a/xvTgE/Sustainability-linked-Derivatives-KPI-Guidelines-Sept-2021.pdf

[14] Sustainability-linked Derivatives: KPI Guidelines, ISDA, September 2021, https://www.isda.org/a/xvTgE/Sustainability-linked-Derivatives-KPI-Guidelines-Sept-2021.pdf

[15] Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

[16] Sustainability-linked Derivatives: Where to Begin, ISDA Future Leaders in Derivatives, May 2022, https://www.isda.org/a/ZfVgE/Sustainability-linked-Derivatives-Where-to-Begin.pdf.

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