An Overview of Sustainability-Linked Derivatives
Warren Buffett, the billionaire investor and CEO of Berkshire Hathaway, famously referred to derivatives as "financial weapons of mass destruction". Over 20 years since that famous remark, far from being perceived as a destructive force, derivatives are being put forward by some as an important tool to drive the transition to a sustainable economy. One component of the derivatives market's contribution to that transition is the development of sustainability-linked derivatives.
This briefing examines what sustainability-linked derivatives are, how they are used and sets out key legal considerations for market participants. The briefing also expresses support for cross-product coordination in relation to the development of legal principles and documentation and for markets to learn from the lessons of the transition from interbank offered rates (IBORs) to near risk-free rates (RFRs).
- What are sustainability-linked derivatives?
Sustainability-linked derivatives are typically based on familiar types of derivatives transaction, such as interest rate swaps, foreign exchange swaps and cross-currency swaps. These familiar transaction types are adapted to incorporate an environmental, social and governance (ESG) pricing component.
The ESG pricing component typically takes the form of a cash-flow, calculated by reference to a party's performance against agreed key performance indicators (KPIs). The KPIs monitor compliance with ESG targets. For example, the KPIs are often targets for reducing greenhouse gas emissions or increasing the use of renewable energy. Performance against the KPIs is usually measured using specific sustainability metrics. The metrics may, for example, measure carbon emission volumes or renewable energy ratios. A party's performance against the KPIs is often verified by an independent third party or linked to ESG ratings provided by a third-party ratings company.
Payments under sustainability-linked derivatives may be adjusted based on the achievement or non-achievement of the sustainability targets reflected in the KPIs. The adjustment of payments creates financial incentives for the relevant party to achieve its sustainability objectives.
To date, the parties to sustainability-linked derivatives have most often been a buy-side counterparty subject to ESG pressures and a bank, with the KPIs measuring the performance of the buy-side counterparty.
As the terms of sustainability-linked derivatives are tailored to the requirements of the parties and to specific sustainability objectives, they are traded over-the-counter (OTC) rather than on an exchange and are governed by bespoke documentation.
There are currently no industry standard templates designed for parties to sustainability-linked derivatives. As sustainability-linked derivatives are based on familiar derivatives products, the legal documentation used for those products is commonly used as a starting point and is adapted to incorporate sustainability-related terms, including KPIs.
The KPIs are generally included in the transaction confirmation (either in full or in a separate agreement which is incorporated by reference). Although KPIs and the consequences of meeting or failing to meet the KPIs are typically the most negotiated terms of sustainability-linked derivatives, market participants should also consider the following:
1. Third-party verification - if the parties to a sustainability-linked derivatives transaction agree that a third-party will assess one of the party's performances against the KPIs, the documentation should contain terms dealing with how information from that third-party will be shared, the process for verification and the consequences if the third-party fails to perform the verification exercise.
2. ESG ratings entities - if the KPIs are linked to ESG ratings provided by a third-party ratings company, the parties may include fallbacks where there is change to the methodology of the ratings company, the rating is unavailable, or the occurrence of a corporate event means that the legal entity providing the rating changes.
3. "Additional Termination Events" - for the purposes of the ISDA Master Agreement, parties should consider whether any "Additional Termination Events" connected to the sustainability-linked elements of the transaction should be included. Additional Termination Events might, for example, be triggered if performance data is not disclosed or is misrepresented, a third-party fails to perform a verification exercise or other corporate events occur that may adversely affect a party’s ESG strategy.
4. Calculation of "Close-out Amount" - parties will need to agree how any sustainability-linked derivatives will be valued for the purposes of the "Close-out Amount" calculation under the ISDA Master Agreement following early termination. For example, the parties will need to consider whether any KPIs will be deemed to have been satisfied for that purpose (noting the argument that such an approach might incentivise parties to trigger early termination to circumvent any ESG requirements) or whether an alternative calculation mechanism will apply.
The consequences of meeting or failing to meet the KPIs are one of the most intensely negotiated elements of sustainability-linked derivatives. Cash-flows can be adjusted by introducing:
1. an obligation for a party to pay a financial penalty, usually in the form of a positive spread, favourable currency exchange rates or a fixed payment (sometimes referred to as a sustainability premium or 'greenium') if the KPI criteria applicable to that party are not met; or
2. the right for a party to receive a financial reward (usually in the form of a negative spread, less favourable currency exchange rates or the waving of a fixed payment (or 'greenium') depending on the type of transaction) if the KPI criteria applicable to that party are met
Where penalty payments are made, these often take the form of donations to sustainable/charitable organisations and/or initiatives. The level of the financial penalty or reward might be ratcheted depending on the number of KPIs that have been met. The frequency of the ESG-related cashflows is usually aligned to any other cashflows made in respect of the derivatives transaction.
Market participants should note that any failure to pay and ESG adjusted cashflow under a sustainability-linked derivative will likely amount to a Failure to Pay or Deliver Event of Default under Section 5(a)(i) of the ISDA Master Agreement.
These cashflow adjustments present issues for valuations, close-out netting, tax representations and collateral calculations under related credit support documentation. Market participants will need to consider these issues carefully.
For regulatory purposes, sustainability-linked derivatives are treated in much the same way as any other OTC derivatives transactions. Regulatory obligations that apply to OTC derivatives generally, for example under the UK on-shored version of the European Market Infrastructure Regulation (EMIR) (including, for example, trade reporting and risk mitigation requirements) also apply to sustainability-linked derivatives.
The Financial Conduct Authority (FCA) rules and guidance in respect of ESG do not currently apply specifically to derivatives. In the FCA’s Consultation Paper on Sustainability Disclosure Requirements (SDR) and investment labels (CP22/20) published in October 2022, the FCA confirmed its intention to avoid making rules specifically relating to derivatives and recommended instead that it monitors developments in the market and implements guidance to increase transparency on the use of derivatives in sustainable investment products.
- Issues and risks
Market participants will need to be aware of risks which are particular to sustainability-linked derivatives. For example:
1. Greenwashing - greenwashing (where a party makes misleading or unsubstantiated claims about environmental performance about its products or activities) is a key challenge across ESG-linked financial products. Greenwashing may manifest itself in a sustainability-linked derivatives context where, for example, the KPIs do not provide, at present, a meaningful stretch on the performance of the party being assessed or are not monitored with adequate diligence. Greenwashing can present significant reputational risk for market participants and can undermine market confidence.
2. Hedging - parties to a sustainability-linked derivative will have limited options to hedge the pricing component, given its bespoke/non-standard nature.
3. Market segmentation - as the use of sustainability-linked derivatives grows, the lack of standardisation means that different approaches are being taken across sectors and geographies. There is also a risk of a divergent regulatory approach across markets. This may lead to market segmentation which can increase costs and reduce liquidity.
- ISDA'S principles for sustainability-linked derivatives
Various industry bodies have published principles for conduct in the sustainable finance sector. These principles provide a voluntary best practice framework for market participants which is intended to enhance the integrity of the market for the products to which the principles relate. For example, the International Capital Markets Association (ICMA) has published 'The Sustainability Bond Guidelines' since 2017 and the Loan Market Association (LMA) has published its 'Guidance on Sustainability-Linked Loan Principles' since 2019.
Following the other markets, on 7 September 2021, ISDA published a paper titled 'Sustainability-linked Derivatives: KPI Guidelines' setting out the overarching principles to be used when drafting KPIs for use in sustainability-linked derivatives transactions. The principles were published in a bid to encourage standardisation and to develop liquidity in the market. ISDA sets out five overreaching principles which are designed to ensure that KPIs are verifiable, transparent and suitable. In summary, the principles are as follows:
1. Specific - KPIs should be clearly and precisely defined to avoid disputes arising between counterparties.
2. Measurable - KPIs should be quantifiable, objective and within the counterparty’s control to achieve. The goal is to ensure there is no ambiguity in establishing whether or not a KPI has been met in order to reduce the scope for disputes.
3. Verifiable - whether or not the counterparty has met the relevant KPIs within the applicable time periods must be verified either by one of the counterparties or an independent third party.
4. Transparent - the counterparties should establish a process for information to be made available to relevant parties following execution of a sustainability-linked derivatives.
5. Suitable - to avoid greenwashing concerns, it is advisable for the KPIs to be appropriate for the relevant counterparty and derivatives structure. Although the chosen KPIs should support sustainability objectives in a meaningful and positive way, what this means in practice will differ between counterparties.
The Guidelines set out in greater detail how the principles might be applied in practice. The ISDA principles offer helpful parameters for market participants offering sustainability-linked derivatives in the market. Parties might also reflect on principles issued in other markets (for example for ICMA and LMA documents referred to above) where appropriate.
- Learning lessons from IBOR transition
"Standardise" is a familiar rallying call in the derivatives market. In the context of sustainability-linked derivatives, there are clear benefits to standardisation. A common framework for documentation, managing lifecycle events and establishing best practice would help to harmonise the market, reduce barriers to entry for new market participants and encourage liquidity.
The vehicle through which large scale standardisation is typically achieved in the derivatives market is ISDA. The derivatives market arguably led the charge during the transition from IBORs to RFRs, which was logical given that the volume of derivatives transactions which required amendment was far greater than other financial products. In the context of sustainable finance however, the derivatives market is behind the loan and capital markets.
The derivatives market can use the spirit of cooperation which developed in the later stages of IBOR transition and learn from the loan and capital markets, leveraging the commonality and, wherever possible, basing its template provisions published by other industry bodies which have been widely adopted in the loan and capital markets. Market participants' familiarity with those documents and underlying principles will provide market confidence and aid understanding which should, in turn, encourage adoption.
In a similar vein, for internal stakeholders within market counterparties offering sustainability-linked derivatives, cross-department/desk co-operation and leveraging existing sustainable finance expertise will help promote success. As with IBOR transition, the best approach is likely to be a joined-up approach.
- The future
The future of sustainability-linked derivatives is intrinsically linked to the broader growth of sustainable finance. To the extent that, as former Governor of the Bank of England Mark Carney has commented, sustainable finance is "the future of finance", then the derivatives markets must adapt to reflect that future.
Most major global economies, including the European Union, the United States and China, have declared targets that align with the Paris Agreement's long-term temperature goal to keep the rise in mean global temperature to well below 2 °C above pre-industrial levels, and preferably limit the increase to 1.5 °C. The Paris Agreement also provides that emissions should be reduced as soon as possible and reach net-zero by the middle of the 21st century. In the UK, the Climate Change Act 2008 (as amended in 2019) has established a legally binding target for the UK to achieve a reduction in greenhouse gases to net zero by 2050.
The ambition to achieve a sustainable economy (and what that means) is not agreed by everyone. As well as pressures for firms to establish ESG, many investment managers have warned in their most recent annual reports of the risks of an investor backlash driven by animosity over ESG principles becoming a perceived threat to profits. Political will and sentiment are constantly changing and the ESG journey is unlikely to be linear. If the focus on sustainable finance continues to gain momentum however, derivatives will have a significant role to play. Sometimes heroes wear capes but this one may don a cap and collar.
Legal Director, Finance
Partner, Finance and Head of Structured Finance and Securitisation