Time to standardise documentation for sustainability-linked derivatives?

Introduction

In recent years, derivatives transactions linked to environmental, social and governance (ESG) targets have become increasingly popular.  Although it is a nascent market, derivative products will play an essential role in funding ESG investment opportunities and managing the risks associated with such investments. In April 2022, the International Swaps and Derivatives Association, Inc. (ISDA) began a survey of market participants on the current forms and use of sustainability-linked derivatives (SLDs) by them (the ISDA SLD Survey). This briefing summaries what SLDs are, the findings of the ISDA SLD Survey and potential future initiatives to standardise documentation for SLDs. 

How are SLDs documented and used in the market?

SLDs can be structured in many ways and one benefit is that they are highly customisable. Currently there are no agreed template or market-standard documentation for SLDs. The ESG overlay usually takes the form of measurement against an ESG KPI that is applicable to one or both counterparties, with satisfaction or failure of compliance with that KPI having a consequence to one or more of the payment flows under the SLD.

Given the importance of ESG KPIs in the context of SLDs, it will continue to be important to the credibility of the nascent SLD market that KPIs are carefully drafted to ensure legal certainty and avoid ambiguity in the terms of SLDs. 

What are sustainability-linked derivatives?

A sustainability-linked derivative is typically a conventional derivative transaction (primarily interest rate swap or FX forward) that embeds, adjusts or creates a cash-flow using key performance indicators (KPIs) designed to measure compliance with ESG targets. 

SLDs are appealing because they are structured as conventional derivative transactions but contain an ESG overlay.  SLDs are not instruments that focus on the use of proceeds for ESG purposes, but instead can act as incentives for businesses that are seeking to meet ESG targets. For example, they may offer a preferable rate compared to business-as-usual transactions, assuming ESG targets are achieved. 

Findings of the ISDA SLD Survey

The results of the ISDA SLD Survey provide a snapshot of the characteristics of certain SLDs currently being entered into by market participants, which include:

• SLD structure: The most common type of conventional product used to create an SLD is an interest rate swap (then being followed by foreign exchange swaps and cross-currency swaps) and using the existing ISDA documentation structure. The ESG-related terms are usually documented in the trade confirmation. However, in some cases KPIs are set out in a separate agreement referenced in the trade confirmation.
• Underlying ESG targets: The ESG targets to be met by derivative counterparties tend to be KPIs related to greenhouse gas emissions but other common targets are linked to ESG ratings given by a third-party rating company.
• Achieving the ESG target: If KPIs are achieved then the outcome under the derivative typically involves either (i) an adjustment to the spread component of the floating rate payable by the complying party, (ii) decreasing the fixed rate payable by such party (or increasing the fixed rate upon failing to meet the ESG target) or (iii) receiving an additional amount of premium. Generally there is no market consensus for how to determine an adjustment to the spread or additional premiums (although, for the latter, it may be calculated by reference to a certain percentage of the notional amount).
• Failure to pay or perform: Some SLD documentation sets out the consequences of non-payment of ESG-related cash flows or non-performance of ESG obligations (such as failure to provide verification that a KPI has been met). The consequences can vary but may be similar to those applied in conventional derivatives trading (such as being viewed as an event of default or listed as an additional termination event). However, some respondents confirmed that failure to satisfy ESG obligations would not affect the underlying transaction. 
• Early Termination: There is no agreed convention on what happens to the ESG aspect of an SLD if the underlying derivative is terminated early. 
• Measuring ESG targets: Parties generally rely on third party verification for determining whether a KPI has been met rather than self-certification. Where utilising third party verifications, parties should consider what additional terms should be included in their documentation in respect of the third party verification entity and process.

What is the path forward for SLDs?

Following the ISDA SLD Survey, it has become apparent that standardised documentation for SLDs is highly beneficial.  To this end, ISDA has set up a new working group to work on legal documentation for SLDs during the course of next year. Whilst standardisation will enhance efficiency and allow market participants to transact with confidence, any standardised documentation will need to be flexible enough to continue to work as the market evolves and to allow customisation of SLDs.  The creation of the new working group represents an important step towards the development of standard documentation for SLDs, which will provide a strong base for the further evolution of the SLD market.