The new clause library which will bring standardisation to sustainability-linked derivatives

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 environmental, social and governance (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.

There are two distinct categories of SLDs:

1. Category 1 SLDs - an SLD where the sustainability-linked elements are embedded within the derivative transaction; and 
2. Category 2 SLDs – an SLD where the sustainability-linked elements are set out in a standalone document referencing the underlying derivative transaction(s).

What does the ISDA SLD Clause Library aim to achieve?

The purpose of the ISDA SLD Clause Library is to provide standardised definitions and provisions to allow market participants to document bespoke SLDs under the ISDA Master Agreement framework. The aim is to bring standardisation to SLDs which, in turn, will help increase liquidity in the market. This standardised documentation is an integral part of the development of safe and efficient derivatives markets for SLDs which will (a) allow market participants to transact with confidence and (b) promote greater liquidity and efficiency in the market.

The inclusion of the definitions and provisions contained in the ISDA SLD Clause Library by parties into their SLD documentation is optional and the ISDA SLD Clause Library provides market participants with drafting options with respect to certain clauses. This approach is beneficial as it ensures that the ISDA SLD Clause Library is flexible enough to continue to work as the market evolves and allows customisation of SLDs so that parties can tailor provisions to their specific circumstances and sustainability goals (as the appropriate elements to consider when documenting and structuring an SLD will differ by transaction and may develop over time). Market participants will therefore need to assess whether any or all definitions and provisions are appropriate for their transaction(s).

How does the ISDA SLD Clause Library interact with the ISDA Master Agreement?

The ISDA SLD Clause Library is a framework of standardised definitions and provisions published through ISDA’s online ‘MyLibrary’ platform. 

The clauses and definitions within the ISDA SLD Clause Library have been drafted for use in:

1. Category 1 SLDs (i.e. for inclusion in market participants’ Confirmations) rather than for Category 2 SLDs; and 
2. one-way SLDs (i.e. SLDs involving ESG KPIs that are applicable to only one counterparty) rather than two-way SLDs (i.e. SLDs involving ESG KPIs that apply to both counterparties).

Parties may of course choose to adapt the clauses and definitions for use with Category 2 SLDs (or with other documents such as master confirmation agreements or the Schedule to the ISDA Master Agreement) and may adapt the clauses and definitions for use with two-way SLDs. 

As provided in the ISDA SLD Clause Library, any of the relevant provisions and definitions therein may be incorporated into a Confirmation and one way for the parties to achieve this would be to include a new paragraph in the relevant Confirmation titled “Sustainability-Linked Provisions” or similar which incorporates the relevant provisions and definitions from the ISDA SLD Clause Library.

What does the ISDA SLD Clause Library contain?

One of the key elements of SLDs is the cashflow that is dependent on compliance with ESG targets. KPIs are designed to measure the extent of such compliance and the assessment of KPIs to determine whether the targets are met is, therefore, of paramount importance. This assessment can be very subjective and the aim of the KPI-related provisions in the ISDA SLD Clause Library is to bring more objectivity to this process.

To this end, the ISDA SLD Clause Library contains provisions and definitions regarding, amongst other things:

a.) KPI Compliance Certificates 

Parties can include provisions in their Confirmations whereby a KPIs achievement score is given (such as a value, percentage or score) representing a party’s performance in respect of the KPI for the relevant period. Such score will be verified by a third-party verification agent (the Verification Agent). Parties will then compare the relevant KPI score against the corresponding KPI target to determine whether the KPI target has been met and will complete and deliver a compliance certificate (a KPI Compliance Certificate) on or prior to the delivery deadline agreed between the parties. The form of KPI Compliance Certificate will need to be inserted as an annex to the Confirmation and should include, without limitation, (i) the KPI achievement score, (ii) confirmation of whether the KPI target was reached in respect of each KPI, (iii) the effect on the relevant SLD and (iv) supporting documentation and/or information for each KPI (in the form agreed between the parties) (KPI Supporting Documentation). Parties can also include consequences that will apply in the event that a KPI Compliance Certificate is not delivered.

b.) Impact of meeting or failing to meet KPI Targets 

Market participants are provided with the flexibility to apply different combinations of triggers and consequences depending on whether or not a KPI target is met. For example, for one KPI, the parties may agree that the related KPI target being reached results in a party receiving a positive cashflow adjustment (such as receipt of a sustainability-linked payment or a change to a fixed/floating rate within the relevant SLD) but nothing happens if the KPI target is not met. Whereas for another KPI, a cashflow consequence could apply if a KPI Target is not met (such as a less beneficial rate being applied). Alternatively, parties could choose to apply a consequence to all KPIs as a group rather than on an individual basis. Other approaches could also be taken but will require the parties to include bespoke drafting. 

If the application of a sustainability consequence results in an amount being due (a Sustainability-linked Payment), the ISDA SLD Clause Library departs from the default position under Section 5(a)(i) (Failure to Pay or Deliver) of the ISDA Master Agreement and provides that such failure shall not constitute an Event of Default or Potential Event of Default. Rather, the parties have the option to elect for such failure to trigger either (i) an Additional Termination Event (with the party that has failed to make the Sustainability-linked Payment as the Affected Party and the SLD as the sole Affected Transaction) or (ii) a Declassification Event (see the section titled “KPI disruption” below for further detail). If the application of a sustainability consequence results in an adjustment being made to the SLD, the ISDA SLD Clause Library does not provide wording to address the consequences of a failure to make such an adjustment and the parties should include bespoke wording if they wish to cover such consequences.

c) KPI disruption 

The ISDA SLD Clause Library includes the concept of a “Declassification Event” which covers scenarios such as (i) the failure by either party to pay all or part of any Sustainability-linked Payment, (ii) the parties' failure to agree on a KPI Adjustment on or prior to the last day of the KPI Discussion Period (see the “Review of KPIs” section below for further detail) and (iii) the failure by the parties to resolve a KPI dispute within the required timeframe (see the “KPI disputes” section below for further detail). If a Declassification Event occurs, each party must ensure that no further announcements or publications are made referring to the relevant transaction as “sustainability linked” and the parties can elect in their Confirmations, in addition to no further adjustment being made to the Transaction, to either (i) reset the relevant economic terms to their level as at the Trade Date without the inclusion of the sustainability-linked provisions or (ii) have the relevant economic terms continue at their pre-declassification level. Market participants can tailor the consequences as appropriate to their specific requirements. The ISDA SLD Clause Library also includes the concept of an “Adverse Sustainability Event” which allows the parties to include a bespoke definition if they want sustainability-linked events which do not directly impact the KPIs to affect the sustainability profile of the Transaction.

d) Review of KPIs 

Parties can include a KPI review procedure in their Confirmations which contemplates the parties agreeing to update KPI(s) or KPI target(s) on an annual basis and/or upon the occurrence of specific events (such as a party determining and notifying the other party that a KPI or KPI target is no longer suitable due to scientific progress, regulatory change or any other external factors) (a KPI Review Event)). Parties can revise the list of KPI Review Events to suit their needs but the rationale for the mechanic is that it can help parties to maintain their sustainability commitments and adapt such commitments as required due to circumstantial changes. Parties must act in good faith and use commercially reasonably procedures to produce a commercially reasonable result when determining whether or not a KPI Review Event has occurred and the ISDA SLD Clause Library provides parties with the flexibility to apply specific criteria to such determination (for example having regard to announcements or publications made by relevant regulators or government authorities and/or best practice for sustainability objectives). Following the occurrence of a KPI Review Event, parties can elect for an optional or mandatory KPI Discussion Period to be initiated (i.e. an agreed period of time following the occurrence of the relevant KPI Review Event during which the parties discuss whether any adjustments can be made to any KPI, any KPI target and/or the SLD (a KPI Adjustment)).  If the parties do not agree on a KPI Adjustment on or prior to the last day of the KPI Discussion Period, the ISDA SLD Clause Library provides that a Declassification Event will occur on such day.   

e) KPI disputes 

The ISDA SLD Clause Library includes a KPI dispute resolution process regarding disputes relating to the validity of the facts contained in the KPI Compliance Certificate or KPI Supporting Documentation. The dispute resolution process follows a similar construct to the dispute mechanics in ISDA’s 1995 Credit Support Annex (English law) and 2016 Credit Support Annex for Variation Margin and provides that if the parties fail to resolve the dispute then the parties can elect in their Confirmations for (i) the Verification Agent to determine the fact or figure in dispute, (ii) the relevant sustainability consequence to apply or not apply (as applicable) or (iii) a Declassification Event to occur.  The KPI dispute resolution process is not intended to replace any other dispute provisions that the parties have agreed more generally for the SLD or their trading relationship. 

Market participants can also include a clause regarding errors in KPI Compliance Certificates which contemplates payments being returned and/or adjustments reversed if such payments/adjustments would not have arisen if the correct information had been provided in the KPI Compliance Certificate.

Commentary

Following the ISDA SLD Survey, it was clear that the market required standardisation to enable trading of SLDs to be developed and to enhance efficiency. The development of a framework of standardised definitions and provisions provides a strong base for the further evolution of the market and represents an important step towards building the common components that will underpin liquidity in the SLD markets.