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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.
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.
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.
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:
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.
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