ESG Derivatives: A Sustainable Trend
With the 2021 United Nations Climate Change Conference (also known as COP26) coming to Glasgow later this month and amid numerous occurrences of extreme weather, there has been an increased global focus on climate change recently which is reflected in the financial markets. By some estimates, the sustainable finance market grew by almost 30% in 2020. Derivatives linked to environmental, social and governance (“ESG”) objectives have been around for several years, but this previously niche marketplace is growing, reinforcing the idea that derivatives have a key role to play in the advancement of ESG objectives in the financial markets and the global transition to a green economy.
In January, ISDA published a paper entitled “Overview of ESG-related Derivatives Products and Transactions”. This paper gave ISDA members insight into the overall universe of ESG-related derivatives, including details of some of the sustainability-linked derivatives traded prior to 2021. Sustainability-linked derivatives are derivatives which create an ESG-linked cash-flow in the context of a traditional derivative instrument (such as an increase in spread linked to a failure to meet an ESG target). Unlike in other ESG financial products, the use of proceeds of a sustainability-linked derivative is not usually controlled (although sometimes counterparties may agree that any increased spread paid as a result of a failure to meet an ESG target will be applied for a sustainable purpose).
One of the biggest challenges for market participants is ensuring that the documentation for their ESG products accurately captures any key performance indicators (“KPIs”) against which ESG targets are measured. KPIs are used in sustainability-linked derivatives to monitor compliance with the relevant ESG criterion – for example, a KPI might be the amount of greenhouse gas emitted by a counterparty over a defined period of time or a percentage of a counterparty’s energy that is produced by sustainable sources. KPIs are therefore a bespoke but crucial element of any sustainability-linked derivative. ISDA has recently published a new paper entitled “Sustainability-linked Derivatives KPI Guidelines“. ISDA’s paper is intended to educate market participants about sustainability-linked derivatives and KPIs, establish a framework of best practices for KPIs and sustainability-linked derivatives, support and promote adequate ESG-related disclosure to sustain the integrity of the sustainability-linked derivatives market and promote the use of ESG-related products to help with transition to a green economy.
The paper also includes a summary of the current ESG derivatives market, including noting that most transactions are between financial institutions and non-financial institutions, and that usually only performance of one of the counterparties is measured against any KPIs (although mutual KPI transactions do exist). The paper proposes that KPIs need to be drafted to be objectively verifiable and give legal certainty over how they operate and impact cashflows to improve market integrity. This can be a challenge when most sustainability-linked transactions are bespoke and private (meaning there is a lack of publicly-available information on KPIs) and there is no industry-standard wording.
The paper sets out five overarching principles for counterparties to bear in mind when choosing KPIs: they should be specific, measurable, verifiable, transparent and suitable. It also notes that counterparties should consider timing and structuring issues when entering into sustainability-linked derivatives – such as what the consequence should be of a KPI target being met outside of a required timeframe, whether any cash-flows linked to KPIs should be taken into account for the purposes of margin calls, or whether there might be any impact on close-out or netting where payments are owed to charities or other third parties following a failure to meet a KPI target. The paper also notes that counterparties need to consider any regulatory, operational, tax or accounting requirements relating to, or implications of using sustainability-linked KPIs that affect, the cash-flows of derivatives transactions.
It seems as though the market for ESG derivatives will continue to grow exponentially and gather momentum. At Mayer Brown, we have already successfully combined the product knowledge of our derivatives team with the ESG expertise of our team of specialist ESG lawyers to act for leading European and US banks on a number of ESG-linked transactions, including several ESG-linked repos and derivatives and various first-to-market transactions. We look forward to continuing to assist our clients as they forge further into this exciting and innovative area of the derivatives market.
