ESG Derivatives: a new way to promote sustainability

Background

In August 2019 the first Sustainability-Linked Derivative (“SLD”) was traded and since then an increase in trading of these derivatives has been observed mostly in European markets but also in the US and Asia-Pacific regions. These derivatives envisage providing an exposure to Environmental, Sustainability and Governance (“ESG”) factors by paying out cash flows to market participants when specific Key Performance Indicators (“KPIs”) are met.

While still in an embryonic stage these financial instruments seem to be a natural consequence of numerous political and legislative factors since they make ESG investments more attractive and gradually a staple of the financial markets. SLDs are a useful link between the traditional financial derivatives market and various ESG goals such as water consumption reduction, climate change and sustainable energy sourcing.

Types of transaction

SLDs create an ESG-linked cashflow that is related to a conventional derivative instrument by using KPIs to monitor compliance with ESG targets. The derivative will include a component linked to defined sustainability targets and should these be achieved then more favourable terms may result.

While many ESG-linked financing transactions and some derivative hedges focus on the use of proceeds for ESG-related purposes, this is generally not the case for SLDs. Unlike traditional "ESG-linked" derivatives, which typically involve an environment-linked commodity (e.g.: carbon credits) the distinguishing feature of SLDs is that the KPIs can create or impact cash flows within conventional derivatives. The underlying instrument may be ESG-related but it does not necessarily need to be. If not ESG related, the KPIs will be ESG driven but entirely separate from the underlying instrument (such as the performance of an interest rate interest rate).

In order to illustrate the forms that SLDs can take we note a couple of recent transactions that are contrasting examples:

• the interest rate derivative entered into between Internationale Nederlanden Groep (ING) and Single Buoy Moorings (SBM), which hedged the interest rate risk of SBM’s $1 billion five-year floating rate revolving credit facility had a loan transaction as underlying which was not ESG related. A positive or negative spread was then added to the fixed rate and based on SBM’s general ESG performance as scored by Sustainalytics.
   
• the sustainability-linked interest rate swap entered into by Natixis and Italo – Nuovo Trasporto Viaggiatori has an underlying that is ESG-related as it contains an incentive mechanism aligned with the sustainable performance indicators outlined in the financing agreement.

KPIs and the corresponding payoff structures can be very diverse. For example, meeting a KPI can result in an increase or decrease in payments, payment of a rebate or fee, a margin or spread amount, or a payment to an agreed charity. The SLD can also take the form of an obligation on the hedge provider to invest, for example, part of the premium or the fees in a sustainable initiative if the end user meets certain ESG obligations, e.g., investing part of its profits in climate change initiatives.

The same or different KPIs can apply to one or both parties to a derivatives transaction and most have been executed between financial institutions and non-financial institutions involved in sectors with substantial ESG-related pressures, including energy, construction, agriculture and transport.

Leveraging and hedging

Market participants are becoming more interested in linking their derivatives to ESG targets, and several ESG-linked products already exist in various forms. On the over-the-counter ("OTC") side, there are structures, in which a counterparty may be incentivised to meet pre-set ESG targets by having to pay a premium on an interest rate swap if it misses those targets or by decreasing the premium if the relevant target is met. Other structures may require a counterparty to make a payment to a bank if it misses an ESG target, which the bank will then put towards an agreed "green project", or the counterparty may require a bank to donate to a non-profit organisation if the counterparty improves its ESG score. This not only creates an incentive for counterparties to comply with their ESG-related targets but may also guarantee a sustainable outcome if they do not.

Like other financial derivatives SLDs also allow market participants to hedge certain exposures of their portfolios by reducing risks including any non-traditional ESG target component. For example, a bank may wish to protect itself against a counterparty whose financial results are sensitive to climate change risk. If a bank enters into an ESG-linked derivative with a counterparty structured such that the counterparty has to pay an increased amount if it misses a pre-agreed ESG target, the bank may be concerned about the counterparty's creditworthiness if it fails to meet those targets and is faced with a higher pay-out. The bank could protect itself in these circumstances by using a credit default swap. Similarly, a bank may have to pay more if the counterparty meets a pre-agreed ESG target and it may wish to hedge itself against this potential increase in expenditure.

Trading

The ESG index-based derivatives market has been one of the fastest growing segments for exchanges. Futures and options track equity indices with companies weighted and evaluated based upon different ESG standards, such as the E-mini S&P 500 ESG Future, the Euronext Eurozone ESG Large 80 Index Futures and the MSCI Emerging Markets ESG Leaders NTR Index Future.

ISDA guidelines for KPIs

What KPIs measure and how they are verified are critically important to the effectiveness and integrity of the SLDs to which they relate.

Drafting accurate KPIs that can be objectively verified and have legal certainty over how they operate and impact cash flows should enhance the credibility of the corresponding SLD and the wider sustainability-linked market. A lack of transparency in KPIs could contribute to a paucity of available observable market information, which could create challenges from an accounting and valuation perspective.

This is an embryonic market and terminology in this space is not uniform. Indeed, the derivatives market lacks a uniform standard to measure ESG performance. The role of derivatives can be crucial in facilitating the development of certain standards, as market players evolve and adapt to ESG principles. To help with this process, ISDA has published certain ESG KPI guidelines which advocate that KPIs should be:

• Clear and well-defined avoiding ambiguities in how the settlement and overall mechanics work in order to avoid future disputes. In particular, a SLD transaction should try to clarify well the KPI definition, its scope, timelines, methodology and consequences for failing to meet a target;
   
• Quantifiable, objective and within the company’s control. A possible way to achieve this would be by benchmarking KPIs against publicly recognised standards such as the UN’s Sustainability Development Goals (SDGs). ISDA recognises this isn’t always possible, hence as an alternative suggests that companies could benchmark versus their own performance;
   
• Verifiable in order to reduce the chance of moral hazard, conflicts of interest and “greenwashing”. Counterparties should be checked to see if they develop and document robust procedures in a readable format ideally by someone with expertise in the field that is relevant for the KPIs in question while ensuring a clear dispute resolution mechanism is agreed;
   
• Suitable. Counterparties should aim SLDs have KPIs that suit their derivatives infrastructure, i.e., that are appropriate and meaningful for their business. Different Counterparties may have different sustainability objectives depending, among others, of their geographic location, the sector in which they operate in and their existing ESG commitments. It is also important considering that the term of the SLD and the period of the observation period for satisfaction of the KPI may differ. For example, if the reference period for compliance is short, then the effectiveness of the SLD in enhancing sustainability may not be obvious.
   
• Transparent. Involved parties should put in place processes for sharing relevant information over the life of the transaction and incorporating provisions that allow relevant information to be shared publicly. ISDA believes that they can support the impact of the SLD and the development of the market overall.

Conclusion

With the continued focus on ESG-related topics in the financial industry, it is just a matter of time before we see an increased use and development of ESG derivatives. Derivatives have already proved useful in tackling climate change and this trend will only continue as the underlying market develops.  The SLD market has a critical role to play in supporting and helping businesses transition to net-zero emissions while allowing investors to hedge climate-related risks and promote sustainability.

ESG derivatives are bespoke bilateral instruments and, as such, there is limited publicly available information on their terms. ISDA refers five basic principles for credible KPIs:  specific, measurable, verifiable, suitable and transparent.

Given the scope for customisation and the ability for parties to add an ESG component or overlay to an otherwise vanilla standardised derivative, there is an opportunity for such transactions to enhance the flow of private capital to achieve sustainability objectives. They can therefore play a role in encouraging the transition to a green economy