ISDA Publishes KPI Guidelines for SLD/ESG Derivatives

Sustainability-linked derivatives (SLD) are a niche and nascent but rapidly growing market. The first SLD was executed in August 2019 and since then a variety of SLD’s have been developed across Europe and more recently in Asia and the US.

SLD’s embed or create a sustainability-linked cashflow using key performance indicators (KPI’s) that are designed to monitor compliance with environmental, social and governance (ESG) targets. One 2018 forecast by the OECD estimated that £6.9 trillion of annual investment will be required until 2030 to meet climate and development objectives and clearly, financial markets will have a substantial role in helping meet these objectives.

To assist the development of this nascent market ISDA has started to issue a series of papers to explore aspects of the ESG sector and to assist in the setting of uniform standards in these early days, including guidance on setting KPI’s.

SLD’s create an ESG-linked cashflow that is a component of, or relates to, a conventional derivative instrument by using KPI’s to monitor compliance with ESG targets; so KPI’s need to be accurately defined in order to have legal certainty over how they operate and impact cashflows so that they can be objectively verified.

While many ESG-linked financing transactions and some derivatives hedges focus on the use of proceeds for ESG related purposes, this is generally not the case for SLD’s. The distinguishing feature is the KPI’s that create or impact cashflows within conventional or vanilla derivatives. KPI’s and what they measure and how they are verified are critically important to the effectiveness and integrity of the SLD’s to which they relate.

SLD’s may take different forms. For example, they could be a vanilla derivatives transaction, such as an interest rate swap, cross-currency swap or forward, with a separate ESG pricing component included by reference to specific KPI’s or, when used as a hedge, the underlying instrument may be ESG related but is not necessarily required to be. If not ESG related, the KPI’s will be entirely separate from the underlying instrument being hedged.

To date, the KPI’s most commonly seen in the SLD market generally fall into one of four categories:

• Reducing behaviour that negatively impacts the environment;

• Encouraging behaviour that is beneficial to the environment;

• Linking counterparty performance to requirements under international agreements, such as the Paris Agreement and;

• Tracking a counterparty’s general ESG performance by reference to an independently produced rating.

As this market is developing rapidly it is likely that the categories of KPI’s will also grow.

In their paper, ISDA has put forward their proposal for five overarching principles for developing KPI guidelines which are, in summary:

1. They should be precisely defined and clearly set out in the documentation to avoid misunderstandings and disputes between counterparties. Timelines, methodologies and reference points and sources should be clearly identified, and fallbacks included.

2. They should be quantifiable, objective and within the counterparty’s control to achieve.

3. They should be verifiable. Whether or not the KPI has been achieved must be able to be verified by one of the counterparties or by an independent third party.

4. They should be transparent. Counterparties should establish a process for information to be made available to the relevant parties following the execution of an SLD.

5. They should be suitable. To avoid greenwashing concerns, it is advisable for KPI’s to be appropriate for the relevant counterparty and derivatives structure, although supporting sustainability objectives in a meaningful and positive way will differ between counterparties.

Other factors should also be taken into consideration. Counterparties should ensure that transactions should be tailored to meet the requirements of the relevant legal and regulatory jurisdictions and the compliance and regulatory obligations that entails.

There are currently no industry standards for the drafting and structuring of SLD’s so in the same paper ISDA has put forward various principles to consider when drafting SLD’s:

• Timing – Market participants should consider alignment of the intended duration of the SLD and the measurement and publication of the KPI’s.

• Margin and Models – Counterparties should agree and document whether the cashflows linked to the KPI should be taken into account for the purposes of margin calls and ensure any relevant margin and risk models can account for the risks associated with the KPI.

• Close out and Netting – Counterparties should consider any potential impact on close out and netting if payment is to be made following the failure to meet a KPI and the impact on cashflows if a KPI cannot be met.

• Clarity and Unambiguity – Market participants should ensure the drafting provisions are clear and unambiguous to avoid the risk of introducing legal and enforceability risks into what otherwise would be a plain vanilla derivatives transaction.

The above is a brief overview of ISDA’s paper which is intended to provide general guidelines in the development of KPI’s and relevant factors to be taken into account when structuring and documenting SLD’s. Much more detail can be found in the paper which is published in the Public Policy section of ISDA’s website – www.isda.org.

With the COP 26 climate change summit just weeks away, and with increasing numbers of countries aiming to achieve net-zero emissions in the coming decades, ESG-related transactions are likely to become more evermore commonplace. FMCR would be pleased to assist clients and discuss their requirements in this rapidly growing and developing derivatives market and we can be contacted on info@fmcr.com