UK: ESG Derivatives: A Sustainable Trend
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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.
Originally published 21, October 2021
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issues and developments of interest. The foregoing is not a
comprehensive treatment of the subject matter covered and is not
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