According to Bloomberg, in 2020, the global market for sustainable debt grew to $732bn, an increase of 29 per cent on 2019. A significant part of the market was the issuance of ESG (environmental, social and governance) linked bonds and loans. These are financing products where the economics of the transaction are in some way linked to an ESG key performance indicator (KPI). ESG-linked products stand in contrast to a classic ESG financing, where the proceeds are used for an ESG-related purpose. Indeed, an ESG-linked RCF or bond-issuance programme is at the top of the virtual coffee agenda for any treasury coverage banker.
The benefits of a financing product with an ESG linkage are clear – the combination of cheaper funding and sustainable environmental or social goals are an elixir for global corporations in 2021. But what does the ESG financing revolution mean for the OTC derivatives markets?
OTC derivatives are bespoke instruments tailored to give exposure to a particular risk, whether for speculative or hedging purposes. How can such contracts be combined with ESG goals? It’s a trickier process than issuers incentivising bond investors by showing their commitment to achieving an ESG goal of their choosing.
Derivatives have a long history of involvement with schemes and arrangements that today we would recognise as ESG focussed. The history of the EU carbon credits market goes back a decade and a half. However, focussing more narrowly on contracts where obligations are linked directly to an ESG objective, rather than merely linked to an environmental underlier, what role is there for OTC derivatives?
Clearly ESG-linked debt might need to be hedged like any other debt issuance, whether for interest-rate or currency risk. But while that would require an OTC hedge like any other, it would not necessarily be an ESG-linked transaction. Could a derivatives contract be used to give debt issuance an ESG angle where it wouldn’t otherwise have one, or to increase its ESG flavour?
The market has started to see a handful of OTC derivatives contracts with a specific ESG-linked element, with a focus to date on environmental targets. The terms of these contracts include a specific incentive to hit pre-defined ESG targets. As with ESG-linked debt issuance, that could involve a reduction in the spread payable by a party if the target is met, or the counterparty contributing to an ESG project if the party with the target to meet hits that target. A small but growing number of these transactions have been executed to date, primarily where the ESG element has been embedded in an interest-rate swap. Often the associated financing has included an ESG element or been for a business focussed on clean energy.
As the ESG-linked debt market has evolved, the KPI-related provisions for assessing ESG performance have evolved too, as market standards have developed. These should provide solid building blocks for the ESG element of similar derivatives contracts. But given the unique nature of a derivatives contract compared to a cash-financing instrument, what additional challenges might need to be considered to build a strong and sustainable ESG-linked derivatives market?
- Valuation: how would a dealer value the ESG component of a swap contract? Would that involve taking a view on likely KPI compliance, and would data always be available to model that? Where a swap is subject to an exchange of collateral, that question may have a real day to day value to the parties.
- Regulatory treatment: a corporate issuer would usually be quite confident that a fixed/floating interest-rate swap fitted squarely within the ’hedging test’ under EMIR. Where the contract contains an extra element – perhaps a spread alteration linked to an ESG objective – is it right to say that the contract remains ’objectively measurable as reducing risks relating to the treasury financing activity’ of the counterparty, when the purpose of the contract is two-fold? At first blush, a good argument about the primary purpose of the contract would seem to be a useful place to start, though each question will need to be assessed and recorded on the facts.
- Dispute resolution: many ISDA based contracts contain well-developed dispute resolution mechanics, often built to address circumstances where the other party believes that the party designated as “Calculation Agent” has failed to meet its contractual duties. Would such duties and procedures sensibly apply to KPI tests for the ESG element of a transaction, or would objective third-party assessment be most appropriate (as for many ESG-linked cash financings), specifically excluding such standard OTC derivatives market provisions?
- Syndicates and transfers: unlike loans or bonds, OTC derivatives are, by their very nature, bilateral products. Where an issuer is looking to syndicate an interest-rate hedge among a group of banks where that hedge has an ESG angle, will market capacity be restrained for 2021 by the bespoke and very new nature of the product?
These and other challenges may serve as bumps in the road to the growth of the market in ESG-linked OTC derivatives. Heavy focus from ISDA on the standardisation of documentation will no doubt assist with progress for a product which will surely look for every opportunity in 2021 and beyond to surf the wave generated by its cash-financing cousins.