Part 1: Sustainability-linked Derivatives – an introduction

The increasing global focus on sustainability issues, and subsequent rising interest in ESG-linked financial instruments, has brought about a number of innovative approaches to financial products, including derivatives. Whilst the current macro headwinds may have moved the spotlight from ESG issues a little, it’s hard to see the focus shifting in the longer-term.

In our series of three blogs we will take a closer look at one such product, Sustainability-Linked Derivatives (SLDs). We will examine certain of their key features and consider how they might develop and be employed by corporates looking to expand or supplement their ESG profile. Given the parallels between SLDs and other types of sustainability-linked financing, in particular loans and bonds, we will also set SLDs in context by looking into the similarities and differences with other ESG products.

Perhaps unsurprisingly given the more opaque nature of its products, the derivatives industry has lagged a little behind other markets in the push towards "green" and sustainable financings. As such, ISDA is keen to be a formative and driving influence in the development of SLDs and in May 2022 published a white paper on this new product type. Thus far, ISDA’s work has involved a high-level discussion of themes identified as relevant to future market participants, including regulatory and risk considerations, documentation, disclosure and verification of key performance indicators (KPIs, i.e. ESG targets) and data management. ISDA’s hope is that shepherding the exploration of these themes will help to establish market norms for these products, to stimulate growth of the market and in turn promote more sustainable financing practices. Indeed, ESG derivatives were a key focus of much of the discussion and energy at the ISDA AGM in Madrid earlier in the summer.

ISDA makes a distinction between "more traditional ESG-related derivatives" on the one hand, and SLDs on the other. "Traditional" ESG-related derivatives are products with an underlying variable that has an environmental angle, for example derivatives referencing carbon credits or allowances. These tend to fit within existing ISDA documentation structures, the templates for trading EU or UK emissions credits being fairly well known.

SLDs, on the other hand, are a newer creation which take standard interest rate or FX products (such as interest rate or cross-currency swaps) and add an ESG-linked overlay to their terms. That might be an adjustment to the cashflows if a particular KPI is met or missed (e.g. an adjustment to the spread or the payment of a premium / rebate) or an agreement to make a charitable payment to a third party if the relevant target is met or missed. These KPIs are highly customisable and can apply to either one or both counterparties.

At this point in time, the market for SLDs is nascent as it distinguishes itself as a new class of ESG derivatives. ISDA and some sell-side institutions are therefore spending an increasing amount of time focussing on the terms of such products, and the related legal and documentary issues. We expect that such developments may be of interest to corporates who wish to start shifting their financing/hedging arrangements towards ESG-linked products, if they haven’t done so already, or use derivatives to add an ESG-linked overlay to their existing financing programmes.

With this in mind, in the next entry of this blog series we will cover KPIs, the defining element of SLDs.