With the 2021 United Nations Climate Change Conference (also known as COP26) taking place in Glasgow later this month and amid numerous occurrences of extreme weather conditions, global attention to the change climate has recently increased, which is reflected in the financial markets. According to 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 market is growing. develops, reinforcing the idea that derivatives have a key role to play in advancing ESG objectives in financial markets and the global transition to a green economy.
In January, ISDA published an article titled “Overview of ESG derivative products and transactions”. This paper provided ISDA members with an overview of the overall universe of ESG-related derivatives, including details on some of the sustainability-related derivatives traded prior to 2021. Sustainability-related derivatives are derivatives that create ESG-linked cash flow in the context of a traditional derivative (such as a spread increase linked to a failure to meet an ESG target). Unlike other ESG financial products, the use of a sustainability derivative product is generally not controlled (although sometimes counterparties may agree that any increased spread paid due to non-compliance with a ESG objective will be applied for a sustainable purpose).
One of the biggest challenges for market players is ensuring that their ESG product documentation accurately captures all of the key performance indicators (“KPIs”) against which ESG targets are measured. KPIs are used in derivatives related to sustainability to monitor compliance with the relevant ESG criterion – for example, a KPI can be the amount of greenhouse gases emitted by a counterparty over a defined period of time or a percentage of the counterpart energy that is produced from sustainable sources. KPIs are therefore a tailor-made but crucial part of any derivative related to sustainability. ISDA recently published a new article titled “Guidance on Key Performance Indicators for Sustainability DerivativesThe ISDA document aims to educate market players on derivatives and KPIs related to sustainable development, to establish a framework of good practices for KPIs and derivatives related to sustainable development, to support and promote a adequate ESG disclosure to maintain the integrity of the sustainability-related derivatives market and promote the use of ESG-related products to assist in the transition to a green economy.
The paper also includes a summary of the current ESG derivatives market, noting in particular that most transactions are between financial institutions and non-financial institutions, and that usually only the performance of one of the counterparties is measured against to KPIs (although mutual KPI transactions exist). The document proposes that KPIs should be written to be objectively verifiable and provide legal certainty on their operation and impact on cash flow in order to improve market integrity. This can be a challenge when most sustainability-related transactions are tailor-made and private (meaning there is a lack of publicly available information on KPIs) and there is no industry standard formulation.
The document sets out five general principles that counterparties should keep in mind when choosing KPIs: they should be specific, measurable, verifiable, transparent and appropriate. It also notes that counterparties should take into account timing and structuring issues when entering into sustainability-related derivatives – such as the consequences of a KPI target being met outside a required timeframe, if flows cash flow related to KPIs must be taken into account. account for the purposes of margin calls, or if there could be an impact on closing or clearing when payments are due to charities or other third parties as a result of a failure to meet a KPI goal. The paper also notes that counterparties should take into account any regulatory, operational, tax or accounting requirements relating to, or implications of using sustainability-related key performance indicators that affect cash flows from transactions on derivatives.