A. INTRODUCTION
The world of today is confronted with an extensive range of economic, social, and environmental challenges, necessitating the active engagement of governments, private sector institutions, and individuals in finding solutions. The concept of sustainable development has emerged within the global society. This idea assumes that there is a connection between consistent economic growth, social security, and the reduction of adverse environmental impacts.
The term "green" is used to describe many ecological processes and phenomena in a vibrant and powerful manner. The term "green economy" refers to an economically sustainable system that enhances the overall well-being of all individuals while operating within our planet's ecological limitations.1
Ecological projects are being carried out to save the environment, mitigate pollution, and enhance resource efficiency. "Green investments" are typically defined as investments in environmentally friendly and resource-saving projects.2 Similarly, "green finance" refers to a collection of relationships that focus on creating and utilising finances to promote ecologically sustainable growth.3
In 2021, the United Nations Climate Change Conference (also known as COP26) provided very important outputs on extreme weather conditions, climate change and their impacts.4 COP26 has been an effective event for financial markets to react to climate change and its indirect effects, and in this respect, it has also created a reference point. According to COP26 estimates and various studies, green finance recorded a growth of approximately 30% in 2020.5
As a result of this perspective, derivatives linked to environmental, social and governance ("ESG") objectives have started to circulate in the markets in recent years. Although this market is not yet as large as traditional derivatives markets, it is growing and developing year by year. These financial instruments are crucial for achieving sustainability objectives and facilitating the shift of financial and global markets towards a green economy.
The main objective of this paper is to examine the mechanism of sustainability-linked derivatives ("SLD"), to analyse the approach to these financial instruments by the International Swaps and Derivatives Association (ISDA), the contract standardisation steps and the details that need to be considered for market transparency and health.
B. WHAT ARE SUSTAINABILITY-LINKED DERIVATIVES?
According to the Climate Action Tracker study, if the current rate of carbon dioxide emission persists, the average temperature is projected to increase by around 3.3°C by the end of the century.6 An analysis of the present policy commitments outlined in the National Determined Contributions ("NDC") reveals that they would only succeed in limiting the increase in global temperature to 3°C by the year 2100, compared to pre-industrial levels.7 Regarding this matter, there is still a significant amount of work to be done, and we must adopt a more ambitious approach. Scientific research indicates that there is a 1% chance of reaching the target rate of 1.5°C as set in the Paris Agreement.8
If the current policies remain essentially the same, the global temperature increase would have substantial economic consequences on the world's Gross Domestic Product ("GDP"). According to the International Renewable Energy Agency ("IRENA"), this impact could reach up to 10% by 2050.9 Alternatively, a recent academic study suggests that the effect on GDP per person would be approximately 7.22%.10 Furthermore, it is projected that by 2100, the amount of stranded assets (fossil fuel processing plants, non-renewable power plants, fossil-fuelled vehicles, etc.) will account for around 3% of the existing capital stock.11 This highlights the necessity to continue with necessary changes in order to protect the economic growth12 and prosperity of the coming generations.13
Clearly, unlike other transformations in financial markets (e.g., the lessons learnt from the 2008 financial crisis), this one gives a "natural" time limit for action and is approaching unstoppably.14 In this case, it will not be enough for governments and individuals to take deliberate action. It is also essential for private sector players to take the necessary actions and develop useful and effective practices and standards around the idea of a sustainable green economy.
As it is known, companies are profit-oriented commercial organisations and shape and conduct their activities around profit maximisation. In this context, sustainability goals do not directly serve the "profitability" phenomenon, which is the raison d'être of companies; they are often seen as an expense item or a social responsibility project. For this reason, developing new models and products which reach sustainability goals will provide financial benefits to companies and will increase the participation of the private sector in the sustainable and green economy and encourage them in this direction.
It is precisely at this point that derivative instruments, which are indispensable in financial life, have emerged in recent years in a new form designed for sustainability purposes.
Sustainability-Linked Derivatives ("SLDs") generate a cash flow that is connected to sustainability goals inside of the structure of a traditional derivative, such as an interest rate swap, cross currency swap, forward, or futures contract. They achieve this by employing Key Performance Indicators ("KPI") to oversee adherence to certain ESG objectives.15 While still in its early stages, it should be noted that various varieties of SLDs have emerged and entered into circulation in the markets.
SLDs are usually customised to fit the specific demands of counterparties, incorporating unique KPIs or sustainable performance targets to fulfil their own ESG requirements. Counterparties may also engage in negotiations over the various outcomes that result from meeting the KPIs or Service Performance Targets ("SPT"). Consequently, these products are presently lacking in liquidity and are designed to suit particular situations.
One or both parties involved can have the same or different KPIs, and achieving a KPI can lead to either an increase or decrease in compensation. KPIs consist of ESG targets such as a company's achievement of carbon emission targets, preference for renewable energy sources and carbon trading. These KPIs are subject to a calculation through matrices such as whether the targets have been achieved or not, or at what rate they are approached, and the amount of payments and/or offsets are calculated to the extent agreed by the parties.
The checks and verifications of these KPIs are usually carried out by third-party service providers and reported in an independent report. KPIs are inconsistent and challenging to authenticate, and the absence of widely acknowledged standards creates opportunities for greenwashing and other forms of risks.16
In practice, SLDs are a relatively recent addition to the derivatives market. The first SLD execution occurred in August 2019 between SBM Offshore and ING Group. The purpose of this transaction was to hedge the interest rate on SBM's USD 1 billion five-year variable rate revolving credit facility.17 After that "leading light" transaction, numerous SLDs with different characteristics appeared in the market, each having KPIs that are usually customised for the particular borrower. These KPIs typically extend over a period of three or more years, making them influential in determining the long-term viability of a company.18
C. ISDA'S APPROACH TO SUSTAINABILITY-LINKED DERIVATIVES
SLDs differ from green or sustainability-linked bonds in that they do not prioritise the use of funds. Instead, they are designed to enhance ESG performance and/or to provide backing for sustainable projects. Due to the absence of a universally accepted definition or standardised documentation for SLDs, they are evolving and developing products that can be organised and shaped in various ways.19
ISDA has published a clause library for SLDs, which offers standardised drafting alternatives for market players to employ during negotiations of SLD transactions with counterparties. In other words, the ISDA Clause Library offers standardised drafting alternatives in various important points, such as specifying the required evidence of sustainability performance and its timing, adjusting cash flows based on the achievement of relevant ESG targets, and providing alternatives for counterparties in the event of disruptions and reviews.20
Scott O'Malia, ISDA's Chief Executive, explains the idea and driving force behind ISDA SLD Clause Library:21
"By their nature, SLDs are highly bespoke transactions, but the language that describes the terms and the objectives does not have to be. The ISDA Clause Library is designed to eliminate unnecessary differences and bring greater standardisation to this market. This will bring more efficiency to the negotiation process and reduce risks, setting the foundations for this market to develop further."
Before the launch of the SLD Clause Library, ISDA had created several documents about SLDs. These included a document outlining the details of early transactions,22 a set of suggested principles for creating KPIs,23 and an examination of the primary regulatory concerns.24
In April 2022, the ISDA initiated a survey to gather information from market participants regarding their current utilisation and implementation of SLDs. This study provides a concise overview of what SLDs are, presents the key findings of the ISDA SLD Survey, and discusses prospective future initiatives aimed at standardising the documentation for SLDs.25 After conducting the survey, ISDA initiated the process of creating uniform terms in order to enhance efficiency while still maintaining the required adaptability to customise SLDs according to participants' goals for sustainability.
The results of the ISDA SLD Survey have identified under several headings the characteristics and required elements of the various SLDs being circulated or designed by market participants:26
- Main SLD Structure: An interest rate swap is the most prevalent type of traditional product utilised to generate an SLD, with foreign exchange swaps and cross-currency swaps following suit. These products are created by employing the established ISDA documentation framework. ESG-related phrases are typically documented in the trade confirmation. However, in certain instances, KPIs are agreed in a distinct agreement that is referred to in the transaction confirmation.
- Targeted Sustainability Goals: Derivative counterparties are expected to achieve specific KPIs relating to carbon footprint, such as greenhouse gas emissions, as part of their ESG targets. Additionally, they may also be required to meet criteria based on their ESG ratings provided by a third-party rating agency.
- Achieving the Targeted Sustainability Goals: If the KPIs are met, the result in the derivative usually involves one of the following: (i) modifying the spread component of the floating rate that the complying party has to pay, (ii) reducing the fixed rate that the party has to pay (or increasing it if the ESG target is not met), or (iii) receiving an extra premium. Typically, there is no agreement among market participants on how to calculate changes to the difference or extra fees (although, for the latter, it might be calculated based on a specific percentage of the initial amount).
- Verifying the Achievement: Parties typically depend on third-party verification to determine whether a KPI has been achieved, rather than relying on self-certification. When using third-party verifications, it is important for parties to carefully evaluate the inclusion of extra terms in their documents regarding the third-party verification service provider and its processes.
- Payment: Some of the SLD documentation outlines the consequences of not paying ESG-related cash flows or failing to fulfil ESG commitments, such as not providing evidence that a KPI has been achieved. The consequences can vary, but they may resemble those imposed in traditional derivatives trading, such as being considered a default event or designated as an additional termination event. Nevertheless, certain participants confirmed that the failure to meet ESG responsibilities would not have any impact on the underlying transaction.
- Early Termination: There is currently no generally accepted standard or practice on the treatment of the ESG component of an SLD in the event that the underlying derivative is terminated prematurely.
In parallel with the findings of the SLD Survey, ISDA has included drafts of standard contractual provisions in its SLD Clause Library, and in this context, it has objectively formulated all the know-how it has acquired and the needs it has identified. Within the scope of the SLD Clause Library, ISDA has categorised SLDs under two categories.27
- Category 1 SLDs refer to transactions in which the relevant KPIs and their associated cashflow implications are incorporated inside the transaction itself. The achievement of the relevant party in meeting the applicable KPI target directly impacts the cashflows of the transaction. All the KPIs and their associated elements are thoroughly recorded in the transaction documentation.
- Category 2 SLDs have a distinct structure where the KPIs and related elements are recorded separately from the derivative transaction they are based on. Within the Category 2 SLDs, the KPIs do not have any impact on the derivative terms, pricing, and cashflows. Alternatively, when the relevant KPI target is achieved, the conditions of the derivative are utilised to calculate the payment based on the KPI. For instance, the hypothetical value of the derivative could serve as the initial amount for calculating a payment based on a percentage.
In substance, the clause library is designed for use in Category 1 SLDs, while the provisions can be modified for application in Category 2 SLDs as well.28 Although there are clause templates addressing different topics and concerns, the most important aspects addressed in the SLD Clause Library are the following: (i) KPI Compliance Certificates; (ii) Impact of Meeting or Failing to Meet KPI Targets; (iii) KPI Disruption; (iv) Review of KPIs; and (v) KPI Disputes.
The ISDA SLD Clause Library provides a framework for parties to manage their sustainability commitments and ensure compliance with KPI targets. This includes provisions for KPI Compliance Certificates, where a KPI achievement score is given to represent a party's performance in relation to the KPI for the relevant period. The score is verified by a third-party verification agent, and parties compare the relevant KPI score against the corresponding KPI target to determine whether the KPI target has been met. A compliance certificate (KPI Compliance Certificate) is then completed and delivered on or prior to the delivery deadline agreed between the parties.
Parties can apply different combinations of triggers and consequences depending on whether or not a KPI target is met. For example, if one KPI target is reached, the parties may agree that the related KPI target being reached results in a positive cashflow adjustment, while another KPI could result in a cashflow consequence if a KPI target is not met. Parties can also choose to apply a consequence to all KPIs as a group rather than on an individual basis.
The ISDA SLD Clause Library departs from the default position under Section 5(a)(i) (Failure to Pay or Deliver) of the ISDA Master Agreement and provides that such failure shall not constitute an "Event of Default" or "Potential Event of Default". Instead, parties have the option to elect for such failure to trigger either an Additional Termination Event (with the party that has failed to make the Sustainability-linked Payment as the Affected Party and the SLD as the sole Affected Transaction) or a Declassification Event.
Parties can include a KPI review procedure in their Confirmations, which contemplates the parties agreeing to update KPI(s) or KPI target(s) on an annual basis or upon the occurrence of specific events (KPI Review Event). Parties can revise the list of KPI Review Events to suit their needs, but the rationale is to help parties maintain their sustainability commitments and adapt them as required due to circumstantial changes.
The ISDA SLD Clause Library also includes a KPI dispute resolution process regarding disputes relating to the validity of the facts contained in the KPI Compliance Certificate or KPI Supporting Documentation. If the parties fail to resolve the dispute, they can elect in their Confirmations for the Verification Agent to determine the fact or figure in dispute, the relevant sustainability consequence to apply or not apply (as applicable), or a "Declassification Event" to occur.
D. CONCLUSION
In the 21st century, green finance has become an indispensable component, not only in society, but also in the corporate sector. It is imperative for governments and business circles to actively pursue green finance initiatives. It is projected that the global green finance market would reach a value of USD 40 trillion by 2030.29
Green financing serves as a catalyst for promoting ecological development through two distinct mechanisms. Firstly, it promotes the active participation of private sector players in adopting environmentally friendly practices and goods. Secondly, it reduces pollution levels by replacing energy-intensive equipment with energy-efficient alternatives.30
However, as is well known, the private sector has profitability-oriented reflexes and commercial and financial success are the top priorities of companies by their nature. In this context, taking "green" steps sometimes carries certain disadvantages for private sector players in terms of effort, financial resources and time. For this reason, the creation and circulation of green-oriented financial instruments that companies can benefit from financially is vital to accelerate and encourage this green transformation.
SLDs fill an important gap at this point and offer unique opportunities to encourage the private sector to green transformation. Since SLDs bring various financial advantages or disadvantages to companies according to their ESG targets and whether or not they can achieve them, or how close they are to them, achieving ESG targets is also associated with a kind of financial benefit.
However, the lack of a sector or market standard for SLDs is a handicap of these products. At this point, ISDA's sector researches, its recommendations on KPIs and the SLD Clause Library are highly effective and efficient materials that respond to the need for standardisation and minimisation of risks sought by the sector.
Ultimately, the threat of climate crisis and environmental factors that our world is currently experiencing show that green transformation can be realised with a common consciousness by governments, private sector and all humanity. For this reason, within the scope of the subject of this paper, it can be clearly said that SLDs are positioned as financial instruments of critical importance in order to encourage and raise awareness of private sector players, and ISDA's efforts serve the market as a "lighthouse" to standardise these products.
BIBLIOGRAPHY
BOOKS AND ARTICLES
Ivanova NG, Katsyuba IA and Firsova EA, 'Green Finance' (2021) 689 IOP Conference Series: Earth and Environmental Science
Kaur G, 'Green Finance Key for Sustainable Development of Economy' (2022) 2 IJARSCT 80
Kahn ME and others, 'Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis' (2019) CAMA Working Paper No. 49/2019
Khan S and others, 'Green Finance Development and Environmental Sustainability: A Panel Data Analysis' (2022) 10:1039705 Frontiers in Environmental Science
Peng J and Zheng Y, 'Does Environmental Policy Promote Energy Efficiency? Evidence from China in the Context of Green Finance' (2021) 9:733349 Frontiers in Environmental Science
Raftery AE and others, 'Less Than 2°C Warming by 2100 Unlikely' (2017) 7 Nature Climate Change 637
OFFICIAL REPORTS AND PUBLICATIONS
Alonso A and Marques JM, 'Financial Innovation for a Sustainable Economy' (Documentos Ocasionales No. 1916, Banco de Espana 2019)
Banque de France, 'Greening the Financial System: The New Frontier' (FSR, Banque de France 2019)
Climate Action Tracker, 'Global Emissions and Temperature' (climateactiontracker.org) (https://climateactiontracker.org/methodology/global-pathways/) accessed 05 May 2024
Climate Action Tracker, 'Warming Projections Global Update' (CAT 2018)
International Renewable Energy Agency, Global Energy Transformation: A Roadmap to 2050 (2019 edn. IRENA 2019)
Damianova A and others, 'Russia Green Finance: Unlocking Opportunities for Green Investment' (Policy Note, World Bank 2018)
Lafakis C and others, 'Moody's Analytics: The Economic Implications of Climate Change' (Moody's 2019)
OECD, 'Climate Change Provided and Mobilised by Developed in Countries in 2016-2020: Insights from Disaggregated Analysis' (OECD 2022)
ISDA, 'ISDA Clause Library – ISDA Master Agreement' (https://mylibrary.isda.org/bookstore) accessed 11 May 2024
ISDA, 'ISDA Launches Sustainability-Linked Derivatives Clause Library' (Press Release, ISDA, 17 January 2024) (https://www.isda.org/2024/01/17/isda-launches-sustainability-linked-derivatives-clause-library/) accessed 06 May 2024
ISDA, 'Overview of ESG-Related Derivatives Products and Transactions' (ISDA 2021)
ISDA, 'Regulatory Considerations for Sustainability-Linked Derivatives' (ISDA 2021)
ISDA, 'Sustainability-Linked Derivatives: KPI Guidelines' (ISDA 2021)
ISDA, 'Sustainability-Linked Derivatives: Where to Begin?' (Future Leaders in Derivatives, ISDA 2022)
ISDA, 'The Way Forward for Sustainability-Linked Derivatives' (ISDA 2022)
ING Bank, 'Introducing the World's First Sustainability Improved Derivative' (ING Bank N.V., 13 August 2019) (https://www.ing.com/Newsroom/News/Introducing-the-worlds-first-sustainability-improvement-derivative.htm) accessed 06 May 2024
United Nations, 'UN Climate Change Global Innovation Hub: COP26 Event Report' (UN 2022)
OTHER SOURCES
Knight J, McAllister-Jones K and Johnston L, 'Sustainability-Linked Derivatives: ISDA Publishes Clause Library' (ashurst.com, 22 January 2024) (https://www.ashurst.com/en/insights/sustainability-linked-derivatives---isda-publishes-clause-library/) accessed 06 May 2024
May N and Rutter N, 'Sustainability Linked Derivatives' (harbertsmithfreehills.com, 11 May 2021) (https://www.herbertsmithfreehills.com/insights/2021-03/sustainability-linked-derivatives) accessed 04 May 2024
Mayer Brown, 'ESG Derivatives: A Sustainable Trend' (mayerbrown.com, 21 October 2021) (https://www.mayerbrown.com/en/insights/blogs/2021/10/esg-derivatives-a-sustainable-trend) accessed 20 April 2024
Norton Rose Fulbright, 'Time to Standardise Documentation for Sustainability-Linked Derivatives?' (nortonrosefulbright.com, December 2022) (https://www.nortonrosefulbright.com/en/knowledge/publications/04f48959/time-to-standardise-documentation-for-sustainability-linked-derivatives) accessed 05 May 2024
O'Connell J and Wright I, 'Take-off for Sustainability-Linked Derivatives with the new ISDA SLD Clause Library?' (hoganlovells.com, 06 February 2024) (https://www.engage.hoganlovells.com/knowledgeservices/news/take-off-for-sustainability-linked-derivatives-with-the-new-isda-sld-clause-library) accessed 05 May 2024
Footnotes
1 NG Ivanova, IA Katsyuba and EA Firsova, 'Green Finance' (2021) 689 IOP Conference Series: Earth and Environmental Science.
2 Jiaying Peng and Yuhang Zheng, 'Does Environmental Policy Promote Energy Efficiency? Evidence from China in the Context of Green Finance' (2021) 9:733349 Frontiers in Environmental Science.
3 Adriana Damianova and others, 'Russia Green Finance: Unlocking Opportunities for Green Investment' (Policy Note, World Bank 2018).
4 United Nations, 'UN Climate Change Global Innovation Hub: COP26 Event Report' (UN 2022).
5 Mayer Brown, 'ESG Derivatives: A Sustainable Trend' (mayerbrown.com, 21 October 2021) https://www.mayerbrown.com/en/insights/blogs/2021/10/esg-derivatives-a-sustainable-trend accessed 20 April 2024.
6 Climate Action Tracker, 'Global Emissions and Temperature' (climateactiontracker.org) https://climateactiontracker.org/methodology/global-pathways/ accessed 05 May 2024.
7 Climate Action Tracker, 'Warming Projections Global Update' (CAT 2018).
8 Adrian E Raftery and others, 'Less Than 2°C Warming by 2100 Unlikely' (2017) 7 Nature Climate Change 637.
9 International Renewable Energy Agency, Global Energy Transformation: A Roadmap to 2050 (2019 edn. IRENA 2019).
10 Matthew E Kahn and others, 'Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis' (2019) CAMA Working Paper No. 49/2019.
11 OECD, 'Climate Change Provided and Mobilised by Developed in Countries in 2016-2020: Insights from Disaggregated Analysis' (OECD 2022).
12 Chris Lafakis and others, 'Moody's Analytics: The Economic Implications of Climate Change' (Moody's 2019).
13 Banque de France, 'Greening the Financial System: The New Frontier' (FSR, Banque de France 2019).
14 Andres Alonso and Jose M Marques, 'Financial Innovation for a Sustainable Economy' (Documentos Ocasionales No. 1916, Banco de Espana 2019) 9.
15 Jennifer O'Connell and Isobel Wright, 'Take-off for Sustainability-Linked Derivatives with the new ISDA SLD Clause Library?' (hoganlovells.com, 06 February 2024) https://www.engage.hoganlovells.com/knowledgeservices/news/take-off-for-sustainability-linked-derivatives-with-the-new-isda-sld-clause-library accessed 05 May 2024.
16 ibid.
17 ING Bank, 'Introducing the World's First Sustainability Improved Derivative' (ING Bank N.V., 13 August 2019) https://www.ing.com/Newsroom/News/Introducing-the-worlds-first-sustainability-improvement-derivative.htm accessed 06 May 2024.
18 Nick May and Nicholas Rutter, 'Sustainability Linked Derivatives' (harbertsmithfreehills.com, 11 May 2021) https://www.herbertsmithfreehills.com/insights/2021-03/sustainability-linked-derivatives accessed 04 May 2024.
19 ISDA, 'Sustainability-Linked Derivatives: Where to Begin?' (Future Leaders in Derivatives, ISDA 2022).
20 ISDA, 'ISDA Launches Sustainability-Linked Derivatives Clause Library' (Press Release, ISDA, 17 January 2024) https://www.isda.org/2024/01/17/isda-launches-sustainability-linked-derivatives-clause-library/ accessed 06 May 2024.
21 ibid.
22 ISDA, 'Overview of ESG-Related Derivatives Products and Transactions' (ISDA 2021).
23 ISDA, 'Sustainability-Linked Derivatives: KPI Guidelines' (ISDA 2021).
24 ISDA, 'Regulatory Considerations for Sustainability-Linked Derivatives' (ISDA 2021).
25 Norton Rose Fulbright, 'Time to Standardise Documentation for Sustainability-Linked Derivatives?' (nortonrosefulbright.com, December 2022) https://www.nortonrosefulbright.com/en/knowledge/publications/04f48959/time-to-standardise-documentation-for-sustainability-linked-derivatives accessed 05 May 2024.
26 ISDA, 'The Way Forward for Sustainability-Linked Derivatives' (ISDA 2022).
27 ISDA, 'ISDA Clause Library – ISDA Master Agreement' https://mylibrary.isda.org/bookstore> accessed 11 May 2024. Please note that ISDA Clause Library is available only by subscription in MyLibrary section.
28 James Knight, Kirsty McAllister-Jones and Lorraine Johnston, 'Sustainability-Linked Derivatives: ISDA Publishes Clause Library' (ashurst.com, 22 January 2024) https://www.ashurst.com/en/insights/sustainability-linked-derivatives---isda-publishes-clause-library/ accessed 06 May 2024.
29 Gagandeep Kaur, 'Green Finance Key for Sustainable Development of Economy' (2022) 2 IJARSCT 80.
30 Soha Khan and others, 'Green Finance Development and Environmental Sustainability: A Panel Data Analysis' (2022) 10:1039705 Frontiers in Environmental Science.
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