Considering Sustainability-linked Derivatives? What You Need to Know

The sustainable finance market is evolving at an accelerating pace. One recent trend garnering growing interest from market participants is the development of “sustainability-linked derivatives” (SLDs).

The first SLD was issued in August 2019. In under four years, based on a market survey on SLDs conducted by the International Swaps and Derivatives Association (ISDA), the number of banks, companies, consultants and other market participants worldwide that have engaged in SLD transactions has grown considerably.[1]

This insight explores the key features of SLDs, and outlines some of the documentation and potential regulatory issues for market participants that are considering engaging in SLD transactions. We also set out our key tips for navigating these issues. 

Key features of SLDs

An SLD is a derivative transaction that creates, embeds or alters one or more payment cashflows using key performance indicators (KPIs) linked to environmental, social and governance targets (ESG targets). When the KPIs of a specified party to the derivative transaction meets (or fails to meet) the ESG targets, the other party to the derivative transaction will provide a financial incentive (or disincentive).

SLDs are highly customisable. Parties can structure SLDs in various ways to meet their respective needs. Terms that can be customised or varied include, but are not limited to:

• whether the SLD is one-sided (with only one assessed party and one assessing party) or two-sided (each party is an assessed party and assessing party with respect to different KPIs)
• the financial incentives (or disincentives) provided when particular KPIs meet (or fail to meet) their respective ESG targets
• the KPIs and ESG targets
• provisions relating to disclosure, verification and consequences of any failure to comply with related obligations

SLDs are usually linked to underlying conventional derivatives transactions, such as interest rate swaps and FX derivatives, where the financial incentive (or disincentive) takes the form of a discount (or increase) to the amount payable by the assessed party in the underlying derivatives transaction. However, this is by no means always the case. It is possible to structure the financial incentive (or disincentive) in other forms, such as a mandatory donation to a pre-approved charitable organisation in the ESG space.

Regulatory issues relating to SLDs

Regulations relating to derivatives

It is important for market participants to consider how SLD contracts fit within existing derivatives regulatory regimes. Over the last decade, the global development of derivatives regulations has led to derivatives being subject to a number of regulatory requirements. While the specific requirements differ by jurisdiction, they generally include licensing, mandatory clearing and margining, trade reporting and trade execution.

One preliminary issue to consider is whether an SLD contract is a “derivative” for the purposes of the relevant local regulations. ISDA has categorised two types of SLDs seen in the market:

• Category 1 SLD (embedded terms): where the KPIs, ESG targets and other associated terms are embedded within the underlying derivatives transaction
• Category 2 SLD (separated): where the KPIs, ESG targets and other associated terms are set out in a separate agreement

Generally speaking, Category 2 SLDs can lead to more complexities on whether they fall within the relevant local regulations, with potentially different results in different jurisdictions[2].

Even if a SLD contract can be characterised as a derivative for the purposes of the relevant local regulations, there are often further regulatory issues to consider, including:

• applicability of hedging exemptions (if available under local regulations) for mandatory margining
• calculation of initial and variation margin
• appropriate fields to be used for the purposes of trade reporting
• applicability of portfolio reconciliation, dispute resolution and portfolio compression obligations

This is by no means exhaustive, and there will be various other jurisdiction-specific regulatory issues to consider.

Regulations relating to sustainability-linked products

In addition to complying with relevant derivatives regulations, if SLDs are characterised as ESG-related or sustainability-linked products (however described), market participants will also need to comply with relevant disclosure, transparency and anti-greenwashing regulations.

For example, in Hong Kong, the Hong Kong Monetary Authority (HKMA) recently published “Due diligence processes for green and sustainable products”, a circular setting out principles regarding the management of green and sustainable products to reduce any potential exposures to greenwashing risks. Although the circular does not specifically mention SLDs, these principles are cast at a high level and are potentially applicable to the full suite of sustainability-linked products that market participants may transact (including SLDs).

In other jurisdictions such as Australia, regulators are also focusing intensely in this area with, for example, the Australian Securities and Investments Commission (ASIC) and the Australian Competition and Consumer Commission (ACCC) having each named environmental claims and greenwashing as a current enforcement priority.[3] Participants in SLD markets will need to have this scrutiny front of mind in developing and documenting their SLDs.

Documentation issues relating to SLDs

As at June 2023, no industry-level standardised documentation for SLDs has been published. In the more well-developed markets of sustainability-linked cash products, industry-wide guidance and materials have been published and made available to market participants for some time[4]. It is noteworthy that, for both sustainability-linked loans (SLLs) and sustainability-linked bonds (SLBs), the relevant industry bodies have chosen to provide guidance in the form of high-level principles that market participants should abide by.

An ISDA working group is tasked with producing a clause bank for SLDs. However, pending its finalisation and publication, it remains to be seen the degree of conformity (or divergence) of the approach taken by ISDA with respect to providing industry guidance on SLDs compared with SLLs and SLBs. The final position taken in ISDA’s publication of these clauses will be relevant to the future direction taken by the cash product markets, and to the interoperability between the sustainability-linked cash product and derivatives markets.

Although the documentation approach in the SLD market is relatively fragmented at present, it is possible to list out certain core issues that will need to be considered by any participant looking to document SLD transactions. Some issues are common between SLDs and their cash product counterparts, while others are more specific to SLDs.

How to navigate the issues – our guide

Please note that the list set out above is by no means exhaustive and there will be other issues that participants will need to consider when entering into any SLD contract.

Conclusion

As highlighted above, there are numerous regulatory and documentation issues that market participants will need to consider when contemplating entering into SLDs. Given the nascent state of the SLD market, there may also be interoperability issues for participants considering SLDs in conjunction with (or as alternatives to) other sustainability-linked products such as SLLs and SLBs.

However, given the increasing market focus on SLDs, there is reason to believe that SLDs will continue to develop in a manner that solves for these issues on an industry-wide basis. With their flexibility and high degree of customisation, we have already seen SLDs becoming an essential part of market participants’ sustainable financial toolkits towards meeting ESG goals and we expect this trend to continue. 

King & Wood Mallesons acts as Australian and China counsel numerous financial markets and derivatives industry bodies . We are a regular participant of derivatives industry working groups (including those relating to SLD documentation and other ESG-related issues).

Please do not hesitate to contact us if you have any enquiries about this article insight or any aspect of SLDs.