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). These can be a useful tool that lowers hedging costs for a business or project while (and by) achieving better ESG-related outcomes.
In this insight, we explore the potential that these products offer to private capital investors and identify some of the nuances that these parties need to navigate when using them.
What are SLDs?[1]
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 meet (or fail to meet) the ESG targets, the other party to the derivative transaction will provide a financial incentive (or disincentive).
What are the main benefits?
- Unlike other sustainability-linked products, SLDs do not focus on, or mandate, the use of proceeds for ESG-related purposes, but rather create or impact cashflows within conventional or vanilla derivatives.
- If ESG targets are achieved, an SLD can lower the cost of capital (by lowering rates or payment obligations) and therefore improve the investor’s return on investment.
- Financial institutions are increasingly allocating larger pools of capital to sustainability-linked products, like SLDs, as customer demand for these products rises. So there is appetite from banks to offer and provide these products. To date, most SLDs have been between financial institutions and non-financial institutions (especially those involved in sectors facing strong ESG pressures, such as agriculture, construction, energy and transport).
- There is no standard set of KPIs, so SLDs are highly customisable and can therefore be tailored to suit a particular company’s or investor’s circumstances and requirements.
How are SLDs relevant to private capital investors?
- For private capital that invests into infrastructure projects, SLDs can become an important component of the project’s overall financing package, especially as part of its hedging of commodity, currency and pricing risk.
- For traditional private equity sponsors (including those considered as ‘core plus’ investors), SLDs present an available and convenient opportunity for their portfolio companies to lower the cost of hedging and to place rigour and consequences around the achievement of the ESG targets. Linking corporate behaviour to ESG targets is increasingly embedding these matters within a company’s treasury and/or risk management functions.
- In both cases, the selection of KPIs that are relevant and appropriate to the company or project entering into the SLD is crucial.
Setting KPIs[2]
The following are the main types of KPIs:
- those which reduce behaviour that negatively impacts the environment, e.g. reducing greenhouse gas emissions, lowering the amount of waste sent to landfill or reducing water consumption;
- those which encourage behaviour beneficial to the environment, e.g. improving energy efficiency and renewable energy use; and
- those which track a counterparty’s general ESG performance by reference to a rating system, e.g. Bloomberg, MSCI or even targets in the UN Sustainable Development Goals.
Against this classification, it is possible to craft almost any KPIs, including KPIs linked to supply chain performance and market standards. Our experience so far is that financial institutions are not fixed in their views about any particular type or form of KPI, which allows companies to be creative and innovative when negotiating these arrangements (provided the criteria above are met). The primary principles which KPIs should meet is that they are specific, measurable, verifiable, transparent and suitable.
ESG targets should also be set at a level which is sufficiently ambitious but achievable. They should also be objective, quantifiable (such as a numerical or percentage measurement) and clearly specified with respect to each observation period. Setting out the targets in this way will also help to mitigate the risk that the target group / project and its performance under the standards established by the ESG targets incurs unwanted attention from regulators and third parties for broader greenwashing concerns.
Other issues to consider
While SLDs offer significant potential benefits, investors should pay attention to some peculiarities when considering the use of, negotiating and documenting these arrangements. For example,.. :
- Margining requirements: SLDs require a more bespoke calculation of any initial or variation margin.
- Greenwashing risk: There is also heightened greenwashing risk associated with an SLD for market participants if the SLD is characterised as ESG-related or a sustainability-linked product. This is particularly relevant in Australia, where, for example, ASIC and the ACCC have each named environmental claims and greenwashing as a current enforcement priority.
- Event of Default or Early Termination Event: Parties need to consider whether the failure to meet an ESG target should trigger an Event of Default or early Termination Event, noting there are alternative consequences or remedies available.
Conclusion
The market for SLDs is likely to grow over the next few years as demand for these products increases. KWM have been at the forefront of advising clients about the creation and use of these products, so please contact us if you’d like to understand any aspect of this insight in more detail or explore how you can leverage our experience and expertise to take full advantage of the opportunities presented by these relatively novel instruments.
Follow this link to see our more comprehensive analysis of the key features of SLDs and some of the regulatory and documentary considerations relevant to these products generally.
See ISDA’s Sustainability-linked Derivatives: KPI Guidelines issued September 2021.
