The nascent sustainability-linked derivatives (SLDs) area is starting to take off, according to a survey by the International Swaps and Derivatives Association (ISDA), and nearly 70 institutions have completed SLDs on the interest rate, currency and other underlyings since the first transaction in August 2019.
- ISDA is to start standardising sustainability-linked interest rate derivatives.
- Market participants are already including sustainability targets in ISDA documentation.
- Emission targets are the key focus for SLDs.
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ISDA launched the survey in April. The findings, which triggered “strong member interest”, provide the most comprehensive picture of SLD activity yet. Against this background, ISDA is moving to start drafting standardised terms for documenting trades.
Respondents cited interest rates as the most important underlying and the priority for ISDA to develop standard contractual terms. Although they ranked FX swaps slightly ahead of cross-currency swaps in importance, the latter attracted more support for standardisation.
Trades on references from other asset classes such as commodities, credit and equities are not common, ISDA found.
Already market participants – which include corporates such as Associated British Ports and Italy’s Enel, as well as major investors such as Aviva in the UK – are including key performance indicators for their sustainability targets in ISDA documentation. The ISDA Master Agreement and 2021 Interest Rate Derivatives Definitions are the most common.
KPIs are typically included in SLDs’ trade confirmations, although a minority reported them being included in separate agreements referenced in the confirmation.
One potential initiative by the association is a standalone confirmation template with its own set of ESG terms, possibly in a clause library format. “This would allow members to create SLDs for different asset classes,” it said.
Given the dominance of interest rate SLDs, participants would use terms from the 2021 ISDA Interest Rate Derivatives Definitions in the template alongside ESG terms. Confirmation templates could also be included, according to ISDA.
Key performance indicators in SLDs
Mirroring the sustainability-linked bond market, the most common KPIs in SLDs reference reductions in greenhouse gas emissions. The survey did not examine emission types; in particular, whether SLD counterparties include indirect Scope 3 emissions along an entity’s value chain.
Almost three times as many respondents cited emissions as the main SLD KPI compared with the next candidate, ESG ratings from independent providers. Other important KPIs include renewable energy as a proportion of energy production, and ESG-related investments and diversity targets also feature, though respondents were divided over how common they are.
ISDA’s survey also dug into areas such as non-payment, early termination and third-party verification, as well as target achievement and, as in the ESG bond markets, “greeniums”. These are sustainability premiums to be paid when targets are met or missed, depending on deal structure.
Although the association leaves counterparties to negotiate pricing bilaterally, it found that SLD greeniums are based on the transaction’s notional amount, though tenor can also be a factor.
A minority reported that a percentage of the notional of multiple trades or a portfolio is the most common basis.
ISDA has already published several papers on SLDs “[i]n response to the growing focus on these products and the likely acceleration of ESG-related financial transactions”. These include one on KPI best practices to ensure legal certainty and enforceability and others on SLDs’ potential regulatory treatment in different jurisdictions.
This article was written by Julian Lewis