Sustainability linked derivatives: An instrument with a potential

– Vinod Kothari, vinod@vinodkothari.com

Sustainability-linked loans and bonds have been surging globally. While there has been a dip in the recent periods (Q3 and Q4 of 2023) owing to tightening of regulatory conditions, the global volumes of sustainability-linked loans stood at around $ 400 billion[1].

However, there is another instrument – a derivative, which also has a linkage with sustainability targets, and that is making a global buzz. ISDA, having named this Sustainability Linked Derivatives or SLDs, is creating proper documentation basis to take this market forward. As of now, the market for SLDs is neither large nor highly standardised, but as credit defaults rose from nowhere and from a purely OTC product into being in the very thick of the global financial crisis, SLDs also merit close attention.

What is an SLD?

Think of usual derivatives in financial business – it will be an interest rate swap, or cross currency swap/FX forward. An SLD adds a sustainability-linked overlay on a typical IRS or FX hedge transaction.

For instance, assume Borrower X has taken a floating rate loan of $ 100 million, say at SOFR + 100 bps. X now hedges interest rate risk by entering into an IRS with Bank A, whereby Bank swaps this for a fixed rate of 4.5%.

Here, if we add an SLD overlay, Bank A will agree to provide a discount of, say 5 bps if X is able to meet certain specified sustainability KPIs. On the contrary, if X fails to meet the KPIs, then X pays a penalty of equal or a different amount. Depending on the agreement, the discount or penalty, or bonus/malus, may either be exchanged between the counterparties or by spent by either counterparty by way of a donation  for a sustainability cause.

Borrower X is the buy-side entity, typically the end-user of a floating rate facility. The sell-side entity is typically a bank or a derivatives dealer.

An SLD is different from sustainability loans, sustainability bonds or sustainability-linked loans or bonds. Being a derivative transaction, the SLD itself does not have any inherent funding. It simply adds a sustainability KPI to an interest rate or forex hedge, which, in turn, may be referenced to an actual funding transaction.

A natural question is: is the borrower of a loan or issuer of a bond wanted to build a sustainability target for itself, it might have done so for the loan/bond itself. So why is it that we are introducing sustainability targets in the derivative, rather than the reference loan/bond itself. However, derivatives are all about transforming the features of a financial asset or liability. Like an IRS transforms a floating rate into a fixed rate loan, similarly, introducing SLD in an IRS transforms a non-sustainability-linked financing into a sustainability-linked one.

Is SLD a fairly well-developed market, with standard documentation? Not really. A 2022 ISDA document admits that “there is currently no agreed definition of an SLD or any market-standard documentation”. However, it is apparent that the product is catching attention in most important financial centres, as buy-side entities are under increasing pressure from ESG enthusiasts to affirm their sustainability commitments.

Category 1 and Category 2 SLDs:

There are two categories of SLDs:

Category 1: The SLD overlay is part of the IRS or FX derivative transaction, as the case may be. That is, the fixed rate leg has an element of penalty or bonus depending on the KPIs being achieved.

Category 2: There is a separate agreement, which references the notional value and the cashflows of a plain vanilla derivative such as an IRS. That is, the IRS and the SLD are though interlinked, as the SLD cashflows are referenced to the IRS, but the SLD is really an independent transaction. Is it between the same parties as the IRS? Well, not necessarily. It may be with affiliates, or completely independent parties.

Is it a derivative really?

Category 1 SLDs, which is what appears to be most common as of now, is merely a sustainability commitment linked to a derivative. But the key features of a derivative contract are that is creates a trade on a volatility. So what is the volatility that an SLD deals with? Can it be said that the ability of an entity to meet the KPIs is the risk that is being traded by the SLD? Can it be contended that the pricing and valuation of an SLD would be based on the probability that the buy-side entity will be able to meet its KPIs? Even if there is such a probability, is there is a magnitude of the gain/loss on a reference borrowing, so as to appropriately price the derivative? Going forward, can SLDs be created completely independent of the reference counterparty whose KPI commitments are referenced in the derivative, such that X and Y trade in the probability of an entity K to meet its sustainability KPIs?

At this fledgling state of development, SLDs are simply expressions of sustainability commitment, and may not be comparable to other derivatives. The amounts of bonus or malus currently being ascribed (though the same is opaque and not reported) also does not appear to be linked with  the probability of the KPIs being met[2].

However, sustainability standards are fast emerging, even as sustainability reporting becomes mandatory. Therefore, it is quite possible that SLDs, like credit derivatives, may snap their linkage with an underlying loan or bond and start trading completely indpependently.

Origin and development of the SLD market

It is commonly believed that the first SLD IRS transaction was done in August 2019 between a company called Single Buoy Moorings Offshore and ING to hedge the interest rate risk of SBM’s $1 billion, five-year floating rate revolving credit facility[3].

The market is entirely OTC and therefore, other than the sporadic reporting of transactions on newspieces, it is not possible to get organised data of transactions. In ISDA document of January 2021 listed details of some 11 transactions which were regarded by ISDA as SLDs, including both IRS and FX derivatives. Obviously, this information is 3 years old. ISDA has been doing spear header work in the field – it has recently [17^th Jan., 2024] compiled a Library of clauses for SLDs.

It is also contended that in 2018, there was a sustainability linked FX hedge transaction structured by BNP Paribas, with Siemens Gamesa (SG), wherein SG was required to attain some KPIs, and if the KPIs are met, BNP will reinvest the premium into reforestation projects.

The typical KPIs

As in case of all ESG-linked debt instruments, SLDs can have KPIs related to one or more of the ESG parameters. The KPIs induce behaviour that positively affects the environment, and curb or penalise behaviour  that negatively affects the environment. The KPIs may also be linked with the counterparty’s performance under some objectively measurable internationally agreed ESG targets. Alternatively, the KPIs may be linked with ESG ratings by recognised rating agencies[4].

ISDA survey of November 2022 shows that greenhouse gas emissions is the most common KPI.

In September,2021, ISDA issued guidelines for KPIs, which recommended that the KPIs should have the following features:

• Specific – clearly spelt out in the documentation, so as to avoid any dispute as to what the same were.
• Measurable – should be quantifiable, measurable and within the control of the entity to achieve.
• Verifiable – It should be possible to verify whether the entity has met the KPIs or not, at the specified time frame.
• Transparent – the documentation should be specify the requirement for information disclosure regarding the KPIs being met or failed to be met by the counterparty.
• Suitable –to avoid greenwashing, it is suggested that the KPIs should be suitable to the counterparty’s business model.

Examples of some SLDs:

In March 2020, Siemens Gamesa entered into an IRS for $ 250 million, with HSBC, which has a provision for donation. If the buy-side entity fails to meet the KPIs, it will make a specified donation. Alternatively, HSBC will make the said donation payment.

Goodman Interlink was reported to have signed a “green IRS” in November 2020, which had a premium pricing for the fixed rate leg if certain green building certifications were obtained.

There are similar transactions in the forex derivatives space as well.

May 2021, Associated British Ports (ABP) entered into an IRS transaction with BNP Paribas, whereby the cost of the hedge will be reduced if ABP met its sustainability KPIs. The KPIs in this case were “significant reduction in its combined Scope 1 and Scope 2 emissions by 2030”. There has been a repack of this transaction with Aviva plc. A repack converts the derivative into an investment product by bringing in a special purpose vehicle. Thus, the SPV converts floating rate cashflows into fixed rate, and then issues securities with the cashflows so converted to investors. Thus, investors get the cashflows featuring the IRS offered by the SPV.

In March 2023, ING is reported to have closed an SLD with Chinese technology sector entity ANT group.

Given there is no reason for the SLD linkage to be restricted to IRS or FX derivatives only, there have also been commodity hedges which have SLD overlay. For example, in May 2021, Standard Chartered reported a commodity hedge for Trafigura that fixes premium linked to greenhouse gas emission targets.

Concluding thoughts: Is it an instrument that holds promise?

Corporate boardrooms will be under increasing pressure to define and achieve their environment quotient, and agreeing to pay a penalty for not meeting environment-related KPIs will only be apt for entities to answer to this increasing responsibility. Derivatives provide an easy way to make that commitment, instead of modifying loan or bond terms. Therefore, it is highly likely that introduction of standard templates for SLDs will make them easy to adopt and transact.

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[1] https://www.reuters.com/sustainability/sustainable-finance-reporting/loans-linked-esg-face-overhaul-by-under-pressure-banks-2023-11-10/

[2] The ISDA Survey of November, 2022 notes that 45 out of 69 respondents confessed that they did not know how the premiums were computed. https://www.isda.org/a/p7cgE/The-Way-Forward-for-Sustainability-linked-Derivatives.pdf

[3] https://www.ing.com/Newsroom/News/Introducing-the-worlds-first-sustainability-improvement-derivative.htm

[4] For an article on ESG rating providers, see here: https://vinodkothari.com/2023/04/regulating-esg-rating-providers-in-india/