Sustainability-linked derivatives markets primed for growth

Following in the footsteps of their cousins in the loan and bond markets, derivatives are the latest financial product to receive the ‘sustainability-linked’ treatment. But while the market looks set for rapid growth, ensuring market integrity remains a key concern.

Mirroring the structure of a sustainability-linked loan (SLL) or sustainability-linked bond (SLB), the rate or sum paid by a borrower in a sustainability-linked derivative (SLD) is aligned to key performance indicators (KPIs). Each KPI relates to a sustainability objective, such as a stated reduction in carbon dioxide emissions. If the borrower fails to meet its target, it will pay a higher rate.

Nascent but growing

It is still early days for this market. The first derivative of this kind was the ‘sustainability improvement derivative’, structured by ING in August 2019 to hedge interest rate risk on a revolving credit facility for offshore energy firm SBM. Similar interest-rate hedging derivatives, as well as several sustainability-linked foreign exchange derivatives, have since been structured by multiple banks. So far, most of these deals have been in Europe, but there have also been some in the US and Asia-Pacific. For instance, in August, ANZ launched SLDs in Australia, Hong Kong, Japan and Singapore.

For their supporters, one of the main benefits of sustainability-linked products is their flexibility. Unlike with ‘green’ or ‘social’ products, sustainability-linked products do not restrict issuers to only spending proceeds on green or social projects. While SLBs, SLLs and SLDs include links to specific sustainability targets, the borrower has the freedom to choose what it spends funds on. This greater versatility can make such structures more appealing as general financing tools, and potentially opens this area of the market to a wider range of companies. To their detractors, however, this crucial difference can make sustainability-linked structures less robust and creates ‘greenwashing’ risk.

The right KPIs

There have also been concerns (also raised in the SLB and SLL markets) that the financial ‘penalty’ or ‘bonus’ for missing or hitting targets is often not large enough to act as a real incentive for firms to change their behaviour.

Bankers engaged in this area are keen to stress the wider benefits that can be achieved through corporates using SLDs. They say the most important consideration is the KPIs that are set, and the opportunity this creates for a discussion with a business about its broader sustainability strategy.

Isabelle Millat, head of sustainability, global markets at Société Générale, says: “We are really looking to improve, via setting up the derivative, the sustainability strategy or targets of corporate clients. We will discuss the financial penalty or bonus with them, but the heart of the matter is really whether the indicators are meaningful. Is the indicator relevant to the client’s line of business? Are we setting targets that are reachable, but ambitious? And are the indicators backed by international standards as much as possible? That is the main back-and-forth.”

This is a view echoed by Bernard Coopman, head of client solutions group at ING. “The financial incentive is a nice to have, but it is not going to change the overall profitability of a company at the end of the year,” he says. “What is of more importance is that the company or other entity is openly making a commitment on these issues and having a contractual incentive, together with the financial party that is supporting them. Putting these issues down in black and white, in a contract, is a real incentive because you are communicating to the wider market, and expectations and pressure are created from that.”

Ensuring credibility

Mr Coopman also accepts that ensuring these markets are developing in a credible manner in a broader sense is imperative, and something that market participants across the sector have a responsibility for.

In September 2021, ING published a position paper outlining its views on ensuring credibility in the sustainability-linked finance markets. It primarily references the SLL and SLB markets, but Mr Coopman says the points it raises are just as relevant for SLDs.

Areas of concern it highlights include the importance of companies setting sustainability strategies — and targets linked to them — that address their most material sustainability risks, that are ambitious in scope and that promote immediate rather than delayed actions. “ING is concerned about the credibility of this market, given the enormous growth of the market for sustainability-linked financial products and their potential for helping to make the real economy more sustainable,” it reads.

“Sustainability KPIs must address a company’s material sustainability issues; sustainability targets must be ambitious and based on best efforts, and wherever possible verified by a reputable, independent party; sustainability strategies must tackle the most difficult problems first.”

Greater standardisation

The importance of setting meaningful KPIs is also stressed in KPI guidelines published by the International Swaps and Derivatives Association (Isda) in September 2021. Isda’s ‘Sustainability-linked derivatives: KPI guidelines’ document states that “to ensure the KPIs chosen are credible, counterparties should ensure they are specific, measurable, verifiable, transparent and suitable.” The document also provides guidance on addressing each of these points.

Bella Rozenberg, senior counsel and head of regulatory and legal practice group at Isda, says the KPI paper “was a first attempt to create a framework and gather information about how firms have been approaching KPIs, and it also laid out an initial foundation for what KPIs should look like”. 

She highlights the importance of bringing some level of standardisation to these markets for them to become scalable, although also flags the tension between greater standardisation and maintaining flexibility. “On the one hand, you have this very nascent market, where people are creating tailored products for particular projects, with specific KPIs linked to that,” she says. “But on the other hand, there is a need to standardise, otherwise it will remain an illiquid market.”

This is an evolving area, and Isda is currently engaging with the market to better understand if there is a desire and need for more formalised guidance. “If there is an appetite for creating a more substantive KPI framework, Isda is ready for that next step,” says Ms Rozenberg. “We are currently assessing market development and market views on this.”

Building on the bond and loan markets

There have been some benefits for the SLD markets in not having to completely start from scratch. Ms Millat suggests that SLD markets have been able to build on what has already been achieved in the loan and bond markets, in relation to issues such as standards for KPIs. “It is a positive that these products have been called SLDs, consistent with the loan and bond markets,” says Ms Millat. Indeed, Isda’s guidelines stress similar points to the SLL principles and SLB principles.

The risk of greenwashing if KPIs are not set with a rigorous enough approach is evident, and bankers accept they have an important role here. Ms Millat says that they do sometimes need to have challenging conversations with clients to ensure that KPIs are stretching enough. She also says the bank will self-censor and there are “certain industries or geographies where we know they are not mature enough in terms of their transition journey and this kind of solution, at this stage, would not be appropriate”.

The right penalty or reward structure

Another area of growing debate is likely to focus on how the premium or discount for missing/hitting is structured. In its position paper ING suggests it is not in favour of donating the premium/discount to charity — a practice used in some deals — as it potentially muddies the waters about how such structures should work, creates challenges around transparency (as the donations are not included in reporting) and also creates a misalignment between the credit risk taken on by the bank counterparty and the payment structure. Other market participants may suggest such a structure reduces the risk of a banking counterparty from ‘profiting’ from a company failing to meet its sustainability targets.

Ms Rozenberg accepts this is a tricky issue, but suggests that other issues, such as creating the right targets, are more pressing in the short term. “Before we get to penalties, I think it’s important to focus on what the payment structure looks like and what the achievement of targets looks like,” she notes.

Regulatory concerns

Other considerations for market participants include how the structuring of a SLD can potentially impact its regulatory treatment, with Isda publishing a paper in December 2021 on regulatory considerations for this market.

“It was an opportunity to look closely at these contracts and see how they operate and fit within current regulatory frameworks,” says Ms Rozenberg, although she stresses this was an initial look at this nascent market. “These contracts are very individual, so it can be difficult to come to broad conclusions.”

It highlights the example of an SLD where a KPI — and the cashflow impact of hitting the KPI or not — is embedded within a derivatives contract; there is a significant possibility of this falling under regulations governing derivatives in the US, EU and UK. This contrasts with a structure where there is an underlying ‘vanilla’ derivative contract and then a separate contract relating to the KPI and cashflow impact, which references the original transaction agreement, where the regulatory treatment is less clear cut.

Deborah North, a partner at Allen & Overy in New York who specialises in derivatives and structured finance transactions, worked on the paper on behalf of Isda. She says that the paper does not raise problems as such, but does include some considerations for market participants to bear in mind, as well as “providing insight for regulators around what is happening in this developing area of the market”. She adds that “for market participants considering these products, I think it's very important that your institution takes a thoughtful approach, for instance on practical issues around how are you going to evaluate the impact on margin requirements and valuation, bearing in mind potential impacts on the cashflow, and adapting internal risk models.”

A greater level of regulatory engagement in these markets seems likely in the coming years.

Speaking about both of the recent Isda papers, Ms Rozenberg says: “The goal here was to make market participants and regulators aware of these of products. And also to demonstrate if you’re thinking about achieving zero emissions and the transition to a greener economy, derivatives can play an important role. These products retain a hedging function, but also help to achieve sustainability goals.”

Growth prospects

Although only a relatively small number of deals of this type have been completed so far, market participants expect that we could see a similar surge in SLD activity, based on the rapid pace of growth within the loan and bond markets.

“It is already accelerating. It is my personal belief that there will be a similar curve evolution that we have seen also within SLLs and SLBs,” says Mr Coopman. “Ten years ago, this was a niche area; now, if you are a large corporate, it is more unusual if you don’t have a sustainability-linked revolving credit facility. That is the strength of this trend, and I think the same could start to apply to the derivatives markets.”

Ms Millat is also optimistic, noting that the market has begun to evolve. “Initially, these derivatives were pitched together with a loan or bond, and would ‘piggyback’ on the sustainability targets of those products. But they are now also happening on a standalone basis,” she says. “And this is interesting because, in some cases, these derivatives are now prompting that wider transition strategy discussion.”