Sustainability-linked derivatives markets primed for growth
Derivatives with sustainability targets attached to them are becoming more common, but are they really an effective tool for improving a company’s sustainability? Marie Kemplay reports on structuring and regulatory considerations
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), with a sustainability-linked derivative (SLD) the rate or sum paid by a borrower, for instance as part of an interest rate swap, is linked to key performance indicators (KPIs). Each KPI relates to a sustainability objective, for example a stated reduction in carbon dioxide emissions. If the borrower fails to meet its target then it will pay a higher rate.
It is still early days for this market, the first derivative of this kind being a “sustainability improvement derivative” structured by ING in August 2019, to hedge interest rate risk on a revolving credit facility for offshore energy company SBM. However, it is growing. Similar interest-rate hedging derivatives, as well as a number of sustainability-linked foreign exchange derivatives, have since been structured by multiple banks, with examples in Europe, the US and Asia.
Freedom and flexibility
For their supporters, one of the main benefits of sustainability-linked products is their flexibility. Unlike with 'green' or 'social' labelled products (like green bonds), sustainability-linked products do not restrict issuers to only spending proceeds on green or social projects. While sustainability-linked bonds, loans or derivatives 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 up 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.
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 companies to change their behaviour.
Bankers engaged in this area are keen to stress the wider benefits that can be achieved through corporates using sustainability-linked derivatives. They say the most important consideration is actually the KPIs that are set, and the opportunity it creates to have 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.”
He 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.
Areas of concern
ING, in September 2021, published a position paper outlining its views on ensuring credibility in the sustainability-linked finance markets. The publication primarily references the SLL and SLB markets, but 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 says, with a later passage adding: “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.”
The importance of setting meaningful KPIs is also stressed in KPI guidelines published by the International Swaps and Derivatives Association in September 2021. ISDA’s Sustainability-linked Derivatives: KPI Guidelines state that “to ensure the KPIs chosen are credible, counterparties should ensure they are specific, measurable, verifiable, transparent and suitable,” and provides guidance on addressing each of these points.
Millat suggests the SLD markets have been able to build on what has already been achieved in the loan and bond markets in relation to these issues. “It is a positive that these products have been called sustainability-linked derivatives, consistent with the loan and bond markets,” she says. Indeed, ISDA’s guidelines stress many of the same points as the Sustainability-Linked Loan Principles and Sustainability-Linked Bond Principles.
The risk of greenwashing if KPIs are not set with a rigorous enough approach is evident, and banks structuring those products accept they have an important role here. Millat says they do sometimes need to have challenging conversations with clients to ensure 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”.
Other considerations for market participants include how the structuring of an SLD can potentially impact its regulatory treatment, with ISDA recently publishing a paper in December 2021 on regulatory considerations for this market. It highlights how an SLD where a KPI, and the cash flow impact of hitting the KPI or not, are embedded within a derivatives contract, is likely to fall under regulations governing derivatives in the US, EU and UK. This is contrasted with a structure where there is an underlying “vanilla” derivative contract and then a separate contract relating to the KPI and cash flow impact, which references the original transaction agreement, where the regulatory treatment is less clear cut.
A thoughtful approach
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 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: “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 cash flow, and adapting internal risk models.”
Although only a relatively small number of deals of this type have been completed so far, based on the rapid pace of growth within the loan and bond markets market participants expect that we could see a similar surge in SLD activity.
“It is already accelerating. And it is my personal belief that there will be a similar curve evolution that we have seen also within sustainability-linked loans and sustainability-linked bonds,” says Coopman. “10 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.”
Millat is also optimistic, and already notes 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.”