ESG in Corporate Treasuries

   2. ESG-linked Derivative Instruments



Author: Federico Bellanti

March 20, 2024

Understanding ESG-compliant derivatives

ESG-linked derivatives (“SLDs”: Sustainability Linked Derivatives) are structured financial instruments whose terms and performance are directly linked to the achievement of a company's ESG objectives.

Like any other derivative, they allow businesses to hedge against various market risks, including interest rates, currency fluctuations and commodity prices, but do so in a manner consistent with the company's sustainability commitments.

The unique feature of these derivatives is that their costs, benefits and structures are influenced by the achievement of the company's predefined ESG targets.


Let's see some examples that show us what form they can take:


  • ESG-Linked Interest Rate Swaps: An interest rate swap is a contract in which two parties exchange future interest payments on a principal amount. In an ESG-linked swap, the interest rate that a company pays or receives can vary depending on whether it achieves, or fails to achieve, predetermined ESG targets clearly identified in the swap agreement itself. In the event of failure to achieve the objectives, the additional cost paid by the company will normally be donated to social or charitable initiatives, according to the methods also pre-established in the contract.
  • Sustainability-linked FX Forwards: A sustainability-linked FX forward might adjust the exchange rate based on ESG performance, such as improvements in employee diversity metrics or reductions in supply chain carbon intensity or any other metric, providing an additional incentive to achieve these objectives.
  • Commodity Derivatives with ESG KPIs: companies exposed to the volatility of raw material prices often use derivatives to hedge this risk during their normal course of operations. ESG-compliant commodity derivatives could link the terms of the hedge to sustainable agricultural practices, ethical sourcing or reduction of environmental impacts related to the production or consumption of the commodities themselves. For example, a coffee producer might enter into a derivative contract that offers more favorable terms as the proportion of sustainably sourced beans increases.

Incorporating ESG KPIs into Derivative Documentation

The careful selection of the KPIs to be taken as reference for the negotiation of derivative contracts is essential. These must be KPIs that are relevant, measurable and directly linked to the company's sustainability objectives. Let's see some examples:


  • Carbon Emissions: a very common KPI is directly linked to the reduction of greenhouse gas emissions. A derivative could include terms that modify its payout at maturity based on the company's success in reducing or containing its CO2 emissions within a predetermined time frame.
  • Use of Renewable Energy: For companies that aim to increase the weight of renewable energy in their consumption, a derivative could link financial terms to the percentage of energy consumption coming from renewable sources.
  • Diversity and Inclusion: Social criteria also play an important role. A derivative could offer better terms as the company reaches certain milestones related to workforce diversity, such as gender parity in leadership positions.
  • Sustainable Supply Chain Management: For businesses with long supply chains, KPIs could focus on the percentage of suppliers who meet certified environmental or social standards.

The Role of the ISDA (International Swap Dealer Association)


Integrating sustainability KPIs into derivatives documentation requires major standardization efforts in documentation. A pivotal development occurred on 17 January 2024, when the International Swaps and Derivatives Association, Inc. (ISDA) unveiled a novel clause library specifically designed for sustainability-linked derivatives (SLDs).

This SLD Clause Library offers a set of contractual terms and definitions specifically designed for “sustainable” transactions, introducing standardized definitions to meet the growing demand for derivatives that align with ESG objectives.


This initiative significantly increases the commercial viability of SLDs, positioning them as an effective financial mechanism to promote sustainable initiatives. The standardization of definitions and terms is fundamental to guarantee transparency in negotiations and avoid those abusive behaviors that can easily overflow into "greenwashing": the ISDA's work in creating a solid framework of clauses for ESG-related derivatives marks a critical step in the standardization and expansion of sustainable financial instruments, facilitating clearer and more uniform approaches to the incorporation of ESG KPIs into derivative contracts.


Both parties in the derivative contract will need to agree on the KPIs verification process, which may involve third-party audit or certification functions: transparency and reporting are crucial to ensuring the credibility of ESG-related derivatives. Companies must provide clear and consistent disclosures about their ESG objectives, the structure of their ESG-compliant derivatives, and progress towards achieving their objectives.

Link:  https://www.isda.org/2024/01/17/isda-launches-sustainability-linked-derivatives-clause-library/

Some recent examples

Also the International Swap Dealer Association (ISDA) has published a very useful research in which it lists a whole series of SDL operations carried out in recent times.


The document dates back to 2021, so we do not have more recent data, but reading it is still very interesting as it gives us a sense of how adaptable these tools are to the specific targets that companies want to take as a reference.

The document, which is free to consult, can be found at the following link:

https://www.isda.org/2021/01/11/overview-of-esg-related-derivatives-products-and-transactions/


And it's not just private companies that use SDLs: in 2022 in New Zealand, the New Zealand's Auckland Council was the first public sector entity to enter into an ESG-related (interest rate) derivative, and in particular to achieve three sustainability objectives linked to its strategic sustainability plan known as Auckland Plan 2050


Formal aspects and regulatory implications of SLDs

But are ESG-Linked derivatives real derivative products?


It's clear that they are. The question, however, introduces an aspect that should not be underestimated, as the deal is structured could attract different regulatory consequences in different jurisdictions.


The ISDA has identified two macro-categories of ESG-linked derivatives (SLD):


  • SLD Category 1: in which the KPIs and Targets, together with the other aspects associated with them, form an integral part of the documentation of the traditional component of the derivative
  • SLD Category 2: in which the KPIs, Targets and everything associated with them are part of an entirely separate document.


Without going into an excessive level of detail, suffice it to mention that in some jurisdictions doubts have been raised regarding their treatability as derivatives (and therefore eligibility to be captured by an ISDA Master Agreement for the purposes of netting, for example).



Regulatory implications: are there any?


Then there are regulatory issues that are by no means secondary to consider when trading these relatively innovative instruments, which are not yet fully transposed into the regulations governing derivative products.


ESG-linked derivatives are not very easy to price in Mark-to-Market terms: a company that wants to add ESG characteristics to a traditional hedging derivative may have to deal with greater complexity in the Portfolio Reconciliation (EMIR) phase, calculation of collateral margins. Nothing impossible, obviously, but it is good to be prepared to have to carry out some more work in the post-trade phases.


Furthermore, it is necessary to analyze how the ESG components of payments will be managed, to assess any regulatory and accounting consequences.

For example, when payment components linked to ESG are added to a derivative created with hedging purposes, it will be necessary to ensure that the nature of the hedging instrument is not lost, which would attract very significant consequences from an accounting point of view, but also for EMIR purposes (in relation to the exclusion of hedging derivatives for NFCs when verifying the clearing thresholds).


In some jurisdictions, participants in ESG-Linked derivative transactions may have to comply with precise rules and specific anti-greenwashing regulations: this is the case of Hong Kong, for example.



A look at the future of SLD


ESG-compliant derivatives represent a significant innovation in the field of sustainable finance, offering companies a tool to deeply incorporate ESG principles into their financial and risk management strategies.

By linking financial instruments to specific, measurable ESG outcomes, companies can incentivize and accelerate progress towards sustainability goals.


As the market for these tools grows, we can expect to see more sophisticated and more diverse products emerge, further integrating the worlds of finance and sustainability.


However, the success of these tools will ultimately depend on the development of robust, transparent and universally accepted standards for measuring and reporting ESG performance, with frameworks like the ISDA's SLD Clause Library leading the way in facilitating this integration.

Share by: