Climate change has recently received increased global attention, which is reflected in the financial markets. By some estimates, the sustainable finance market has grown by nearly 30% in 2020. Derivatives linked to environmental, social and governance ("ESG") objectives have been around for several years, but this previously niche market is growing rapidly, reinforcing the idea that derivatives have a key role to play in advancing ESG objectives in the financial markets and the global transition to a green economy.
In January, ISDA published an "Overview of ESG-related Derivatives Products and Transactions". This document provided ISDA members with an overview of the global universe of ESG-related derivatives, including details on some of the sustainability-related derivatives traded before... 2021.
Sustainability-linked derivatives are derivatives that create an ESG-related cash flow in the context of a traditional derivative instrument (such as an increase in spread related to the non-achievement of an ESG objective).
Unlike other ESG financial products, the use of proceeds from a Sustainability-Linked Derivative are generally not controlled (although counterparties can sometimes agree that any spread increase paid due to non-achievement of an ESG objective will be applied to a sustainable objective).
Sustainability-Linked Derivatives KPIs
One of the biggest challenges for market participants is to ensure that the documentation of their ESG products accurately reflects the key performance indicators ("KPIs") against which ESG objectives are measured.
KPIs are used in sustainability-related derivatives to monitor compliance with the relevant ESG criterion - for example, a KPI might be the amount of greenhouse gases emitted by a counterparty over a defined period of time or the percentage of a counterparty's energy that is produced by sustainable sources. KPIs are therefore a bespoke but crucial element of any sustainability-related derivative.
ISDA recently published a new document entitled "Sustainability-linked Derivatives KPI Guidelines".
With the growth of sustainable investing, there is a growing demand for derivatives that are specifically linked to ESG objectives, and that link returns to sustainability performance and impact. These sustainability-related derivatives typically rely on conventional hedging products (such as currency swaps or futures) with an ESG pricing component added, creating highly customizable transactions using various key performance indicators to set sustainability goals.