Sustainability-Linked Derivatives

In our previous articles, we have discussed different sustainable assets classes and explored green bonds and their implications in more detail. To further expand this portfolio of different sustainable assets that investors can invest in, this week’s article will concern sustainability-linked derivatives (SLD).

In today’s markets, there is a plethora of financial assets, derivatives, and funds with restricted investment strategies to choose from. As sustainability is becoming a mainstream concern, the return on these asset classes is becoming increasingly more profitable and a viable investment strategy.

Similarly to sustainability-linked loans (SLLs) or sustainability-linked bonds (SLBs), such as green bonds, sustainability-linked derivatives (SLDs) link the performance of the financial asset to a specific key performance indicator (KPI). The selected KPI relates to a sustainability objective which lays within the normal course of business of a company and a specific target that it wants to reach.

In contrary to “traditional” ESG financial products, SLBs are not contractually obliged to target the inflow of funds towards sustainable development. In contrary to green bonds, where the issuer outputs a principal and coupon payments for the purpose of investing the income into sustainable projects, SLDs are taken on by companies that want to expand their impact. The company takes on a loan from, for example, a bank and agrees to link the interest payments on this loan to certain sustainability linked KPIs, such as CO2 emissions. The lender can utilize the principal as it wishes, but if it does not follow its targeted KPIs, this loan will become more expensive. It is thus an incentive for both parties involved to invest into sustainable projects that will assist in reaching the predetermined targets.

Now, as there is so much liberty in these contracts, some companies might be able to take advantage of these derivatives. This means that the issuer is open to reinvest the income in virtually any project they see as profitable, even if it does not follow the targets of the selected KPIs. This can be problematic, as these types of investments would thus not create any real impact. In some contracts, the counterparties thus agree that if the goals are not met, any income resulting from the failure of meeting ESG targets will invested into reaching this goal. This is an additional incentive for the borrower to perform well. However, as these assets are still commonly traded over the counter, there are no standardized contracts, and this depends solely on the two trading parties.

SLBs are very new to the market. The first of its kind was structured by ING in 2019, but has seen a developed interest in the following years. Multiple banks in the USA, Asia and Europe have issued similar products since. To create standardized products, some global derivative exchanges have also “launched a series of new equity index futures and options contracts tied to ESG benchmarks.” (May & Rutter, 2021)

Of course, taking on these types on contracts is done on the free will of companies. It is purely done to create positive impacts and give concrete targets and assurance to stakeholders that the company is ready to become more sustainable. To create incentives for companies to take on these types of derivatives, there should also be a possible upside to them. SLDs can lead to two possible advantages, explained in the two following examples:

Hedging against fluctuating interest rates

In Janurary 2020, the Italian rail operator Italo – Nuovo Transporto Viaggiatori took on a €1.1 Billion SLL, with €900 million committed to refinancing the company’s low-carbon rolling stock. To hedge itself against fluctuating interest rates on the refinancing of this debt, the SLL offered a good alternative, as long as it manages to stay within the ESG targets it has set out. The creates a monetary incentive for the rail operator to develop a more sustainable business model, while at the same time profiting from lower interests. This should thus lead to an overall win-win situation.

Hedging against fluctuating foreign exchange rates

In September 2019, the Italian gas and power company Enel took on a €1.5 Billion sustainability-liked cross-currency swap to hedge itself against fluctuating interest and exchange rates risks. The underwriter, Société Générale, issued a currency swap at a discounted rate, with the condition that Enel would commit to rising its renewable electricity generation capabilities from 45.9% to 55% by the end of the year. In case this target was not reached, the interest rates on the loan would rise, creating an incentive to stick to this target.

To conclude, the market for sustainable assets continue to grow and companies willing to create an impact can choose between different derivates to help with their development. By linking financial incentives to sustainability-linked KPIs, any company that takes on a SLD is rewarded for the effort it makes. For this system to function properly, it is also important that the KPIs are selected appropriately and lead to actual impact. Standardization of these assets would further help with this development, and it is thus in many stakeholders’ interest that they continue to be issued.

Sources

Harrison, A. (2021, October 21). ESG Derivatives: A Sustainable Trend | Perspectives & Events | Mayer Brown. Mayer Brown. https://www.mayerbrown.com/en/perspectives-events/blogs/2021/10/esg-derivatives-a-sustainable-trend

ISDA. (2021a, December). Regulatory Considerations for Sustainability-linked Derivatives. https://www.isda.org/a/58ngE/Regulatory-Considerations-for-Sustainability-linked-Derivatives.pdf

ISDA. (2021b, December 1). Regulatory Considerations for Sustainability-Linked Derivatives – International Swaps and Derivatives Association. https://www.isda.org/2021/12/01/regulatory-considerations-for-sustainability-linked-derivatives/

May, N., & Rutter, N. (2021, March 11). Sustainability linked derivatives. Herbert Smith Freehills | Global Law Firm. https://www.herbertsmithfreehills.com/latest-thinking/sustainability-linked-derivatives

Pavoni, S. (2022, January 13). Sustainability-linked derivatives markets primed for growth. Sustainable Views. https://www.esg-specialist.com/sustainability-linked-derivatives-markets-primed-for-growth/