On 17 January 2024, the International Swaps and Derivatives Association, Inc. (ISDA) launched a new clause library – this time for sustainability-linked derivatives (SLDs) – that sets out template contractual terms and related definitions for SLD transactions ("SLD Clause Library").1 The SLD Clause Library introduces standardised provisions for SLDs to meet the growing market demand for derivatives products that are linked to environmental, social and governance (ESG) goals, enhancing the commercially viability of SLDs as an effective financial tool to facilitate the delivery of sustainable initiatives.
In this insight, we examine the nature and purpose SLDs and how the SLD Clause Library could facilitate increased engagement and participation in SLD transactions.
An SLD is a derivative transaction with an ESG overlay, taking into account specific measures and targets in the form of Key Performance Indicators (KPIs). KPIs are built into contractual arrangements for SLD transactions to incentivise ESG performance and facilitate the implementation of sustainable initiatives. Examples of KPIs include:2
- A real-estate owner and developer successfully generating business-to-business integration opportunities that contribute to the United Nations Sustainable Development Goals
- A global logistics property group obtaining and maintaining green certification of buildings
- An Italian power and gas company increasing installed renewable electricity generation capacity.
For achieving KPIs and performing against ESG targets, there will be a consequence for a counterparty (generally on the buy-side). For example, if the relevant KPI target is met by a party, that party benefits from a positive cashflow adjustment or a donation is made to an agreed ESG-related charitable organisation.
SLDs are usually linked to another underlying derivatives transaction, typically an interest rate swap or FX derivatives, although this is not always the case.
Provisions of the SLD Clause Library
The SLD Clause Library provides a framework for SLD transactions by setting out standard definitions and provisions designed to be incorporated in a Confirmation for an SLD transaction, and form the base of SLD transaction documentation. The SLD Clause Library deals with a range of key provisions, including:
- Assessment of KPIs during a specified KPI observation period, and verification of KPIs by a third-party verification agent
- Requirements for compliance certification
- Consequences for meeting and failing to meet specified sustainability consequence triggers
- Mechanisms to review and update KPIs on a regular basis
- Consequences of "adverse sustainability events" and "declassification events".
In terms of application, the SLD Clause Library focuses on Category 1 SLDs (that is, SLDs where KPIs and the corresponding impacts on cash flow in the transaction are explicitly included within the SLD agreement). The terms could be equally applicable - with some finessing - to Category 2 SLDs (where KPIs and the corresponding impacts on cash flow are set out in a separate agreement referable to the SLD agreement) as well as two-way SLDs where both counterparties may receive benefits under the agreement for performance against ESG targets.
Key considerations for market participants
The SLD Clause Library is widely expected to become similar to the ISDA Master Agreement the base document for most SLD transactions.
SLDs will be customisable through the use of different KPIs, meaning that the general provisions in the SLD Clause Library will need to be adapted to the context of an individual transaction. There are a number of elections that parties can make in order to reflect their preferred approach. Key points of consideration for market participants include:
- Paying careful attention to the KPIs and whether they are relevant and applicable to the context and ESG goals underpinning the transaction (such as the entity's overarching ESG strategy)
- Regulatory compliance, including whether any mandatory trade or sustainability reporting requirements would apply
- Dispute resolution and consequences for failing to meet KPIs
- The availability of review in cases of under/over-performance
- As a sell-side counterparty, due diligence on the buyer to better understand the buyer's ability to service and meet the KPIs
- As a buy-side counterparty, strong accountability, governance and financial processes to facilitate the meeting of KPIs.
Market participants may also need to consider a range of commercial, operational, regulatory and legal issues relevant to their individual circumstances.
Role of the SLD Clause Library
While at the time of writing, SLD trading volumes are much smaller than more traditional ESG-related derivatives, such as those involving the sale and purchase of carbon credits, there is a growing demand for SLDs in the global market as an alternative sustainable financing mechanism. This is representative of a broader shift in the market to redirect financial flows towards initiatives geared towards addressing ESG issues such as the climate and biodiversity crises.
The SLD Clause Library terms are intended to be used by market participants globally, not only as a set of standard terms but as a means of documenting bespoke transactions. The standard terms in the SLD Clause Library are likely to bring about important consensus, and foster growth, in this market. As with other ISDA documents, such as the recently released Verified Carbon Credit Definitions, they reflect industry input and are likely to be subject to regular review by ISDA to reflect industry feedback.
With significant increases in sustainable finance needed, innovative forms of finance have a crucial role to play. Alongside SLDs, we are seeing the market move towards sustainability-linked loans, green bonds, and debt conversion. One example that we have advised on is the debt-for-nature swap involving the exchange of Ecuador's sovereign bonds for a loan made from the proceeds of a marine conservation-linked loan to direct finance flows towards marine conservation in the Galápagos Islands.3
Our derivatives lawyers operate as a single team across our global network, with a long-standing history of advising on derivatives transactions and sustainable finance. We are currently engaged on multiple levels advising entities on derivatives transactions with an ESG lens and have unrivalled expertise to assist with SLD transactions. Please reach out to the Baker McKenzie contacts above or the key global contacts on our website should you have any questions.4
2 ISDA, Overview of ESG-related Derivatives Products and Transactions, January 2021.