ESG-related derivatives products have a key role to play in helping companies meet their sustainability targets. One type of ESG derivatives that parties are increasingly looking to is SLDs.
For more information on SLDs and ESG derivatives more generally, please see our previous alerts:
What are SLDs?
SLDs create a sustainability-linked cashflow in the context of a conventional derivative, such as an interest rate swap or cross currency swap or forward. They do this by using Key Performance Indicators (KPIs) to monitor compliance with certain ESG targets. Although still a nascent market, different types of SLDs have emerged.
SLDs are typically tailored to counterparties’ particular needs, with bespoke KPIs or sustainable performance targets (SPTs) to meet their individual ESG requirements. Counterparties also may negotiate the different consequences of meeting the KPIs or SPTs. Accordingly, they are currently illiquid products tailored to specific circumstances. The same or different KPIs can apply to one or sometimes both counterparties and meeting a KPI could result in an increase or decrease in payments, payment of a rebate or fee, a margin or spread amount or payment to an agreed charity.
To date, SLDs have been structured as bilateral bespoke instruments so there is little public information available on their terms or format and no clear standard approach taken to documentation. Additionally, there is no common format on how KPIs should be developed. As a result, there have been some concerns that the KPIs are inconsistent and hard to verify and that the lack of widely accepted standards opens the door to greenwashing.
What is the ISDA SLD Clause Library?
Against this backdrop of a developing SLD market and strong interest from ISDA’s members in SLDs for some consistency of approach, ISDA has published the ISDA SLD Clause Library, which is a framework of standardised definitions and provisions that provide market participants with clauses with which to document their SLD transactions. There are standard form drafting options, including in relation to disruption and review events, adjusting the payment mechanics and assessing whether relevant ESG targets or SPTs have been met. In addition, it is possible to incorporate targets defined in related sustainability-linked cash instruments in order to minimise any basis risk between the SLD and related cash instrument.
The ISDA SLD Clause Library is not an ISDA Definitional booklet but a compendium of different drafting options that parties may wish to include in their OTC derivatives Confirmations depending on the nature of the transaction. Using these standardised clauses should therefore save on cost, negotiation time and provide some legal certainty.
However, as SLDs are typically bespoke transactions that parties structure according to their particular circumstances and sustainability targets, it will be important to assess which clauses and associated definitions from the ISDA SLD Clause Library might be appropriate for any given transaction. One benefit of the ISDA SLD Clause Library is that the clauses can be used as a starting point and then tailored to the specific needs of the counterparties. It will therefore be essential to work through any clauses used and related definitions or provisions that might also be appropriate. Careful drafting is also key to ensure that the KPIs are precisely defined and effective, so that it is clear whether or not a KPI has been met in order to avoid any disputes. Provided there is enough uptake by the market, using these standardised ISDA clauses should help provide certainty and clarity.
Although ISDA decided against producing standard clauses for the actual KPIs or ESG targets themselves, given the bespoke nature of SLDs, there is a “KPI Table”, which is a standard format that firms can use to set out their ESG-related KPIs as an annex to the Confirmation.
The ISDA SLD Clause Library is available on the ISDA MyLibrary platform. As the market develops and the changes are made to the ISDA SLD Clause Library over time, the ISDA SLD Clause Library will be updated and reversioned on the MyLibrary platform in a single consolidated form.
What types of SLDs are contemplated by the ISDA SLD Clause Library?
The ISDA SLD Clause Library is for use with SLDs where the KPIs and related impact on cashflows are embedded within the derivative transaction. The clauses could, though, be adapted for use with SLDs where the KPIs and related impact on cashflows are set out in a separate agreement that references the underlying derivatives although they do not specifically contemplate these types of SLDs so provisions would have to be amended accordingly. It should be noted that the ISDA SLD Clause Library is designed for one-way SLDs, where only one party is looking to achieve certain sustainability goals but, again, the clauses could be adapted for use in respect of two-way SLDs. When tailoring or adapting provisions from the ISDA SLD Clause Library, parties should take care that the correct elections are applied and any relevant definitions are also incorporated.
Although the ISDA SLD Clause Library is designed to be asset class agnostic, there is specific wording to amend the payment terms under the 2021 ISDA Interest Rate Derivatives Definitions and the 1998 FX and Currency Options Definitions given that that interest rate and FX derivatives are the typical types of derivatives used for SLDs.
How to approach using the ISDA SLD Clause Library?
Parties can incorporate relevant clauses from the ISDA SLD Clause Library by adding a new sustainability-linked provisions section to their Confirmation. In addition, any economic adjustment provisions such as to the fixed or floating amounts would need to be built into the existing provisions. It will be important to ensure that any defined terms used in the clauses that parties incorporate into their Confirmations are carried across to the Confirmation together with any related definitions. Consequently, it will be essential to track through the definitions and any related terms to ensure that they are tailored to the parties’ circumstances and that the Confirmation contains all the necessary terms. ISDA has included some helpful drafting notes, which provide some guidance as to which related definitions in respect of a particular provision might also need to be incorporated into the Confirmation.
For example, the concept of a “KPI Compliance Certificate” (which can be included as an annex to the Confirmation) links into many other concepts, including KPI targets and supporting documentation, delivery or failure to deliver such a certificate and associated delivery deadlines. The KPI Compliance Certificate could be produced by one of the parties or a third party (a KPI Verification Agent) and there are related definitions for the period of time during which the KPI is observed to have been satisfied or not.
What other issues should parties think about?
ISDA understands that counterparties, on the whole, will use third party verifiers for these types of transactions. Care will need to be taken when selecting a third party verifier given that currently, as IOSCO noted in its report published in 2021, there is a lack of transparency and regulatory oversight with regards to the methodologies they use. Parties may wish to consider how events affecting the third party verifier may impact the SLD, including the impact of a third party verifier default or insolvency or where its methodology changes and how any fees will be payable.
Other points to consider include confidentiality and whether the existence of the SLD should be permitted to be publicly disclosed.
When entering into an SLD with a related sustainability bond or loan, care will need to be taken to ensure that the relevant provisions of the bond or loan are accurately set out in the Confirmation for the SLD.
What regulatory considerations might apply?
As with any derivative product, parties should ensure that they comply with applicable regulatory requirements, including in relation to reporting, risk mitigation, disclosure and conflicts of interest. Depending on the type of SLD you are contemplating, EU or UK EMIR may apply so you will need to agree with your counterparty whether any cashflows linked to the KPIs should be taken into account for the purposes of any margin calls.
In addition, parties should check whether any wider ESG regulatory measures might apply. In the UK, for example, SLDs may fall within the Financial Conduct Authority’s (FCA) new anti-greenwashing rule, as currently set out in its Guidance Consultation in November 20231
What does this mean for structured products?
It is interesting to consider the extent to which these clauses or concepts might feed through to sustainability-linked structured products and, if so, whether these clauses might influence the drafting of legal documentation, including the development of disclosure standards on bespoke sustainability-linked structured products.
In order for liquidity in the SLD market to develop, there is further work to do in the market around standardisation and also in relation to how compliance can be monitored on an on-going basis. It will be beneficial to the market if regulators work together to ensure that standards are consistently applied on a global basis across products. ISDA has a key role to play in fostering this global cooperation.
Final Thoughts
Derivatives are an important component of the market’s continued, and accelerating, transition to sustainable finance. The publication of the ISDA SLD Clause Library should not only provide some useful drafting guidance to parties for SLD transactions but, over time, these standard clauses, if taken up by the market, should foster transparency and help develop liquidity.
This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.
Authored by Jennifer O'Connell and Isobel Wright.
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