Global: Sustainability-Linked Derivatives: ISDA’s case for standardization in a globalized world

By neub9
6 Min Read

On January 17, 2024, the International Swaps and Derivatives Association, Inc. (ISDA) introduced a new clause library for sustainability-linked derivatives (SLDs). This SLD Clause Library sets out template contractual terms and related definitions for SLD transactions to meet the increasing market demand for derivatives products linked to environmental, social, and governance (ESG) goals. This enhances the commercial viability of SLDs as an effective financial tool for sustainable initiatives.1

In this insight, we examine the nature and purpose of SLDs and how the SLD Clause Library could facilitate greater engagement and participation in SLD transactions.

SLDs Explained

An SLD is a derivative transaction with an ESG overlay, incorporating specific measures and targets in the form of Key Performance Indicators (KPIs). KPIs are integrated into contractual arrangements for SLD transactions to incentivize ESG performance and support the implementation of sustainable initiatives. Examples of KPIs include:2

  • A real-estate owner and developer generating business-to-business integration opportunities contributing to 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 organization.

SLDs are commonly 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 furnishes a framework for SLD transactions by providing standard definitions and provisions designed to be incorporated in a Confirmation for an SLD transaction, forming the basis of SLD transaction documentation. The SLD Clause Library deals with various 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 regularly
  • Consequences of “adverse sustainability events” and “declassification events”.

Regarding application, the SLD Clause Library focuses on Category 1 SLDs, while the terms could be equally applicable to Category 2 SLDs as well as two-way SLDs with some refinements.

Key Considerations for Market Participants

The SLD Clause Library is expected to become the base document for most SLD transactions, similar to the ISDA Master Agreement. SLDs can be customized through the use of different KPIs, requiring the general provisions in the SLD Clause Library to be adapted to the context of an individual transaction. Key points of consideration for market participants include:

  • Paying careful attention to the relevance and applicability of KPIs to the ESG goals underpinning the transaction
  • Regulatory compliance and mandatory trade or sustainability reporting requirements
  • Dispute resolution and consequences for failing to meet KPIs
  • The availability of review in cases of under/over-performance
  • Due diligence on the buyer by the sell-side counterparty
  • Strong accountability, governance, and financial processes for the buy-side counterparty 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 SLD trading volumes are currently smaller than more traditional ESG-related derivatives, there is a growing demand for SLDs in the global market as an alternative sustainable financing mechanism. The SLD Clause Library terms are intended for global use by market participants, not only as a set of standard terms but also 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, reflecting industry feedback and input.

With the need for significant increases in sustainable finance, innovative forms of finance play a crucial role. Alongside SLDs, the market is moving towards sustainability-linked loans, green bonds, and debt conversion. Our derivatives lawyers have unrivaled expertise to assist with SLD transactions for entities engaged in derivatives transactions with an ESG lens. Please reach out to the Baker McKenzie contacts or the key global contacts on our website for any questions.4

1 ISDA Launches Sustainability-Linked Derivatives Clause Library

2 ISDA, Overview of ESG-related Derivatives Products and Transactions, January 2021.

3 World’s Largest Debt Conversion for Marine Conservation

4 Derivatives & Financial Products

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