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Green Derivatives may be Ripe for Standardisation

Increasing interest in sustainability-linked derivatives prompts ISDA to consider standardising terms of instruments to support green transition.

The International Swaps and Derivatives Association (ISDA) is mulling whether to create standardised definitions for use in documentation for sustainability-linked derivatives (SLDs).

SLDs embed or create a sustainability-linked cashflow using KPIs designed to monitor an entity’s compliance with ESG targets. “In simple terms, they are typical derivatives transactions with an ESG add-on that affects payment flows,” ISDA said.

Since the first SLD was executed in August 2019, an increasing number of market participants have expressed an interest in transacting these derivatives, which ISDA said “have the potential to contribute to the green transition”.

ISDA has already published several SLD papers, including one that sets out best practices for drafting KPIs to ensure legal certainty and enforceability. It has also examined the regulatory treatment of SLDs under the derivatives regulatory regimes of key jurisdictions including Hong Kong and Japan.

The association said its papers to date have generated interest among its membership for the development of certain standardised terms and contractual provisions related to SLDs to improve trading efficiency.

Suitable for standardisation

In a new paper, ISDA provided an assessment of the current state of SLD documentation based on information from members engaging in SLD transactions.

The survey found that firms are currently using the existing ISDA documentation structure and ISDA definitions to incorporate SLDs into documentation for fixed-floating interest rate swaps and other derivatives.

In addition, ESG-related terms are often included and defined in trade confirmations. Some of the new terms (e.g. KPIs, sustainability premiums, ESG ratings) appear to be “consistent in purpose across firms” and therefore may be suitable for further industry standardisation, ISDA said.

Some SLD agreements set out consequences if ESG-related payments are not made when due or if there is a KPI-related failure – which may be similar to those observed in traditional derivatives trading (e.g. viewed as an event of default).

Other areas that could benefit from standardisation are situations where third-party verification is relied upon for determining whether a particular ESG-related KPI has been met.

“There may be an opportunity to create standard terms that address the relationship and obligations of the counterparties with regards to the third-party verification entity,” ISDA said.

In addition, SLD agreements that use ESG ratings for KPIs may benefit from standardisation as they often use provisions to address situations where a rating is not available, a methodology change has taken place, or there is an identity change of the ESG rating entity.

Path forward

Given strong member interest and the various common features of SLD agreements, ISDA said it will consider whether it is appropriate to draft standardised terms for documenting SLD trades.

“For example, ISDA could produce a standalone confirmation template with its own set of ESG terms, possibly in a clause library format,” the paper said. “This would allow members to create SLDs for different asset classes.

“As most SLD trading appears to be related to interest rate derivatives, firms would use terms from the 2021 ISDA Interest Rate Derivatives Definitions in the template, alongside ESG terms and/or confirmation templates.”

While standardisation of certain key terms and contractual provisions would enhance efficiency in the trading of SLDs, ISDA said there will continue to be a need for contracts to be customisable to suit particular client needs or sustainability objectives.

ISDA said it will take these considerations into account when determining when to begin work on standardised terms.

 

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