Sustainability-linked derivatives: ISDA publishes clause library

Standardised SLD provisions and definitions

On 17 January 2024, the International Swaps and Derivatives Association (ISDA) published the ISDA Sustainability-Linked Derivatives Clause Library, a bank of standardised provisions and related definitions that market participants can use to document sustainability-linked derivatives (SLDs).  The clause library is available on ISDA MyLibrary.

In this briefing we provide an overview of SLDs generally and summarise key elements of the new clause library. 

Capitalised terms have the meanings given to them in the clause library or the ISDA Master Agreement.

What are SLDs?

SLDs are conventional derivative contracts that incorporate a pricing component determined by reference to one or more sustainability-based key performance indicators (KPIs). If the relevant party meets its KPI Target, this gives rise to an economic consequence. For example, the party might be required to pay more to the other party or to make a separate payment to an ESG-friendly cause. 

SLDs are highly bespoke and the KPIs vary widely, but all have a sustainability-based objective. For example, a party may be required to maintain a certain ESG rating, or reduce greenhouse gas emissions by a pre-agreed amount. Common underlying transactions are interest rate swaps, cross-currency swaps and currency forwards, although a sustainability-linked overlay could, in principle, be added to any combination of product type and asset class.

SLDs do not typically feature limitations on use of proceeds, in the way that sustainability-linked loans do, as the defining characteristic of SLDs is the overlay of the sustainability-related KPI.

SLD categories

ISDA divides SLDs into two categories:

• Category 1 SLDs are transactions where the applicable KPIs and related cashflow consequences are embedded in the transaction itself.  Whether or not the relevant party attains the applicable KPI Target has a direct bearing on the transaction's cashflows. The KPIs and related factors are all documented in the transaction documentation.
• Category 2 SLDs are structured differently, with the KPIs and related factors being documented separately from the underlying derivative transaction. Under category 2 SLDs, the derivative terms, pricing, and cashflows are not affected by the KPIs. Instead, if the applicable KPI Target is met, the terms of the derivative are used to calculate the KPI-based payment.  For example, the notional amount of the derivative might be used as the base amount for calculating a percentage-based payment.

The clause library is intended for use in Category 1 SLDs, although the provisions can be adapted for use in Category 2 SLDs too.

Importance of KPIs

KPIs are fundamental to all SLDs. Payment of any sustainability-based pricing component will depend on whether a specified KPI is attained. In some cases, they might also include a ratchet under which payment amounts increase or decrease in proportion to the levels of attainment. For example, if a particular KPI is exceeded by a certain percentage, that might result in a corresponding percentage uplift in the ESG-based payment amount. Therefore it is critical that the KPIs are carefully drafted, quantifiable and objectively verifiable.

With this in mind, ISDA published KPI guidelines for SLDs in September 2021. The guidelines do not prescribe particular approaches to KPIs, and deliberately avoid recommending certain types of KPI, so as to avoid inadvertently creating "ISDA-approved" KPIs. Instead, the guidelines describe over-arching best practice principles, namely that KPIs are specific, measurable, verifiable, transparent and suitable for the counterparties and structure in question.

ISDA clause library

Now the market has a library of clauses and related definitions for use when documenting SLDs. Given the importance of KPIs in SLDs, it is no surprise that the clauses focus on their documentation and verification. The assumption is that most SLDs will be "one-way", meaning that only one party will have KPI targets. However, drafting guidance is also provided for two-way SLDs.

We discuss some of the clause library's key concepts below.

KPI Table

The concept of a KPI Table is central to the SLD framework. Under each SLD, the parties can document the aspects of each KPI in a table, which can be customised by transaction. The clause library incorporates a sample template table, which contains recommended fields that tie into the clause library and definitions.

Recommended fields include:

• KPI Observation Period;
• KPI Reference Party (being the party required to meet the applicable KPI Target);
• KPI Target;
• Sustainability Consequence Trigger; and 
• Sustainability Consequence.

KPI Observation Period

One of the core concepts of the new documentation framework is the KPI Observation Period. This is a defined period for which the relevant party's performance under each KPI is assessed. For each KPI Observation Period, the parties measure their compliance with each KPI and allocate an appropriate KPI Achievement Score. This is then verified by the Verification Agent and measured against the corresponding KPI Target to determine whether the KPI Target has been met.

As a commercial matter, the length of the period agreed must be appropriate for the sustainability benefit to be credible.

It is best practice for an independent third party to be appointed as Verification Agent, to minimise the risk of greenwashing and disputes. If the SLD is two-way (i.e. both parties have KPI Targets), a Verification Agent will need to be appointed for each party.

KPI Compliance Certificate

Once a party has met a KPI Target, it delivers a KPI Compliance Certificate to the other party. The form of certificate is agreed in advance and annexed to the KPI Table. Delivery of the KPI Compliance Certificate is critical as this is the means by which the parties demonstrate whether or not a KPI Target has been met, triggering the Sustainability Consequence (see Sustainability Consequences below).

The clause library also contains drafting that can be used if the parties agree to provide proof of compliance by publishing relevant information on their websites, rather than delivering a KPI Compliance Certificate.

If any information provided under or in connection with a KPI Compliance Certificate is found to be false, inaccurate or misleading, any payment or adjustment made as a result of that information is returned or reversed.

KPI Reviews

KPIs can be reviewed periodically and/or on the occurrence of certain events. For example, the parties might agree to review the KPIs if one of the KPIs is no longer considered suitable for the parties and/or transaction type.

Sustainability Consequences

A key element of each SLD is its Sustainability Consequence. This is the  payment-based consequence of the relevant party hitting or missing the applicable KPI Target. These consequences will vary considerably by transaction, but the clause library provides drafting for the following:

1. Fixed Rate Adjustment;
2. Fixed Amount Adjustment;
3. Floating Rate Adjustment;
4. FX Option Adjustment; 
5. FX Forward Adjustment; and
6. Sustainability Amount Payment (i.e. the Sustainability Amount Payer makes a stand-alone payment to the other party).

A separate column in the KPI Table allows for further details in respect of each of the above to be specified. For example, if the Sustainability Consequence is Sustainability Amount Payment, the parties would specify the amount to be paid or the calculation methodology in this column.

Each Sustainability Consequence has a Sustainability Consequence Trigger. Again, these are highly customisable, but the four variants of Sustainability Consequence Trigger included in the table are:

A.  KPI Target met;
B.  KPI Target not met;
C.  All KPI Targets met; and 
D.  No KPI Targets met.

The exact formulation will depend on the outcome to be achieved but if, for example, A or B above were used, there would be a Sustainability Consequence for each KPI Target, and each would have its own Sustainability Consequence Trigger. In that way, it would be possible for some but not all KPI Targets to be met, and therefore for some but not all Sustainability Consequences to be realised. Under C and D above, all KPI Targets would need to be met for the Sustainability Consequence to occur.

For example, if two parties want to structure a one-way SLD under which Party A would make a payment to Party B if Party A were to fail to meet its KPI Target, they could use drafting options 6 and B, with Party A as the Sustainability Amount Payer.

If the parties want to structure a two-way SLD under which Party A would receive a Fixed Rate Adjustment in its favour if it were to meet all of its KPI Targets, and Party B would receive a Fixed Rate Adjustment in its favour if it were to meet all of its KPI Targets, they would use drafting options 1 and C and specify the applicable parties in the KPI Table.

The obligation to make any payment arising as a result of a Sustainability Consequence (defined as a Sustainability-linked Payment in the clause library) is conditional on no Event of Default or Potential Event of Default having occurred under the applicable ISDA Master Agreement, and no Early Termination Date having occurred or having been designated, in line with Section 2(a)(iii) of the ISDA Master Agreement.

Declassification Event

For SLDs documented under an ISDA Master Agreement, the failure to make any Sustainability-linked Payment would, absent any amendment, constitute an Event of Default. However, the clause library offers drafting to lessen the effect of any such failure, by making it either an Additional Termination Event or a Declassification Event.

A Declassification Event is a new term under the clause library and encompasses a range of events, including (i) failure to make a Sustainability-linked Payment, (ii) occurrence of an Adverse Sustainability Event (see Adverse Sustainability Events below), and (iii) termination, amendment or similar of a related Reference Sustainability Obligation (where the SLD was being used for hedging purposes, this would typically be the instrument being hedged).

The effect of a Declassification Event is twofold:

• it prevents the parties from referring thereafter to the transaction as "sustainability linked", thereby mitigating the risk of greenwashing; and
• it stops any further payments or adjustments being made on the basis of the Sustainability Consequence. There is also a drafting option to reset any amounts or percentages that have already been adjusted to the original level at the trade date.

Adverse Sustainability Events

Adverse Sustainability Events are sustainability-linked events that do not directly impact the transaction's KPIs but which the parties have agreed will affect its sustainability profile. For example, in a loan-linked hedging, sustainability-related events impacting the loan might not directly impact the transaction's KPIs but might indirectly affect its sustainability profile.

The drafting variants included in the clause library provide for either all Sustainability Consequences to be paused until the Adverse Sustainability Event ceases or for a Declassification Event to occur.

Disputes

The clause library also contains provisions for handling disputes as to the validity of a KPI Compliance Certificate or related documentation. As discussed above, these are critical as they demonstrate whether or not the relevant party has attained the KPI Target and trigger the Sustainability Consequence(s).

The proposed approach to disputes follows that taken with regard to disputes under ISDA's 1995 English law Credit Support Annex and 2016 VM Credit Support Annex, by providing for the undisputed portion of the relevant payment to be paid while the parties consult on the disputed amount.

The parties need to specify which of them has the right to raise disputes in this area, or whether both parties can do so.

Commentary

The first publicised SLD transaction was executed in August 2019, so this is still a relatively new market. Since then various companies from a broad range of sectors have entered into SLDs, with many more expected to follow suit. As with any new market, the publication of standardised provisions should accelerate its growth by streamlining the process of negotiating and documenting transactions.

However, whilst the clause library provides the mechanics for transactions, market participants will need to address legal, regulatory and structuring questions in relation to SLDs, including:

• How should the SLD be characterised for regulatory purposes? How will any applicable disclosure requirements be satisfied?
• Does the SLD need to be margined? If so, how should the sustainability-linked component be valued for margin calls and how should any valuation disputes be resolved?
• If there is a close-out, how should the SLD be valued – should it assume that the KPI Target has been met or not?
• Is the SLD within the list of transactions covered by the relevant ISDA netting opinions?

Future developments

Where a KPI Target requires the achievement or maintenance of a particular ESG rating, market participants will need to consider current proposals in the UK and the EU to regulate ESG ratings providers. For example, if adopted, the proposals will introduce new rules around the establishment of ratings methodologies, which will need to be taken into account when setting a KPI Target. Any new legislation may also introduce rating transparency requirements, which could influence how KPI Targets are set.

Similarly, the Financial Conduct Authority's proposals for a broad new "anti-greenwashing" rule will lead to further scrutiny of KPIs used in financial products - sustainability-linked loans, green bonds and green securitisations, as well as SLDs. Under the new rule, the FCA may consider KPIs a marketing tool used to incentivise counterparties to enter into an SLD, in which case SLD structurers would need to be wary of falling foul of the new requirements.

For more information on SLDs in practice, please contact our Derivatives team.