ESG-linked derivatives come up in legal and contract work, where the target terms are written into the trade confirmation, and in risk management, where the treatment of valuation and collateral is decided.

How payments change with the result of a target

In an ESG-linked derivative, part of the swap payments rises or falls depending on whether an environmental or social target is met. ESG stands for environmental, social, and governance. The measure of the target is called a KPI (key performance indicator), and the level to reach is called an SPT (sustainability performance target). Whether actual results reach the SPT decides how much the payments change1.

Consider a hypothetical example in which a company (the fixed-rate payer) has borrowed 10 billion yen at a floating rate. To fix the cost of the loan, it enters a 3-year interest rate swap with a bank. The notional amount is 10 billion yen, the same as the loan. The payer pays a fixed rate of 1% and receives a floating rate. The basics of the swap are covered in Interest Rate Swaps.

Now add a condition linked to the payer's target for reducing greenhouse gas emissions. If the target for the year is met, the fixed rate is cut by 0.05 percentage points to 0.95%. If it is not met, the fixed rate is raised by 0.05 percentage points to 1.05%. Suppose the target is met in years 1 and 3 and missed in year 2. The payer's fixed-rate payments are then as shown in Figure 1.

↑ Receive　↓ PayFixed-rate payments seen by the fixed-rate payerYear 1 (met)Year 2 (missed)Year 3 (met)−95 million yenFixed 0.95%−105 million yenFixed 1.05%−95 million yenFixed 0.95%
Figure 1Fixed-rate payments that change with the target result
Figure description

The figure shows only the fixed rate paid by the fixed-rate payer in a swap with a notional amount of 10 billion yen. The payer pays 95 million yen in year 1 (met), 105 million yen in year 2 (missed), and 95 million yen in year 3 (met). It does not show the floating-rate receipts. The length of each arrow is a rough guide to the size of the amount. Depending on the target result, the payment moves up or down by 5 million yen from the unadjusted 100 million yen (a 1% fixed rate).

For one year of interest, the adjustment is 10 billion yen × 0.05% = 5 million yen. In a year the target is met, the payer pays 5 million yen less. In a year it is missed, the payer pays 5 million yen more. The floating-rate payments on the loan are offset by the floating rate received on the swap, so the payer's net cost together with the loan is just the fixed-rate part. The loan's margin is charged separately.

Target result Fixed rate Fixed-rate payment (one year, million yen) Difference from no adjustment (1% fixed rate, million yen)
Met 0.95% 95 5 lower
Missed 1.05% 105 5 higher

How targets and adjustments are set

The practices and regulation described from this section onward are based on law-firm commentary and regulatory reports. The sources date from January 2021 for the types of ESG-related derivatives, November 2021 for EU regulation and the market, and May 2023 for UK regulation and trading practice.

The content of the target and the adjustment made when it is met are decided by the parties for each trade. Examples of KPIs are the reduction of greenhouse gas emissions and the share of renewable energy used. Results are either confirmed by an independent third party or linked to an ESG rating assigned by a third-party rating firm2. In a 2019 trade, the spread on the fixed rate was increased or decreased according to ESG performance scored by a rating firm1.

The party to which a KPI applies may be one party or both parties to a trade1. Most trades were between a counterparty expected to meet ESG goals (the buy side) and a bank, and the KPIs measured the performance of the buy-side party2.

Besides raising or cutting the interest rate, the adjustment for meeting a target can take the following forms21.

Form of adjustment Description
Spread A positive or negative spread is added to the fixed rate
Exchange rate In a cross-currency swap or similar trade, a more or less favorable rate applies depending on the target result
Fixed payment A fixed amount is paid if the target is not met and not paid if it is met
Donation The payment for missing a target is made as a donation to an organization working on sustainability
Tiers The size of the adjustment changes in steps according to the number of KPIs met

The adjustment payments were usually timed to match the other payments of the trade2. The contract was built on a standard derivatives contract (such as an ISDA Master Agreement), with the KPI terms written in the trade confirmation. In some cases the KPIs were written in a separate agreement that the trade confirmation referred to2.

Principles for linking terms to targets had been developed for loans before derivatives3. The principles of the Loan Market Association (LMA) and others are voluntary guidance (February 2023 edition). They say KPIs should be material to the borrower's business and comparable, and make independent external verification of target achievement a necessary element4.

ESG-related derivatives are not limited to ESG-linked derivatives. One law firm's commentary listed the following six5.

Type Description Page with more detail
ESG-linked derivatives A price element linked to an ESG target is added to an interest rate swap or a cross-currency swap. They are tailored to each client Explained in the text
ESG-related credit derivatives Credit default swaps are used to manage the credit risk of counterparties that may be affected by climate change CDS Indices (iTraxx, CDX)
ESG-related listed derivatives Equity index futures and equity index options linked to ESG indices, used for purposes such as hedging ESG portfolios
Emissions trading Derivatives on emission allowances or emission offsets, used by companies covered by a cap on emissions to meet their obligations and manage risk
Renewable energy and fuel derivatives These hedge the risk from fluctuations in renewable energy production
Catastrophe and weather derivatives These soften the loss from specific natural disasters and the risk from unexpected weather Weather Derivatives

Credit derivatives also include trades that use indices built on ESG criteria to take on, or hedge, the risk of ESG-related companies in each region5.

History and market status

The main events between the first example trade in 2019 and 2023 are as follows.

Date Party Event
August 2019 ING, SBM Offshore Entered a derivative to hedge the interest rate risk of a USD 1 billion, 5-year floating-rate revolving credit facility1
2020 Enel, JP Morgan Used a cross-currency swap to hedge the currency and interest rate risk on a sustainability-linked bond of GBP 500 million issued in 20201
September 7, 2021 International Swaps and Derivatives Association (ISDA) Published guidance on how to build KPIs3
October 2022 UK Financial Conduct Authority (FCA) Said it did not intend to create rules specific to derivatives, and that it would set out guidance to increase transparency6
May 31, 2023 European Securities and Markets Authority (ESMA) Noted in its progress report on greenwashing that new products such as derivatives with ESG features may make it harder to verify sustainability claims7

In the August 2019 trade, a positive or negative spread was added to the fixed rate according to a score of ESG performance. In the 2020 trade, the interest rate on the swap rose if either side failed to meet its environmental targets1. The FCA stated its position in consultation paper CP22/20, on sustainability disclosure requirements and investment labels6.

ESG-linked derivatives were bilateral products made trade by trade, with little published information on their terms and low liquidity1. There was also no industry-standard template, and the trades were built on a standard derivatives contract with terms such as KPIs added2.

Treatment under existing derivatives regulation

This section is based on UK and EU sources.

In the UK, ESG-linked derivatives were treated in much the same way as other OTC derivatives. The trade reporting and risk mitigation obligations also applied in the same way, under EMIR (the European Market Infrastructure Regulation) as brought into UK domestic law6. The FCA's ESG rules and guidance did not specifically target derivatives6.

In the European Union (EU), there was uncertainty over how far ESG reporting and disclosure rules applied1. These rules are the SFDR (the Sustainable Finance Disclosure Regulation, on sustainability-related disclosures in the financial services sector) and the Taxonomy Regulation (which sets a framework to encourage sustainable investment)8.

Challenges in target levels and verification

One challenge is whether a target requires real improvement. Greenwashing is a practice in which sustainability-related statements or actions do not clearly and fairly reflect the actual sustainability profile of a company, financial product, or financial service, and may mislead investors or others9. In ESG-linked derivatives, it can arise when a KPI does not require meaningful improvement from the party being assessed, or when the confirmation of results is inadequate2.

Concerns had been raised that there was no common format for building KPIs, so that KPIs were inconsistent and hard to verify. The absence of a widely accepted standard was also said to leave room for greenwashing1. The guidance ISDA issued in September 2021 sums up the principles for KPIs in five points, including that they be specific, measurable, and verifiable. The content of the five points is based on a law firm's commentary10. When a trade is linked to an ESG rating, the contract may include a fallback way of deciding the result if the rating methodology changes or the rating ceases to exist11.

Another challenge is the shape of the market. The part of the price linked to targets is built from trade-specific terms, so hedging options are limited. If there is no standard template and efforts vary by industry and region, the market may split, raising costs and lowering liquidity12.

What this page does not cover

Treatment of ESG-linked derivatives in Japan and moves toward standardization after May 2023 are not covered on this page.

Notes

  1. Hogan Lovells, "Sustainability-linked derivatives: some practical considerations" (November 12, 2021), the sections "What are SLDs?", "What types of SLDs have been issued to date?", and "Regulatory requirements". ↩ ↩2 ↩3 ↩4 ↩5 ↩6 ↩7 ↩8 ↩9 ↩10

  2. Addleshaw Goddard, "An Overview of Sustainability-Linked Derivatives" (May 26, 2023), the sections "What are sustainability-linked derivatives?", "Documentation", "Cashflows", and "Issues and risks". ↩ ↩2 ↩3 ↩4 ↩5 ↩6 ↩7

  3. Addleshaw Goddard (May 26, 2023), "ISDA's principles for sustainability-linked derivatives". ↩ ↩2

  4. Loan Market Association and others, "Sustainability-Linked Loan Principles" (February 2023 edition), page 3 (PDF page 3), "Selection of KPIs", and page 4 (PDF page 4), "Verification". ↩

  5. Hogan Lovells, "ESG derivatives: new tools unlocking capital in sustainable finance" (January 13, 2021), the section "Key products identified by ISDA". A summary of an ISDA document. ↩ ↩2

  6. Addleshaw Goddard (May 26, 2023), "Regulation". ↩ ↩2 ↩3 ↩4

  7. ESMA, "Progress Report on Greenwashing" (May 31, 2023), paragraph 17 at the start of section 3 (PDF page 12). ↩

  8. ESMA, "Progress Report on Greenwashing" (May 31, 2023), the list of abbreviations (PDF page 75), the rows for "SFDR" and "TR". The SFDR is Regulation (EU) 2019/2088, and the Taxonomy Regulation is Regulation (EU) 2020/852. ↩

  9. The same ESMA report, Executive summary (PDF page 4). The common understanding of greenwashing agreed by the three European Supervisory Authorities (ESAs). ↩

  10. Addleshaw Goddard (May 26, 2023), "ISDA's principles for sustainability-linked derivatives". The five principles are Specific, Measurable, Verifiable, Transparent, and Suitable. ↩

  11. Addleshaw Goddard (May 26, 2023), "Documentation", subsection "ESG ratings entities". ↩

  12. Addleshaw Goddard (May 26, 2023), "Issues and risks", subsections "Hedging" and "Market segmentation". ↩

  13. Addleshaw Goddard (May 26, 2023), the end of "Cashflows". ↩

  14. Hogan Lovells (November 12, 2021), "SLDs: practical documentation considerations", subsection "Margin requirements". ↩