Our view, as a member of the ISDA Sustainable Finance Working Group, is that by sharing these guidelines, ISDA has provided both institutional support and also a clear indication that they expect SLDs to become a meaningful part of the wider derivative market.

ISDA defines an SLD as a conventional derivatives product that incorporates an ESG-linked cashflow, whereby the ESG feature is aligned to an agreed KPI or KPIs. Both, the KPIs and the resulting cashflow impacts vary. Meeting a KPI could result in an increase or decrease in payments, a specified cash payment, a change in spread or margin or even a cash payment to a charity. KPIs can be one-way (apply to one counterparty e.g. a corporate) or two-way (apply to both counterparties); and for the latter, the KPIs can be the same or different.

At this point you’re probably wondering how ISDA plans to support the growth in this market, when SLDs are so bespoke?

1.  Specific – KPIs should be clearly and precisely defined

The key is to ensure the KPI(s) and surrounding mechanics are documented in a clear, precise and unambiguous way. This will minimise the possibility of future disputes and ensure there is a defined process in different scenarios. For example: how do you treat the ESG component if the transaction is closed out early? Areas to consider include (but are not limited to) the KPI definition, scope, timelines, methodology and consequences for failing to meet a target.

2.  Measurable – KPIs should be quantifiable, objective and within the company’s control to deliver

ISDA suggests benchmarking KPIs against publicly recognised standards whether at a global, regional or local level; for example the UN’s Sustainability Development Goals (SDGs). This benchmarking can also help with verification (see below). ISDA recognises this isn’t always possible, hence as an alternative suggests that companies could benchmark versus their own performance.

3.  Verifiable – Get them checked, and check who is doing the checking

The association proposes to verify whether a KPI has been met by following this process: Use 1) an independent third party or 2) one of the counterparties to the transaction. Clearly 1) is more straightforward – it reduces the chance of moral hazard, conflicts of interest and, of course, greenwashing. However, if not practical, ISDA suggests that the verifying counterparty develops and documents robust procedures in a readable format. In this scenario, it is important to consider the seniority and subject-matter expertise of the verifier, and, again, ensure a clear dispute resolution mechanism is agreed.

4.  Transparency – Share as much as you legally and realistically can

Outside of establishing a process for sharing relevant information over the life of the transaction, ISDA highlights incorporating provisions that allow relevant information to be shared publicly. They believe this can support the impact of the SLD and the development of the market overall.

5.  Suitable – Make them appropriate!

Clearly any KPIs need to be relevant to the counterparty and product they reference, but ISDA also highlights the importance of the impact that the SLDs should have and the term of the observation period - too short, and the effectiveness of the SLD may be called into question.

• The devil is in the detail. This market is bespoke and still evolving – there is currently no standardised wording for SLDs and there may never be (given the flexibility these products allow). Clearly and precisely documenting all aspects of the KPI, its mechanics and the product implications across all possible eventualities will reduce ambiguity, in case of future disputes, while enhancing the credibility and integrity of the SLD.
• Consider timing. This includes when and how regularly the KPI is assessed, but also the term of the SLD vs. the KPI. For example, if the SLD is seven years but the respective KPI has a target in three years, how credible is the SLD in those final four years to maturity? And furthermore, how impactful is the SLD in affecting long-term decision making if it’s too short?
• Consider wider regulation. If compliance with, or failure to reach, a KPI may become material to a counterparty’s share price, and they were required to disclose this failure under the SDG, then the other counterparty may need to manage restrictions on further disclosure and related trading activity (e.g. under insider trading or market abuse regimes). Tax and accounting implications should be assessed as well to fully capture the economic value of a transaction as some rules may be tricky and can differ across jurisdictions. ISDA published a separate paper on accounting considerations for ESG in derivative transactions under US Generally Accepted Accounting Principles (GAAP).
• Keep the KPIs relevant and appropriate. How will the ESG component impact the provisions of what is otherwise a well-understood derivative? Whether early termination, additional reps and warranties or new disclosures – make sure all bases are covered. The ESG component also doesn’t need to be a margin adjustment – it could be an alternative structural feature as long as it’s relevant and appropriate for the KPI and the counterparty.

Helpfully, these guidelines are comparable to those published by the Loan Market Association (LMA) and International Capital Market Association (ICMA), and as such there are synergies of using comparable metrics across the financing structure.

The clear message from ISDA is to ensure ESG KPIs are relevant, stretching and well documented. Minimising ambiguity and creating transparency around SLDs is critical to addressing greenwashing and encouraging the credible growth of this market.

If you would like more detail or have any questions, please reach out to your usual NatWest contact – we’d be happy to discuss this with you in more detail.

Thank you to Antonina Plakhotniuk for the helpful research assistance.

Example cashflow mechanics for margin step-up / down approach