Despite some counter-revolutionary forces, especially in the US, it seems likely that environmental, social and governance (ESG) concerns will continue to be increasingly significant factors in the structuring and execution of derivative transactions. We have covered the growth of the ESG derivative market (sometimes referred to as sustainability-linked derivatives) on the Long and Short of It previously.

Sustainability-linked derivatives (SLDs) are derivatives which embed an ESG-linked cash-flow in a traditional derivative instrument (such as an increase in spread linked to a failure by a counterparty to meet an ESG target). Unlike in other ESG financial products, the use of proceeds of a sustainability-linked derivative is not usually controlled (although sometimes counterparties may agree that any increased spread paid as a result of a failure to meet an ESG target will be applied for a sustainable purpose). Typically, SLDs are documented under an ISDA Master Agreement, and the ESG-related terms are contained in the trade confirmation.

In previous surveys, ISDA has reported common themes in ESG related provisions in SLDs, but noted a lack of standardization, which may hold back the growth of this important market and detrimentally affect the efficiency of trading in SLDs. Accordingly, ISDA has recently launched a clause library for SLDs, designed to provide standardized drafting options for market participants to use when negotiating SLD transactions with counterparties. The aim is to improve efficiency in the market but maintaining flexibility for SLDs to be tailored to meet firms’ sustainability and financing needs.   

The ISDA SLD Clause Library (which can be found on the ISDA MyLibrary platform) provides standard-form drafting options in several key areas, including:

  • KPI compliance: provisions stipulating what evidence of sustainability performance must be delivered and when. Typically, parties will assess their KPIs in respect of the relevant observation period to determine a KPI achievement score. This score will be verified by a third-party verification agent. KPI compliance certificates will be delivered for monitoring purposes (or alternatively parties can refer to sustainability disclosures on their websites);
  • Sustainability consequences: mechanisms to adjust cashflows depending on whether relevant ESG targets have been met, depending on the type of transaction/definitions incorporated;
  • Disruption/review: options available to counterparties following disruption and review events;
  • Disputes: there are suggested provisions for resolving disputes in relation to the validity of the facts contained in a KPI compliance certificate or supporting documentation. The provisions are not intended to replace any other disputes provisions that the parties have agreed more generally for the transaction or their trading relationship. If the parties fail to resolve a dispute, a third party may adjudicate, the relevant sustainability consequence will not occur or the transaction could be de-linked from the sustainability provisions.

Please speak to your Mayer Brown contact if you would like assistance with SLD transactions.