Sustainability-linked derivatives are an exciting addition to a Treasurer's ESG toolkit, say Nick Fletcher, Rates Solutions at Lloyds Bank Corporate Markets and Jenny Burrett, Director, Sustainability & ESG Finance, Lloyds Bank.
Sustainability is now a key part of the strategic agenda for many companies. It has rapidly become the norm to take environmental, social and governance (ESG) factors into account when making business decisions. Both companies themselves recognise the crucial role they can play in making the world a better place, and investors, consumers, non-governmental organisations, and regulators continue to push companies to focus on these topics.
The use of sustainable finance is becoming more commonplace across all sectors in the UK. Sustainable financing is a lever that can support the integration of sustainability strategies across all areas of an organisation, demonstrate the company’s commitment to its sustainability targets, and incentivise and encourage continuous improvement of ESG performance. As the sustainable finance market evolves and grows, we are starting to see attention now turning to the derivatives market with the development of sustainability-linked derivatives (SLDs).
What are SLDs and how do they work?
SLDs work like standard derivatives, enabling companies to mitigate, or hedge, various financial risks, such as changes in foreign exchange rates, interest rates or other factors impacting their operations, such as commodity prices.
Derivatives are an everyday part of many treasury teams’ toolkits, helping to reduce uncertainty by limiting exposure to factors outside of companies’ control.
As the name suggests, SLDs add a sustainability component to a derivatives structure. Companies are incentivised to commit to, and achieve, sustainability targets and objectives. The sustainability linkage works the same as sustainability-linked loans or bonds; companies set targets for key performance indicators (KPIs) that reference specific ESG objectives, and if these targets are achieved, the pricing for the derivative is adjusted. For example, the coupon on an interest rate swap might be reduced or a rebate received on an FX forward.
While many derivatives are standardised (with some even traded on exchanges), SLDs are bespoke as they are linked to a company’s ESG targets. Typically, sustainability-linked transactions reference different environmental and social commitments, such as greenhouse gas emissions, waste, and diversity and inclusion.
Investors and lenders are increasingly more focused on ESG-related issues and are asking more questions. Bank counterparties can work closely with companies to support them in structuring their sustainability framework, and coordinate the sustainability elements and questions across Lenders.
Choosing the right KPIs
A key step for a company planning to execute an SLD is selecting material and relevant ESG metrics as reference KPIs. A KPI should be pertinent to a company’s operations and also stretch the company while still being achievable: finding the right balance can be tricky.
The companies that typically consider an SLD tend to already have a fairly sophisticated approach to ESG; they may have accessed the sustainability-linked loan or bond market previously and can utilise these existing frameworks for their SLD. If, however, a company is at the beginning of their sustainability journey, they can still consider an SLD and work alongside bank counterparties to structure their sustainability-linked elements.
In September 2021, the International Swaps and Derivatives Association (ISDA) published guidelines for SLDs, including five overarching principles for KPI selection. These can help companies to set targets that are seen as credible by their bank counterparties, any third party verifying the KPIs, and investors and other stakeholders. ISDA suggests that KPIs should be:
- Specific – with clear targets, scope, timelines, and reference points or sources. Methodology and fallbacks should be included in the documentation and the consequences of failing to meet the KPI should be stated.
- Measurable – objective, quantifiable and within the company’s control to achieve. One way to do this is to benchmark it against a standard such as the UN Sustainable Development Goals.
- Verifiable – by one of the parties to the transaction or, as is preferable to avoid potential conflicts of interest, an independent third party.
- Transparent – with a process detailing what information is made available to which parties and how frequently.
- Suitable – for the company and derivatives structure, factoring in counterparty size, geographical location and existing ESG commitments.
How is the market evolving?
The SLD market has only existed for a few years (the first publicised transaction was in August 2019) and the private nature of the product means that the details of transactions are limited. However, a number of large infrastructure, energy, agri-business, transport and other companies have already executed interest rate and FX SLDs with a variety of tenors.
As SLD language becomes more standardised (assisted by the publication of several guidance papers by ISDA), knowledge and understanding of SLDs are expected to grow, and therefore the number of transactions is likely to increase.
For companies that use derivatives to manage their FX, interest rate or other risks, SLDs can be part of both their ESG and hedging practices. They are an additional tool that they can use to embed sustainability across their organisations.
Lloyds Bank has an experienced Sustainability and ESG Finance team of around 30 people that are ready to provide support and advice on developing a sustainability framework, as well as accessing the sustainable finance market across multiple different instruments, such as loans, bonds and derivatives. The team would be delighted to discuss the issues raised in this article and support companies with sustainable finance.
N.B. The information contained in this entry is provided by the above supplier, and does not necessarily reflect the views and opinions of the publisher