In our last blog we considered the nature of Sustainability-Linked Derivatives (SLDs) (see here). This blog focuses on certain issues relating to key performance indicators (KPIs) which are core to the operation of SLDs and provide the link to the relevant sustainability objective by which the relevant term of the SLD is priced.
KPIs can be customised for each transaction to suit the specific requirements of the counterparties and the sectors in which they operate. While KPIs might link to any ESG-relevant goal, we are focusing on the environmental element of ESG given that such KPIs are the most prevalent form in the current market. Typically, these KPIs promote behaviour that benefits the environment and disincentives behaviour that negatively impacts the environment. This is achieved by setting quantifiable thresholds relating to e.g. reducing carbon dioxide emissions, or increasing renewable energy generation.
Given the potential ambiguity and scope of KPIs, sustainability-linked products often raise concerns of potential “greenwashing”. Such concerns arise where users of ESG financial products set KPIs at unambitious levels or simply operate at their day-to-day levels. The FCA in the UK is just one regulator focussed on the issue. In a letter to the AFM Chair, the FCA noted that a number of applications for authorisation of investment funds with an ESG or sustainability focus “often contain claims that do not bear scrutiny”. The FCA further stated in its 3-year strategy that it is building metrics to “monitor the incidence of misleading markets for ESG products” and “monitor enforcement and supervisory cases of financial crime, fraud and mis-selling of ESG related products”.
Industry bodies are also focussed on such concerns, and in trying to foster growth in sustainability linked products, have aimed their guidance at building the credibility of sustainability-linked products to defend against accusations of “green-washing”. The ICMA and LMA approach gives broadly start to finish guidance on the construction and operation of sustainability linked finance products. ISDA deviates from this approach and focusses more specifically on KPIs with a tighter focus on ensuring the clarity, robustness and transparency of the KPI which sits at the heart of an SLD.
Most corporates will be inclined, if possible, to set standard KPIs across its suite of finance products to ease the burden of managing various KPIs. Whilst on the face of it the different approach of the industry bodies may seem confusing, it is not surprising that ISDA’s approach to KPIs is more forensic, although there are shared themes around verification, measurability and transparency. The ISDA Guidelines are more focussed on setting “clear” KPIs, such that there is less room for disputes between the counterparties on assessing whether a KPI has been met. This includes detailed guidance on setting the reference point for KPIs, methodology for calculation and inclusion of fallbacks where a KPI is not available. Furthermore, on verification, ISDA suggests that counterparties should establish a dispute resolution mechanism to address breaches or disagreements on satisfaction of the KPI. In our view, one way this could apply is to provide that calculation agent-type dispute provisions apply, if available, in the absence of an independent third-party verifier. Given the background of ISDA’s work and their expertise in issues related to benchmarks and adjustments, it appears natural for ISDA to focus on such issues in some depth to balance high standards of market integrity with the wide range of KPIs which counterparties may wish to refer to in a custom OTC product.
While the ISDA guidelines focus on narrower principles and are more in depth, the broader principles emphasised by ICMA and LMA should not be overlooked in the context of SLDs. ICMA and LMA highlight various principles, for example (i) the importance of the KPIs being “material” to the issuer, such that they should be at the core of the corporate’s ESG strategy, and (ii) benchmarking targets against competitors in the same industry and requiring justification to deviate from industry standards. Given issuers’ preference for consistency across products and wanting to defend against “greenwashing” accusations, corporates will want to ensure the best of both worlds; balancing specific robust contractual terms at the same time as bigger principles enumerated by ICMA and LMA.
In summary, ISDA’s guidance takes a different approach to KPIs from that produced by the ICMA and LMA which reflects the way the derivatives world approaches standards of documentation and benchmarks. That is not to say similar standards of contractual robustness are not appropriate in a bond or loan, but rather to point out that ISDA is focussed on building a model for SLDs that seeks to balance customisable KPIs with the level of robust detail inherent in ISDA documentation for other asset classes. This is right and proper – to avoid “greenwashing” each business needs to focus its KPIs suitably and appropriately but likewise the market will struggle with contractual terms for SLDs which lack the clarity and integrity seen in other asset classes. The key for derivatives will be matching documentation standards and consistency with suitable business flexibility, allowing the products to meet the requirements of each individual business. Achieving this will help to minimise the risks of “greenwashing” and significantly boost the credibility of and trust in SLDs.
In the next entry of this blog series, we will touch on regulatory issues relating to SLDs.