ESG-related derivatives: regulation & valuation

The most popular financial instruments in this regard are sustainability-linked loans and bonds. But more recently, corporates also started to focus on ESG-related derivatives. In short, these derivatives provide corporates with a financial incentive to improve their ESG performance, for instance by linking it to a sustainable KPI. This article aims to provide some guidance on the impact of regulation around ESG-related derivatives.

As covered in our first ESG-related derivatives article, a broad spectrum of instruments is included in this asset class, the most innovative ones being emission trading derivatives, renewable energy and fuel derivatives, and sustainability-linked derivatives (SLDs).

Currently, market participants and regulatory bodies are assessing if, and how new types of derivatives fit into existing derivatives regulation. In this regard, European and UK regulators are at the forefront of the regulatory review to foster activity and ensure safety of financial markets. Since it’s especially challenging for market participants to comprehend the impact of these regulations and the valuation implications of SLDs, we aim to provide guidance to corporates on these matters, with a special focus on the implications for corporate treasury.

Categorization & classification

When issuing an SLD, it’s important to understand which category the respective SLD falls in. That is, whether the SLD incorporates KPIs and the impact of cashflows in the derivatives instrument (category 1), or if the KPIs and related cashflows are stated in a separate agreement, in which the underlying derivatives transaction is mentioned for setting the reference amount to compute the KPI-linked cashflow (category 2). This categorization makes it easier to understand the regulations applying to the SLD, and the implications of those regulations.

In general, a category 1 SLD will be classified as derivative under European and UK regulations, and swap under US regulations, if the underlying financial contract is already classified as such. The addition of KPI elements to the underlying financial instrument is unlikely to change that classification.

Whether a category 2 SLD is classified as a derivative or swap is somewhat more complicated. In Europe, this type of SLD is classified as a derivative if it falls within the MIFID II catch-all provision, which must be determined on a case-by-case basis.

Overall, instruments that are classified as derivatives in Europe will also be classified as such in the UK. But to elaborate, a category 2 SLD will classified as a derivative in the UK if the payments of the financial instrument vary based on fluctuations in the KPIs.

When a category 2 SLD is issued in the US, it will only be classified as a swap if KPI-linked payments within the financial agreement go in two directions. Even if that is the case, the SLD may still be eligible for the status as commercial agreement outside of swaps regulation, but that is specific to facts and circumstances.

Apart from the classification as derivative or swap, it is also helpful to determine whether an SLD could be considered a hedging contract, so that it is eligible for hedging exemptions. The requirements for this are similar in Europe, the UK, and the US. Generally, category 1 SLDs are considered hedging contracts if the underlying instruments still follow the purpose of hedging commercial risks, after the KPI is incorporated. Category 2 SLDs are normally issued to meet sustainability goals, instead of hedging purposes. Therefore, it is unlikely that this category of SLDs will be classified as hedging contracts.

Regulation & valuation implications

When issuing an SLD that is classified as a derivative or swap, there are several regulatory and valuation implications relevant to treasury. These implications can be split up in six types which we will now explain in more detail. The six types (risk management, reporting, disclosure, benchmark-related considerations, prudential requirements, and valuation) are similar for corporates across Europe, the UK, and the US, unless otherwise mentioned.

Risk management

As is the case for other derivatives and swaps, corporate treasuries must meet confirmation requirements, undertake portfolio reconciliation, and perform portfolio compression for SLDs. Additionally, regulated companies are required to construct effective risk procedures for risk management, which includes documenting all risks associated with KPI-linked cashflows. While these points might be business as usual, it must also be determined if and how KPI-linked cashflows should be modeled for valuation obligations that apply to derivatives and swaps. For instance, initial margin models might need to be adjusted for SLDs, so they capture KPI-linked risks accurately.

Reporting

Corporate treasuries must report SLDs to trade repositories in Europe and the UK, and to swap data repositories in the US. Since these repositories require companies to report in line with prescriptive frameworks that do not specifically cover SLDs, it should be considered how to report KPI-linked features. As this is currently not clearly defined, issuers of SLDs are advised to discuss the establishment of clear reporting guidelines for this financial instrument with regulators and repositories. A good starting point for this could be the mark-to-market or mark-to-model valuation part of the EMIR reporting regulations.

Disclosure

Only Treasuries of European financial entities will be involved in meeting disclosure requirements of SLDs, as the legislation in the UK and US is behind on Europe in this respect, and non-financial market participants are not as strictly regulated. From January 2023, the second phase of the Sustainable Finance Disclosure Regulation (SFDR) will be in place, which requires financial companies to report periodically, and provide pre-contractual disclosures on SLDs. Treasuries of investment firms and portfolio managers are ought to contribute to this by reporting on sustainability-related impact of the SLDs compared to the impact of reference index and broad market index with sustainability indicators. In addition, they could leverage their knowledge of financial instruments to evaluate the probable impacts of sustainability risks on the returns of the SLDs.

Benchmark-related implications

In case the KPI of an SLD references or includes an index, it could be defined as a benchmark under European and UK legislation. In such cases, treasuries are advised to follow the same policy they have in place for benchmarks incorporated in other brown derivatives. Specific benchmark regulations in the US are currently non-existent, however, many US benchmark administrators maintain policies in compliance with the same principles as where the European and UK benchmark legislation is built on.
Prudential requirements

Since treasury departments of corporates around the world are required to calculate risk-weighted exposures for derivatives transactions as well as non-derivatives transactions, this is not different for SLDs. While there is currently little guidance on this for SLDs explicitly, that may change in the near future, as US prudential regulators are assessing the nature of the risk that is being assumed with in-scope market participants.

Valuation

The SLD market is still in its infancy, with SLD contracts being drawn up are often specific to the company issuing it, and therefore tailor made. The trading volume must go up, trade datasets are to be accurately maintained, and documentation should be standardized on a global scale for the market to reach transparency and efficiency. This will lead to the possibility of accurate pricing and reliable cashflow management of this financial instrument and increases the ability to hedge the ESG component.

To conclude

As aforementioned, the ESG-related derivatives market and the SLD market within it are still in the development phase. Therefore, regulations and their implications will evolve swiftly. However, the key points to consider for corporate treasury when issuing an SLD presented in this article can prove to be a good starting point for meeting regulatory requirements as well as developing accurate valuation methodology. This is important, since these derivatives transactions will be crucial for facilitating the lending, investment and debt issuance required to meet the ESG ambitions of Europe, the UK, and the US.

For more information on ESG issues, please contact Joris van den Beld or Sander van Tol.