Investments and hedges linked to environmental, social and governance (ESG) factors are growing fast, seen by market participants as an effective and efficient way to meet climate and development objectives. With the COP26 climate change summit just weeks away, and with increasing numbers of countries aiming to achieve net-zero emissions in the coming decades, ESG-related transactions are likely to become even more prevalent. But as volumes continue to grow, industry standards and best practices need to keep pace to ensure this market functions safely and efficiently.

ISDA has been thinking hard about this issue, and this week published two new papers that explore specific aspects of the ESG sector. The first sets out best practices for the drafting of key performance indicators (KPIs) for sustainability-linked derivatives (SLDs). These instruments are just one example of a wide range of ESG-related hedges – they essentially link cashflows on a conventional derivative like an interest rate swap to the meeting of specified ESG objectives, using a set of KPIs to measure compliance.

A variety of SLD structures and payouts have emerged so far, but there is no common format or configuration for the KPIs that are so essential to the effectiveness and smooth operation of these transactions. Our Sustainability-linked Derivatives: KPI Guidelines paper is an initial attempt to create a common framework to ensure KPIs are specific, measurable, verifiable, transparent and suitable. We hope that widespread adherence to these principles will promote greater consistency and improve the transparency and credibility of these instruments.

The second paper focuses on issues associated with the current accounting treatment of ESG transactions. Under US Generally Accepted Accounting Principles, the ESG element of a green bond or loan could be classed as an embedded derivative, requiring that component to be split out and reported at fair value. This is problematic as a lack of observable data means ESG features are currently difficult to value, resulting in information that is unlikely to be useful to readers of financial statements.

Instead, our Accounting Analysis for ESG-related Transactions and the Impact on Derivatives paper proposes two possible solutions to reduce the operational burden on firms, and recommends ESG-related issues are better covered through the qualitative sustainability disclosures that many institutions already publish.

These are just two issues – there are plenty of others we are also looking at. In July, we published a paper showing that the forthcoming Fundamental Review of the Trading Book would lead to disproportionately high capital requirements for carbon certificates and recommending an alternative treatment that would better align capital with the risk these instruments pose.

The development of liquid carbon trading markets is widely seen as crucial in meeting sustainability targets – making it all the more important that banks aren’t deterred from acting as intermediaries due to inappropriately high capital requirements.

Regulated emissions trading systems have been established in several jurisdictions, and work is under way to develop a framework for a scalable voluntary carbon market via the Taskforce on Scaling Voluntary Carbon Markets – an initiative that ISDA is involved in.

As this market grows, a sound governance framework, solid legal principles and robust documentation will be vital, and this will be a focus of our work. Indeed, ISDA has already published a variety of templates to support the trading of emissions and certain types of environmental derivatives, including US and EU emissions annexes and, most recently, the ISDA US Renewable Energy Certificate Annex.

Ambitious emissions-reduction targets set by the public and private sector mean ESG-related financing, investment and risk management products are certain to grow. Our priority is ensuring the safety and efficiency of derivatives markets as we transition to a more sustainable economy.

The latest event in ISDA’s Trading Forum series on September 30 will focus on ESG. Click here to book your free-to-attend pass.

Read ISDA’s ESG-related papers:

Sustainability-linked Derivatives: KPI Guidelines

Accounting Analysis for ESG-related Transactions and the Impact on Derivatives

Implications of the FRTB for Carbon Certificates

Financing a US Transition to a Sustainable Low-Carbon Economy

Overview of ESG-related Derivatives Products and Transactions

Derivatives in Sustainable Finance: Enabling the Green Transition