ISDA Seeks to Establish ESG Standards

The International Swaps and Derivatives Association (ISDA) has published two white papers that examine key aspects of the market for environmental, social and governance (ESG) transactions. It says its aim is the establishment of robust standards and best practices for this sector.

The papers focus on key performance indicators (KPIs) for sustainability-linked derivatives and the accounting treatment for ESG transactions. They come in response to rapid developments in the scope and scale of ESG-related investments and hedges as market participants strive to meet climate and development objectives.

The sustainability-linked derivatives (SLD) paper sets out proposed guidance for drafting KPIs, which are fundamental to the effectiveness and credibility of these transactions – something that could become more important as scepticism over some firms’ ESG claims grows. ISDA says KPIs are critical to the effectiveness and integrity of the SLDs to which they relate, adding they need to be accurately defined in order to have legal certainty over how they operate and impact cashflows and so they can be objectively verified. “This will enhance the credibility of SLDs and the sustainability-linked market as a whole,” ISDA states.

Sustainability-linked derivatives tie cashflows on conventional hedging instruments to the meeting of specified ESG objectives using KPIs to measure compliance. As such, the paper sets out principles to ensure those KPIs are specific, measurable, verifiable, transparent and suitable.

The second paper describes issues associated with the current accounting treatment of ESG transactions. Under US Generally Accepted Accounting Principles, ISDA explains the ESG component of a bond or loan could be classed as an embedded derivative requiring bifurcation and accounting at fair value. However, it adds, 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.

In response, the paper proposes alternative approaches that will improve the value of the information reported.

“ESG investments and hedges will be absolutely critical in the transition to a green economy, enabling companies to meet their sustainability goals effectively and efficiently,” says Scott O’Malia, ISDA’s chief executive. “Given the rapid growth of this sector, it’s important we develop standards and best practices to ensure the market functions safely and efficiently. These papers make an important contribution to this work and complement other ISDA initiatives on legal documentation and definitions for ESG-related derivatives.”