The International Swaps and Derivatives Association, Inc. (ISDA) published two new whitepapers examining key aspects of the fast-growing market for environmental, social and governance (ESG) transactions, with the aim of establishing 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.
The first paper sets out proposed guidance for drafting KPIs, which are fundamental to the effectiveness and credibility of these transactions.
Sustainability-linked derivatives tie cashflows on conventional hedging instruments to the meeting of specified ESG objectives.
KPIs 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.
The principles recommended are to ensure that KPIS are specific, measurable, verifiable, transparent This will enhance the credibility of SLDs and the sustainability-linked market as a whole.
The other paper outlines issues associated with the current accounting treatment of ESG transactions.
Under US Generally Accepted Accounting Principles, the ESG component of a bond or loan could be classed as an embedded derivative requiring bifurcation and accounting at fair value.
However, 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, according to ISDA.
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,” said said Scott O’Malia, ISDA’s Chief Executive.
He added, “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,”
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