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SUSTAINABLE DERIVATIVES: THE “GIVING TREE”

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Jennifer Kafcas, Lauren Blaber, Alvino Van Schalkwyk and Harry Polan

 

Momentum continues to gather pace towards building a sustainable economy, especially since the start of the pandemic. As a result, financial markets have seen a considerable increase in the focus on, and deal volume with respect to, sustainability-linked loans and bonds.  It has been a logical progression that the sustainability tree sprouts a new leaf with the development of environmental, social and governance (ESG) linked derivatives.  These products enable, among other things, firms and companies to hedge risks associated with sustainable investments including project risk, interest rate and currency risks.  This will be all the more important given the need to hedge risks from any underlying loan and its related sustainability criteria.

While ISDA has outlined the broad range of derivatives in sustainable finance, furthering the development of this product type (including, among others, sustainability-linked derivatives, ESG-related credit default swaps, exchange-traded derivatives on listed ESG-related equity indices, emissions trading derivatives, renewable energy and renewable fuels derivatives, and catastrophe and weather derivatives), this article focuses on more conventional derivatives transactions, such as interest rate swaps (IRS) and Foreign Exchange (FX) transactions used by market participants to hedge the risk arising from green bonds and loans. Though these transactions are no different conceptually from a product standpoint than any other IRS or FX transaction, it is important to understand the inherent structural and deal term differences.

 

Finance-linked sustainable derivatives (OTC)

A number of sustainability-linked derivatives have been issued in recent years, which add an ESG pricing component to conventional IRS and FX hedging instruments. The table below provides examples of recently issued sustainability-linked derivatives. As this is a developing market, the transaction volume has been very low, but uptake is expected to increase over coming years.

 

Parties Deal Information
BNP Paribas & Siemens Gamesa €174 million FX forward, under which Siemens Gamesa will pay a premium on their forward if they do not meet certain ESG targets. If paid, that premium shall be used to finance local reforestation projects in Spain. The premium shall be calculated using a metric assigned by a third-party sustainable finance specialist.
Société Générale & Enel Cross currency swap, by which Enel hedged their euro-dollar exchange rate and interest rate risk under a $1.5 billion sustainability-linked bond. If Enel does not meet certain renewable energy targets, the swap will be re-priced to their detriment.
New World Development (NWD) & DBS Hong Kong Interest rate swap linked to the United Nations Sustainable Development Goals, hedging interest rate risk under NWD’s HK$1 billion sustainability-linked loan. If NWD generates at least eight business-to-business opportunities that contribute to the Sustainable Development Goals, DBS will sponsor certain NWD social innovation projects.

 

As evidenced above, ESG-linked derivatives can take on a number of characteristics and structures, including:

  • Derivative pricing. One counterparty having a number of prescribed ESG targets which, if met, will lead to a downwards ratchet in the pricing of the derivative (with such pricing often increasing if the targets are not met).
  • Fixed payments. If ESG targets are not met by the corporate, a fixed payment can be required to the issuing bank, which will be put towards a green project.
  • Triggers linked to a company’s ESG rating. If the ESG rating of the corporate increases, a benefit can be awarded to them (e.g. interest rate discount).
  • Both parties having ESG targets papered into their derivatives contracts. Corporates can receive a discount on the interest rate under the derivative if they meet their ESG targets, with that discount increasing if the issuing bank fails to meet its own ESG targets.
  • Charitable giving requirements. A failure by the corporate to comply with its ESG targets can lead to it being required to make contributions to non-profit organisations, with the bank having to make such contributions if the corporate’s ESG targets are met.

As sustainability-linked products gain traction, a degree of care will be required to ensure ESG targets are finely balanced and verifiable. Verification is essential for market transparency, for ESG products to be considered credible and for lenders and corporates alike to avoid reputational risks. Furthermore, the ability of a corporate to verify reliable compliance with ESG targets could provide a significantly smoother path through their lender’s credit approval process and in turn the lender’s ability to verify will enable it to better monitor the performance matrix set by the underlying loan or bond.

 

Renewable Energy and Renewable Fuels

In addition to the above OTCs, renewable energy hedging transactions (including power hedge transactions) are important for market participants to hedge the risk associated with fluctuations in renewable energy production, and in doing so, encourage more capital to be contributed to renewable energy projects.

Typical documentation with respect to the above type of trades are Power Purchase Agreements (PPAs) which document the purchase of power and associated renewable energy certificates between a renewable energy generator (the seller) and a purchaser of renewable electricity (the buyer). PPAs do not require companies to contribute directly to enhanced ESG standards, however they can help catalyse a shift to clean energy sources as they reduce market price volatility for buyers, and reassure sellers that a buyer will purchase power generated from renewable energy assets, thus encouraging the financing of such projects.  In an ESG-linked transaction, these types of arrangements can be replicated by covering the credit risk element in the intercreditor terms.  As an alternative the market may develop such that in lieu of these structures the underlying risk with respect to market price volatility is documented under an ISDA and secured under the financing and intercreditor documentation. This structure is fast approaching.

 

Expected developments in 2021

Climate change and, therefore, a sustainable economy remain front and centre for governments and regulators worldwide.  In 2020,countries like Japan, China, South Korea, Hong Kong and the UK set net carbon neutrality objectives and most recently the USA, following the inauguration of President Biden, announced plans to spend $2 trillion over four years to aid in the fight against climate change, all following the commitment already set by the EU.

Whilst the need for banks and corporates to develop and consider bespoke products to promote true progress in ESG compliance may hinder any radical uplift in ESG-linked derivatives volumes over the course of 2021, we anticipate that as banks and corporates continue to familiarise themselves with the requirements of such products, integrating ESG elements into derivatives trades will begin to be common practice.

In view of this, derivatives market participants will be eager to continue to drive ESG-linked derivatives volumes and to develop new and innovative ESG products facilitating the mobilisation of capital towards sustainable investments to ensure that they continue to significantly improve ESG standards, and to strengthen their contribution to the green finance drive.

 

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ENTRUST INTRODUCES ADAPTIVE ISSUANCE™ PRODUCTION ANALYTICS SOLUTION TO OPTIMIZE CARD ISSUANCE OPERATIONS

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The new solution provides intelligent, data-driven insights to card issuers with Central Issuance systems for improved and timely management decisions

 

Entrust, a global leader in trusted identity, payments and data protection, today introduced the Production Analytics Solution, designed to provide real-time data and actionable insights to optimize card issuance operations. The solution is part of the Entrust Adaptive Issuance software platform trusted by banks, governments and other organizations worldwide.

With the complexity of card issuance environments and lack of real-time visibility into production system operations, card issuers have difficulty effectively overcoming efficiency challenges across the production ecosystem. Entrust has leveraged more than 50 years of expertise in the card issuance market to develop a platform that will provide the intelligent data and expert support needed to master operational planning for the alignment of people, equipment and processes, positioning card issuers as leaders within the industry.

“Card issuers are in search of solutions that help bring efficient continuous process improvements and optimization to the production floor,” said Dan Good, Vice President, Payment and Identity Issuance Solutions at Entrust. “The Entrust Production Analytics Solution was developed by the same engineers that built the systems it supports. And, we’ve gone a step further to provide one-on-one consultation to our customers, allowing them access to our team of experts to help identify and remove bottlenecks, increase operational efficiency and reduce production costs.”

 

How it works

The Entrust Production Analytics Solution collects information directly from the Central Issuance systems on the production floor and converts it into a dynamic dashboard of data for in-depth analysis. It offers point-and-click drill down capabilities to refine the accumulated data over any time interval, and the data can be shown in a variety of ways to see the most appropriate insights for the operation.

Key features and benefits of the subscription includes:

  • Real-time, actionable data collection that supports SPC (Statistical Process Control) methodology to monitor production statistics and trends for immediate problem solving
  • Regular industry expert engagements that will provide in-depth analysis of data and actionable recommendations for card issuer efficiency improvements

Regular software updates and new features

 

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UK READY TO SPEED UP THE DIGITAL TRANSFORMATION REVOLUTION

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More than half of businesses set to accelerate projects due to pandemic

British business is set for a digital revolution according to a survey which indicates that 56 per cent of companies are speeding up plans because of the pandemic.

With so many employees working from home, and a battle to get back on track after a year of turbulence, businesses are realising their processes and systems are potentially outdated and in need of an overhaul.

The survey, commissioned by Crown Records Management, revealed:

  • 32 per cent are planning digital transformation in the next 12 months to cope with the new normal.
  • A further 24 per cent plan to act within five years.
  • 66 per cent say the pandemic has made the C-Suite in their business recognise the importance of digital transformation.
  • 30 per cent say allowing employees to work at home efficiently is now a key driver for digital transformation.
  • 27 per cent do not view their business as having already ‘gone digital’.
  • Only 26 per sent say they have already fully digitised all their back-office functions.

David Fathers, Regional General Manager at Crown Records Management, said: “There was already a big desire from UK businesses to develop a digital strategy even before the pandemic, driven by a demand for improved data security and a need to be more competitive in the market.

“But these survey results show that companies now want to increase the pace of change because of the events of the last year.

“Having so many employees working from home has shone a light on the inadequacies of systems currently in place in many companies, of all sizes. Employees have found that information has been difficult to track down and slow to access.

“There’s a myth that Western countries such as the UK are so far ahead in the digital field that most businesses have already undergone digital transformation.

“The survey showed that only a quarter of businesses have fully digitised all their back-office functions, which means there is a long way to go.”

The survey, undertaken by Censuswide, polled 401 decision makers at companies across the country with between 250 and 5000 employees.

David Fathers added: “We also asked whether people considered their business as having already ‘gone digital’ and surprisingly 27% said ‘no’.

“That figure was even higher in London at 30% and highest of all in companies of between 250-500 employees – at 46%.

“It is vital that businesses begin the digital journey soon. The benefits are compelling.

“Digital solutions can help a business become more efficient, save time and money, and make it simpler for employees to do their job – and that’s even before we begin to think about compliance and data security, which are huge business issues in the modern world.

“Perhaps it has taken the pandemic for some boardrooms to wake up to the importance of digital transformation, but if the intentions set out in this survey become reality, it can only be a good thing for UK business.”

 

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