ESG: the outlook for derivatives and structured products

Key regulatory developments

2021 continued to be a year of great regulatory change in the ESG space in both the EU and the UK. A number of new regulations came into force and several further changes were proposed.

In particular:

• The Commission adopted a delegated act, which entered into force on 30 December 2021, setting out the content, methodology and presentation of the KPIs that non-financial and financial undertakings are required to disclose under Article 8 of the Taxonomy Regulation. Financial undertakings will need to disclose (i) taxonomy-eligibility from 1 January 2022 and (ii) taxonomy-alignment from 1 January 2024.
• Another delegated act adopted under the Taxonomy Regulation sets out the conditions under which an economic activity qualifies as contributing substantially to climate change adaption or mitigation and for determining whether the economic activity causes no significant harm to any of the other environmental objectives in the Taxonomy. It began applying on 1 January 2022. Separate delegated acts are expected in 2022 on the technical screening criteria for (i) nuclear power and natural gas and (ii) the other four environmental objectives in the Taxonomy.
• The final rules amending MiFID II, UCITS, AIFMD, Solvency II and Insurance Distribution Directive to integrate sustainability risks and sustainability factors into decision-making were published, most of which will apply from August 2022. Broadly, these changes require uplifts to existing frameworks around risk management, conflicts, suitability assessments and organisational policies and procedures to ensure that ESG risks and factors are appropriately considered.
• The Level 1 Sustainable Finance Disclosure Regulation (SFDR) came into force on 10 March 2021. The SFDR requires various product and entity level disclosures to be made by in-scope firms (broadly EU fund managers and financial advisers). However, the detailed provisions contained in the Level 2 RTS have been delayed and will not apply until 1 January 2023. As such, until that time, firms are required to comply with the Level 1 provisions only. This is not straightforward as the detail (e.g. the detailed templates for use in the disclosures) is provided in the Level 2 RTS. The Commission has suggested that firms can demonstrate Level 1 compliance in this interim period by following the draft Level 2 RTS, although it is nonetheless hoped that supervisors will show forbearance in this period.
• Under new rules that came into effect on 1 January 2022, FCA regulated asset managers and asset owners, including life insurers and pension providers, will have to disclose how they take climate-related risks and opportunities into account in managing investments and they will also have to make disclosures about the climate related attributes of their products.

And of course, both COP26 and the transition to the Biden administration in the U.S. shone the spotlight on ESG across the world. In 2022, we expect to see a focus on how market participants can comply with their obligations under an increasingly complex global ESG framework.

Although most of these rules do not directly capture derivatives and structured products, asset/fund managers, insurers and pension providers will be caught. It is therefore important that banks in the derivatives and structured products space are aware of the regulation that their clients need to comply with, and we are increasingly seeing investors look to the banks to help them navigate their way through the regulation and to provide the information to allow them to make the relevant disclosures. It will also be key to think about how structured products are being marketed and what is disclosed in issue level documentation, particularly where such products are being promoted as green.

Sustainable structured products

We saw a wide range of sustainable structured products in 2021 and expect a significant rise in issuances in 2022.

• Sustainable notes and repackagings remain a key mechanism for providing investors with sustainable investments in a familiar format. As well as green or blue bonds being repackaged and sustainable payouts being included, sustainable commodities can be used to create a “green” product. In particular, carbon remained an attractive commodity in 2021 and the trend for repackaging carbon credits is set to continue and grow in 2022, with investors seeking exposure to the rising price of carbon and energy companies wanting to lock in delivery of carbon for their compliance purposes. Although largely confined to the mandatory carbon market at present, the growing focus on the voluntary carbon market means it is likely that we will start seeing new and innovative structures using voluntary carbon credits (VCCs). Repackaging structures are not currently directly captured by the SFDR and Taxonomy Regulation, but dealers and arrangers will need to think about how regulatory changes such as the MiFID II ESG amendments that will apply from August 2022 and other investor considerations will impact their structuring and marketing of these products. For more information, please see our note on ESG considerations for repackagings.
• Green regulatory capital transactions/synthetic securitisations and CLOs continue to be popular, with the market focusing on how ESG can be integrated into these products ahead of the development of a specific sustainable securitisation framework.
• With “green” structured products now firmly established in the market, we are seeing increased interest in focusing on the “S” of ESG. In particular, we expect to see more social financing structures designed to facilitate financing into a developing country, often backed by insurance/a guarantee given by a World Bank entity such as MIGA.

Sustainable derivatives

2021 saw the market consider how derivatives can play a part in the sustainable finance drive and this looks set to continue in 2022, with the market expected to focus in particular on carbon trading and sustainability linked swaps (SLDs).

• 2021 brought the establishment of the UK Emissions Trading Scheme following the UK’s departure from the EU (and accordingly, the EU Emissions Trading Scheme). This necessitated new ISDA standard documentation to support the OTC trading of UK Allowances, and many entities will be looking this year at utilising this. We expect the next big topic in the carbon space to be VCCs, with ISDA’s recent whitepaper (which we were delighted to work on with them) exploring the current legal treatment of VCCs and setting out recommended steps to be taken at both a global and jurisdictional level to foster greater legal certainty and enhance the secondary market.
• ISDA also published several papers on SLDs (swaps whereby the pricing adjusts depending on whether the counterparty meets certain pre-agreed ESG targets or “KPIs”) in 2021, and 2022 is likely to be an important year for these relatively new types of derivatives as the industry looks at whether any framework or standardisation is possible. The hope is of course that by establishing best practices, greenwashing in this area will be reduced and that in turn will strengthen the integrity and credibility of the market.

Sustainable benchmarks

2021 saw benchmark administrators getting to grips with the Low Carbon Benchmark Regulation and the various delegated acts setting out the detail of the required disclosures. We expect a continued focus in 2022 on sustainable benchmarks, with many administrators looking to offer one of the two new benchmarks created pursuant to the Low Carbon Benchmark Regulation. The new Corporate Sustainability Reporting Directive which has been proposed to revise and enhance the ESG reporting rules currently in the Non-Financial Reporting Directive will also be of interest to benchmark administrators, as it may help to address the difficulties in accessing the necessary data that they face when complying with their disclosure obligations.

For more information, please see our ESG Legal Outlook 2022 and Financial Regulation Horizon Report 2022.

This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors.