Sustainability-Linked Derivatives (SLDs) are customizable transactions that use key performance indicators (KPIs) to set sustainability targets. The first SLD was launched in the EU in 2019.
The International Swaps and Derivatives Association (ISDA) published an Overview of ESG related products and transactions, namely:
ESG-related credit derivatives
ESG-related exchange - traded derivatives
Renewable energy and renewable fuels
Catastrophe and weather derivatives
Furthermore, ISDA distinguishes between 2 types of SLDs
Category 1 SLDs : The KPI(s) and the related impact on cashflow(s) are embedded within the derivatives transaction. An example of a Category 1 SLD could be a cross-currency interest rate swap (IRS) that provides additional payments or a preferential exchange rate when the KPI is met.
Category 2 SLDs : The KPIs and cashflows related to them are set out in a separate agreement that references underlying (generally vanilla) derivatives transactions for setting the reference amount to calculate the KPI-linked cashflow. The terms (including pricing) of the underlying transactions (which may include transactions with other affiliates of the parties) would generally not be affected. An example of a Category 2 SLD could be an agreement to make a payment if a counterparty meets its KPIs, with the payment calculated as a percentage of the notional amount of unrelated, separately documented derivatives transactions.
ISDA released a Paper setting out regulatory considerations for SLDs from an EU, UK and US perspective taking into account the category.