Banks explore ESG-linked deal contingents

Trend for tying derivatives to ethical criteria could soon extend to deal contingent hedges

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Users of deal contingent hedges may soon be able to link the derivatives to ethical targets, as banks consider launching trades with an environmental, social and governance (ESG) component.

“We should be doing them,” says Christopher Wall, global head of foreign exchange structuring at Deutsche Bank. “We will do them. When there’s client demand for a solution then banks will step up to the plate, so I’m already firing emails about it.”

ESG-linked derivatives already exist in various forms. In one structure, a client pays a reduced rate on an interest rate swap if it meets pre-set targets, or a higher rate if it misses the targets. Another structure requires the client to make a fixed payment to the bank if it misses an ESG target, which the dealer puts towards a green project.

Deal contingent trades are typically foreign exchange or interest rate hedges used by M&A acquirers, which only kick in if the deal succeeds. The trades have been popular with banks in recent years for the profits they bring in, but dealers run the risk of being left with naked hedges if the deal falls through.

To include an ESG-linked element in a deal contingent is theoretically simple, says Benoit Duhil de Benaze, director of European private equity at hedging adviser Chatham.

“Deal contingent hedges can be applied to any derivative, whether that’s an FX or interest rate ESG-linked derivative or a plain vanilla derivative,” says de Benaze. “It’s just a question of time before we see the first one.”

ESG-linked deal contingents may be applicable to companies that are seeking to replicate the hedging requirements of the target company, dealers say.

“If a client makes an acquisition, they will then take on the hedging needs of the company they’re acquiring. Using a deal contingent framework which ensures that their upfront hedge is ESG compliant is an interesting concept,” says Deutsche Bank’s Wall.

The first derivative linked to ethical or sustainable targets was launched in August 2019, when ING struck an interest rate swap with Dutch oil and gas services company SBM Offshore using a rate that was partly dependent on a range of ESG criteria.

Other banks have issued green derivatives since then. BNP Paribas released a sustainability-linked FX forward in October that requires the client to pay a premium to the French bank should they not meet their ESG targets. BNP Paribas will then use this premium to finance forestry projects.

For deal contingent hedges linked to project finance transactions to become ESG compliant, experts says the underlying financing would likely need to meet ethical standards – such as being used to finance a windfarm, for example.

Having an ESG component would certainly add complexity and complication as to how you risk-manage it, but it’s still possible to risk-manage

Head of FX sales at a large dealer

A potential snag for these transactions is the time required to finalise them. Deal contingent trades are typically put together quickly – “within a couple of days”, says Max Poulin, FX risk management solutions at Deutsche Bank. But agreeing on a set of ESG targets with the client can be a drawn-out process.

“There’s still a bit of work to be done before we’re able to offer an ESG structure within the timeframe considered for deal contingent transactions,” Poulin says. “If the transaction involves hedging an underlying green project then that might be feasible, but if it’s linked to a public company M&A transaction then that might require a new structure to be put in place.”

Another concern for dealers is whether they are able to hedge the risk of the trade. For deal contingent ESG interest rate swaps, hedging shouldn’t pose problems, says the head of FX sales at a large dealer. The only risk involved in such a trade from a bank’s perspective is that the client meets the ESG target and pays a lower interest rate, which is possible to hedge, the head says.

“Having an ESG component would certainly add complexity and complication as to how you risk-manage it, but it’s still possible to risk-manage,” the head says.

ESG derivatives structuring has advanced in other areas too. Most recently, JP Morgan has created a cross-currency swap linked to both JP Morgan’s and the client’s ESG targets. Issued to Italian electricity company Enel earlier this month, the £500 million ESG cross-currency basis swap requires both Enel and JP Morgan to pay interest to each other every six months, with the interest rate increasing or decreasing depending on how well either side meets their ESG targets.

For Enel, its ESG targets are linked to the amount of renewable energy it generates – with a target to reach a renewable capacity equal to or higher than 60% of its total consolidated capacity by December 31, 2022. Meanwhile, JP Morgan’s ESG target is to arrange $200 billion of funding this year for climate change action and the United Nation’s sustainable development goals, which will be achieved by underwriting green bonds.

If Enel meets its ESG targets, it receives a discount on the interest rate it is paying under the swap, and if it fails to meet its target then its discount will be eliminated and it will pay the full interest rate. If JP Morgan fails to meet its target, then the discount for Enel will increase.

Enel was also involved in the world’s first sustainability-linked cross-currency swap with Societe Generale in September 2019.

Editing by Alex Krohn

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