Sustainability-linked derivatives

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Sustainability-linked derivatives
/səsˌteɪnəˈbɪlɪti lɪŋkt dɪˈrɪvətɪvz/ (n.)

It is said that the ancient people of Easter Island felled every tree on the island while erecting statues to their Gods and ancestors. The decaying root systems compromised the soil, which accelerated erosion, in which nutrients were washed away, plants could not regrow and eventually the whole ecosystem was wrecked. The island became all but uninhabitable.

This was quite the disaster in the service of trying to please some imaginary people.

This “ecocide” theory, popularised by Jared Diamond a generation ago, is out of favour with hand-wringing snowflakey academic types nowadays. ISDA’s council of elders may feel the same way about the JC’s corresponding “swapicide” theory.

Is ISDA desperately trying to stay relevant? Recent clumsy land-grabs of ICMA/ISLA territory and forays into crypto give that impression. In any case, the irony that ISDA’s latest foray into the new normal — “sustainability-linked derivatives” — should so resemble a notorious example of environmental disaster is rich:

A community of earnest toilers, supposedly there to vouchsafe the community’s onward prosperity, falls into the throes of a voguish collective delusion and sets about a wastes every tree in sight pursuing mad, hypercomplicated and illogical schemes for imaginary investors who no-one has seen, let alone heard expressing demand for such an offering.

ISDA’s recent missteps Even so this feels like a step further through the looking glass, deeper down the rabbit hole. ISDA’s previous follies at least tried to cater to existing markets and regulatory imperatives, however cack-handedly. Sustainability derivatives are an attempt to create a new one out of — ~cough~ — hot air.

How they are meant to work

If its discussion paper is anything to go by, not even ISDA has a clear idea what a sustainability-linked derivative would look like. Their best suggestion is that it would be some kind of plug-in to a normal swap — say an interest rate swap — containing a ratchet device to adjust the parties’ respectively spreads dependent on their compliance (or not) with certain pre-agreed ESG key performance indicators.

Perhaps ISDA hasn’t followed the media coverage of greenwashing, but objectively measuring environmental impact is hard, and open to abuse.

Nor is this a derivative in the sense normally understood, but rather more a random penalty clause: a payment derived not from some observable third party indicator, but an internal metric entirely within the counterparty’s gift to game: I know what targets I can plausibly meet; my counterparty has no idea at all.

This becomes an open invitation to systematic insider dealing on ones own operations, especially since swaps are by their nature bilateral. What is to stop buisnesses shorting their own sustainability credentials, and incentivise their own transition towards carbon and modern slavery?

And what has any of this to do with my counterparty? Why is paying, or not paying, cash away to a random stranger any kind of benefit to the environment? Why would a counterparty make itself hostage to my compliance effort? What incentive does it have to offer a discount just because I have cracked my own gender pay gap? Just by way of applause for its moral aspiration? That is not how commerce works. Besides, how is it supposed to hedge that?

The sustainability a counterparty should really care about is that of its counterparties’ solvency. Good corporate governance — and sorry, millennials, the JC is with Milton Friedman on this: that means focus solely on shareholder return — is after all reflected in my credit spreads: how likely does the market regard my bankruptcy. This is coded into my spreads when I trade swaps. But once traded, these are not then adjusted during the life of the trade — hence a rich lifetime of employment for credit value adjustment traders. But in any case, my incentive is to manage my business as best I can so that when I trade I achieve the tightest spreads. That is all the incentive the market has needed, until now, to promote sustainability. Hardcore Libtards may differ — we are all libtards now — but nothing has changed.

There is force in the idea that carbon credits are derivatives not so much of environmental damage as much as of regulatory fashion. SLDs aren’t event that. These aren’t even derivative at all. They penalise, and reward, innocent parties.

See also

• Credibility derivatives
• Stakeholder capitalism