Sustainability-linked derivatives

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

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It is said that the ancient people of Easter Island felled every tree on the island while erecting statues to their Gods and ancestors. Without the root systems the island’s topsoil crumbled and eroded, nutrients washed away, plants did not grow and eventually the whole ecosystem was wrecked. The island became all but uninhabitable and has not recovered in 400 years, but still has magnificent statues.

This was quite the disaster in the service of trying to please 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 in which a community of earnest toilers, bent on vouchsafing everyone’s onward prosperity but caught in the throes of a voguish delusion that everything is different this time sets about demolishing every tree in sight in the pursuut of mad, hypercomplicated, illogical schemes to solve imaginary problems for nonexistent investors.

What is ISDA up to? Is It trying to stay relevant? Are we watching an industry association having a midlife crisis?

Some — such as the JC — say there has always been something quixotic about an organisation who proclaims it is there to promote “safe efficient, markets” promulgatingv things like credit derivatives, but even so this feels like a step further through the looking glass; a tumble deeper down the rabbit hole.

The ’squad’s prior follies at least tried to cater to existing use cases, markets and regulatory imperatives, however cack-handedly.

Sustainability-linked derivatives feel like an attempt to create a new market no one is asking for out of — well — hot air.

How “SLDs” are meant to work

If its own discussion paper is anything to go by, no-one (yet!) has a clear idea what a sustainability-linked derivative should look like. ISDA proposes a sort of plug-in to a normal swap containing a ratchet device adjusting the spreads on parties’ respective payment obligations dependent on their own compliance (or not) with pre-agreed ESG key performance indicators.

But it is hard to see how this incentivises anything.

Now, objectively measuring environmental impact is hard, and open to abuse even when you aren’t talking your own book. But even so, greenwashing risk is the least of the problems here. Higher up the list is basic intellectual incoherence.

For a start, this is not a derivative in any normally understood sense. It is more like an arbitrary penalty clause: a payment derived not from some observable third party indicator, but an internal metric entirely within the counterparty’s gift to game: it knows what targets it can and cannot plausibly meet; its counterparty has — short of due diligence no-one will care to do just to execute a swap (among other things, it might bugger up your marginal carbon footprint) — no idea at all.

Insofar as an SLD is a derivative, it is a self-referencing one. They don’t much like those, usually, at ISDA. There is a reason they don’t let athletes bet on games they are playing in.

So this becomes an open invitation to systematic insider dealing on one’s own operations. And that is assuming a wily trader stays “long” her own firm’s sustainability performance at all times. But swaps are by their nature bilateral. What is to stop her shorting her own sustainability credentials, incentivising her employer’s transition towards carbon and modern slavery?

And why, exactly, should a firm’s trading counterparties care? What has any of this to do with them? What benefit accrues to the environment when one swaps desk pays more or less cash away to another? Why would my counterparties make themselves hostage to my ESG compliance effort? Why should they suffer a penalty just because I have cracked my gender pay gap? (Isn’t there reward enough in just doing that, by the way? What does it say about economic incentives to basically bribe people to promote staff fairly?)

In any case, commerce does not work by gifting emoluments to virtuous strangers just because they recycle shopping bags. Swaps traders certainly don’t. And besides, how are you supposed to hedge that?

The “sustainability” a counterparty should really care about is its counterparties’ solvency. That kind of 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.

My brokers will not let me off my credit premiums just because I care about the polar bears. If they don’t get their money back the knowledge that I did my bit for African water scarcity will be cold (wet?) comfort.

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