Climate clause

ESG Linked Pricing Adjustment for Derivatives Transactions

Lara's Clause

A generic guide and checklist to introduce sustainability linked principles into derivatives documents where the ESG-related performance criteria is not linked to any other underlying loan documents.

This is a climate clause

This clause brings climate considerations to your drafting. It is not yet net zero aligned. To align this clause with net zero, use our toolkit or join one of our events.

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Why use this?

The proposed clause is a starting point for counterparties to introduce sustainability-based principles that can then be tailored to bespoke derivative products based on the different ESG requirements of the counterparties.

The clause will incentivise counterparties by introducing a corresponding increase or decrease in derivatives pricing depending on whether such targets are met.

Derivatives play an essential role in advancing the sustainable finance agenda and in mobilising large amounts of capital needed for sustainable investments over the next decade.

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The clauses on this website (and published in our Climate Contract Playbook) have been prepared in good faith on a pro bono basis and are free to download and use. The clauses have been drafted and edited by a variety of lawyers and, as such, the approaches to drafting may not conform to any particular drafting norms. We acknowledge this as a consequence of the collaborative drafting process.

The clauses on this website (and published in our Climate Contract Playbook) are provided on an ‘as is’ basis and without any representation or warranty as to accuracy or that the clauses will achieve the relevant climate goal or any other outcome.

This website (and the Climate Contract Playbook) does not comprise, constitute or provide personal, specific or individual recommendations or advice of any kind, and does not contain legal or financial advice. The clauses are precedents for legal professionals to use, amend and negotiate using their professional skill and judgement and at their own risk.

While care has been taken in the drafting of these clauses, neither The Chancery Lane Project nor any of its contributors owe a duty of care to any party in relation to their preparation and do not accept any liability for any errors or omissions, nor for any loss incurred by any person relying on or using these clauses or any other person. Users should use their own professional judgement in the application of these clauses to any particular circumstance or jurisdiction or seek independent legal advice.

At present, all the clauses are based on the laws of England and Wales. We encourage the conversion of these precedent clauses for use in other jurisdictions.

The clause

[] KPI TERMS

[Drafting note: KPI Terms to be slotted in as a distinct new part of the trade Confirmation.]

KPIs: The Key Performance Indicators as set out in the Annex. [Drafting note: The KPIs in the Annex could provide for a yearly reset of the KPIs, to ensure continual improvement and high ambition.]

KPI Test Date: [●] in each [calendar year]. [Drafting note: Annual KPI test date is generally expected to be some weeks after the financial year end of Party [A][B] to allow for the  gathering of information and reporting.]

KPI Verification*: On [each] KPI Test Date Party [A][B] will provide in writing to the [other party]/[External Validator] all necessary information (“KPI Information”) for the [other party]/ [External Validator] to make an assessment as to whether Party [A][B] has satisfied:

  • the KPIs in respect of the financial year of Party [A][B] ending on [●] immediately preceding the relevant KPI Test Date; or
  • the Net Zero Condition including, without limitation, the GHG Reporting [and disclosure of Offsetting Strategy] with respect to Party [A][B] [and its subsidiaries].

Based on a review of KPI data and information on the KPI reporting process supplied by Party [A][B], the [other party]/[External Validator] will determine the extent of Party [A][B]’s compliance with [the KPIs and] the Net Zero Condition. To the extent that the [other party]/[External Validator] requires further information to complete the assessment and validation, [A][B] will provide such additional information in writing to the [other party]/[External Validator]. For the avoidance of doubt, the determinations of the [other party]/[External Validator] will be final and binding upon the parties in the absence of manifest error.

* [Drafting note: Where appropriate, the KPI Information/ GHG Reporting can be verified by an external validator (rather than the other party). The drafting includes both options.]

** [Drafting note: As per above, the KPI Test Date is expected to fall some weeks after the financial year end date for annual KPI testing.]

External Validator: [Insert name of ESG services provider] or any successor entity appointed by Party [A][B] to act as the External Validator.


ANNEX – KPIs

[Drafting note: consider providing for yearly reset of the KPIs, to ensure continuous improvement and high climate ambition.] 

Indicator Description: [Insert 2 or more ESG KPIs which are specific to Party [A][B] and specify if these are to be reset every year (and if so, what the updated KPIs will be)]

[Some examples derived from ICMA and LMA guidelines on sustainability linked debt products include:

  • GHG Emissions Reduction
  • Energy Efficiency
  • Water Consumption
  • Affordable housing
  • Circular Economy
  • Renewable Energy
  • Access to Essential Services
  • Socioeconomic advancement]

Key Performance Indicator (KPI) Target: [Insert KPI targets for the 2 or more ESG KPIs selected above.]

 

Indicator Description: Achievement of Net Zero Target*

Key Performance Indicator (KPI) Target: [Insert KPI target for Achievement of Net Zero Target.]

* [Drafting note: if this KPI is chosen, use additional definitions set out in the Net Zero Condition Rider.]


NET ZERO CONDITION RIDER

[Drafting note: If the selected KPI is the achievement of the Net Zero Condition, slot in additional definitions from the Net Zero Condition rider into the KPI Terms part of the trade Confirmation.]

GHG Emissions: Party [A][B]’s [and its subsidiaries’] emissions of GHGs from all sources, categorised as scope 1, 2 and 3 emissions by the GHG Protocol as updated from time to time, each expressed as a total in units of carbon dioxide equivalent (CO2e) and calculated in accordance with the GHG Protocol or such other equivalent and generally recognised GHG emission calculation methodology. [Drafting note: Scope 1, 2 and 3 emissions are defined on page 27 of the GHG Protocol.]

GHG Protocol: The Greenhouse Gas Protocol: A Corporate Accounting and Reporting Standard, Revised Edition 2015, as updated from time to time.

GHG Reporting: Reporting of GHG Emissions to a standard not less than that required by the [GHG Protocol] [Science Based Targets Initiative] [UK government’s Streamlined Energy and Carbon Reporting (SECR)]. [See Carbon Trust, SECR explained: Streamlined Energy & Carbon Reporting framework for UK business (April 2019).]

Greenhouse Gases (GHGs): The natural and anthropogenic gases which trap thermal radiation in the earth’s atmosphere and are specified in Annex A to the Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) [or otherwise specified by the UNFCCC at the date of this [ISDA confirmation/ ISDA agreement]], as may be amended from time to time[, which include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), sulphur hexafluoride (SF6) and nitrogen trifluoride (NF3)].

Net Zero: A state of balance by 2050 or sooner between all of [Party [A][B]’s] sources and sinks of emissions of Greenhouse Gases [in each calendar year] achieved by both an overall reduction and a removal of emissions of GHGs to achieve the goals of the Paris Agreement.

Net Zero Condition: This condition shall be satisfied if the Net Zero Interim Target is met on or prior to each KPI Test Date, as determined in accordance with the KPI Verification requirements set out herein.

Net Zero Interim Target*:

(i) Reduction of annual GHG Emissions by Party [A][B] [and its subsidiaries] by: a minimum of [7]%** against the previous year’s GHG Emissions [to achieve a state of Net Zero as soon as possible] [Drafting note: This can be linked to the relevant Net Zero target or left generic by reference to a state of Net Zero as drafted.].

(ii) Removal of GHGs associated with the implementation of the Offsetting Strategy to address [all][[●]% of]*** annual Residual Emissions of Party [A][B] [and its subsidiaries] [to achieve a state of Net Zero [as soon as possible]] [Drafting note: This can be linked to the relevant Net Zero target or left generic by reference to a state of Net Zero as drafted].

* [Drafting note: Insert more specific, tailored, interim goals towards the Net Zero Target here as applicable.]

** [Drafting note: This can be tailored, depending on the relevant industry sector. To halve emissions every decade a 7% year on year reduction is required on average. See the ‘Carbon Law’; and  J. Rockström et al., ‘A roadmap for rapid decarbonisation’, Science 355.6331, 1269-1271 (2017); Summary Report: Race to Zero criteria consultations; EU Technical Expert Group on Sustainable Finance, TEG final report on EU climate benchmarks and benchmark ESG disclosures (September 2019). The different scenarios in the 1.5°C scenario envelope determined by the Science Based Targets initiative (SBTi) vary in linear reduction rate (2020-2035) from 4.2%-6% but the SBTi advises setting the most ambitious target possible. According to the SBTi Corporate Manual, the minimum ambition required for a sector may be more or less ambitious than this. The methodology used to determine this figure is described in section 4 and Appendix 3 of the SBTi’s Pathway to Net Zero SBTi Technical Summary (October 2021) and takes into account synergies and trade-offs between different mitigation pathways and SDGs.]

*** [Drafting note: Ideally all residual emissions would be offset to achieve net zero, but if this is not achievable, insert an agreed percentage here, linked to the parties’ respective net zero target plans.]

Offsetting Strategy: A plan specifying:

(i) the carbon credits that will be purchased by Party [A][B] [and its subsidiaries] from a project that has been verified in accordance with [insert name of voluntary standard] or under the United Nations Framework Convention on Climate Change (UNFCCC) clean development mechanism (CDM) [or [successor/ equivalent] UNFCCC mechanism] to offset its Residual Emissions;

(ii) [how/that] the emissions of GHGs* avoided, reduced or removed by the project are additional;

(iii) how Party [A][B] [and its subsidiaries] will transition from using credits resulting from offsetting projects that avoid or reduce third party emissions of GHG to those from projects that remove emissions of GHG from the atmosphere and involve long-term storage methods that have a low risk of reversal [over millennia]; [and]

(iii) how Party [A][B] [and its subsidiaries] will [use best endeavours to] reduce its use of credits by reducing its Residual Emissions [to zero/ by [●] %] by 2050; and

(iv) the impact of the relevant offsetting projects on a just transition and wider social and ecological goals.

* [Drafting note: The reference to “emissions of GHGs” here is to GHG emissions generally. The defined term GHG Emissions is not used because, in general, the defined term relates to the emissions of a party relating to a particular agreement or transaction.]

Residual Emissions: The GHG Emissions that are emitted after all reasonable efforts have been made by Party [A][B] [and its subsidiaries] to reduce GHG Emissions from all operations including value and supply chains.

[END OF NET ZERO CONDITION RIDER]


KPI-Linked Payment Adjustment provisions

[Drafting note: This table as drafted deals with floating payment provisions. Users of this clause may want to replace the floating payment provisions with fixed payment provisions as appropriate/ required.]

Floating Payment 2 [Drafting note: It is expected that this amount is a premium in addition to the other payment flows reflecting the rest of the commercial deal between the parties.]

Floating Payment 2 Payer: Party [A][B]

[Floating Payment 2 Condition: The Floating Payment 2 will become due in the event that Party [A][B] does not satisfy the relevant KPIs. For the avoidance of doubt, the Floating Payment 2 will not become due in the event that Party [A][B] does satisfy the relevant KPIs.]

[Floating Payment 2 Amount: [Currency] [Amount]*/[The product of (a) the [[Currency][Amount]]; and (b) the percentage the External Validator determines the KPIs to have been satisfied pursuant to KPI Verification in the calendar year of the Floating Payment 2 Payment Date.] [Drafting note: This alternative is intended to be applied in respect of annual tests of the degree to which the KPIs have been satisfied.]

* [Drafting note: This option is applicable to the Net Zero KPI; for drafting simplicity this is a fixed sum. It could be a rate applied to the Notional Amount and a day count fraction could be applied if it is attractive to incentivise the Floating Payment 2 Payer to meet its Net Zero Target more quickly.

Floating Payment 2 Payment Date(s): [●] Business Days following the date on which [External Validator][Party [A][B]] determines that the relevant KPIs have not been satisfied.

Option 1 [Drafting note:  This option entails a payment being made from one Party to the other. This may trigger application of the Uncleared Margin Rules, depending upon the regulatory status of the parties. Parties should consider the impact of these Rules when deciding whether to adopt this option.]

Floating Payment 2 Receiver: Party [B][A]

The Floating Payment 2 Receiver intends to pay the Floating Payment 2 Amount (less any deduction or withholding for or on account of any tax*) to [description of environmental cause/ charity, including (if appropriate) a fallback] within [10] Business Days of its receipt from the Floating Payment 2 Payer, but it is under no obligation to do so.

[Upon the termination of the Transaction in whole, no further amounts shall be payable under this part of the Confirmation save for (i) any amount that has already fallen due and remains unpaid; and (ii) any amount that falls due on a Floating Payment 2 Payment Date falling after the termination of the Transaction but that is in respect of a KPI Test Date that occurred on or prior to the date of such termination.] [Drafting note: Parties may wish to consider carving out from the close-out amount calculation any FUTURE payment(s) that may have arisen under this payment provision as it would be difficult to value/ calculate the KPI linked component of the close out amount.

* [Drafting note: This is not the defined term Tax because that term is used in respect of payments under the ISDA master agreement, and this payment would not be pursuant to the ISDA master agreement.

Option 2

Floating Payment 2 Receiver: [Description of environmental cause/ charity.

[Drafting note: Party A and Party B should notify the environmental cause/ charity of the potential for this payment to be made before the Trade Date of the Transaction, so that the environmental cause/ charity can ensure that it has prepared for any anti-money laundering or other ‘know your customer’ check that it might need to satisfy. Parties may wish to specify a fallback or agree the process for identifying a replacement/ successor charity.]

Floating Payment 2 Receiver’s notice details: For the purposes of Section 12(a) of the Agreement: [Insert notice details for the environmental cause/ charity.] The Floating Payment 2 Receiver may by notice to the Floating Payment 2 Payer change the details above.

Floating Payment 2 Receiver’s account details: In relation to payments of Floating Payment 2, Section 2(d)(i)[and (ii)]* of the [Agreement] shall apply as if the Floating Payment 2 Receiver was Y, except that, [(a)] in relation to paragraph (i)(4), the second sentence (including sub-paragraphs (A) and (B)) shall not do so[; and (b)** paragraph (ii) shall not do so] [Drafting note: This (b) is only required for 2002 ISDA master agreements, (and (a) need not be described as such in the absence of (b)).].

Section [2(e)]/[9(h)]*** of the [Agreement] shall apply except that references to the “other party” shall be replaced by “Floating Payment 2 Receiver”.

[Insert account details of environmental cause/ charity.]

* [Drafting note: Text in square brackets “[and (ii)]” applicable if the ISDA master agreement is a 2002 version, rather than a 1992 multicurrency one.]

** [Drafting note: The environmental cause/ charity cannot be expected to perform obligations which arise under an ISDA master agreement.]

*** [Drafting note: Choose the appropriate version depending upon whether the relevant ISDA master agreement is the 1992 multicurrency version or the 2002 version.]

Floating Payment 2 notification process: The Floating Payment 2 Receiver may by notice to the Floating Payment 2 Payer change the details above. In the event that Floating Payment 2 becomes due, the Floating Payment 2 Payer will notify the Floating Payment 2 Receiver in writing, with a copy to Party [B][A], within [2] Business Days.

Breach of Agreement: The failure of the Floating Payment 2 Payer to pay the Floating Payment 2 to the Floating Payment 2 Receiver in accordance with this provision shall constitute a Breach of Agreement (which shall be an Event of Default pursuant to Section 5(a)(ii) of the Agreement (Breach of Agreement)) if such failure is not remedied on or before the thirtieth day after notice of such failure is given to the party by either Party [B][A] or the Floating Payment 2 Receiver (provided that, in the event the notice is given by the Floating Payment 2 Receiver, the Floating Payment 2 Receiver provides a copy of such notice to Party [B][A]). [Drafting note: This would trigger dialogue between Party [B][A] and the Floating Payment 2 Receiver so that Party [B][A] knows if the Floating Payment 2 Payer ultimately satisfies its payment obligation. However, this dialogue is not a contractual obligation of those two parties.] However, the Floating Payment 2 shall not constitute an Unpaid Amount. [Drafting note: This is because an Unpaid Amount is defined as an amount owing to a party under the ISDA master agreement (which the Floating Payment 2 Receiver is not). Furthermore, including it as an Unpaid Amount could have consequences for the ISDA legal opinion in respect of the governing law of the relevant ISDA master agreement.]

Third party rights: The Parties agree the Floating Payment 2 Receiver may enforce its rights to receive the Floating Payment 2 Amount. [Drafting note: This provision replicates the position set out in the Contracts (Rights of Third Parties) Act 1999 but this provision is incorporated here in case the effects of this legislation have been excluded.

[Section 3(d) Representation: For the purposes of Part 3(b) of the Schedule to the Agreement, the KPI Information delivered by Party B pursuant to KPI Verification shall be covered by the Section 3(d) Representation.] [Drafting note: This provision shall apply if Party [A][B] is providing KPI Information.]

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