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ESG derivatives gain traction with landmark Kiwi deals

Alongside its first sustainability-linked loan, Auckland Council has signed the world’s first public sector sustainability derivatives contract with a spread based on emissions reduction, fleet transition and diversity of procurement, underscoring the usefulness of such contracts to treasurers.

By Adrian Murdoch

Helen Mahoney of Auckland Council says the authority plans to add further sustainability targets as it converts its other borrowing facilities. (Photo courtesy of Auckland Council)
  • New Zealand’s Auckland Council has signed the first (publicly disclosed) public sector ESG derivative contract as an early mover in this nascent area.
  • The credit spread narrows if the council hits its three sustainability performance targets.  
  • The council has also converted debt to its first sustainability-linked loan and plans to do the same with the rest of its debt facilities. 

Sustainability-linked derivatives remain off the financial radar of most companies. The International Swaps and Derivatives Association said in a report in January last year that such ESG instruments represent “a niche, nascent market”, and its size is difficult to assess as many deals are not publicly disclosed.   

But these instruments are of potential value to treasurers and the market for them is growing, albeit slowly. They derive their value from financial markets and a company’s ESG performance and can be used to hedge interest rates, foreign exchange (FX) risk or inflation.  

That is assuming they hit their sustainability targets. For those that hedge interest rate risk, for example, the credit spread charged by the arranger shrinks by a pre-agreed amount if the client meets certain goals.  

In New Zealand, where both the public and private sectors are relative pioneers in sustainability, ESG derivatives have emerged recently, ahead of their appearance in most other countries.  

Take the government’s drive to accelerate its transition to cleaner energy and the country having been the first to announce mandatory climate disclosures from the financial sector; sovereign investor New Zealand Superannuation Fund’s reputation as a leader in carbon emissions reduction; or state transport operator KiwiRail becoming the first company in the shipping sector globally to raise debt certified by the Climate Bonds Initiative, in September.  

New Zealand’s first sustainability-linked derivative came in late February from Metlifecare. The retirement village operator signed a NZ$75m interest rate hedge with Bank of New Zealand.  

Its pricing is linked to a reduction in greenhouse gas (GHG) emissions; the construction of six new aged care communities, which aim to achieve the highest rating from the New Zealand Green Building Council; and both making all of its portfolio dementia-friendly – as accredited by Alzheimers New Zealand – and increasing the number of dementia care beds in its portfolio.  

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The hedge came off the back of the company’s NZ$1.25bn sustainability-linked loan in mid-December.  

A council first

That deal was followed in mid-March by Auckland Council, which brought the world’s first public sector ESG derivative contract, according to Capital Monitor data. The council for New Zealand’s largest city agreed a NZ$120m interest rate derivative, alongside the conversion of a NZ$200m standby lending facility provided by ANZ into its first sustainability-linked loan.  

Rated AA and Aa2 by S&P and Moody’s, Auckland Council has form with sustainable financing. It was the country’s first issuer of green bonds in June 2018 with a capped NZ$200m 3.17% five-year green bond to fund its electric train network and has issued $1.4bn in green debt since then, in both New Zealand dollars and euros (see chart).  

“As sustainability-linked facilities started to evolve, it was a natural progression for us,” says Andrew John, Auckland Council’s treasury funding manager.  

Both the derivative and the loan will run for three years – though the latter will keep rolling forward – and are linked to the same three key performance indicators (KPIs): emissions reduction, fleet transition and diverse procurement.  

The world’s first sustainability-linked derivatives contract emerged in August 2019 and was developed by Dutch bank ING for SBM Offshore, a Netherlands-based supplier of floating platforms for the offshore energy industry.  

Designed to hedge the interest rate risk of SBM’s $1bn five-year floating rate revolving credit facility, the contract entails the company paying a positive or negative spread over the fixed rate of the swap based on the company’s ESG performance, as determined by opinion provider Sustainalytics. 

The product took almost a year to surface in Asia. In June 2020, Singapore-based agribusiness conglomerate Olam International signed a sustainability-linked US dollar/Thai baht FX derivative with Deutsche Bank. There is a discount on the forward if the company strengthens its supply chain sustainability. 

The first Antipodean version of the product emerged at the end of October last year, when Ramsay Health Care signed an ESG-linked interest rate swap with National Australia Bank (NAB).  

Neither the notional size nor the details of the contract have been disclosed, but the sustainability objectives for the Sydney-based international healthcare provider include targets for emissions reduction and renewable energy use, first aid training and supply chain sustainability. 

Further KPIs planned

For the Auckland Council loan and derivative, there had initially been a list of five KPIs, says Helen Mahoney, Auckland Council senior corporate sustainability adviser; the other two focusing on biodiversity and waste. The council plans to add further targets as it converts its other borrowing facilities, she tells Capital Monitor.  

Mahoney says the three chosen KPIs – in addition to the conventional requirements that they must show ambition, be measurable and have a track record – had to link to the council’s strategic plan for sustainability: Auckland Plan 2050.  

The first KPI target is to reduce the council’s Scope 1 and 2 GHG emissions – those produced by the council itself or by the energy and heat it uses. It has both interim and long-term goals to that end.  

As part of the council’s overall plan to cut GHG emissions by 50% by 2030 and achieve net-zero emissions by 2050, it intends to reduce GHG emissions by 12.2% by next year and 16.8% by 2024. That is from a 2019 baseline – the first year for which the council has full figures.  

As of this year, Mahoney says, the council has achieved a 2.8% reduction, assisted by the electrification of Auckland’s commuter rail fleet, a move funded by the green bond in 2018.  

The second KPI is based on the number of low-emission buses operating in Auckland Transport’s fleet. The council sees this as a proxy for the challenge of cutting Scope 3 emissions – those produced by the company’s suppliers and customers.  

Auckland Council has made Australasia’s biggest electric bus order.

The KPI was chosen because transport makes up “a massive portion of our group emissions”, says Mahoney. The council estimates that it accounts for at least 40% of Auckland’s emissions profile. 

The council had 33 low-emission electric buses as of June last year and it aims to have 166 by June 2024, with the new buses replacing diesel models. 

The KPI will be difficult to achieve, John says, because of the challenges thrown up by international supply chains. There is a lead time of between 18 months and two years for the buses to be delivered, and getting access to the vehicles has been “a bit of a challenge”.  

Auckland Transport has placed orders for components for 161 e-buses so far from Chinese manufacturers CRRC and Yutong and from Alexander Dennis in the UK. They will be assembled by Kiwi Bus Builders in Tauranga. Three of the e-buses were delivered in February and 158 more are scheduled to enter service between August 2022 and June 2025. 

The council adds that negotiations are under way for more electric bus orders to help meet its targets. 

The third KPI is diversity-related because the council was very keen to set a social focus target, says Mahoney. The aim is to support businesses and social enterprises in Auckland owned by Maori and Pacific Islanders via the council’s social procurement policy. 

Based on money spent rather than the number of contracts, the target is to hit 5% of the total value of contracts being agreed with Maori and Pacific Islander businesses. As of June last year, the council was “just over halfway there”, Mahoney says, declining to provide the current percentage. It wants to achieve 4% by 2023 and 5% by 2024.  

Converting more debt facilities

The council declined to disclose the interest rate for the loan, but John says that the maximum step-up and step-down is around three basis points. 

For the derivative, which swaps a floating for a fixed rate, the structure is “very simple” and mirrors the step-up/down in the loan, he adds. For both the step-up and down, if the council achieves one target then the rates stay as they are. If two targets are achieved, there is a reduction, and if all three KPIs are met, there is a further reduction. The saving is not huge, says John, but the deal is only a starting point.  

While the council has no plans for sustainability-linked bonds “in the pipeline at the moment”, it has a further NZ$800m in bank facilities, and discussions have started with a view to converting them all to sustainability-linked facilities.  

“There will be some impact [in terms of cheaper funding] as we start adding on these facilities and the aggregation starts to take place,” John says.  

The effect from the further sustainability-linked swaps that are planned could be even greater. “The [initial] swap was only NZ$120m, but we have got more than NZ$11bn of swaps in on our books,” he points out.  

It should be noted that Auckland Council’s use of derivatives has been criticised in the past. In 2020, it booked a NZ$1.4bn two-year loss on interest rate derivatives after interest rates fell. Labour Party leader David Cunliffe blasted the loss as “absolutely incompetent”.  

But the council appears to have this back under control. In September last year, it reported a net gain of NZ$780m on derivatives – more than wiping out 2020’s losses of NZ$665m.  

What’s more, the use of derivatives does not appear to concern the international rating agencies. In September, S&P confirmed its rating, highlighting the city’s “strong economic and liquidity profile” and “the council’s experienced management”. This was echoed by Moody’s when it did the same in October last year, highlighting the council’s “strong governance practices”. 

The new derivatives contract can surely be seen as purely positive: Auckland Council will reduce its costs if it achieves environmental and diversity improvements. What’s not to like? 

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