ESG-Linked Swaps and the New Governance School of Regulatory Scholarship

To some extent, this is another collection of words about an acronym that collects words, in the largely passive and meaningless manner of a lint roller.  Elizabeth Pollman recently developed a deft history of the acronym ESG, which stands for the “environmental, social. and governance” factors that are increasingly used in connection with business and investment management practices.[1]  My own view is that the term primarily rebrands a set of considerations long active in the debates over commercial and financial activities – whether in managerial, policy, or academic contexts – previously referenced through language of corporate social responsibility.  Whether meaningfully deriving from a new set of principles or simply representing a step in the maturation of efforts to align business activity with broader social impacts, ESG is associated with the broad deployment of contemporary management practices in addressing a wide range of risks and opportunities.

In brief, whatever one thinks of ESG, private efforts to rigorously monitor environmental and other social impacts from business activity are an important stage in a regulatory life-cycle.  These private efforts develop a substrate for future public regulation, which is generally both more forceful and more comprehensive in its reach.  The core observation is that even if public bodies can know what non-financial outcomes to regulate and how much to do so, a measure of those outcomes is required.  While it is common for legal scholars to assume that rational regulation is trivial to produce and its absence is owed to industry opposition, political failure, and other dynamics susceptible to expression through rational actor models, historic observation implies a more modest conception of human capacities.  In this regard, it is helpful to analogize the ongoing development of social accounting to the earlier development of financial accounting.

Efforts to present the inputs, outputs, and net accruals (or losses) of economic activity date back millennia to an era preceding the origin of money as a medium of exchange.  Some of the oldest surviving business records consist of strings where knots were used to represent quantities such as amounts of livestock or grain that had been accumulated or traded.[2]  Financial accounting matured over a long period, responding to capacities (such as the development of writing and media) and demands (such as growth in trade, use of capital from passive investors, development of longer term and capital intensive projects, advent of ventures with depreciable assets such as factories and railroads, and public regulation). By the fourteenth century, Tuscan merchants had developed the system of double entry accounting that captures the distinct financial unit of an entity (i.e., for every debit there is a credit and vice versa so that profitability is tied to the claims on the business with every asset of a going concern financed through debt or equity claims so the balance sheet balances). Although most law school students become (or should become) familiar with this system through their statutory readings when they cover partnerships in their business associations class, not many appreciate that the accounting concepts driving public law (e.g., in tax; bankruptcy; banking, securities, derivatives, and other financial regulation; antitrust; business associations; utilities regulation) were developed over hundreds of years in the service of private interests focused on gathering and communicating measures of assets, liabilities, profitability, and other financial features.  These concepts were imported into UK law in the mid-1800s to serve investor protection goals, some decades later into the regulation of rates in railroads and other natural monopolies, and by the early 1900s into American tax and banking law.

The concepts and practices that business regulation at the outset of the modern era relied on for its content and implementation were previously developed through private efforts at maintaining financial records of business position and performance.  This is not to say that private regulation is superior or more fundamental than public.  Indeed, a neat divide between public and private is absent today and even more artificial historically.  Judges interpreted accounting concepts in contracts since the time of Hammurabi, thereby making the concepts more meaningful and private investment in them more worthwhile.  Accounting was practiced and developed by governmental units (e.g., manors, boroughs) in parallel with private enterprise.  And public law created standards for the accounting industry and encouraged its development.  History resists categorical views of one sphere or another having primacy, teaching that some questions of the “whether the chicken or the egg came first” variety motivate little besides political rhetoric.  Instead, the observation is that public regulators (whether legislators, agency officials, judges, or others) are human and as such have limited capacity.  Regulators incorporate concepts and tools that are already available when writing new laws due to limits on legal engineering, which include constrained imagination as well as the costs of conditioning regulation on measures and other observations (or stated from another perspective, the conditions for applying legal carrots and sticks available to modern lawmakers weren’t practically available a few decades ago, just as future lawmakers predictably will have access to yet unknown means for deploying legal incentives that contemporary lawmakers lack).  Private industry is an important source of the concepts and tools lawmakers use.

These observations are consonant with so-called “New Governance” theory, which rejects simple explanations of (or distinctions between) public and private regulatory efforts.  Instead, in the words of Ian Ayres and John Braithwaite, “Practical people who are concerned with outcomes seek to understand the intricacies of interplays between state regulation and private orderings . . . . The empirical foundation for their analysis of what is good regulatory policy is acceptance of the inevitability of some sort of symbiosis between state regulation and self-regulation. . . .”.[3]  More generally, regulation is a co-determined outcome.  There are no central actors, and no over-arching coordination.  Instead, independent but interacting actors exert force opportunistically, contingently, and without any global agenda.  Within the New Governance framework, ongoing efforts at measuring environmental and other social outcomes in the setting of private contracts acquire an additional significance.

The efforts of lawyers, consultants, bankers and other professionals innovating social measures that condition rights and obligations within private arrangements are arguably more important as investments in regulatory capital than for their direct contributions.  Over the preceding years, these metrics have been adopted into private arrangements such as supply and other vendor agreements, credit agreements (e.g., bonds and loans), proxy-advisory services aimed at shareholders, executive compensation plans, and more recently, swap agreements.  In all of these contexts, private actors incorporating measures of social impact invest in concepts and practices that public actors may later incorporate into law.  The observable proliferation of ESG-relevant considerations across these contractual and quasi-contractual contexts raises a number of questions.  How do the capacities and motivations of the various constituencies using ESG measures compare?  How are these differences reflected in variations of provisions and processes expressing ESG considerations?  Are some (quasi-) contractual channels more efficacious than others at achieving (certain) ESG priorities?  What risks (in addition to opportunities) does steering by ESG metrics pose?[4]

After introducing the general interplay of private and public forces in regulation and exploring specific instances of public law incorporating privately developed tools, my paper hones in on the increasing use of ESG metrics in swap agreements.  As alluded to, each context where private parties deploy incentives conditioned on socially relevant metrics poses its own considerations. This is no less true of swaps than other areas.

Swaps, like other derivatives, are instruments for (re-)allocating risk.  A common example is the transfer of risk related to fluctuation of economic variables such as interest rates, currency exchange rates, or prices of various assets (e.g., energy, metal, or agricultural commodities).  Within the last few years, these contracts that traditionally have been used for hedging or speculation have come to include terms that modify cash-flows based on ESG-related targets.  For example, an interest rate swap may include a provision that modifies the rate payable by a quarter of a percent based on whether a counterparty achieves a greenhouse gas emissions reduction target.  ISDA, which is a trade association for the swap industry, has been reporting on the advent of these modifiers, referring to the resulting transactions as ESG-linked swaps.[5]

Typically, those seeking to enter into a swap (i.e., end-users) reach out to a source of liquidity, traditionally a swap dealer.  The swap dealer’s long-term business consists of finding market participants with reciprocal interests in risk-shifting, such as a commodity producer (e.g., Chevron for energy, ADM for agriculture), and either (i) a commodity consumer (e.g., respectively, American Airlines, Coca-Cola), (ii) a speculator wishing to take the opposite position (e.g., go long in energy or agriculture), or (iii) another swap dealer that has taken the risk from such a consumer.  Most swap dealers – at least with respect to non-physical commodities (e.g., interest and currency-exchange rates) – are the major banks or their affiliates.  Swap dealers are subject to rigorous regulation, which among other things, penalizes the warehousing of risk as distinct from its transfer to other market participants.  Among other things, capital requirements and the Volcker Rule restrict the speculative (as distinct from liquidity provision) activity of banks and their affiliates.

ESG terms in swap agreements create idiosyncratic sources of risk that are not subject to offset.  While American Airlines may wish to support its future purchases of jet fuel with a swap that allows it to periodically pay today’s price for a volume of jet fuel in exchange for receiving a future period’s price for that same volume, it is unlikely that American Airlines or any other market participant will want to take the risk that Chevron does not transition towards a renewable energy generation base.  Similarly, who may want to take on the risk (and have capacities to value it) that a certain employer fails to diversify its workforce?  The lack of naturally offsetting supply and demand for ESG risks in the marketplace interacts with regulations discouraging the accumulation of risk in the swap dealer community, deterring experimentation.  This is one way that the positive interplay of public and private regulation is endogenous.

As another example, the end-users themselves are subject to regulation.  Post-Dodd-Frank, swaps are subject to margin requirements that, among other things, mandate that certain end-users post collateral when transacting with dealers.  The collateral is meant to protect the dealers and broader financial system from credit risk tied to end-users’ default.  However, an exemption is provided if the swap is being used to hedge.  Thus, Chevron taking a short position (i.e., paying the prevailing market rate and receiving a fixed rate) on jet fuel through a swap does not need to post collateral. But if that same instrument also has a provision penalizing Chevron if it doesn’t achieve renewable energy source transition targets, the instrument’s cash flows cease to be a (full) hedge.  Indeed, the additional payment obligations from such failure would exacerbate the setback in transitioning to green energy production.  As a result, end-users’ experimentation with ESG-linked swaps may be stymied by margin and other rules that preference hedging over speculative transactions.  Rules like these are one reason that ESG-linked swap transactions are concentrated in the EU and other jurisdictions outside of the U.S.

The above is not to say that the regulatory burdens on entering into ESG-linked swap transactions should be relaxed.  The proposition is more modest.  U.S. financial regulators (whether through FSOC coordination or otherwise) should familiarize themselves with the transactions taking place in other jurisdictions and consider whether nudges towards experimentation are worth the complexity, risk, and other costs of elaborating regulation.  One way that the current regulatory landscape in the U.S. may be adapted is through regulatory sandboxes, as examined by Hillary Allen[6].  Another means is through extensions of hedging exemptions or capital relief with respect to swaps providing for modest cash flow alterations based on ESG-related targets.  Because regulation affects the costs of deploying ESG considerations in private arrangements, regulators have a lever that may modulate the rate of private-sector investment in regulatory technology.

Firm normative views as to the desirability of “subsidizing” ESG-linked swaps through modifying regulations are reserved for subsequent inquiry.  Instead, my work focuses on (a) analyzing specific design issues with respect to ESG-linked swaps (excluded from this brief overview) and (b) presents case studies illustrating dynamics that complement the core insights of the New Governance school.  These dynamics include (1) the incorporation of private regulatory efforts in the development of subsequent public law, (2) specifically, how deployment of ESG-related provisions in private contractual arrangements enable subsequent public lawmaking, and (3) the impact of regulation on the practice described in (2), and thus the capacity of regulation not only to affect the targeted activity (e.g., collateralization of speculative swaps) but also the degree of unforeseeable symbiosis[7] between private- and public-regulatory interaction.


[1] Elizabeth Pollman, Corporate Social Responsibility, ESG, and Compliance, in The Cambridge Handbook of Compliance (Benjamin van Rooij & D. Daniel Sokol eds., 2021).  There are hundreds of scholars studying ESG from various perspectives, and voluminous literature on the subject from various angles.

[2] There is a fascinating history of accounting technologies preceding the widespread use of written numerals.  See J.R. Edwards, A History of Financial Accounting at 9 (Routledge 2014) (“In earlier, less literate, times, when ‘records’ were substantially in non-written form, accountability involved no more than the agent providing an oral account of the disposition of resources entrusted to him.  This account was listened to (hence the term auditor from the latin audire) by individuals sufficiently familiar with the transactions to assess the accuracy of the statements made.”); id. at 40 (“In the twelfth century, the tally was a narrow hazel wood stick 8-9 inches long . . . notched to indicate the amount received.  The word tally comes from the French ‘tailler,’ meaning to cut, and different cuts represented different denominations of money.”)

[3] Ian Ayres & John Braithwaite, Responsive Regulation: Transcending the Deregulation Debate 3 (Donald R. Harris et al. eds., 1992).

[4] The proliferation of social accounting metrics poses at least two concerns.  First, there is a question as to the reliability of the metrics (sometimes expressed as criticism of “greenwashing”).  There is a thoughtful drive towards credibility in financial regulation.  This is reflected in the SEC’s earlier skepticism of non-GAAP financial measures and, more broadly, non-financial metrics in disclosure (such as when technology companies began to share user engagement statistics as a reflection of their astronomic growth starting in the closing years of the 1900s).  It is also reflected in the forced migration from LIBOR after discovery of weaknesses in the submission process of hypothetical rather than actual lending transactions.  A rigorous distrust, however, is in tension with the evolution of understanding of business impact across more subtle dimensions than financial results.  For a number of subjects of interest within social accounting it is at best unclear whether measures may be derived that are as verifiable and meaningful as measures used in financial accounting, which can often be reconciled against prices in specific transactions or balances in bank accounts.  However, there is a question as to whether less reliable data may be better than no data at all even if it is relatively certain that self-interest will skew reported figures where verification is limited.  Robert Eccles & Kazbi Soonawalla have engaged in penetrating analysis comparing the promise of social accounting with the achievements of financial accounting.  Second, while quantification is necessary for sophisticated management, quantification can also distract from non-quantified considerations and distort decision-making.  Relatedly, the proliferation of targets can create pretext for self-serving conduct on behalf of stewards rather than hone their direction.

[5] Swaps, like most contracts, are private.  They are hard to study, particularly prior to the imposition of public reporting requirements under the Dodd-Frank Act and international equivalents.  There is no comprehensive public database of swap transactions that include details such as the inclusion of ESG-linked payment provisions. However, ISDA members include swap dealers and many users of swaps and at least some of these members have been calling attention to their sustainability related contractual innovations and voluntarily providing related information.

[6] Hilary J. Allen, Regulatory Sandboxes, 87 Geo. Wash. L. Rev. 579, 580 (2019).

[7] As discussed in the paper and extensive other literature, private efforts often detract from the efficacy of public regulations.  This paper does not argue that symbiosis is the only or the primary dynamic between public and private actions with regulatory impact.

This post comes to us from Professor Ilya Beylin at Seton Hall University Law School. It is based on his recent article, “ESG-Linked Swaps and the Next Chapter of Regulatory Innovation,” forthcoming in the Review of Banking and Financial Law and available here.