To meet the ambitious targets set by the UN 2030 Sustainable Development Goals (SDGs), the finance markets must be utilised to a much greater degree to enable sustainable projects and allow access to wider sources of capital. There are two key components to achieving this: greater transparency and greater objectivity.
The EU’s consultation on the Renewed Sustainable Finance Strategy (launched on 8 April 2020) consolidates the many sustainable finance initiatives proposed by EU consultations and draft legislation and invites the business community to have its say on our sustainable finance future. We focus below on some key themes of the consultation that can provide the required transparency and objectivity, especially ESG ratings, the EU Taxonomy and green securitisation.
EU Sustainable Finance Evolution
- Of the world’s major powers, the EU is leading the way in the sustainable finance sphere with its Action Plan on Sustainable Finance (though China and the US are also making progress). The EU consultation launched on 8 April 2020 and concluding on 15 July 2020 contains a comprehensive list of topics for consideration and comment (there are more than 100 questions). The EU’s intention is for this consultation to pull together all the work of the Technical Expert Groups (TEG) (see reports in June 2019 and March 2020), the political agreement on the EU Taxonomy, as well as the sustainability- and transparency-related disclosure regulation that has been enacted in the past 6 months. The consultation’s deadline is 15 July 2020.1
- By the European Commission’s own admission,2 the current size of the sustainable finance market is insufficient to meet even the EU’s environmental and climate action objectives by 2050, let alone the more ambitious global targets for 2030 enshrined in the UN SDGs. The current COVID-19 crisis will place huge strain on public and private finances but it has put Environmental, Social and Governance (ESG) related investing in even greater focus.
- Achieving the SDGs will only be possible by expanding the ESG investment universe so that greater pools of capital can (and are willing to) access it. The two key components to achieving this are: greater transparency and greater objectivity. Below we examine some elements of the consultation which can provide that transparency and objectivity.
- The EU Taxonomy (to be enshrined in the Taxonomy Regulation) will apply to (i) financial market participants offering financial products in the EU; and (ii) large companies who are already required to provide non-financial reporting under the Non-Financial Reporting Directive (2014/95/EU).
- During its phase in from 2021-2022, the EU Taxonomy will require disclosure by the financial market participant or the fund raising company, as applicable, as to how their investments measure up against the EU Taxonomy criteria and guidelines. The TEG report from March 2020, while not EU law, contains very useful guidance for the practical implications of the EU Taxonomy and the manner and form in which disclosure should be made. More precise legal guidance will come in the form of regulatory technical standards by the end of 2020.
- The introduction of the EU Taxonomy and the disclosure that accompanies it should provide a significant level of both transparency and objectivity that has been previously lacking, applying the same requirements across financial products and financial market participants.
- A key risk to the success of the EU Taxonomy lies in the limits of its application. It does not, for example, directly apply to the borrowers of green loans or all issuers of green bonds. However, while this is true, one key point to note is that because bond funds, portfolio managers and securitisation funds are caught by the Taxonomy definitions and therefore have to report on the Taxonomy alignment of their funds, there will be an almost de facto requirement for borrowers or issuers of green loans/bonds to report on their own Taxonomy-alignment (or not). Borrowers and issuers of ‘green’ financial instruments would therefore be wise to build Taxonomy compliance into their plans from today to cater for this outcome and get ahead of an incoming market trend. The TEG report contains some helpful suggestions for what that disclosure might look like.3
- While the EU Taxonomy will be a great step forward in the search for an objective standard in sustainable investment, it focuses more on environmental and climate related goals than the social and governance goals which comprise the other two elements of ESG investing.
- One of the more practical ways in which the EU is considering addressing this issue is through ESG ratings (the EU consultation invites comment on this subject at section 1.3, Questions 17-21).
- The European Securities and Markets Authority concluded, in July 2019, that it would not mandate that credit rating agencies incorporate sustainability issues into each credit rating they produce, since ESG issues will not always affect the credit quality of a companies (such factors can still be incorporated in a credit rating if necessary). However, for each company that states it is pursuing ESG, sustainable or green goals or for each financial instrument stating to pursue the same, the introduction of a requirement for an ESG rating is a logical step, which would promote greater transparency.
- The parties best placed to provide ESG ratings would be the third-party data analytics companies which already perform this role across the market. One common criticism of the ratings provided by these companies is that agencies comparing the same company or investment can often produce quite different results from another. The solution to this is to introduce the requirement to have a minimum of two ESG ratings (as already exists for structured finance instruments under Article 8c of the Regulation (EU) 462/2013 on credit rating agencies (CRA III). Investors would then have a fuller objective picture with which to assess the ESG credentials of the company or investment. In turn, this would promote comparability of investments. Amending CRA III to achieve this should not be too cumbersome.
Green Standards and Disclosure Requirements
- Much good work has already gone into the development of the sustainable finance market, especially the Green Bond Principles (GBPs) developed by ICMA, the Green Loan Principles (GLPs) developed by the LMA/LSTA/APLMA and the white paper produced by the G20 Working Group on Sustainable Finance. Enshrining these principles into a set of mandatory requirements that can apply objectivity across the board is the next step.
- Currently, there are many different standards or taxonomies, the use of which is often optional, resulting in regional markets which have become internally fragmented. This is does not aid transparency and objectivity and it does not have to be the case. While there will always be differences between certain regional markets to address their own unique needs, within a region, whether the EU, US, China or Latin America, a more harmonised approach should be achievable. The EU Taxonomy (and the delegated regulations that will implement its constituent parts) has the potential to pull all of these together into one set of rules for the EU and which may serve as a template for other regions.
- One of the biggest problems in the ESG investment sphere currently is the fear of greenwashing, where a financial product is marketed as ESG when the reality is somewhat different. The introduction of the EU Taxonomy will change that. In scope entities will need to disclose according to the Taxonomy and the Sustainability-Related Disclosure Regulation (Regulation 2088/2019), providing investors with the desired transparency and providing a clear demarcation between products that are ESG-focused and products that merely consider ESG (the latter have been labelled ‘ESG Consideration’ products4).
- As part of the EU’s broader efforts to bring greater transparency and objectivity to the sustainable investment market, alongside the EU Taxonomy, the EU has developed a Green Bond Standard (EU GBS),5 which builds on the GBPs. The EU GBS can be used for any type of listed or unlisted bond or capital market debt instrument by any public or private issuer, whether in the EU or outside. Compliance is, at the time of writing, voluntary.
- As the use of both the EU Taxonomy and the EU GBS increases from 2021, financial market confidence and liquidity will grow and the issuers who continue to avoid alignment may well be put at a disadvantage. The alignment with the ICMA GBPs should encourage non-EU issuers to comply as well. The COVID-19 crisis has increased the focus on environmentally and socially responsible investing as a goal in itself, without any of the other benefits that can accompany such investment, for example more favourable interest rate on borrowings. Regulators have also discussed potential risk weight benefits for the banks who market the financial products6 as well as government or EU guarantee schemes for certain more junior portions of sustainable financial instruments.7 When one accounts for these incentives as well, the case for alignment becomes even more compelling.
- The requirement for financial market participants to use the EU Taxonomy and the expansion of the requirement to obtain ESG ratings would be significant steps in opening up the ESG investment market to the $3-5 trillion dollars of investor capital that needs to be deployed if we are to achieve the SDGs by 2030.8
- However, bank balance sheets and direct private investment may not be sufficient on their own to scale up the ESG investment market with the speed required to achieve the 2030 SDGs. Green securitisation can provide the answer here – in either a static or a managed form, securitisations can take groups of green bonds and loans (whether broadly syndicated debt or infrastructure debt), both freeing up space on bank balance sheets for additional ESG lending and offering a new type of investor access to the ESG financial markets (for example the longer term insurance or pension fund investors who may be interested in the AAA rated tranches of securitisation debt).
- Two regulatory steps which would increase the potential scope of the green securitisation market would be, firstly, amending the requirement under the Securitisation Regulation (Regulation 2017/2402) that the simple, transparent and standardised (STS) label, which allows investors to benefit from favourable capital treatment, can only apply to static securitisations – this rules out the majority of the CLO market (the most common type of securitisation globally by volume) from benefitting from STS treatment; and, secondly, removing the ability for issuers to self-certify their STS compliance. There is no sign yet, however, that any regulatory action is underway in this regard.
The EU consultation on the Renewed Sustainable Finance Strategy offers the business community the chance to influence the blueprint for Europe’s sustainable future. It distils the key issues raised in the past few years of EU-wide work on sustainable finance into a comprehensive-yet-achievable programme and is the final stage before the EU Taxonomy comes into effect in 2021 and beyond. The transparency and objectivity provided by the EU Taxonomy can provide great potential benefits to financial market participants - from investors seeking this clarity on ESG, to issuers and borrowers seeing more favourable pricing of their debt, to governments and infrastructure providers seeking project finance – and set an example for other regions to emulate.