Beware the law of unintended consequences as the EU floats imposing its new green standard on a reluctant market
Green bonds play an increasingly important role in financing assets needed for the low-carbon transition. The long-awaited proposals for the the EU Green Bond Standard ("EU GBS"), a European Union ("EU") standard aimed at increasing transparency and accountability, represent one of the biggest developments in the sustainable debt capital markets in the last decade. The proposed regulation was first published by the European Commission (the "Commission") in July 2021 as part of a wider Strategy for Financing the Transition to a Sustainable Economy. In December 2021, the rapporteur of the EU GBS file at the European Parliament published a draft report, with some amendments representing a fundamental shift from the Commission's original proposals. In this briefing, we take a closer look at the latest developments as the regulation makes its way through the European legislative process.
European Parliament draft report – key elements
In December 2021, the rapporteur of the file at the European Parliament published his draft report in which some significant changes to the original proposal from the Commission were put forward. We take a closer look at some of the most important changes below
1. Mandatory vs. voluntary label
The Commission's original proposal was for a voluntary green bond standard, with the EU GBS to set the benchmark for the most "high-quality" green bonds in the European ESG bond market. The standard was intended to complement and co-exist with existing market-based standards and principles, most notably, the International Capital Market Association ("ICMA") Green Bond Principles which the vast majority of existing green bond issuances are aligned with. In contrast, the amended proposals require the Commission to determine, by December 2023, the deadline and practicalities of making the EU GBS designation mandatory for all bonds marketed as environmentally sustainable between 2025 and 2028.
The proposal to make the EU GBS mandatory has rightly caused some concern amongst market participants, with the ICMA publishing its concerns in an analysis paper in January 2022. The ICMA notes that a mandatory standard could result in many unintended consequences such as fragmentation of the international green bond market (due to the EU following different rules to the rest of the international capital markets), potential migration of issuers to other markets with less stringent requirements and a contraction of the sustainable bond market as issuers switch to traditional (non-sustainable) DCM and banking sources instead.
Whilst it may be that a case could be made for a mandatory standard in the future, at a time when the EU has been highlighting the importance of channelling private investment towards the transition to a climate-neutral economy and encouraging growth of the sustainable finance market, the proposal to consider making the EU GBS mandatory as early as 2023 seems premature. This is particularly true in light of the EU GBS requirement for taxonomy-alignment of projects as the EU Taxonomy is an evolving tool, with issuers still getting to grips with the level of information required to taxonomy-align economic activities. One of the original intentions of the EU GBS was to minimise disruption to the existing green bond market whilst developing the market for high quality green bonds - a mandatory standard is likely to do the opposite and could certainly limit market growth.
2. Expansion to all European sustainable bonds
Another significant amendment is the expansion of the documentation, reporting and certain other aspects of the EU GBS to cover all types of sustainable bonds (including social bonds, sustainability bonds and sustainability-linked bonds) rather than focusing solely on green bonds. According to the draft report, the aim of the expansion in scope is to ease the comparability to other sustainable bond issuances by introducing a standardised format for disclosures for each issuance of a sustainable bond. The registration and supervision powers of ESMA have also been expanded to include external reviewers of all sustainable bonds.
Significantly, the amended proposals require the incorporation of a 'sustainable bond factsheet' into sustainable bond prospectuses prepared in accordance with the EU Prospectus Regulation. This is likely to cause concern for market participants who have as yet been reluctant to include ESG related information in such bond prospectuses due to, amongst other things, the additional costs involved and the potential liability attached to prospectus disclosure.
The expansion in scope would apply from the entry into force of the EU GBS regulation (i.e. sustainable bonds already issued at the date of entry into force would not be required to comply with regards to the disclosure requirements and the use of external reviewers).
Whilst there is a case for greater standardisation of disclosure formats and verification for sustainable bond issuances from an investor perspective, the amended proposals are considerably wider in scope and more stringent than originally set out by the Commission and, as noted above, have the potential to dissuade ESG bond issuance altogether. The ICMA analysis paper referred to above warns that it would "fundamentally change the liability and costs incurred by sustainable bond issuers in Europe" without "any regulatory or financial incentives to counterbalance this".
3. Taxonomy Alignment Plans
Amendments have been proposed to the requirements for taxonomy alignment plans (see below for an explanation of taxonomy alignment plans) such as a requirement for such plans to have annual intermediate targets (to be reviewed by an external reviewer), where any failure to achieve the targets twice would lead to the loss of the EU GBS label. The amended proposals set out further details on transition plans including a mandate for ESMA to develop regulatory technical standards specifying minimum requirements for transition plans in due course. Issuers would also be subject to administrative sanctions for failure to adhere to taxonomy alignment plans.
4. Other Measures
The amended proposals also require issuers of green bonds within the EU to adhere to certain entity-level sustainability requirements that include adherence to the principle of ‘do no significant harm’ referred to in the EU Taxonomy Regulation (Regulation (EU) 2019/2088) (the "Taxonomy Regulation"), through the consideration of principal adverse impacts in investment decisions, and by aligning to minimum safeguards as set out in Article 18 of Regulation (EU) 2020/852.
The proposals also exclude the financing of gas and nuclear power generation, in line with current market practice (although it should be noted that the Commission began consultations with the Member States Expert Group on Sustainable Finance and the Platform on Sustainable Finance on a draft text of a Taxonomy Complementary Delegated Act covering certain gas and nuclear activities, which have been the subject of much debate).
Quick recap of the EU GBS
The Commission published a draft legislative proposal for the EU GBS in July 2021. The Commission's proposal envisaged a voluntary "gold standard" to help scale up and raise the environmental ambitions of the green bond market. The EU GBS is intended to be open to all EU and non-EU issuers, including corporates, sovereigns, financial institutions, governments and other public bodies and is intended for a broad range of securities, including covered bonds and asset-backed securities. See below for the key features of the EU GBS:
Alignment with EU Taxonomy: The EU GBS requires that issuers must allocate 100 per cent. of the proceeds raised by the bonds to economic activities that meet the EU Taxonomy requirements by the time the bonds mature.
Requirements and reporting: The EU GBS sets out some detailed requirements, particularly on pre- and post-issuance reporting. Prior to issue, issuers will be required to publish a ‘green bond factsheet’ setting out the concrete funding goals and environmental objectives of the bonds. The concept of a factsheet is not dissimilar to bond frameworks which are typically published by ESG bond issuers, however, the EU GBS sets out a prescribed format in the form of a template. The factsheet will be subject to a ‘pre-issuance review’ by a registered external reviewer to ensure that the bonds meet the requirements of the EU GBS. Once the bonds have been issued, issuers will be required to provide yearly allocation reporting until full allocation and obtain a post-issuance review by an external reviewer following full allocation. Issuers are also expected to publish at least one impact report on the overall environmental impact of the bond.
Supervision by ESMA: The EU GBS sets out detailed provisions on external reviewers of EU GBS. They are required to register with the European Securities and Markets Authority ("ESMA") to perform their role and will need to meet the conditions for registration on an ongoing basis. ESMA is empowered to develop draft regulatory technical standards specifying conditions for registration, organisational requirements, qualifications of senior management and staff, internal policies and procedures, as well as assessment methodologies.
The EU GBS – Views in the market
There have been various position papers and analysis published on the Commission's proposals for the EU GBS, including an opinion published by the European Central Bank (the "ECB") in November 2021 following a request from the European Parliament. The ECB welcomed the EU GBS and was broadly supportive of the proposals, noting that in order to become the prime green bond standard in the EU, a "clear commitment" was needed to make the EU GBS mandatory for newly issued green bonds within a "reasonable time period". In addition, the ECB opinion also touched on some interesting aspects of the EU GB proposals which have also been the subject of market discussions:
Taxonomy Alignment Plans
The proposed regulation envisages that the use of proceeds of EU green bonds are to relate to economic activities that meet the taxonomy requirements, or that will meet the taxonomy requirements within a defined period of time (five years or ten years from the issuance date of the bond if justified by the specific features of the economic activities concerned) as set out in a "taxonomy-alignment plan". The proposed regulation does not go into detail on how the longer period of ten years is justified by the "specific features" of the economic activities set out in the plan, although the European Parliament draft amendments provide a long lifetime of physical assets as an example.
The taxonomy alignment plan aspect of the EU GBS has been broadly well received by the market as it allows the use of the EU GBS as a transition tool. However, the ECB noted in its opinion that the fact that taxonomy alignment can be achieved within five or ten years raises the risk that supervisory powers and sanctions established in the proposed regulation will not be sufficient where the issuer fails to comply with the plan. The European Parliament draft report amendments would seem to go some way to addressing this concern, with the addition of intermediate targets and administrative sanctions (as discussed in paragraph 3 above). However, it may be that these proposed amendments go too far in the other direction and may have the effect of stifling transition finance, particularly if issuers consider the taxonomy alignment plan requirements too burdensome or are put off by the risks arising from sanctions for failure to adhere to their plans.
100 per cent. Taxonomy Alignment
One of the key aspects of the EU GBS is the requirement to allocate 100 per cent. of the proceeds of the bonds to finance taxonomy-aligned economic activities before maturity of the bond. The market has been broadly supportive of this and the ECB noted in its opinion that "alignment with the Taxonomy Regulation underlines the centrality of the Taxonomy Regulation in the EU’s sustainable finance strategy and provides a credible basis for assessing the sustainability of the use of proceeds of issuances of EU GBS green bonds".
However, one potential issue with taxonomy alignment is that the proposals do not provide for flexibility in situations where the technical screening criteria may not be directly applicable as a result of the innovative nature, the complexity, the location and/or other legitimate factors of the projects. In addition, the technical screening criteria is not fully evolved yet and there is no flexibility for situations where criteria have not yet been developed (for example, environmental objectives three to six in the Taxonomy Regulation). The EU Technical Expert Group on Sustainable Finance (the "TEG") in its original recommendations on the EU GBS suggested that flexibility should be allowed in these circumstances, with an approved verifier confirming that any green projects contribute substantially to at least one of six environmental objectives in the Taxonomy Regulation, while not significantly harming any of the other environmental objectives, and complying with minimum safeguards.
This lack of flexibility may have an impact on take up by issuers and in particular may have a greater impact on how willing non-EU issuers, who may prefer to use regional taxonomies or other standards instead, are to use the EU GBS label.
One of the key concerns with the EU GBS has been the partial grandfathering aspect of the proposals. It has always been intended that the delegated acts adopted as part of the Taxonomy Regulation are to be subject to review and amendment, reflecting the need for the technical screening criteria to be dynamic and to allow for technological and scientific advances to be reflected.
In the context of the EU GBS, in case of a change in the technical screening criteria after an EU GBS-compliant bond is issued, issuers can only make use of pre-existing criteria for a further five years, effectively making the grandfathering partial and temporary. The lack of full grandfathering has caused some concern in the markets, and there has been debate about what partial grandfathering actually means (as discussed in an ICMA analysis on the EU GBS in July 2021), although the European Parliament draft report now clarifies that issuers should not have to re-allocate their allocated bond proceeds in the case of changes to the delegated acts under the Taxonomy Regulation. The ECB opinion also supports full grandfathering on the basis that it would provide certainty for issuers and investors, and consequently facilitate the functioning and growth of the EU GBS market.
ESMA Supervision of External Reviewers
The proposals for a registration and supervisory regime for external reviewers outlined in the EU GBS will be a welcome step in the right direction, particularly given that the market has been calling for closer regulatory oversight of external reviewers and ESG ratings providers more generally for some time now. Most recently, the International Organisation of Securities Commission (IOSCO) published an ESG ratings report setting out its recommendations for improving transparency and addressing conflicts of interest.
In January 2022, ESMA also published a letter to the co-legislators with its views on the EU GBS focusing on the external reviewer supervision regime. ESMA welcomed its supervisory role but also expressed some concerns regarding the timing of delivery of technical requirements which are expected to be specified by regulatory technical standards (in the current proposals, ESMA is empowered to develop these standards specifying further details on the supervisory regime prior to the start of its supervisory mandate and within twelve months after entry into force of the EU GBS). ESMA also raised some concerns regarding the functioning of the third country regimes as well as the appropriateness of the resourcing and funding model provided for ESMA’s supervision.
The EU GBS proposals are currently being examined by the co-legislators: (i) within the European Parliament, the proposals will be considered by the Committee on Economic and Monetary Affairs (ECON), and (ii) within the Council, the working party on financial services will meet to discuss the proposals. Once both co-legislators agree their positions, trilogue negotiations can commence. Whilst the exact timing for this is as yet unclear, we can expect to see further developments on the EU GBS in the first half of 2022.
Whether the EU GBS remains voluntary or not is likely to be a key discussion point in trilogue negotiations. So will the shape of taxonomy alignment plans and the expansion in scope to sustainable bonds. In whatever guise it takes, the EU GBS will be an important development in the EU sustainable finance market, with the potential to enhance transparency, effectiveness and credibility.
The EU GBS has a tough course to navigate. Accessibility of the EU GBS label is key for attracting issuance, particularly from the international and transition finance market, and flexibility in the regulation would allow the EU GBS to grow, potentially into a de-facto global standard. At the same time, rigorous requirements are needed to facilitate the issuance of high-quality green bonds and promote credibility in the green bond market and it remains to be seen whether the final proposals for the EU GBS will strike that right balance.