Recent developments concern the EU taxonomy, the EU green bond standard, and new sustainability-linked bonds
By Paul A. Davies and Michael D. Green
Earlier this month (June 2020), the EU released answers to frequently asked questions (FAQs) about the work of the European Commission (the Commission) and the Technical Expert Group on Sustainable Finance (TEG) regarding the sustainable finance taxonomy (the Taxonomy) and the EU Green Bond Standard (EU GBS).
Additionally, the Commission released an impact assessment and consultation on how to best translate the EU GBS initiative into legislation. Meanwhile, the International Capital Market Association (ICMA) also announced the launch of new Sustainability-Linked Bond Principles (SLBP).
FAQs on the Sustainable Finance Taxonomy
A key theme addressed by the FAQs was the legal process and future development of the Taxonomy. The Regulation for the Taxonomy text was formally approved by the European Parliament on 18 June 2020 (the Taxonomy Regulation). The Taxonomy Regulation tasks the Commission with establishing a list of environmentally sustainable activities, as well as defining technical screening criteria for each environmental objective. These criteria will be established through delegated acts by the Commission. As explained in the FAQ document, the Commission will draw on the TEG’s recommendations in order to draft the delegated act for climate change mitigation and adaptation (Delegated Act), due to be adopted by 31 December 2020, and enter into force in December 2021. The delegated acts for the remaining four environmental objectives (protection of water and marine resources; transition to a circular economy; pollution prevention and control; protection and restoration of biodiversity and ecosystems) are due to be adopted by the end of 2021, and enter into force by the end of 2022.
The Commission will hold a consultation prior to the Delegated Act’s adoption at the end of 2020, in order for stakeholders to provide responses to the technical screening criteria (likely in September and October 2020). In addition, the Commission will consult EU member states on the Delegated Act through the Member State Expert Group on Sustainable Finance. The FAQ document notes that Member States and the European Parliament will have the right to object to the Delegated Act even after its adoption by the Commission (for a period of four months, with the possibility of a two month extension). Prior to adopting the Delegated Act, the Commission will also consult the forthcoming Platform on Sustainable Finance (to be composed of academic experts and the European Environment Agency, amongst others).
Social and Brown Taxonomy Plans
The FAQ document also addresses speculation over whether the Commission intends to extend the Taxonomy to address social objectives, as well as develop a “brown” taxonomy on environmentally harmful activities. Regarding social objectives, the FAQ notes the current Taxonomy Regulation provides that, for an economic activity to qualify as sustainable, it must be carried out with minimum social and governance safeguards. Nonetheless, a review clause contained within the Taxonomy Regulation requires the Commission to publish a report by 31 December 2021 on the possibility of extending the scope of the Taxonomy to include social objectives. The review clause also tasks the Commission to report on the provisions required to extend the Taxonomy to economic activities that are environmentally harmful (brown activities), as well as activities that do not have a significant impact on sustainability (low-impact activities), by the end of 2021.
Financial Risk Assessment and Disclosure Obligations
The FAQ further outlines the interaction of the Taxonomy with financial risk assessment and existing disclosure obligations. The FAQ highlights that Action 8 of the Action Plan on Financing Sustainable Growth refers to the Taxonomy as a key tool to assess the adequacy of banks’ prudential rules. The document further notes that Article 501c of the CRR 2 provides a mandate to the European Banking Authority to assess the need for a dedicated prudential treatment of exposures concerning assets or activities and their environmental and/or social objectives. Additionally, the FAQ document clarifies that any company subject to an obligation to publish non-financial information under the Non-Financial Reporting Directive will be required to disclose how, and to what extent, its activities are aligned with the Taxonomy as of 1 January 2022.
Green Bond Standard Consultation
The Commission published its consultation on the establishment of an EU GBS on 12 June 2020. The consultation will remain open until October 2020. The TEG had previously proposed a draft version of the EU GBS in June 2019, as well as a usability guide in March 2020, as reported on in a previous blog post.
The consultation is designed to gather technical input from relevant stakeholders in the green bond market, particularly issuers, investors, and related service providers. The document outlines the following key components of a proposed EU GBS, as recommended by the TEG:
- The alignment of the use of proceeds from the bond with the Taxonomy
- The publication of a Green Bond Framework
- The mandatory reporting on the use of proceeds (allocation reports) and on environmental impact (impact reports)
- The verification of compliance with the Green Bond Framework and the final allocation report by an external registered or authorised verifier.
By linking the EU GBS to the Taxonomy, the Commission hopes to reduce uncertainty about what constitutes a green investment, which is considered a barrier to green bond market growth. Further, the Commission aims to reduce obstacles to the market by standardising costly and complex verification and reporting processes, as well as by establishing an official standard to which potential incentives could be linked.
The Commission intends for the EU GBS to build on the Commission’s Green Deal, a framework of legislation aimed at progressing the EU to its goal of net-zero emissions by 2050 (as reported on in a previous blog post). To this end, the Commission states “the aim of an EU GBS is to establish a recognisable and high-quality standard for green bonds to […] fuel an increase in funding for investments in green projects and activities”.
The ICMA announced its launch of the new SLBP on 9 June, 2020. Sustainability-linked bonds are defined as debt securities whose issuer commits to certain sustainability objectives. The payments required under the bonds are linked to the issuer’s achievement of pre-defined sustainability objectives. Therefore, the pricing and payments under such bonds may vary according to the issuer’s performance against sustainability metrics within a certain timeframe.
Unlike ‘traditional’ green bonds, the proceeds of sustainability-linked bonds may be put towards general purposes, rather than necessarily aligned with specific sustainability projects. The SLBP therefore challenge the idea that the use of a bond’s proceeds determine whether it may be considered green or sustainable.
The SLBP contain guidance on aspects to consider in relation to sustainability-linked bonds, including:
- The selection of key performance indicators in order to measure the issuer’s sustainability objectives
- The calibration of sustainability performance targets
- The characteristics of the bonds
- Reporting and verification requirements
The unrestricted nature of bond proceeds may render sustainability-linked bonds attractive to bond issuers, compared to other green bond alternatives. For the same reason, sustainability-linked bonds would likely contain fewer monitoring requirements concerning the use of proceeds (if any at all). Arguably, sustainability-linked bonds encourage scrutiny of the overall sustainability performance of a company, rather than merely focusing on the activities funded by the bond proceeds.
These collective developments highlight the continued rapid developments with respect to ESG matters and the financial sector, as well as continued regulatory developments as governments increasingly focus on directing private capital towards sustainable activities and investments.
Latham & Watkins will continue to monitor developments in this area.
This blog post was prepared with the assistance of Emilie Cornelis in the London office of Latham & Watkins.
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