Ramping up ESG regulation
Originally a self-regulated sphere in which voluntary principles underpinned activity, ESG debt is attracting increasing regulatory focus — especially in Europe, where the EU’s ambitious Action Plan on Sustainable Finance is creating a demanding new framework around the market. What does this imply for issuers and investors? And are other regions in step with European developments? Clifford Chance and Latham & Watkins clarify the state of play.
The raft of measures that make up the EU’s Action Plan on Sustainable Finance — including the Taxonomy for Sustainable Activities, the Green Bond Standard (GBS) and the Sustainable Finance Disclosure Regulation (SFDR) — represent European regulators’ response to the need to mobilise more capital in pursuit of Paris Agreement targets.
The original Sustainable Finance Action Plan in 2018 plan was bolstered in July 2021 by the publication of the EU’s Sustainable Finance Strategy, a second wave of regulatory actions to be implemented and considered, including exploring the possibility of official labels for sustainability-linked and transition bonds, consideration of regulating green mortgages and consumer loans, an expansion of the Taxonomy and a clarification that investors’ fiduciary duty includes considering the effects of their investments on the environment and society.
“There has been a proliferation of legislation on the buy side to support the ultimate objective of the Sustainable Action Plan, which was to focus on the re-orienting of capital flows towards sustainable activities and making sure that long-termism is built into all strategic objectives,” says Kate Vyvyan, partner at Clifford Chance.
But while sustainable finance products, particularly ESG debt, have seen exponential growth in recent years, inconsistent definitions of sustainability were nonetheless constraining its capacity to scale up.
“The market generally considered that the absence of a taxonomy was one of the main factors holding the sustainable finance market back,” says Ed Kempson, counsel, capital markets and global co-ordinator of sustainable finance at Latham & Watkins. “There was uncertainty on the investor side and on the corporate side as to what was or was not sustainable, and without certainty there just was no prospect of moving this market forward as it needed to be. It was and continues to be an essential development.”
“The growth in the volume of green and social bonds has been remarkable in the last few years,” adds Cristina Lacaci, head of ESG structuring for global capital markets at Morgan Stanley. “This has also led to additional complexity. The EU Taxonomy and other regulatory initiatives will be helpful in providing a common language when it comes to structuring ESG financings.”
She highlights the EU Taxonomy thresholds as a useful measure that provides consistency. “We now tend to use them for many categories, like generation of electricity or clean transportation.”
The EU’s initiative highlights its self-appointed role as the driver of sustainable finance through its Green Deal and Action Plan. “The Taxonomy is the clearest evidence of the way in which Europe and the European investor base is leading the market,” Kempson believes.
A key feature will be the EU’s unprecedented €240bn green bonds programme, which will make it the world’s largest issuer of the product by far. Not only will 30% of the funding for its huge €800bn ‘Next Generation EU’ recovery plan be through EU green bonds, but these will model the new standard by being fully compliant with the taxonomy and GBS.
“In the second half of 2021 and particularly next year, we expect the EU Taxonomy and EU Green Bond Standard will become increasingly important in terms of disclosure requirements facing issuers, as well as in the structuring of new transactions,” says Alexander Menounos, head of EMEA DCM and global co-head of IG syndicate at Morgan Stanley. “That should be helpful in achieving consistency and transparency for the market.”
Issuers set to step up
Despite the EU Commission’s recent proposal for a Corporate Sustainability Reporting Directive (CSRD) to extend the reach of the older Non-Financial Reporting Directive (NFRD), adopting the Taxonomy is not yet mandatory — though Article 8.2 of the Taxonomy legislation does require issuers to disclose the extent of their operating and capital expenditure’s alignment.
“The requirements aren’t there on the new issuance side at the moment — for those corporate issuers that are coming to market to be disclosing in their issuance documentation their overall ESG objectives or strategy,” notes Vyvyan.
As a result, many new issues are still launched with no reference to the new benchmark for sustainable financial products. For example, the recent landmark sustainability-linked bond for EQT (notable for its gender KPI, see accompanying Diversity chapter) makes no reference to the Taxonomy, though it does reference the Paris Agreement.
“That is in line with ICMA recommendations and certainly consistent with how the market has been approaching compliance with the EU Taxonomy or otherwise,” notes Manoj Tulsiani, partner, debt capital markets at Latham & Watkins.
“Of course this is a work in process to embed this into the market,” says Kempson. “The most important thing is for market practice to develop into a position where if you’re doing a green bond you should be taxonomy-compliant and this will come, hopefully, in Europe with the Green Bond Standard.”
L&W judges that it will. “We expect to see more issuers explicitly aligning their sustainable finance products to the EU Taxonomy and hope to see that more broadly in other markets,” Kempson affirms.
Certainly, issuers are moving up the ESG debt learning curve. “Focus among the issuer community has increased exponentially over the last 18 or 24 months,” Tulsiani reports.
Grappling with GBS
As it is a voluntary standard for now, major investors are unlikely to rely on the GBS exclusively. Morgan Stanley Investment Management (MSIM), for example, regards part of its responsibility as a steward of capital as being to not take labels for granted. “In the same way as we approach the Green Bond Principles and second-party opinions, we feel it is important to develop our own processes to assess these instruments,” says Navindu Katugampola, global head of sustainability at MSIM.
“We feel there is an obligation on asset managers to think critically and not just buy things because they correspond to a standard,” he adds, noting that the “spectrum of [ESG debt] issuance is almost outpacing labels as the pace has accelerated and moved laterally”.
Moreover, some investors question whether 100% GBS-aligned holdings would constitute appropriate diversification of exposures. “The base case is that we are likely to still have a spectrum of issuers to achieve well diversified portfolios,” Katugampola says.
One growing concern is the potential for regulatory arbitrage — ‘taxonomy shopping’, as some have termed it — as further taxonomies emerge around the world. Already both China and the UK (no longer bound by EU legislation after Brexit) are developing their own taxonomies, while some observers see scope for the new Biden administration to promote a US taxonomy.
The Chinese scheme is an outlier. Although Chinese regulators have said that they are seeking alignment with the EU Taxonomy, this appears questionable as China is on a non-aligned pathway to net zero in 2060, not 2050.
More generally, as disputes over the inclusion of natural gas and nuclear power in the EU Taxonomy underscore, there is a risk of regional and national taxonomies deferring to industries and sectors with greater weight in their jurisdiction.
In turn, that could incentivise issuers to adopt whichever taxonomy is least burdensome for them. “That’s certainly something that we hope that we do not see,” says Kempson. “We hope that people understand the fundamental importance of making this a truly sustainable transition. But to expect there to be no discussion as between regional taxonomies is probably naïve.”
The current raft of European legislation and initiatives creates potential inconsistencies in disclosure and reporting requirements under the Taxonomy, SFDR, NFRD and future CSRD for entities under different regimes. One example is the prospect of banks needing to disclose data about exposure to companies that are not under the same requirement.
“It is a concern that there is not a universality in reporting standards in the taxonomies. What you’ll find in the future is a lot more focus at the policy level to try to bring that together in a coherent disclosure regime,” says Kempson, who notes that some reporting requirements under the taxonomy are “imperfect, as you would expect in a very nascent and developing regulatory framework”.
More generally, the CSRD has far broader scope than the NFRD, which applied only to the largest European companies. “This is hugely increasing the scope of entities that are brought within the regulation,” Vyvyan notes.
Bank capital receives EBA green light
Regulatory action is likely to shape the future trajectory of ESG debt from banks — both sustainability-linked bonds (SLBs) and subordinated capital instruments, including AT1 quasi-equity, in green or social format.
SLBs are challenged by MREL (minimum requirements for own funds and eligible liabilities) eligibility (see accompanying sustainability-linked bonds chapter). In addition, the European Banking Authority (EBA) has required additional investor disclosures for ESG capital — the highest risk debt banks offer.
“The EBA is focused on enhancing disclosure of capital risks to make sure that green investors know exactly what they are getting into,” notes Charles-Antoine Dozin, head of capital, ratings and liability management advisory at Morgan Stanley.
While bail-in risk is the main concern, the flagged areas also include rollover risk (the potential for green proceeds to be in cash temporarily if asset and liability maturities do not match perfectly).
The guidelines the FIG sector had been eagerly anticipating, following the EBA’s initial observations on green and social Tier 2 debt in an MREL report last autumn, were finally published in late June.
“Thanks to the additional guidance, whoever had concerns regarding residual regulatory risk of issuing capital in green/social format should now feel comfortable,” Dozin judges, adding that “while in line with expectations and the key themes of the Q4 MREL report, the EBA’s best practice recommendations provide a concrete approach to improve issuance programmes and minimise the reputational risk authorities have identified”.
However, market participants have focused on the EBA’s reminder that step-ups and fee-based constructs are not compatible with regulatory instruments. The confirmation dashed hopes that banks may be allowed to issue SLBs in the wake of their great popularity in the corporate sector and appears likely to slow down the evolution of the asset class.
“The EBA is walking a fine line here between maintaining a neutral stance on the format and ensuring that eligibility criteria do not get diluted in the process,” Dozin comments. “Barring targeted changes in the level one text to clarify notions such as credit standing, it may be some time before SLBs take off”.
Clarification of the regulator’s stance on ESG AT1 is also crucial. “The acknowledgment of the instrument in the AT1 monitoring reporting where the EBA flags that coupon cancellation risks should be properly highlighted should revive interest in the format.”
This expansion includes bringing non-EU entities under the legislation. “Under the Transparency Directive amendments, you’re bringing in all issuers, even non-EU issuers that have retail debt or equity listed on a regulated market of the EU,” she adds, noting that purely wholesale debt offerings are not caught.
While the burden for smaller companies is significant, especially as the CSRD appears more stringent than its predecessor, Vyvyan points out that they may be spared the legislation’s full force. “When we see the finer detail, we are going to find that the particular characteristics and capacities of SMEs are taken into consideration and they may be able to either comply voluntarily or have some lesser standards applied to them.”
More generally, she emphasises the spirit of the proposal. “That’s helpful for the investment community, a real extension of scope in a useful way.”
Investors feel push and pull
More broadly, investors are facing an even greater near-term regulatory burden than issuers. “Pressure around disclosure has come in through the buy side with a need for investors to disclose in accordance with the regulations that apply to their activities,” says Vyvyan.
“There is a swathe of regulation coming our way,” Katugampola acknowledges. Besides the EU Taxonomy, he cites the Task Force on Climate-related Financial Disclosures (TFCD), as well as the prospect of scrutiny from the US Securities & Exchange Commission (SEC).
“TCFD represents best practice in climate disclosure, providing financial market participants with important and decision-useful information. This is validated by the 2,100 companies across 78 countries that are supporters of TCFD, representing $23tr in market cap,” says Matthew Slovik, head of global sustainable finance at Morgan Stanley.
As a result, asset managers are experiencing push from regulators and pull from clients towards sustainability. This includes both greater emphasis on ESG and transparency over how they factor sustainability considerations into their investment decision-making.
Katugampola describes the twin influences as a “virtuous circle” that will help embed appropriate practices.
The need to satisfy the new regulations also highlights the dynamic environment for asset managers around ESG. “It is a continually evolving landscape, in the same way as the processes, tools, models and data that we use are evolving.”
This evolution represents “something of an arms race” as asset managers keep looking to improve the range and diversity of their products.
Katugampola views this positively. “It benefits clients and places additional duty on us to be a responsible steward of capital,” he affirms. GC