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.