Dechert LLP

Introduction

The need for one set of clear environmental, social and governance guidelines is an issue of increasing importance for UK and European capital market participants. For issuers, the ability to demonstrate compliance with authoritative guidelines will add reputability to issuances marketed as being green and sustainable, so is likely to increase investor interest and attract more favourable regulatory treatment.

The International Capital Markets Association (“ICMA”) Green Bond Principles 2018 have been the most widely used set of ESG-related guidelines to date. ICMA estimates that, in 2020, its green or sustainable bond principles were referenced by 97 percent of the sustainable bonds issued globally. ICMA’s green and sustainability bond principles are voluntary process guidelines that recommend, inter alia, issuer transparency in their use of proceeds, and issuers generally demonstrate their adherence by commissioning a “second party opinion” from an independent external provider in connection with the assessment of their issuance.

These and other existing principles and frameworks have, however, been subject to criticism as being too broad and disparate either to adequately guide investors or to add real credibility to issuers. In particular, in recent years, the perceived risk of “green washing” otherwise unsustainable assets in certain cases through use of these and other principles and classification systems has been increasingly cited by critics of green bond offerings.

ICMA Green Bond Principles 2021

On 10 June 2021, ICMA published its Green Bond Principles 2021 (the “2021 ICMA Principles”), the first update since the issuance of its initial green bond principles in 2018. Updated versions of ICMA’s Social Bond Principles and Sustainability Bond Guidelines were also issued.

On the launch of the 2021 ICMA Principles, Chief Executive of ICMA, Martin Scheck, commented: “The [ICMA principles] are the foundation for the global sustainable bond market. The 2021 edition will continue to support its growth and innovation as we tackle the pressing issues of sustainability and climate transition, while also giving the issuers who are committed to financing change, further guidance on transparency and reporting as the market evolves.”

The 2021 ICMA Principles focus on strengthening disclosure obligations, and aim to increase transparency, specifically regarding: (i) use of proceeds, process evaluation and selection, management of proceeds and reporting; (ii) issuer-level sustainability; and (iii) issuer processes to identify and manage perceived and known social and/or environmental risks. A second focus of the 2021 ICMA Principles is harmonisation with other ESG frameworks, by: (i) encouraging the supply of information on the degree of alignment of projects with other official or market-based taxonomies; and (ii) including links and references to complementary ICMA guidance in, among others, its Climate Transition Finance Handbook and the Harmonised Framework for Impact Reporting and the Guidelines for External Reviews.

While these updates appear to seek to address developments in the market and certain criticisms of the 2018 ICMA principles, the market’s reaction to these updates, and whether they are considered to go far enough, remains to be seen.

The European Union’s Commitment to Sustainability

European financial and regulatory authorities are becoming increasingly politically motivated to establish effective and reliable ESG guidelines and disclosure procedures. Through the European Green Deal, announced by the European Commission in 2019, the EU has committed to be climate-neutral by 2050 (the “Green Deal”). The EU aims to encourage the flow of funds towards more sustainable technologies and businesses in order to help it reach its 2050 aims.

Climate change is being increasingly recognised as a financial stability risk and, accordingly, an important area of banking supervision. In January 2021, the Institute of Law and Finance held a conference on Green Banking and Green Central Banking, at which the President of the European Central Bank stated in her keynote address that:

We recognise that our active role…can influence the development of certain market segments…Climate change is one of the greatest challenges faced by mankind this century, and there is now broad agreement that we should act…The ECB will contribute to this effort within its mandate, acting in tandem with those responsible for climate policy. 

It is now anticipated that climate change concerns will be reflected in the monetary policies of major European central banks, and, though the shape of that reflection is still emerging, it appears that climate change risk will be managed, at least in part, through financial regulation and the pricing of climate change risks into the terms on which collateral is accepted. 

The EU Classification System: the “Green Dictionary”

In line with the Green Deal, the EU is currently developing an action plan to: (i) channel investment into projects that will further the transition to a climate-neutral economy; (ii) build sustainability considerations into risk-management procedures; and (iii) make sustainability considerations an integral part of its financial policy. Two key pillars of this plan are the EU Taxonomy and the Delegated Acts, which create a classification system for determining whether or not an economic activity is sustainable (these have been described as the ‘world’s first “Green Dictionary”’); and the Corporate Sustainability Reporting Directive.

Under the EU Taxonomy Regulation 2020 (the “EU Taxonomy”), the acceptable Environmental Objectives of the EU are: (i) climate change mitigation; (ii) climate change adaption; (iii) the sustainable use and protection of water and marine resources; (iv) the transition to a circular economy (including waste prevention, re-use and recycling); (v) pollution prevention and control; and (vi) the protection and restoration of biodiversity and ecosystems.

A particular economic activity will qualify as being environmentally sustainable if it: (i) contributes substantially to one or more of, and does not significantly harm any of, the Environmental Objectives; (ii) is carried out in compliance with the minimum safeguards set out in the EU Taxonomy; and (iii) complies with the technical screening criteria.

The EU Taxonomy also tasks the European Commission with establishing future Delegated Acts (which are referred to, together with the EU Taxonomy, as the “EU Framework”). Delegated Acts will not be able to change the essential elements of the EU Taxonomy but are expected to add to and define its scope. The Delegated Acts are designed to be “living documents” and to evolve with stakeholder input over time. The first of the Delegated Acts came into force at the end of May 2021 and is currently undergoing a four-month scrutiny process run by the EU Parliament and Council. According to the European Commission, this first Delegated Act covers “roughly 40 percent of [EU-]listed companies, in sectors, which are responsible for almost 80 percent of direct greenhouse gas emissions in Europe” and includes detail on how to determine whether or not economic projects in the forestry, energy and transport sectors can be marketed as being “green”.

Mandatory Disclosure Requirements under the EU Taxonomy

At present, the EU Framework is not intended to set out mandatory lists of where green-minded investors must invest but instead to act as authoritative guidelines on whether or not issuers can add “green wrappers” to their offerings. In addition, there is a mandatory disclosure requirement in the EU Taxonomy, under which any undertakings subject to an obligation to publish non-financial information under the Accounting Directive (Directive/34/EU) will also have to disclose how and to what extent its activities are associated and comply with the Environmental Objectives. A further Delegated Act is expected to be published in 2021, which will specify the content and presentation of this information.

Future Updates: Nuclear Power and Natural Gas as Transitional Activities

Issuers in the oil and gas sector should be aware that nuclear power and natural gas assets are expected to be reviewed in accordance with the EU Taxonomy’s classification process by way of a further Delegated Act expected to be published later this year. There is significant debate as to whether projects in these areas should be able to benefit from “green” labels. Given the controversy of the decision, commentators have suggested that a compromise ‘halfway’ status and recognition may be granted in these areas; with the activities unlikely to receive fully favourable treatment, but potentially able to benefit from partial recognition as “transitional activities” for countries and governments using these power-sources to reduce dependency on fossil fuels.

The EU’s Corporate Sustainability Reporting Directive and EU Sustainability Reporting Standards

Issuers considering launching sustainable bonds in the European capital markets should also be aware that, in April 2021, the EU Commission adopted a proposal for a Corporate Sustainable Reporting Directive (“CSRD”), which aims to revise and strengthen its existing Non-Financial Reporting Directive (Directive 2014/95/EU) by extending sustainability reporting requirements to all EU-based large companies and all EU-listed companies. The CSRD proposal also introduces more detailed reporting requirements, as well as a requirement to report according to mandatory EU sustainability reporting standards. Such standards, which are expected to be tailored to EU policies, while contributing to, and building on, international standardisation initiatives, are being developed by the European Financial Reporting Advisory Group and the first set of standards are expected to be adopted by October 2022. According to the European Commission’s website, issuers will be obliged to report on how sustainability issues, including climate change, affect their business and the impact of their activities on “people and the environment”.

The CSRD is due to be scrutinised by the EU Parliament and Council from April 2021 for between three and six months, and is expected to be adopted by the European Commission by the end of 2022.

Conclusion

The regulators, authorities and industry associations operating in the UK and European capital markets are increasingly focusing on the development and harmonisation of ESG classification systems, to act as clear guidelines under which economic activities may be marketed as being “green” or “sustainable”. In particular, issuers should be aware of the new 2021 ICMA Principles (expected to become the new industry standard), that further Delegated Acts are expected to be published under the EU Taxonomy and the expected introduction of the CSRD. Various industry bodies are also working on the development of further ESG-related guidelines and it is expected that more classifications, principles and frameworks will be developed before rules become harmonised or current voluntary frameworks are adopted in a format that is mandatory. In addition, regulators and market participants are expected to continue to develop and add to existing rules to address questions of “green washing” and more controversial industry sectors, such as those involving fossil fuels and nuclear power, as market participants continue to be attracted to, and ask increasing questions relating to, green and sustainable investments.

Although voluntary, the current classification systems are expected to become authoritative in the sustainable markets. Compliance may become an increasing ongoing burden on issuers, as the related disclosure obligations are expected to broaden and strengthen the obligations relating to what information should be shared with investors during the lifespan of the securities.

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