Akin Gump Strauss Hauer & Feld LLP

Environmental, social and governance (ESG) factors continue to play an increasingly significant role across the capital markets and have an impact on a range of financial instruments and products. We have previously written about green and sustainability-linked instruments and how various stakeholders are shaping the evolution of these products. We also have been tracking efforts by the International Swaps and Derivatives Association (ISDA) to develop standards and best practices for financial instruments that incorporate, or take into consideration, ESG-related factors. In the case of the former, for investors who focus on “green” instruments, it can be difficult to determine what activities can be considered as genuinely green if there is no standardised definition or benchmark, and this has caused some uncertainty within the market. Relatedly, ISDA’s work has focused on developing key performance indicators (KPIs) for use in connection with ESG-linked financial trades.

In an effort to set a standard for how investors can determine what is green, and in turn assisting companies (or governmental bodies) issuing green bonds to raise capital—having regard both for progressive sustainability and the risk of greenwashing—the European Commission has adopted a regulation proposal1 on European Bonds, with a view to creating the “European Green Bond Standard”. In short, the proposal sets out a framework for bonds to fund environmentally sustainable activities within the meaning of the European Union Taxonomy Regulation. Prior to issuing the bonds, issuers will need to publish an externally reviewed “green bond factsheet,” setting out funding and environmental objectives; and following issuance of the bonds, issuers will be required to publish yearly reports demonstrating how they are allocating the proceeds of the bonds to economic activities that meet the sustainability standards under the EU Taxonomy Regulation. Once adopted, the Regulation is expected to set a new standard intended to provide a guarantee of a high quality, sustainable instrument for investors to rely on and which companies, public authorities and issuers (including those located outside of the EU) can use to raise funds.

As we have written previously, against the backdrop of the European Green Deal and related sustainable finance initiatives, participants in the financial markets have identified opportunities to incorporate ESG metrics into documentation for various financial instruments. In response, ISDA recently published two white papers. The first paper focuses on sustainability-linked derivatives and provides guidance to end-users drafting KPIs, which ISDA states are “fundamental to the effectiveness and credibility of these transactions.” The second paper covers a range of issues currently injecting complexity into the accounting treatment of these financial products, noting that a “lack of observable data means ESG features are currently difficult to value, resulting in information that is unlikely to be useful to readers.”

As with many issues within the evolving intersection of ESG and financial transactions, stakeholders are in search of reliable, comparable data to support the transactions themselves and any disclosures or other reporting that may accompany such transactions now or in the future. As a result, ISDA underscores the importance of drafting KPIs that can be “objectively verified” and have “legal certainty.” ISDA notes that, to date, KPIs have generally been tailored to the specific needs of the counterparties and have been crafted to encourage or discourage certain behaviors (e.g., reducing emissions) or to track alignment to ESG principles more generally. ISDA fully expects that counterparties will develop new areas of focus as these products continue to develop and usage expands. ISDA closes the paper by identifying five “overarching principles” for KPIs: specificity; ability to measure; objectively verifiable; transparency; and suitability. To address accounting complexities for these instruments, the second paper focuses on alternative accounting approaches (e.g., the International Financial Reporting Standards 9 model) that may provide readers with more useful information.

We will continue to monitor developments on these fronts and publish updates accordingly.

1 The European Green Bond Standard “is a voluntary standard to help scale up and raise the environmental ambitions of the green bond market.” The proposal is intended to set a “gold standard” for sustainable finance. It is hoped that the proposal, comprised of four key principles (taxonomy alignment; transparency; external review; and European Securities and Markets Authority supervision) “will be useful for both issuers and investors of green bonds. For example, issuers will have a robust tool to demonstrate that they are funding legitimate green projects aligned with the EU taxonomy.”