Can you explain the upcoming sustainable finance regulation in Europe as it relates to issuers and investors?
In May 2018, The European Commission announced an action plan on sustainable finance, that included four components. In June 2019, the Technical Expert Group (TEG) on Sustainable Finance published reports on each of the four components described below:
a. EU Taxonomy
Stage: (Interim) Technical report proposed by TEG
A legislated taxonomy that aims to facilitate sustainable investment. Such a taxonomy would clearly define a list of economic activities assessed and classified as green and sustainable based on their contribution to EU sustainability related policy objectives.
b. EU Green Bond Standard (GBS)
Stage: Final report proposed by TEG (awaiting legislation)
A voluntary, non-legislative green bond standard that will award the ‘EU Green Bond’ label to those who wish to meet the GBS requirements. The GBS will be voluntary. Compliance with the GBS label will need to be assessed by an EU-accredited verifier.
Note: In addition to the EU Green Bond Standard proposed by the TEG, the European Commission is exploring the use of an EU Ecolabel for sustainable financial products that are aligned with the EU Taxonomy.
c. Climate benchmarks and benchmarks’ ESG disclosures
Stage: (Interim) report proposed by TEG
A proposal for the creation of two new climate benchmark labels (EU Climate Transition Benchmark and a Paris-aligned Benchmark), and the requirements index providers would need to meet in order to apply these labels to their benchmark products. In addition, this proposal also includes disclosure requirements for Sustainability benchmarks and recommendations for broad benchmarks.
d. Non-binding guidelines on non-financial reporting (reporting climate related information)
Stage: Directive published by European Commission (already legislated)
This is an addition to the non-financial reporting Directive (2014/95/EU), which requires large, publicly listed companies with over 500 employees to disclose certain non-financial information. The European Commission has published these additional non-binding guidelines to provide guidance to companies on: 1) disclosure of climate risks in alignment with TCFD recommendations and 2) disclosure of non-financial information that aligns with the European taxonomy.
Sustainability in Disclosures and Accounting for Investors
In addition to the above disclosure requirements for corporates, the European Commission in April 2019 also set out requirements for asset managers and financial market participants in relation to the disclosure of sustainability risks and impacts. This regulation would come in effect under MiFID II, AIFMD, UCITS Directive, IDD and Solvency II.
How is Sustainalytics responding to the EU regulatory process?
The TEG has put out calls for feedback for each of its interim reports. Sustainalytics has provided feedback on the EU Taxonomy interim report, the Green Bond Standard interim report, and the Climate Benchmarks and benchmarks’ ESG disclosures. Internally, Sustainalytics has a working group that is assessing the impact of the European regulatory initiatives on its clients and products.
European Union Sustainable Taxonomy
What is the EU Sustainable Taxonomy?
It is a classification tool to help investors and companies make informed investment decisions on environmentally friendly economic activities. The EU Taxonomy is a list of economic activities with performance criteria for their contribution to six environmental objectives. These are:
- Climate change mitigation;
- Climate change adaptation;
- Sustainable use and protection of water and marine resources;
- Transition to a circular economy, waste prevention and recycling;
- Pollution prevention and control; and
- Protection of healthy ecosystems.
Currently, the EU Taxonomy only has listed activities for climate change mitigation and adaption (the first two objectives). The taxonomy as it stands is not complete and does not have performance criteria for all six objectives.
What are the performance criteria for the six environmental objectives?
Performance criteria for the Climate Change Mitigation and Climate Change Adaptation, two of the six environmental objectives, has been developed in the current version of the taxonomy. The other four objectives will be developed in due course.
What is a taxonomy compliant activity?
To be taxonomy compliant, an economic activity must:
- Contribute substantially to at least one of the six environmental objectives;
- Do no significant harm to the other five environmental objectives;
- Meet minimum social safeguards; and
- Comply with the technical screening criteria.
Who are intended users of the Taxonomy?
The TEG proposes two primary users of the Taxonomy:
- EU or the Member States – when adopting or setting requirements on the market actors with respect to financial products or corporate bonds that are marketed as environmentally sustainable.
- Financial Market Participants – when offering financial products as environmentally sustainable investments or as investments having environmentally sustainable characteristics.
What feedback did Sustainalytics provide TEG on the EU Taxonomy?
Sustainalytics feedback centered on the usability of the Taxonomy and its impact on issuers. Primarily, the feedback included the following points:
- The use of quantitative thresholds raises the bar for entry into the green bond market for issuers. Collecting data to demonstrate compliance with thresholds adds a cost to the issuer. In addition, some of the thresholds are too high for issuers to meet and could reduce the size of the green bond market. For example, in the first draft of the taxonomy, the threshold for existing green buildings was to demonstrate 50% energy efficiency.
- While we agree with the basic principle of ‘Do No Significant Harm’ (DNSH) to other environmental and social objectives, we expect that demonstrating compliance with detailed DNSH criteria will increase the cost of issuance. Our feedback was to use proxies (such as ESG ratings) to demonstrate compliance with DNSH criteria wherever possible.
Implications of the EU Taxonomy for Issuers
What is the impact of the EU Taxonomy in the green finance market with respect to green bonds?
Overall, we believe the Taxonomy to be robust, and expect that it will create rules-based clarity in the green finance market. In the long term, a standard approach to defining green could also catalyze a pricing incentive for the green finance market. However, in the short term, there is a risk that it increases the cost of green bond issuance.
How is the EU Taxonomy different from how Sustainalytics defines sustainable economic activities?
We are currently in the process of doing a gap analysis between our approach and the EU Taxonomy and will have a more detailed response on this in due course.
What is Sustainalytics’ view on the EU Taxonomy as it relates to other green bond standards?
In general, Sustainalytics views the EU Taxonomy as just one point of reference in the market and expects the taxonomy to co-exist with other norms and standards, such as Green Bond Principles, Climate Bonds Standard, and various regional guidelines.
Create Standard and Labels: EU Green Bond Standard
What is the EU Green Bond Standard?
The EU Green Bond Standard (GBS) is a voluntary standard to label bonds as green. The EU GBS has the following components:
- Alignment with the EU Taxonomy: Green projects must comply with all criteria in the EU Taxonomy, including the DNSH criteria
- Publication of Green Bond Framework: In addition to the four components of the GBP, the EU Framework must include:
i. An explanation of how the issuer’s strategy aligns with their EU Green Bond and with the EU environmental objectives.
ii. Information on methodology or assumptions to be used for the calculation of key impact metrics
- Mandatory reporting on allocation of proceeds and impact of proceeds
- Mandatory verification of the Green Bond Framework from an accredited verifier
Implications of the EU Green Bond Standard for Issuers
Is the EU Green Bond Standard mandatory for all green bonds issued in Europe?
No, it is a voluntary standard.
Do I need to get my existing green bond verified again against the EU Green Bond Standard?
While this is not required, investors may want to know the extent to which an issuer’s green bond aligns with the EU GBS and the EU Taxonomy.
Can the EU Green Bond Standard be used and applied in other regions, or is it specific to Europe?
The EU GBS label can be applied by any issuer who wishes to label their bond as an EU Green Bond compliant with the European definition of green. However, the thresholds in the EU Taxonomy are specific to the European context, and to the EU’s goal to reach a carbon neutral economy by 2050. Such thresholds and requirements may be difficult for issuers from other regions to meet. Issuers from other regions that are issuing bonds in Euro (for European investors) may wish to communicate the degree to which their green bond is aligned with the EU GBS.
How does the EU GBS clarify the type of expenditure and assets allowed in green bonds?
As per the EU GBS, both physical and financial assets are eligible for green bonds. Working capital and Operational Expenditure (OPEX) that can be attributed to the operation and maintenance of the green asset is allowed. However, OPEX that cannot be tied to physical assets such as purchasing, and leasing costs is not eligible.
What does the EU GBS say about the look-back period for assets?
As per EU GBS, physical green assets can qualify without a look-back period, and OPEX tied to assets has a look-back period of three years before the issuance of the bond. Sustainalytics’ view is that generally market expectations have been to accept a look-back period of two to three years as best practice, but a look-back period for assets is not required.
Is Sustainalytics accredited to provide verification against the EU Green Bond Standard?
The accreditation scheme is not yet in place, but Sustainalytics is expected to become an approved verifier under the EU Green Bond Standard.
How is Sustainalytics’ SPO expected to evolve in response to the EU Green Bond Standard and Taxonomy?
In addition to providing verifications against the EU GBS, Sustainalytics is considering how its SPO and its approach to defining sustainable economic activities will evolve in response to these regulatory developments.
How will investors’ use of the EU Green Bond Standard impact green bond issuers?
Currently, there is no mandatory requirement for investors to use the Green Bond Standard. Investors are encouraged to disclose what percentage of their portfolio meets the EU Green Bond Standard. Investors in the green bond market may want to know more information about the degree to which the issuer’s green bond aligns to the EU Green Bond Standard.
What is the purpose of setting up requirements for benchmarks?
The requirements are meant for benchmark providers and administrators to provide more transparency, clarity and comparability around indexes in order to further use their influence in the market to encourage greener capital allocation (i.e., through passive product and benchmarking activities).
What is proposed with regards to climate-related benchmarks and disclosures?
The European Parliament and the European Council agreed on a set of disclosure requirements for Sustainability benchmarks and recommendations for broad benchmarks. In addition, they developed the definition and methodology of two climate-focused benchmarks:
- EU Climate Transition Benchmark; and
- EU Paris-aligned Benchmark
What are the definitions and requirements for the climate-focused benchmarks?
EU Climate Transition Benchmark
a. Create benchmarks with 30% less emissions than the broader benchmark
b. Considered to be climate risk reduction benchmark
c. Meant to help the transition to a low-carbon economy
a. To create benchmarks with 50% less emissions than the broader benchmark
b. Considered to be climate opportunities benchmark
c. Significant impact on climate change mitigation through a shift of their investment allocation from GHG intensive activities - notably fossil fuels - to renewable energy and energy efficiency
a. To take a best-in-class approach; i.e. reduction cannot be via re-allocation of capital into low impact sectors
b. Must start considering Scope 3 in relevant sectors within four years
c. Must continue to reduce carbon footprint by 7% annually (in accordance with the global decarbonization trajectory implied by IPCC’s most ambitious scenario: 1.5 degrees Celcius).
What are the disclosure requirements for the general benchmarks?
Disclosure requirements are set for all benchmarks except for interest rate and currency benchmarks, and sovereign issuances are not within scope. The primary purpose is for benchmark providers to disclose whether there are any ESG signals/considerations embedded into their benchmarks (all benchmarks).
For those that are “ESG” benchmarks, they must disclose on several criteria at the portfolio level. Along with the minimum disclosure criteria, a statement of ESG philosophy must be included.
For those benchmarks that are not meant to be ESG benchmarks, this disclosure becomes optional (but is still encouraged). However, a statement indicating their lack of ESG considerations must still be included.
Sustainability in Disclosures and Accounting for Investors
What is the purpose of disclosure and transparency requirements for institutional investors and asset managers?
The EU Commission aims to increase transparency on how asset managers and institutional investors comply with their fiduciary duty and to address lack of disclosure which can often result in investors not having the information they require regarding sustainability.
Separately, regulation on disclosures relating to sustainable investments and sustainability risks was formally adopted by the European Parliament and the European Council in April 2019. This sets out requirements on how asset managers, insurance companies and investment or insurance advisors should integrate sustainability risks into organizational requirements, operating conditions, risk management and target market assessment requirements.
What are the disclosure requirements for financial products targeting sustainability objective?
Financial products targeting sustainability objectives are required to disclose:
- How the sustainability objectives are met and, if an index has been designated as a reference benchmark, whether and how it is consistent with the sustainability objectives.
- The extent to which sustainability objectives are attained, the overall sustainability-related impact of the financial product and, where an index has been designated as a reference benchmark, a comparison through sustainability indicators of the respective impacts of the financial product and a broad market index.
- A description of the sustainability objectives of the product and information on the methodologies used to assess, measure and monitor the sustainability objectives.
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