Introduction
The Council of the European Union and the European Parliament announced on 28 February 2023 that they had reached a provisional agreement on the creation of European green bonds (EuGB).
Initially, on 6 July 2021, the European Commission published a legislative proposal on EuGB referred as the EuGB Regulation which sets the establishment of the EuGB Standard or EuGB label. The regulation targets to lay the foundation for a common framework of rules regarding the use of the EuGB in accordance with the European Union Taxonomy Regulation's definition of bonds that seek ecologically friendly goals. Additionally, the EuGB Regulation aims to establish a mechanism for registering and overseeing businesses that serve as independent examiners of green bonds compliant with the EuGB framework. [1]
What is a ‘Green Bond’?
Before analysing the details of the EuGB Regulation, it would be beneficial to have a look at the definition and criteria of a ‘green bond’.
In contrast to other forms of credit, green bonds promise to use the money raised for climate change or environmental projects. They are a sort of loan issued by public or private organisations to finance themselves.
The European Investment Bank (EIB) debuted a particularly unusual offering of green bonds on 5 July 2007, for the first time. By funding initiatives that help achieve Sustainable Development Goals 7 (affordable and clean energy) and 13 (climate action), green bonds can be distinguished from other types of bonds.
Green bonds are only used for green projects that have a positive impact on the environment. The most common examples are renewable energy, energy efficiency, clean transportation and waste management.
According to the criteria established by the International Capital Market Association (ICMA), the Green Bond Principles are as follows:
(1) The funds will be used for
green projects that will have a beneficial effect on the environment.
(2) The issuer of a green bond must
transparently notify the investors of the environmental sustainability goals,
allowing for them to be assessed and externally reviewed.
(3) The funds management will be
appropriately and transparently controlled by the issuer, which will allow an
auditor to perform a complementary review.
(4) The issuer of this type of
bonds will periodically update the information about how the funds are used and
the environmental benefits obtained.
(5) In its latest update to the green financing framework, Iberdrola has incorporated alignment with the principles of the EU taxonomy. This step aims to stimulate private investment in sustainable growth, foster a neutral climate economy, and establish a standard for issuing green bonds within the EU. [2]
Why does the EU Commission set EuGB Regulation?
The EU Commission has described climate change and environmental degradation as an existential threat for Europe and the world. It will require enormous investments to transition to a modern, resource-efficient and sustainable economy. Private investments will be essential to finance this transition and must be encouraged. The overarching objective of the interrelated EU ESG regulations, influencing diverse sectors of the economy, is to facilitate information accessibility and reporting throughout the value chain. Subsequently, this enables fund providers to factor in such information while making decisions about lending or investment endeavours. [3]
On the level of the financing instruments, EuGB Regulation’s overarching goal is to minimise disruption to already established green bond markets while facilitating the expansion of the European market for green bonds. It is an established market in existence since 2007 worth an estimated 2.8 trillion. The EU Commission anticipates that the growth of this market will assist in achieving the environmental and climate goals set forth by the EU in the Paris Climate Agreement. The EuGB standard is, therefore, a piece in the puzzle of the broader EU Action Plan on Financing Sustainable Growth, which looks to channel more investments towards environmentally sustainable projects and activities. Improved transparency and the establishment of a clear and uniform standard are intended to usher in the next evolutionary stage of the market and accelerate the financing of the transition of the economy. [3]
Furthermore, the EuGB Regulation intends to lower the possibility of ‘greenwashing’ by establishing strict guidelines for the issuance of green bonds. [1]
What are the key features of the EuGB Label?
EuGB Standard label has two key features: (1) relating to the use of proceeds and (2) relating to the disclosure requirements.
The use of proceeds’ requirements state that the net proceeds of the EuGB labelled bonds must be fully invested in environmentally sustainable activities aligned with the EU Taxonomy prior to maturity of the bond. [3] EU Taxonomy refers to the classification system that defines criteria for economic activities that are aligned with a net zero trajectory by 2050 and the broader environmental goals other than climate within the EU’s sustainable finance framework. The EU Taxonomy allows financial and non-financial companies to share a common definition of economic activities that can be considered environmentally sustainable. [4]
Put simply, the EU Taxonomy can be likened to a dictionary that investors and businesses can use to evaluate whether specific economic activities qualify as ‘environmentally sustainable.’ For an economic activity to qualify, it must significantly contribute to one of the six identified environmental objectives, aligned with related targets, and adhere to established social and governance safeguards. For each of these environmental objectives, the EU taxonomy defines so-called technical screening criteria, which are set per economic activity. Therefore, it can be stated that the taxonomy alignment is challenging.
Moreover, the success of the EU Green Bond Standard will ultimately depend, on the one hand, on the ability of corporates to meet these criteria with the proceeds of their green bonds. On the other hand, it will rely on the level of comfort they will be able to give to that effect to investors and banks that will support these issues. Accordingly, it is expected that due diligence processes shall evolve as a result, including to ascertain compliance with the minimum social and governance safeguards, for taxonomy alignment. [5]
In acknowledgement of these challenges, certain limited flexibility was introduced in the file text of the EU Green Bond Standard around taxonomy alignment. In the name of creating flexibility, the provisional agreement allows for 15% of the proceeds from an EuGB to be invested in sectors not yet covered by the EU Taxonomy, such as aviation. Additionally, it permits investment in economic activities that comply with the EU Taxonomy requirements but lack developed technical (green) screening criteria, as is the case for agriculture. In other words, initially, issuers of EuGBs would need to ensure that at least 85% of the funds raised by the bonds are allocated to economic activities that align with the EU Taxonomy Regulation. The provisional agreement added a 15% "flexibility pocket" to guarantee the EuGB standard's usability from the beginning of its existence. The purpose and necessity of this flexibility pocket will be re-evaluated as Europe moves closer to achieving climate neutrality and as more and more lucrative green investment possibilities are anticipated to become available in the ensuing years. Although the extra flexibility is helpful, questions have been raised about the voluntary EuGB standard's adoption in the future given the usability problems with the EU Taxonomy that have been found. [1]
Furthermore, issuers must comply with mandatory pre- and post-issuance disclosures. These disclosures must be in accordance with prescribed templates and the pre-issuance Green Bond Fact Sheet as well as the post-issuance allocation report must be subject to external review. The external reviewer must be registered with and supervised by the European Securities and Markets Authority (ESMA). As a side note, ESMA is an independent EU Authority located in Paris which is responsible for regulating and supervising the financial markets. ESMA replaced the Committee of European Securities Regulators on 1 January 2011. It is one of the three new European Supervisory Authorities set up within the European System of Financial Supervisors. [6]
Going into more detail in reporting requirement, there are three types that the issuer should follow.
Firstly, there is the pre-issuance fact sheet, which is similar to the current Green Bond framework. This fact sheet needs to be reviewed by an external reviewer pre-issuance and needs to be accompanied by a positive opinion. The external reviewer report can relate to a single EuGB or several EuGB issuances.
Secondly, there are allocation reports, which need to be prepared for every 12-month period throughout the life of the Green Bond until the full allocation of proceeds. For the issuers published in the capital expenditures (CAPEX) plan, until the completion of such plan. These reports should set out the actual rather than the intended allocation of proceeds, together with details of the amounts and proportion of proceeds allocated to which types of activities. As with the pre-issuance fact sheet, an allocation report can relate to one or more EuGB issuances. It is also worth noting that issuers are required to obtain a post-issuance review by an external reviewer after the full allocation of the proceeds which needs to be accompanied by a positive opinion. However, where the portfolio approach is used, each allocation report must be subject to external review unless no changes to the portfolio have been made from the prior reporting year.
The final type of issue reporting is the post-allocation impact report. This report should be prepared at least once, following the full allocation of the proceeds. The post-allocation impact report will include details on the environmental impact of the use of proceeds. Issuers may choose to have this report reviewed by an external reviewer, but this review is not mandatory.
It is important to note that issuers are required to publish each of these reports on their websites and notify the relevant EU competent authorities and ESMA following publication. The templates for the reports are all set out in the annexes to the regulation. Pre-issuance disclosure, post-issuance allocation and impact reporting is already a feature of the current Green Bond market. Under the EuGB Standard, the prescribed templates need to be followed. [7]
Separate to the label, the regulation also creates a standalone optional disclosure regime for other non-labelled green bonds and green sustainability-linked bonds (SLB) marketed in the EU. This standalone disclosure regime could be a useful way for issuers to signal their sustainability ambitions whilst they work towards the EuGB label. The label will be available to all issuers, both within the EU and outside, provided their green bonds meet the requirements of the label set out in the regulation. Moreover, the requirements include that the label is only available to issuers that publish an EU Prospectus Regulation-compliant prospectus, and also extends to exempt issuers under the EU Prospectus Regulation. [3]
This optional disclosure will also be welcome by the investor community as well, especially in the short term. The reason being that it will standardise disclosures for green bonds and green sustainability-linked bonds in a way that markets have not seen before. Not only will it help investors with their own Sustainable Finance Disclosure Regulation reporting obligations, but it is also likely to improve comparability of bonds in the market. In addition to investors asking or requiring issuers to use these templates, issuers might want to use this regime as a way of signalling their ambition while they work towards the Energy Efficiency (EE) Green Bond label. For example, if an issuer who does not have enough taxonomy-aligned assets or projects to achieve the EE Green Bond label, or an issuer of a green SLB, they might want to opt into this disclosure regime to give more credibility and robustness to their issuance. Therefore, in that way, this regime is an opportunity for issuers to demonstrate sustainability credentials and commitment to their transition pathway. [8]
When marketing a green bond, all issuers that opt to utilise the EuGB standard must not only provide a lot of information about how the bond's revenues will be used, but also demonstrate how those investments fit into the company's overall transition strategy. A global green transition is thus a condition of the EuGB standard, which the preliminary agreement appears to have included as a new criterion. [1]
When will the first green bond using the EuGB label be issued?
The agreement reached between the European Council and the European Parliament is provisional and still needs to be confirmed and adopted by the Council and the European Parliament. The EuGB Regulation will start applying 12 months after its entry into force which is expected to take place in autumn 2023. [1] Therefore, the first green bond issuance under the EuGB label is expected to take place earliest in autumn 2024. The recitals of the regulation provide a clear indication that EU institutions and the EIB are going to be encouraged to be among the first issuers of EU Green Bonds for which the take-up is expected to be gradual. Issuers will need to ensure that they have sufficient taxonomy-aligned projects or activities in existence or in the pipeline before issuing an EuGB labelled instrument. Additionally, issuers will need to be comfortable that they have the necessary information, both at the instrument and the issuer level, to meet the detailed disclosure requirements of the label. Certainly, as the EU's wider sustainability disclosure regimes accelerate, the data gaps hindering many issuers from using the standard will abate. Consequently, transactions in the wider bond market will be visible which is expected to start with the pure-play renewable energy companies. [3]
Prepared By: Sude Çapoğlu
References:
1. Norton Rose Fulbright Insights, ‘Update: Provisional Agreement Reached on the European Green Bond Standard’, UK Publication, March, 2023, available through https://www.nortonrosefulbright.com/en/knowledge/publications/3a31a991/update-provisional-agreement-reached-on-the-european-green-bond-standard
2. Iberdrola Investments, ‘What are green bonds and what are they for?’, available through https://www.iberdrola.com/sustainability/investments-green-bonds
3. Linklaters Thought Leadership, ‘EU Green bond Regulation Podcast Series’, Episode 1, available through https://linklaters.podbean.com/e/eu-green-bond-regulation-what-is-this-all-about-esg/
4. European Commission, ‘EU Taxonomy for Sustainable Activities’, European Union official website, available through https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en
5. Linklaters Thought Leadership, ‘EU Green bond Regulation Podcast Series’, Episode 2, available through https://linklaters.podbean.com/e/eu-green-bond-regulation-eu-green-bond-label-and-taxonomy-alignment-capital-markets/
6. European Securities and Markets Authority (ESMA), ‘About ESMA’, ESMA official website, available through https://www.esma.europa.eu/about-esma
7. Linklaters Thought Leadership, ‘EU Green bond Regulation Podcast Series’, Episode 3, available through https://linklaters.podbean.com/e/eu-green-bond-regulation-transparency-requirements-for-eu-gb-labelled-bonds-capital-markets/
8. Linklaters Thought Leadership, ‘EU
Green bond Regulation Podcast Series’, Episode 4, available through https://linklaters.podbean.com/e/eu-green-bond-regulation-opt-in-disclosure-regime-for-other-green-bonds-and-green-slbs-capital-markets/
