This article provides an overview of the Green Bond Regulation proposed by the EU Commission in June 2021 and the most recent developments as the Commission’s proposal makes its way through the EU legislative process, in particular the draft report published by the rapporteur of the European green bond dossier at the EU Parliament in December 2021, which includes some fundamental changes, together with their analysis by the International Capital Markets Association (ICMA) in a report published in January 2022.
By Daniel Bono / Giulia Ghezzi (Reference: CapLaw-2021-01)
1) Introduction
In a global market that is getting more and more focused on climate change awareness and environment protection, the market for green bonds increased over the past years and with it the need for establishing market standards at the international level. This resulted in the establishment of market-based green bond standards such as the green bond principles (the ICMA Green Bond Principles) supported by the International Capital Markets Association (ICMA), and Climate Bonds Initiative’s Climate Bond Standards.
On 6 July 2021, the European Commission published a legislative proposal for a regulation to create a European Green Bond Standard (EUGBS) (the EU Green Bond Proposal) together with its renewed Strategy for Financing the Transition to a Sustainable Economy. The European Green Bond Standard would be part of the EU’s measures to achieve carbon neutrality by 2050 through the EU Green Deal and has the potential to become the new “gold standard” for green bonds.
While the EU Green Bonds Proposal is based on and designed to be compatible with existing market-based standards, which reflect market best practice, it would go further in certain key aspects, in particular by requiring alignment with the EU’s taxonomy for sustainable activities (EU Taxonomy Regulation (EU) 2020/852, the EU Taxonomy Regulation), a classification system aimed at giving capital markets an agreed, scientifically reliable view of environmentally sustainable activities, and by requiring registration and supervision of external reviewers by the European Securities and Markets Authority (ESMA).
In October 2021, the European Union issued its first EUR 12 billion green bond to finance member states’ environmentally beneficial projects as part of its COVID-19 recovery fund. Thirty percent of the EU’s up to EUR 800 billion COVID-19 recovery scheme will fund environmentally beneficial projects.
2) Overview of the EU Green Bond Proposal
a) Overview
The EU Green Bond Proposal notes that despite vigorous market growth, the issuance of green bonds remains a fraction of overall bond issuance, representing about 4% of overall bond issuance in 2020 and that various existing initiatives for environmentally sustainable bonds do not ensure common definitions of environmentally sustainable economic activities. It also notes that diverging rules on the disclosure of information, on the transparency and accountability of external reviewers reviewing environmentally sustainable bonds, and the eligibility criteria for eligible environmentally sustainable projects, impede the ability of investors to identify, trust, and compare environmentally sustainable bonds, and the ability of issuers to use environmentally sustainable bonds to transition their activities towards more environmentally sustainable business models.
b) Voluntary staandard
To address the above mentioned concerns, the EU Green Bond Proposal seeks to provide the basis for a common regulatory framework for the use of the ‘European green bond‘ or ‘EuGB‘ label for bonds that finance environmentally sustainable activities within the meaning of the Taxonomy Regulation. As proposed, the EU Green Bond Proposal would create a voluntary standard. This standard would co-exist with existing market standards (notably the ICMA Green Bond Principles). The EU Green Bond Proposal intends to create a ‘gold standard’ for green bonds that would also be available to issuers outside the EU. As proposed, the standard would be open to corporations, sovereigns and financial institutions as well as issuers of covered bonds and asset-backed securities.
c) EU Taxonomy Alignment and Grandfathering
A key feature of the EU Green Bond Proposal is its alignment with the EU Taxonomy Regulation by requiring that the proceeds of the bonds must be used for environmentally sustainable activities that meet the requirements of Article 3 of the EU Taxonomy Regulation in effect at the time the bonds are issued, specifically in accordance with the technical screening criteria established by the EU Commission under the EU Taxonomy Regulation (TSCs) by the time the bonds mature.
In the event of a change in the TSCs, there is a grandfathering provision that allows issuers to use the TSCs applicable at the time of the bond issuance for five years. The EU Green Bonds Proposal also supports issuers in a transition to environmental sustainability, as European green bonds can be used to fund long-term projects (up to ten years) to align an economic activity with the EU Taxonomy Regulation.
d) Transparency, External Review and ESMA Supervision
Other key aspects of the EU Green Bonds Proposal include transparency requirements and the requirement for review by an external reviewer to verify that bonds comply with the EU Green Bonds Proposal, in particular for alignment of the funded projects with the EU Taxonomy Regulation. External reviewers must be registered with and are supervised by the European Securities and Markets Authority (ESMA) and will be required to meet the conditions for registration on an ongoing basis.
The transparency requirements include the publication of (i) an European green bond factsheet together with a pre-issuance review by an external reviewer before the bonds are issued to the public, (ii) an annual report on the allocation of proceeds until full allocation thereof and (iii) an impact report at least once during the life of the bond. Issuers are also required to obtain post-issuance review by an external reviewer of the first allocation report after full allocation of the bond proceeds.
3) Amendment Proposals for the EU Parliament and associated ICMA Analysis
a) Overview
In December 2021, the rapporteur of the EU Green Bond Regulation file at the European Parliament released a draft report containing certain proposed amendments to the EU Green Bond Proposal (the Amendment Proposal), which, if adopted as proposed, would in some respects represent a fundamental shift from the EU Commission’s Green Bond Proposal. In response, ICMA published a report in January 2022 entitled “Analysis of the amendments to the EuGB Regulation proposed by the Rapporteur of the EU Parliament” (the ICMA Analysis). The most consequential proposed amendments and the associated ICMA Analysis are described below.
b) Unintended consequences of a mandatory standard
While the EU Commission has proposed a voluntary green bond standard that is intended to set the “gold standard” for the most high-quality green bonds while also co-existing with established green bond market standards, most notably the ICMA Green Bond Principles, the Amendment Proposal requires the EU Commission to establish by December 2023 the deadline and practicalities for the mandatory adoption of the EU Green Bond Regulation between 2025 and 2028.
A mandatory application of the EU Green Bond Regulation has raised legitimate concerns among market participants. The ICMA Analysis noted that this is completely at odds with the approach proposed by the EU Commission and the various expert groups representing market participants and stakeholders that have contributed to the EU Green Bond Standard. It could cause unintended negative consequences such as market fragmentation, migration to other markets and contraction of the green bond market as issuers may decide to switch to traditional (non-sustainable) capital market or bank funding sources. In addition, the ICMA Analysis notes that in 2020, over 95% of green bonds globally were aligned with the ICMA Green Bond Principles with voluntary commitments to disclose use of proceeds, provide allocation and impact reports and use the services of external reviewers. Therefore, as a mandatory framework, the EU Green Bond Regulation may hinder rather than promote the growth of the green bond market.
c) Expansion to all types of sustainable bonds may discourage issuers
While the EU Commission’s proposal focused exclusively on environmentally sustainable “green” bonds, the Amendment Proposal would expand the scope of the EU Green Bond Regulation to all types of sustainable bonds (including social bonds, sustainability bonds and sustainability-linked bonds) as of its entry into force. The ICMA Analysis noted that the Amendment Proposal would fundamentally change the liability and cost incurred by issuers of sustainable bonds in the European market and that while the stated intention is to improve transparency and integrity of the sustainable bond market, the most likely and unintended outcome would be to discourage issuers from using it.
d) More stringent rules for Taxonomy alignment plans may increase liability and reputational risks
The Amendment Proposal includes more stringent rules for Taxonomy alignment plans. Among other things, these amendments include a requirement for Taxonomy alignment plans in relation to European green bonds to be based on annual interim targets, which would be subject to an annual external review. Moreover, failure to meet these targets twice would result in loss of the European green bond designation and issuers may face administrative sanctions and actions for failing to adhere to Taxonomy alignment plans. In addition, the Amendment Proposal would require a mandatory assessment of Taxonomy alignment for all sustainable bonds by external reviewers (before and after issuance). The ICMA Analysis notes that the associated increase in liability and reputational risks would be very likely to deter the issuance of European green bonds.
4) Outlook
The EU Commission’s EU Green Bonds Proposal is currently being considered by the EU Parliament and the EU Council as co-legislators. Once both co-legislators have agreed their positions, interinstitutional negotiations will commence. Although the exact timing of these further steps in the EU legislation process is not clear yet, further developments of the EU Green Bonds Standard are likely in the first half of 2022.
Daniel Bono (daniel.bono@nkf.ch)
Giulia Ghezzi (giulia.ghezzi@nkf.ch)