Outstanding ESG bonds reached EUR 1.7 tn in 1H23, an increase of 28% in 1 year and 663% since 1H18, with green bonds dominating the market (63%) (ESMA TRV Risk Analysis of 6 October 2023 “Sustainable Finance, The European sustainable debt  market – do issuers benefit from  an ESG pricing effect?”, ESMA50-524821-2938).

                                           
          
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Market analyses show that investors not only prefer sustainable  debt instruments, but if they are willing to forego returns in the process and thus contribute to the  existence of the ‘greenium’. The United Nations  Development Program (2021) defines the  greeniumas ‘pricing benefits based on the logic that investors are willing to pay extra or accept  lower yields in exchange for sustainable impact.’This means that sustainable debt instruments price inside their yield curve, i.e. theyoffer lower yields at equal or higher prices as opposed to their conventional debt counterparts, provided that all other instrument and issuer  characteristics are (almost) equal (Climate Bonds  Initiative, 2021).  

Pricing premium of sustainable debt may point towards investors’ confidence in and preference for these instruments. One possible reason driving this confidence may lie ina lower perceived risk level of sustainabilityrelated products. In terms of non-traditional riskfactors, investors may believe that conventional debt carries higher financial risks, such as high volatility in valuations or assets becoming stranded due to, for example, climate-change induced natural disasters, or they may consider sustainability-oriented issuers to be better placedto face any regulatory transition risk without significant disruptions. While these perceptionsmay not always reflect the instrument’s actual  riskiness, they can drive emotional responses  and investment decision-making (Hoffmann etal., 2015; Raut et al., 2023).

The above ESMA TRV Risk Analysis of 6 October 2023 indicates that a vast set of different kinds of bonds with a sustainability element can broadly be distinguished into two categories: use of proceed  bonds (UoP) and sustainability-linked bonds  (SLBs).  

UoP bonds have their proceeds earmarked for a  specific sustainability project or activity, with the  aim of raising financing for a pre-defined  sustainability purpose. These bonds are typically further distinguished by the  sustainability character of the financed project and are typically split into green bonds (for those where the proceeds are earmarked for an environmental purpose, such as reduction of CO2  emissions or the restauration of biodiversity), social bonds (for social purposes such as  healthcare or social housing) and sustainability bonds, which contain both environmental and social elements.

EU Green Bond Standard (EU GBS) aims to address barriers identified in the EU framework for a sustainable finance. Firstly, by reducing uncertainty about what constitutes green investment by linking it to the EU taxonomy (avoiding greenwashing). Secondly, by standardising costly and complex verification and reporting processes, and thirdly, by establishing an official standard to which potential incentives could be linked. The EU GBS as proposed by the Commission Technical Expert Group on Sustainable Finance (TEG) is intended to finance both physical and financial assets and includes the use of the latter as security (i.e. as a covered bonds or assetbacked securities).

The key components of such a standard – as recommended by the TEG and building on best market practices such as the Green Bond Principles and the Climate Bonds Initiative labelling scheme – should be:

(1) alignment of the use of the proceeds from the bond with the EU Taxonomy;

(2) the publication of a Green Bond Framework;

(3) mandatory reporting on the use of proceeds (allocation reports) and on environmental impact (impact report); and

(4) verification of compliance with the Green Bond Framework and the final allocation report by an external registered/authorised verifier.

Also the EBA Discussion Paper of 3 November 2020 on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03, p. 92) underlines the Green Bond Principles build around four key components:

(1) use of proceeds,

(2) process for project evaluation and selection,

(3) management of proceeds, and

(4) reporting.

However, the Green Bond Principles do not provide criteria for eligible projects, however, the Climate Bonds Standard provides sector-specific eligibility criteria for assets and projects.

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Verena Ross, ESMA Chair, European Association of Corporate Treasurers Summit– Brussels, 17 March 2022, ESMA71-319-210

The GBS will, once adopted, be a voluntary label which issuers can choose to adhere to. Where an issuer wants to market a bond as green, however, the obligations set out in the standard will be binding on the issuer. The most important obligation concerns the allocation of proceeds of the issuance to assets or activities aligned with the EU Taxonomy Regulation. In addition, the issuer will be required to make a range of information available to the investor about the use of the proceeds. Two separate mechanisms of compliance monitoring are foreseen in the proposal. First the national supervisor of the issuer will be competent to check overall compliance of the issuer with the requirements in the standard. Second, the issuer will be required to solicit the services of an independent verifierthat will perform verification of the issuer’s disclosures pre- and postissuance. ESMA’s role in this respect will consist in authorising and supervising the independent verifier and supporting coordination among national supervisors.

 

The proposal for the EU Green Bond standard comprises four key elements:

a. alignment with the EU Taxonomy, as stipulated according to the Taxonomy Regulation, as proceeds from EU Green Bonds should be used to finance or refinance activities that contribute substantially to at least one of the six environmental objectives, do not significantly harm any of the other objectives and comply with the minimum social safeguards. Where technical screening criteria have been developed, these should also be met, although the standard allows for deviations in specific cases;

b. publication of a green bond framework, which confirms the voluntary alignment of green bonds issued with the EU Green Bonds Standard, explains how the issuer’s strategy aligns with the environmental objectives, and provides details on all key aspects of the proposed use-of- proceeds, processes and reporting of the green bonds;

c. mandatory reporting on use of proceeds (allocation report) and on environmental impact (impact report);

d. mandatory verification of the green bond framework and final allocation report by an external reviewer.

The Usability Guide, TEG Proposal of March 2020 for an EU Green Bond Standard puts this into the following context (p. 12):

“The international bond markets are mainly used to raise capital for general (corporate or public) purposes, based on the risk profile of the issuer, represented by its credit rating and the remuneration offered in the form of interest paid.
Traditional bond investors focus on these parameters rather than on the use-of-proceeds, i.e. how issuers will actually employ the funds being raised. Bonds are also therefore typically (re)financing instruments where capital is raised on the strength of the entire balance sheet of the issuer and the level of debt it can support.
Green bonds represent a considerable innovation, through their focus on green use-of-proceeds, providing transparency for investors on the green projects that are being financed or refinanced, as well as additional information on the management of proceeds, impact reporting and external reviews. Green bonds have provided bond investors the capacity to become involved in corporate environmental strategies. It has also enabled bond markets to become a powerful force in green finance, notably including climate mitigation finance.
The EU GBS incorporates the use-of-proceeds approach along with a clear interpretation of other innovative aspects of green bonds”.

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See also:

 

EU Green Bond Standard, European Commission website

 

ICMA Green Bond Principles (GBP) 

 

Partly aligned bonds

 

The main label currently used in Europe are the ICMA green bond principles and over the past few years a boom could be observed in the issuance of green bonds aligned with this standard (Verena Ross, ESMA Chair, European Association of Corporate Treasurers Summit– Brussels, 17 March 2022, ESMA71-319-210).

As regards the issuance of a bond that is partly EU GBS aligned (for the climate-related part) and partly ICMA Green Bond Principles based, the said TEG Usability Guide of March 2020 contains an explanation that such structure “is possible but it would not be deemed to be an EU Green Bond. While all EU GBS aligned bonds are GBP-aligned by definition, an EU Green Bond should meet all criteria of the EU GBS and be fully aligned with the EU Taxonomy for its use-of-proceeds”.

 

SFDR

 

The Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector (SFDR) lays down harmonised rules for financial market participants and financial advisers. This includes rules on transparency, among others, for the provision of sustainability‐related information with respect to financial products promoting sustainability characteristics or financial products with sustainability objectives.

In the SFDR “financial market participants” are those that manufacture investment-based products such as investment funds where the investment fund itself is the “financial product”. The said TEG Usability Guide of March 2020 observes, for the purposes of the SFDR, a bond is not considered as a “financial product” and an issuer of fixed-income securities (i.e. bonds, including EU Green Bonds) is not considered a “financial market participant” - thus, there is no direct impact from the SFDR on issuers of EU Green Bonds.

 

Taxonomy Regulation/NFRD

 

The said TEG Usability Guide of March 2020 makes the following observations with respect to the Taxonomy Regulation’s impact on the EU Green Bond disclosure framework:

  • the Taxonomy Regulation uses the same definitions for “market participant” and “financial products” as the SFDR;
  • there is therefore no direct obligation or impact on EU Green Bond issuers arising from the Taxonomy Regulation;
  • there can also be an indirect impact, as the SFDR and the Taxonomy Regulation define new disclosure requirements for a broad range of asset owners, asset managers and manufacturers of investment products that may as a result generally be seeking information on EU Taxonomy-alignment from issuers in the bond market.
  • separately, however, the Taxonomy Regulation creates reporting obligations for companies subject to the NFRD.

Companies subject to the Non-Financial Reporting Directive (Directive 2014/95/EU - the NFRD) are required to disclose certain information on the way they operate and manage social and environmental challenges. EU rules on non-financial reporting only apply to large public-interest companies with more than 500 employees, covering approximately 6,000 large companies and groups across the EU, including listed companies, banks, insurance companies, and other companies designated by national authorities as public-interest entities.

Under the EU Taxonomy Regulation the same companies that are subject to NFRD must include in their non-financial statement information on how and to what extend their activities are associated with environmentally sustainable economic activities.

Under the EU Taxonomy Regulation, there is a requirement on Member States and the EU to apply the taxonomy if they were to create requirements on issuers in respect of corporate bonds that are made available as environmental sustainable. This simply means that if the EU were to develop an official green bond standard it has to apply the EU taxonomy.

For non-financial companies, the disclosure must include:

(i) the proportion of turnover aligned with the EU taxonomy; and

(ii) CapEx and, if relevant, OpEx aligned with the taxonomy.

 

Regulation on European green bonds 

 

On 6 July 2021 the European Commission published the proposal for the Regulation on European green bonds. As the EU executive body explains in its communication, "once it is adopted by co-legislators, this proposed Regulation will set a gold standard for how companies and public authorities can use green bonds to raise funds on capital markets to finance such ambitious large-scale investments, while meeting tough sustainability requirements and protecting investors.

This 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. And investors buying the bonds will be able to more easily assess, compare and trust that their investments are sustainable, thereby reducing the risks posed by greenwashing.

The new EUGBS will be open to any issuer of green bonds, including companies, public authorities, and also issuers located outside of the EU".

According to the European Commission there are four key requirements under the proposed framework:

- Taxonomy-alignment: The funds raised by the bond should be allocated fully to projects that are aligned with the EU taxonomy;
- Transparency: Full transparency on how the bond proceeds are allocated through detailed reporting requirements;
- External review: All European green bonds must be checked by an external reviewer to ensure compliance with the Regulation and taxonomy alignment of the funded projects;
- Supervision by the European Securities Markets Authority (ESMA) of reviewers: External reviewers providing services to issuers of European green bonds must be registered with and supervised by the ESMA. This will ensure the quality of their services and the reliability of their reviews to protect investors and ensure market integrity.

Regarding the last aspect the ESMA in the Letter of 25 January 2022 to Co-Legislators on Regulation for European Green Bonds shared some views on necessary mechanisms allowing third country external reviewers to offer their services in the European Union. In general, such mechanism is intended to help establish the EU Green Bond Regulation as a global standard. Principally, the envisioned equivalence and endorsement regimes are largely based on what has been in operation for credit rating agencies under the CRA Regulation. For equivalence, there will be the assurance provided by a legal and supervisory framework in the third country where the external verifier is based. For endorsement, there will be the assurance of a direct supervisory relationship between ESMA and the EU legal entity that is endorsing services from a third country entity. However, ESMA cautions that the approach taken regarding the recognition regime, only requires a third country external reviewer to have a legal representative in the EU. Consequently, ESMA will have limited visibility over these activities, which will be further aggravated by the lack of a supervisory counterpart in the third country. Therefore, the ESM suggests to delay the implementation of this regime until ESMA has had the opportunity to register EU external reviewers and build up the supervisory regime for these entities, including the endorsement and equivalence regimes.

The supervisory regime could then, as the next step, be opened up to include recognised external reviewers.

On 28 February 2023, the European Parliament and the Council reached a political agreement on the European Commission's proposal for a European Green Bond Regulation. The regulation will form an integral part of the EU Green Deal as well as create a high-quality, voluntary EU standard that issuers can make use of, either instead of or on top of existing market standards.

The main requirements for an issuer to be able to issue a bond under the label of the European Green Bond are as follows:

  • most of the funds raised by the bond must be allocated to projects that are aligned with the criteria of the EU Taxonomy;
  • there are disclosure requirements to ensure full transparency on how issuers allocate the money raised by the bond;
  • all European green bonds must be checked by an external reviewer (registered and supervised by the ESMA), which will check that the issuer is complying with the requirements of the GBS and the Taxonomy.

The use of the templates freely available under the the European Green Bond Regulation will be strictly voluntary. 

On 30 November 2023 Regulation (EU) 2023/2631 of the European Parliament and of the Council of 22 November 2023 on European Green Bonds and optional disclosures for bonds marketed as environmentally sustainable and for sustainability-linked bonds has been published in the EU Official Journal.

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