To deliver change, regulation must respect the efficiency of the debt capital markets

When the European Council adopted the EU Green Bond Regulation on 24 October 2023, the press release stated: “The new standard will foster consistency and comparability in the green bond market, benefitting both issuers and investors of green bonds. Issuers will be able to demonstrate that they are funding legitimate green projects aligned with the EU taxonomy.”

The aim of regulation in this area is to promote funding for genuine sustainable investment, and finance the move to deliver Net Zero. Investors are demanding more information to provide them with assurance that their investments are contributing to this change, and to combat any potential risk of greenwashing. However, previous experience in the debt capital markets is that prescriptive regulation may drive issuers elsewhere if bond issuance becomes overly burdensome, costly or risky, especially if there is little or no premium. There was a move away from retail issuance following the introduction of PRIIPs, MiFID II requirements and other regulation that made the selling of securities to retail more burdensome. Legislators therefore need to walk a tightrope with new green regulation; balancing market efficiency against their objectives to ensure any developments don’t shrink markets and make it harder to finance change.

The EU Green Bond Regulation

The EU Green Bond Regulation provides for a voluntary label (EuGB label) for the green use of bond proceeds, which is being seen as a gold standard. The voluntary nature of the label is sensible due to the prescriptive requirements through which proceeds need to have been fully allocated before maturity of the bond according to the criteria set out in Article 3 of the Taxonomy Regulation.

The challenges of taxonomy alignment have been well documented. The proceeds must be allocated in a way that contributes substantially to one or more of the environmental objectives set out in Article 9 of the Taxonomy Regulation, does no significant harm to any other environmental objectives, and complies with minimum safeguards and technical screening criteria (TSC). There is a limited flexibility pocket for up to 15 per cent of proceeds that do not comply with TSC if relevant TSC have not entered into force by the date of issuance. The TSC are very detailed and require granular data to assess alignment. They also do not yet cover every activity that could be deemed to make a substantial contribution to environmental objectives.

In addition to these detailed requirements around the allocation of proceeds, use of the EuGB label will entail significant disclosure. The label requires a pre-issuance factsheet that must be reviewed externally, with the EU Green Bond Regulation mandating that reviewers register with the European Securities and Markets Authority (ESMA) and comply with certain conditions. The factsheet will need to address some forward-looking requirements, which may pose challenges, including how the bonds are expected to contribute to the issuer’s taxonomy-aligned assets, turnover, capital expenditure and operating expenditure (for companies that required to report under the Corporate Sustainability Reporting Directive (CSRD)). There are also concerns around timing, as the launch of a new transaction could be delayed by the need to produce a factsheet before issuance.

There are other disclosure requirements, including an allocation report and review and impact report. The competent authority of the home member state will have supervisory powers over compliance with the disclosures, publication and will even be able to suspend trading in EuGB label bonds. There may be a concern that a failure to meet the disclosure requirements could risk imposition of such measures, although it isn’t yet clear exactly how the supervision will be conducted.

Moving away from the EuGB label, the EU Green Bond Regulation also provides an alternative, optional scheme of sustainability disclosures following voluntary templates for:

• use of proceeds bonds not using the EuGB label, but marketed as environmentally sustainable, or
• sustainability-linked bonds (SLBs). The rapporteur, Paul Tang, has said that this is for issuers “that are keen to show they are serious about their green claims but not yet able to adhere to the strict standards of the gold standard. With a clear system for disclosures, any green bonds not using this system will likely be looked at with increasing suspicion.”

However, there may still be some challenges complying with these voluntary alternative disclosures, depending on the content of the guidelines the Commission needs to prepare. In particular, as under the EuGB label, an issuer subject to Article 8 of the Taxonomy Regulation (i.e., companies that will be required to sustainability report under the CSRD) will need to disclose how the bond proceeds are expected to contribute to the issuer’s taxonomy-aligned turnover, capital expenditure and operating expenditure. This may involve forward-looking statements, which issuers currently prefer not to provide in debt prospectuses due to potential liability concerns. As mentioned earlier, there are also concerns surrounding the challenge of measuring taxonomy alignment.

While the EuGB label and alternative optional disclosures are, so far, voluntary, the EU Listing Act amendments providing for new annexes to the Prospectus Regulation for non-equity securities that are advertised as taking into account ESG factors or pursuing ESG objectives are worth noting. A Commission statement from 19 October 2023 suggests these will take into account the experience with the voluntary guidelines that will be prepared for green bonds under the EU Green Bond Regulation. If the requirements for a Prospectus Regulation-compliant prospectus for a green bond track the voluntary guidelines for the alternative pre-issuance disclosures mentioned above, this would effectively make them mandatory and any concerns will depend on the content of those guidelines, as highlighted earlier.

The approach elsewhere

From a broader international perspective, most market participants follow the International Capital Market Association (ICMA) Principles. The ICMA’s Green Bond Principles, Social Bond Principles, Sustainability Bond Guidelines and Sustainability-Linked Bond Principles are regularly updated to reflect the latest evolution of products and ESG thinking and constitute the prevalent voluntary standard for sustainable bonds.

In addition, and to avoid fragmentation, some national regulators have joined forces to develop common standards for green bond issuances. The ASEAN Green Bond Standards, for example, have been developed by South-East Asian capital markets authorities in conjunction with the ICMA’s Green Bond Principles but provide more specific guidance for issuers in South-East Asia. Green bond issuances within the region often comply with both ICMA and ASEAN principles.

The Common Ground Taxonomy (CGT), which is the result of a comprehensive mapping exercise between China’s and the EU’s taxonomies, covers areas that are within the scope of both taxonomies. While there are no regulatory requirements to follow it, the CGT has piqued the interest of international markets since it was initially released in 2021 with some issuers labelling their green financial products as CGT-aligned.

Returning to the topic of regulatory developments, the UK government, as part of the overhaul of the UK prospectus regime, will delegate a greater degree of responsibility to the Financial Conduct Authority (FCA) in respect of admission to trading, including when a prospectus is required for admission and what it must contain. In the FCA’s engagement papers¹ published in May 2023, it explores, for green, social or sustainability-labelled debt instruments, the desirability of strengthening the connection between the information provided in the prospectus and that described in other documentation such as bond frameworks. Obviously, the detail will not be seen until rules are drafted, but certainly the options outlined give the FCA scope to build on existing and evolving market practice. In addition, the FCA suggests that aspects of sustainability-related information could be included within the category of “protected forward-looking statements”, providing alleviations from liability to encourage issuers to include more forward-looking information in their prospectuses. At the moment, it therefore seems a UK green bond regulation is not on the horizon.

The need for flexibility rather than rigidity

Regulators must ensure issuers aren’t driven away by rigid regulatory requirements while providing investors with the information they need to invest in green financial products that can be used to finance projects that will help achieve Net Zero. The current efficiency of the debt capital markets in relation to ESG bonds issued in line with existing ICMA principles needs to be respected by providing sufficient flexibility in order to deliver that change.

Footnote

^{1. “Admission to trading on a regulated market” , “Protected forward-looking statements”, and “Non-equity securities”}