In the earlier parts in this Philip Lee Green Finance Series for Climate Finance Week Ireland 2020 we considered the EU Green Deal (Note 1) and the EU Taxonomy, Putting the Green in Green Finance (Note 2). In Part 3 of the Series, we look at Green Bonds and Green Loans as a means to finance the up to €290bn estimated annual investment needed to support climate transition and adaptation in line with the Paris Agreement targets.
In order to finance the measures and investments needed for climate mitigation and adaption measures, lending will be required to large corporates, SMEs and consumers to support the transition to the low carbon economy in the form of deep retrofit programmes, and other mitigation and loan transition steps. Green bonds, green loans and sustainably linked loans will provide the financial firepower to fund the necessary measures. Using the taxonomy and reporting structures investors and banks will have a benchmark from which they assess, disclose and measure the merits and alignment of the investments and loans they are making.
Green Bond Standard
As part of the action plan the HLEG delivered a report on the establishment of an EU Green Bond Standard (EU GBS), building on the Taxonomy with a classification system for sustainable economic activities. The implementation of this is currently under consideration by the Commission1. The ICMA and the ISEAN Green Bond Standards already provide guidance on the issuance of green bonds. With the global green bond market set to grow to €1tr by the end of 2021 and €2tr by the end of 20232 the EU GBS will be hugely influential.
The purpose of the EU GBS is to reduce uncertainty around what constitutes green investment and provide greater transparency in the EU by linking to the Taxonomy, standardising verification and reporting processes and establishing an official standard to which incentives could be linked.
The components of the EU GBS are:
- Alignment of 'use of proceeds' with the Taxonomy;
- Publication by issuers of a Green Bond Framework;
- Mandatory reporting on 'use of proceeds' (allocation reporting) and environmental impact (impact reporting);
- Independent verification of compliance by issuers with Green Bond Frameworks.
In terms of the issues yet to be addressed in finalising the EU GBS is whether, (1) the EU GBS should be mandatory to all 'green bonds' at the date of issue or on a "whole of life" basis, (2) if 'use of proceeds' must be 100% aligned with the Taxonomy or if some flexibility may be permitted by reference to technical screening criteria (the concern being to prevent greenwashing but whilst also supporting transition activities by issuers), ie "substantially contribute to one of the six objectives in the Taxonomy provided they "do no significant harm" (DNSH) and meet minimum safeguards, and (3) the extent to which the EU GBS might permit refinancing of existing green projects as "green activities" .
The Taxonomy and EU GBS user guide provide guidance on this DNSH principle and minimum safeguards principles.
The Loan Market Association (LMA) have separately published guidance documents to support lenders in the form of the Green Loan Principles (GLP) for green loans, and the Sustainability Linked Loan Principles (SLLP) for sustainable loans. The adoption of the Taxonomy and the regulatory technical standards (RTS) again provides the basis and standards upon which lenders and investors can assess and monitor the environmental sustainability of green or sustainable projects or loan portfolios
The GLP address green loans made available to finance exclusively green projects which align with the stated principles, ie:
- use of proceeds on a green ring fenced basis;
- evaluation and selection of projects;
- management of proceeds; and
- reporting on compliance and delivery of set green performance/savings.
The SLLP relate to any loans that "incentivise achievement by the borrower of targeted sustainability performance objectives" (but not ringfenced in the way required by the GLP). Similar to the GLP, loans should:
- be consistent with the borrower's ambitious and meaningful sustainability strategy;
- be monitored and measured against clear targets/performance criteria, whether they be bespoke, sector specific best practice or verified industry standards/specific SDGs (ie. UN Sustainable Development Goals);
- be reported upon against the performance targets; and
- be subject to review and verification. The applicable interest rate may be dependent on performance against the sustainability targets by way of interest rate ratchet mechanisms.
Again and again we continue to see the importance of the EU Taxonomy and the regulatory technical standards (RTS) being produced as part of the TEG group which are fundamental to having a reliable standard or green label for products, the disclosure of related information through the SFRD and NFRD frameworks and investor confidence, transparency and preventing greenwashing. The maintenance of investor and market confidence is key to the success of the transition on the scale required.
There has been much talk about the use of "Greeniums" or "Brown Penalising Factors" in the context of green loans. From a regulatory perspective there is resistance to a lighter capital treatment being applied to green loans. However it is clear that physical and transition risks for lenders will be recognised as part of the supervisory process and prudential treatment of assets on balance sheets. The outcome in that context depending on your perspective, might be seen more in the light of a brown penalising factor in the medium term for those lenders that do not effectively implement a successful sustainability strategy. As we have seen in the earlier parts of this Series, disclosure requirements in the SFDR (Sustainable Finance Disclosure Regulation), the NFDR (Non-Financial Reporting Directive) will drive this transition as part of a twin track approach with institutions required to disclose the extent to which they are Taxonomy aligned and the strength of their "green ratio". Their green ratio being the metre stick by which the impact on climate change of the activities they finance will be judged and ultimately their attractiveness to investors.
The GLP and SLLP linked to the Taxonomy provide lenders with guidance and the ability to address necessary elements of their loan documentation for the purposes of delivering green financing. Fundamentally though it sends the message that green finance is not about just wind or solar farms, it is relevant to every loan that a bank advances or has advanced within its portfolio, from "green" loans to real estate loans to working capital loans, banks will need to consider the impact and emissions arising from the activities they finance.
In the final part of our Series and on the culmination of Climate Finance Week Ireland 2020 we will look at the integration of the green finance measures, and how they can support the delivery of a circular economy.
1. The Commission is also to consider social bonds in the context of Covid-19 and the development of a set of Social Bond Principles.
2. NN Investment Partners October 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.