Another step closer to the end of the EU Green Bond Standard journey

We previously set out in this publication (see here) the key takeaways from the provisional agreement reached by EU authorities on the final text regarding the regulation of the EU Green Bond Standard (EU GBS). Last week, a consolidated text following these agreements was leaked. It is set to be made public in a final format following final votes from the European Parliament (the Council has adopted the consolidated text last Wednesday). This should take place around September. Once adopted, the EU GBS is expected to set the golden standard for what constitutes a green bond in the EU (called European green bonds or EuGBs). Meanwhile, while it remains a voluntary standard, it should support transparency and comparability of green bonds, also preventing greenwashing.

Below, we have highlighted some of the key highlights included in the consolidated document.

Use of proceeds

One of the key features of the EU GBS is the eligible use of proceeds of the bond. The final text shows that the following type of assets/expenditures are eligible for EuGBs: fixed assets (excluding financial assets); capital and operating expenditures (capex and opex, respectively) that were incurred no more than three years before issuance date of the EuGB; financial assets that were created no later than 5 years after issuance date; and assets/expenditures of households (also classified as a sub-category of financial assets). Financial assets are defined under the EU GBS as “debt or equity, or a combination thereof”. However, as per IFRS, financial assets include as well an entity’s contractual rights to receive cash/financial assets from another entity (see here), which would include therefore granted loans in a financial institution’s balance sheet. We therefore argue that those would also classify as financial assets under the EU GBS, although more clarity needs to be given on that. On that note, one could also assume that a mortgage loan is deemed to be classified as an “asset of a household” from a bank’s point of view, implying that under the final EU GBS, financial institutions would have to potentially comply with separate requirements whether the financial asset entails a mortgage or not. For financial assets, in case the issuer uses the portfolio approach (see more on this below), then the condition of financial assets having to be created no later than five years after the issuance date of the EuGB does not apply (our understanding is that this means that all eligible financial assets need to be created on or before issuance date of the EuGB, but that is also not clearly specified). While not properly clarified, we assume that these requirements apply to also assets/expenditures of households, as these are a sub-category of financial assets. Financial assets should also be allocated to a maximum of three subsequent financial assets in a row. It is a bit unclear what exactly is meant with this clause and also whether assets/expenditures of households are excluded from this requirement.

Flexibility pocket of 15%

While proceeds of EuGBs need to (eventually) finance only EU Taxonomy aligned activities, the proposed Regulation includes also a flexibility pocket. That means that issuers may have 15% of the EuGB proceeds not aligned with the EU Taxonomy. This is the case if the financed activity is either (i) not yet covered by the EU Taxonomy; or (ii) in the context of financial international support (which usually refers to financing by or to governments/SSAs), such as climate finance reported to the EU and the UNFCCC, and official development assistance (ODA) reported to the OECD. These refer mainly to activities outside the scope of the EU Taxonomy.

Point (i) related to the fact that when the provisional agreement with regards to the EU GBS was reached, the EU Taxonomy for four out of the six environmental objectives was still under development. Moreover, there were no updates on when a delegated act covering these activities (the so-called Taxonomy Environmental Delegated Act) would be published. However, a few weeks ago, the EU Commission has released a draft Taxonomy Environmental Delegated Act, which was open for feedback until the 5th of May (see our note on this here). Also more recently, the Platform on Sustainable Finance published a review (see here) on the proposed document. Therefore, it seems that the Taxonomy Environmental Delegated Act will be finalized shortly after, or even before, the application of the EU GBS Regulation. This brings into question exactly which activities would be covered by point (i) mentioned above. The draft Taxonomy Environmental Delegated Act does mention a few activities that are not yet covered by the work done by the Commission, such as agriculture, forestry and fishing. As the Commission highlights, for now, the analysis “prioritises those economic activities and sectors that were identified as having the biggest potential to make a substantial contribution to one or more of the four environmental objectives and for which it was possible to develop or refine the recommended criteria without further delay”. Hence, this makes it hard for issuers to properly distinguish which activities will or will not be included in the EU Taxonomy in the future, as there are activities that could be financed by EuGBs, but are not yet covered by the EU Taxonomy.

The use of a portfolio approach

It is not uncommon that green bond issuers make use of the so-called “portfolio approach” when allocating proceeds. This means that instead of directly linking proceeds to expenditures/assets, all these are added to one big portfolio, which should at least match the size of the green bond issuance. The final version of the EU GBS seems to only permits that for financial assets. These, combined, need also to exceed the total value of the EuGBs outstanding.

Financing of gas and nuclear energy

As per the final EU GBS, issuers need to disclose pre-issuance, whether bond proceeds are intended to be allocated to transitional or enabling activities (as per Complementary Delegated Act for the EU taxonomy). More than that, issuers need to make clear whether the proceeds will fund taxonomy-aligned nuclear energy and/or fossil gas activities.

Disclosure on transition plans

If an issuer is subject to publishing transition plans as per the CSRD (this mainly refers to large undertakings and public small and medium-sized undertakings), it is now also required to disclose how the EuGB proceeds intend to contribute to the funding and implementation of those transition plans. It is a bit unclear though how that exactly will work in practice. Transition plans are defined as “the plans (…) to ensure that its business model and strategy are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5 degrees in line with the Paris Agreement (…) and the objective of achieving climate neutrality by 2050”. Hence, this brings into question (i) whether issuers without clear transition plans can issue EuGBs and (ii) how exactly do they need to assess the contribution of the EuGB towards its transition plans (e.g. is there a need for a methodological approach?).

Grandfathering

The final text of the EU GBS includes a seven year grandfathering period. That means that an issuer has seven years to adjust alignment of proceeds, if there is an amendment in the EU Taxonomy. This relates exclusively to proceeds that (i) have not been allocated yet, or (ii) are included in the capex plan and do not meet yet the Taxonomy requirements (we assume the latter relates to for example, assets that are still under construction). The Regulation also allows for issuers that foresee that the activity financed by the EuGB is at risk of not complying with the amended EU Taxonomy within seven years, to publish a plan (which shall be reviewed by an external reviewer) where it states how it intends to align the activity and how it aims to mitigate negative consequences from the non-alignment.

For financial assets that are allocated using a portfolio approach, the grandfathering criteria is slightly different. In this case, issuers need to make sure that all activities included in such portfolio are aligned with the EU Taxonomy criteria that was applicable during the seven years prior to the publication of the allocation report (and the allocation report is done annually until full allocation, under the portfolio approach). This means that if the EU Taxonomy criteria is amended, then an asset that was already included in the portfolio, can continue to be part of the “eligible assets pool” for at most seven years after the Taxonomy revision, even though those proceeds were already allocated.

Capex plans

The issuer needs to publish a so-called capex plan in the case that the proceeds of the EuGB refer to capex or opex, which do not fully meet EU Taxonomy requirements at issuance date. This plan needs to specify until when all expenditures funded by the EuGB will be EU Taxonomy-aligned (and this needs to be a date before the bond maturity). Furthermore, full EU Taxonomy alignment needs to be reached within a maximum of five years from issuance date, unless a period of up to ten years is justified by specific features of the activity itself (we would assume this refers to, for example, technologies which are still under development). Obviously, the ten years exception also needs to comply with the requirement that the pre-established deadline by the issuer needs to be a date before the bond maturity.

60 days after all the Capex plan has been reached, and all proceeds now comply with the EU Taxonomy, an external reviewer will need to confirm this EU Taxonomy alignment. A summary of the Capex plans needs to also be included in the bond prospectus, making it also therefore a legally binding document.

Post-issuance transparency documents

Issuers of EuGBs need to disclose an allocation report on an annual basis and until full allocation of proceeds, which may relate to one or multiple issuances of EuGBs (that means, they are not required to issue one report per bond). The allocation report shall also contain (if applicable) information on the progress made with regards to the achievement of the Capex plans. This allocation report shall be verified by an external reviewer after the full allocation of proceeds. If, however, the EuGB proceeds finance a portfolio of financial assets, then the report shall be done on an annual basis, unless there has not been any changes on allocation.

Issuers need to also disclose an impact report stating the environmental impact of the use of proceeds, but only after the full allocation of proceeds. As information on the environmental impact of green bonds is sometimes crucial for investors to do their own impact reports, this clause might be prejudicial for investors.

External reviewers

Another important ingredient of the EuGBs relates to external reviewers. These will have to be registered with the European Securities and Markets Authority - or ESMA (also including reviewers located in third-country jurisdictions). EuGB external reviewers will therefore be under the supervision of ESMA, which will charge fees for external reviewers due to its registration/supervisory role. It also has the right to impose fines if external reviewers commit certain infringements.

For sovereign issuers, the review of the allocation of bond proceeds can be done by a state auditor instead of an external reviewer. However, even in this case, external reviewers are still required to confirm alignment of the bond’s use of proceeds with the EU Taxonomy.

ESMA will publish draft regulatory technical standards on the registration of/regulation for external reviewers within 12 months after the EU GBS regulation entries into force.

Complicating factor regarding external reviewers is that there cannot be EuGBs issued without properly registered external reviewers at ESMA. But this process will take a while until it has been fully set-up (as stated above), and might not be completed at the time that the EU GBS becomes effective. In order to solve this issue, the final version of the EU GBS includes a transitional period: External reviewers will have up to 18 months after the entry into application of the EU GBS Regulation to provide EuGB alignment confirmation to issuers, even if the process of their ESMA accreditation is still pending. In this case, reviewers need to notify ESMA and comply with the Regulation requirements on a best-effort basis. Furthermore, for non-EU reviewers, there needs to be a legal representative located in the EU during this transitional period. This might result in a few of the existing external reviewers in the market (e.g. Moody’s, MSCI) not being able to provide confirmation of alignment during these 18 months.

Green securitisation

A new feature of the final text is that it also includes requirements with regards to green securitisation. Interestingly, the Regulation makes it clear that bond proceeds refer to “proceeds obtained by the originator from selling the securitised assets to the SSPE (Securitisation Special Purpose Entity)”. This makes it clear that the securitised pool is not necessarily composed by green assets, but can also consist of regular assets from the balance sheet of the originator. However, the Regulation does require that none of the securitised exposures comprise fossil fuel. Issuers should also disclose the share of securitised exposure that finance EU Taxonomy-aligned activities.

Furthermore, originators shall fulfil the EU GBS requirements on a pro-rata basis (based on their share in the pool of securitised exposure). One exception is that synthetic securitisation (where a party buys credit protection on a portfolio of assets) cannot use the EuGB designation.

Legally binding transparency of EuGBs

The bond prospectus from an EuGB shall make reference to the EU GBS Regulation. This means that National Competent Authorities (NCA) will supervise and ensure that issuers comply with their obligations. NCAs have then the ability to impose admin sanctions and other administrative measures to issuers if they don’t comply with the Regulation. NCA however do not verify the truthfulness or accuracy of the information provided by issuers, nor that the obligations regarding allocation of proceeds have been complied with (as this is taken care of by external reviewers, which in turn, are regulated by ESMA). Nevertheless, the failure to disclose information would allow NCAs to step in, making EuGBs’ transparency (that is, reporting) a legally binding obligation for issuers.

Disclosure for non-EU GBS aligned ESG bond issuers

The final text of the EU GBS Regulation also states that “the Commission will publish guidelines [within 12 months after the EU GBS Regulation comes into force] with a view on voluntary templates for pre-issuance disclosures for issuers of bonds marketed as environmentally sustainable and sustainability-linked bonds”. This shall include, for example, the previously mentioned disclosure on how the bond contributes to the issuer’s transition plans, and how bond proceeds contribute to the issuer’s taxonomy-aligned turnover/capex/opex (if applicable). Hence, it is also unclear whether this template for non-EU GBS aligned ESG bonds will also refer to something similar to the European Green Bond Factsheet, or whether it will refer to a different document. Specifically for Sustainability-Linked Bonds (SLBs), the template will include (among others) disclosure on the rationale, level of ambition, materiality and calculation methodology of KPIs.

Other remarks

The final version of the EU GBS also contains the following:

• Three years after the Regulation enters into force, the Commission will publish a report about the need to regulate the SLB market, accompanied by a legislative proposal

• Five years after the Regulation enters into force, and every three years thereafter, the Commission will submit a report evaluating (among others) the update of the EU GBS and its use/impact in the bond market as well as the transition to a sustainable economy.

Implications for the green bond market

While the EuGB is definitely a big step forward to the green bond market, it may also lead to some disturbances in the near- and medium-term. First of all, we think that the first EuGBs that will come to the market will benefit from stronger investor demand than regular (or non-EU GBS aligned) green bonds. That is not only because these bonds will have a “first mover” factor that will certainly attract investors’ attention, but also because a few of the existing dark green bond funds (that is – the ones that are classified as Article 9 under the SFDR) have already set EU Taxonomy alignment targets. EuGBs will therefore be a quick and efficient way for those investors to meet these targets. The direct consequence of a stronger demand towards EuGBs will be a higher greenium, compared to regular green bonds. This will therefore lead to a differentiation in the ESG bond market, at least initially.

We also note that the clarification by the Commission on the SFDR a few weeks ago (see here) will likely result in more Article 9 funds having less strict targets linked to the EU Taxonomy. This could reduce the demand of investors towards EuGBs, as some investors slowly loosen (or fully discard) their EU Taxonomy alignment targets. This will however, likely only occur only in the more medium-term.

Furthermore, the market for EuGBs is likely to remain small in the coming few years. That is because only a small amount of undertakings have so far been able to scan their assets and expenditures against EU Taxonomy alignment. In particular financial institutions, for example, should struggle to find eligible assets until companies start formally disclosing this information. The latter, on the other hand, will only occur once CSRD reporting requirements start to be fully in place. In that respect, we expect utility companies to become the first EuGB issuers, as they are well able to provide evidence about full EU Taxonomy alignment (including Do No Significant Harm), while this can still be quite challenging in some other sectors. More generally, more publicly available data, application of Taxonomy requirements in subsidy schemes, permits and market requirements are therefore necessary to expand the availability of eligible assets and therefore, the issuance of EuGBs.

Information on EU Taxonomy alignment will certainly pick after CSRD-aligned reporting start to emerge, and, as we previously noted, we should see more EuGBs after that. However, in the more medium- to long-term, we also expect that EuGBs will likely lose their appeal. That is because the EU GBS will bring some challenges for both issuers and investors, as we highlight below.

For issuers: the costs related to the ESMA’s supervision and registration of external reviewers will certainly be passed through to issuers. That is, the costs of issuing green bonds that comply with the EU GBS will be higher than of issuing regular (non-EU GBS aligned) green bonds. Hence, issuers will only have a financial incentive to issue EuGBs if those are translated into material funding advantages (such as higher greeniums) in the primary market. Issuers will therefore need to weight the costs and benefits of EuGBs and will not issue them if the costs exceed the benefits. While we think this will unfortunately be the case in the more medium- to long-term (as we will explain below), it remains to be seen if the cost-benefits analysis will weight in favour of EuGB issuances.

For investors: over time, it might not be justifiable to keep bearing the higher prices (higher greenium) of EuGBs. As we previously noted, investors might be willing to accept the higher greenium to quickly comply with internal EU Taxonomy targets. However, as issuers also start to report on EU Taxonomy alignment (as per the CSRD), investors will more easily be able to also ensure alignment through normal bonds. On top of that, when it comes to assessing EU Taxonomy alignment of investments, the SFDR does not yet specify any distinction between EuGBs and regular green bonds that have also provided an EU Taxonomy alignment assessment, but do not carry the EuGB label. This means that investors might also decide to just invest in regular green bonds to meet their own Taxonomy targets (perhaps complemented with the to-be-announced voluntary templates), as these fulfil fairly similar purposes (also in terms of transparency), but are less costly. On top of that, as we previously noted, it might even be that with time, “green” investors no longer need to set EU Taxonomy requirements.

We note as well that as per CSRD, statutory auditors are also allowed to check the alignment of assets/expenditures with the EU Taxonomy (see here). This means that EU Taxonomy alignment, which is properly verified by a credible third party, will already be part of regular reporting of undertakings. Hence, this brings into question what would be the benefit in the long-term of having EuGBs, as it will also no longer provide additional (EU Taxonomy) information. We emphasis the EU Taxonomy information part, as in terms of additional transparency, the EU GBS does not differ significantly from the existing market practices and recommendations of the ICMA Green Bond Principles. Regular green bonds can also improve in quality over time, supported by, for example, the voluntary templates to be developed by the Commission. Certainly, the legally binding attribute of the EU GBS and the regulation of external reviewers give investors an additional assurance on the degree of confidence towards the information provided by EuGB issuers. But it seems debatable whether this reduced greenwashing risk justifies the higher costs.

In the long-term, we also expect there to be other standards. For example, China has already its own Taxonomy, the UK is in the process of developing it, and we should also expect similar moves from other large green bond issuing countries such as the US. Issuers should then have more incentive to issue green bonds that align with their own national standards. The EU Taxonomy also relies heavily on EU regulation. All these factors should also make it challenging for non-EU issuers to issue EuGBs. All in all, the EU GBS could also therefore lead to some regional fragmentation of the green bond market in the long-term.