European Green Bonds And Sustainability-Linked Derivatives – A Brief Update – Finance and Banking – European Union – Mondaq News Alerts

Environmental, social and governance (ESG) factors continue to
play an increasingly significant role across the capital markets
and have an impact on a range of financial instruments and
products. We have previously written about green and
sustainability-linked instruments and how various stakeholders
are shaping the evolution of these products. We also have been
tracking efforts by the International Swaps and Derivatives
Association (ISDA) to develop standards and best practices for
financial instruments that incorporate, or take into consideration,
ESG-related factors. In the case of the former, for investors who
focus on “green” instruments, it can be difficult to
determine what activities can be considered as genuinely green if
there is no standardised definition or benchmark, and this has
caused some uncertainty within the market. Relatedly, ISDA’s
work has focused on developing key performance indicators (KPIs)
for use in connection with ESG-linked financial trades.

In an effort to set a standard for how investors can determine
what is green, and in turn assisting companies (or governmental
bodies) issuing green bonds to raise capital—having regard
both for progressive sustainability and the risk of
greenwashing—the European Commission has adopted a regulation
proposal¹ on European Bonds, with a view to
creating the “European Green Bond Standard”. In short,
the proposal sets out a framework for bonds to fund environmentally
sustainable activities within the meaning of the European Union
Taxonomy Regulation. Prior to issuing the bonds, issuers will need
to publish an externally reviewed “green bond factsheet,”
setting out funding and environmental objectives; and following
issuance of the bonds, issuers will be required to publish yearly
reports demonstrating how they are allocating the proceeds of the
bonds to economic activities that meet the sustainability standards
under the EU Taxonomy Regulation. Once adopted, the Regulation is
expected to set a new standard intended to provide a guarantee of a
high quality, sustainable instrument for investors to rely on and
which companies, public authorities and issuers (including those
located outside of the EU) can use to raise funds.

As we have written previously, against the
backdrop of the European Green Deal and related sustainable finance
initiatives, participants in the financial markets have identified
opportunities to incorporate ESG metrics into documentation for
various financial instruments. In response, ISDA recently published
two white papers. The first paper focuses on sustainability-linked
derivatives and provides guidance to end-users drafting KPIs, which
ISDA states are “fundamental to the effectiveness and
credibility of these transactions.” The second paper covers a
range of issues currently injecting complexity into the accounting
treatment of these financial products, noting that a “lack of
observable data means ESG features are currently difficult to
value, resulting in information that is unlikely to be useful to
readers.”

As with many issues within the evolving intersection of ESG and
financial transactions, stakeholders are in search of reliable,
comparable data to support the transactions themselves and any
disclosures or other reporting that may accompany such transactions
now or in the future. As a result, ISDA underscores the importance
of drafting KPIs that can be “objectively verified” and
have “legal certainty.” ISDA notes that, to date, KPIs
have generally been tailored to the specific needs of the
counterparties and have been crafted to encourage or discourage
certain behaviors (e.g., reducing emissions) or to track alignment
to ESG principles more generally. ISDA fully expects that
counterparties will develop new areas of focus as these products
continue to develop and usage expands. ISDA closes the paper by
identifying five “overarching principles” for KPIs:
specificity; ability to measure; objectively verifiable;
transparency; and suitability. To address accounting complexities
for these instruments, the second paper focuses on alternative
accounting approaches (e.g., the International Financial Reporting
Standards 9 model) that may provide readers with more useful
information.

Footnote

1 The European Green Bond Standard “is a
voluntary standard to help scale up and raise the environmental
ambitions of the green bond market.” The proposal is intended
to set a “gold standard” for sustainable finance. It is
hoped that the proposal, comprised of four key principles (taxonomy
alignment; transparency; external review; and European Securities
and Markets Authority supervision) “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.”

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