On 6 July 2021, the European Commission published a legislative proposal on European green bonds (the EuGB Regulation). The EuGB Regulation will lay the foundation for a common framework of rules regarding the use of the “European Green Bond” (EuGB) designation for bonds that pursue environmentally sustainable objectives as defined by the Taxonomy Regulation. It also sets up a system for registering and supervising companies that act as external reviewers for green bonds aligned with the EuGB framework.
The broader aim of the EuGB Regulation is to facilitate the further development of the European market for green bonds while minimising disruption to existing green bond markets. The Commission hopes that the development of this market will help meet the EU’s climate and environmental objectives under the Paris Agreement on climate change. The EuGB Regulation also aims to reduce the risk of “greenwashing” by setting high standards for the issuance of green bonds.
The EuGB Regulation forms part of the European Green Deal which set an objective of making it easier for investors and companies to identify environmentally sustainable investments while ensuring that such investments are credible. The Commission highlights that the issuance of green bonds remains at a fraction of overall corporate bond issuance (4% in 2020), and that growth in the market will provide a source of significant green investment and help meet the investment gap of the European Green Deal.
The EuGB Regulation builds on the final report of the Technical Expert Group on Sustainable Finance (TEG), published in June 2019, which recommended the introduction of a voluntary, non-legislative standard, building on best market practices. The TEG recommended that an EU Green Bond Standard should be comprised of four elements: (1) alignment with the taxonomy, (2) publication of a Green Bond Framework, (3) allocation and impact reporting, and (4) conducting mandatory verification and a final allocation report.
The Commission has decided to take a legislative route, although the EuGB will be a voluntary standard and so market participants will have a choice of whether to use the EuGB designation or not. That said, it is likely that the EuGB will become the market standard for green bond issuances in the EU and therefore institutional investors will demand green bonds that carry the EuGB designation. Market participants issuing green bonds in the EU that are not compliant with the new rules may also run the risk of greenwashing, which means that compliance might be necessary in order to avoid regulatory scrutiny.
The use of the EuGB designation will be limited to issuers of bonds that comply with the requirements until maturity of the bond. The EuGB designation will be available to all issuers that make available environmentally sustainable bonds to EU investors, both EU and third country issuers, as well as issuers of covered bonds and securitisations where the securities are issued by a special purpose vehicle.
Eligible financial assets/expenditures
The use of proceeds from EuGB will need to be exclusively allocated to eligible expenditures, comprised of fixed assets that are not financial assets, capital expenditures, operating expenditures and financial assets. Eligible financial assets are in turn defined as debt, equity or a combination of both.
Before maturity of the bond, issuers will be required to allocate the proceeds only to financing, or in certain cases also to refinancing, eligible fixed assets, eligible expenditures or eligible financial assets, or a combination thereof. Issuers will not be allowed to deduct costs from the collected proceeds for the purposes of this allocation. Sovereign issuers will also be allowed to allocate bond proceeds to certain other types of expenditure, such as tax relief, subsidies and investment grants.
All use of bond proceeds will need to relate to economic activities that meet the criteria for environmentally sustainable economic activities, as set out in the Taxonomy Regulation, or that will meet such criteria within a defined period of time (no more than 5-10 years), as set out in a taxonomy-alignment plan.
In order for an economic activity to comply with the taxonomy, it must meet the following criteria:
- make a substantial contribution to one or more of the environmental objectives;
- not significantly harm any of those environmental objectives;
- be carried out in compliance with the minimum (social) safeguards; and
- comply with the technical screening criteria.
In view of the expected technological advancements in the field of environmental sustainability, the technical screening criteria are likely to be reviewed and amended over time, based on the technical advice of the Platform on Sustainable Finance. As such, issuers will need to apply the taxonomy criteria applicable at the point in the time when the bond was issued for allocations to fixed assets, capital expenditures and operating expenditures, or when the debt was created for allocations to financial assets. However, where the taxonomy criteria are amended, the amended criteria would then need to be applied to the bond within 5 years from their date of application.
It should also be noted that the requirement to allocate the proceeds of European green bonds to the financing or refinancing of eligible assets or expenditures will not prohibit the issuer of such bonds from using fixed or financial assets as a security for the bond, nor should it prohibit such issuers from linking the return paid to holders of the bond to the performance of the project financed by the bond.
Transparency and external review requirements
The EuGB Regulation will require that a bond may only be offered to the public in the EU after prior publication of the European green bond factsheet, which will be published on the issuer’s website along with the pre-issuance review of the EuGB factsheet by an external reviewer.
The issuer will be required to draw up EuGB annual allocation reports until the full allocation of the proceeds of the bond, and publish them no later than three months following the end of the reference year. The issuer will also be required to obtain a post-issuance review by an external reviewer of the first allocation report following the full allocation of bond proceeds. There will also be a requirement for the issuer to draw up an impact report on the environmental impact of the use of the bond proceeds after full allocation, at least once during the lifetime of the bond.
Sovereign issuers will also be able to obtain pre- and post-issuance reviews from a state auditor or any other public entity that is mandated by the sovereign to assess alignment with the requirements.
Where a prospectus is mandated for the issuance of the bonds, it will need to be clearly stated in the prospectus that the bond is issued in line with the EuGB Regulation, and the information contained in the EuGB factsheet will also need to be included.
There are additional obligations requiring issuers to maintain on their websites, until the maturity of the bonds, all of the documents drawn up by the issuer under the EuGB Regulation, including respective pre-issuance and post-issuance reviews. There are also requirements regarding the use of languages and for the notification of certain documents to the European Securities and Markets Authority (ESMA).
External reviewers for EuGB
The EuGB Regulation will require external reviewers to register with ESMA and meet the conditions for registration on an ongoing basis. Once registered, an external reviewer will be permitted to conduct its activities throughout the EU. An external reviewer will be required to notify ESMA in advance of any material changes to the conditions for its initial registration. ESMA will have the ability to refuse to register an external reviewer and to withdraw its registration under certain conditions, such as non-compliance with the transparency rules or where it submits false statements during the registration process. ESMA will be required to maintain a database on its website with all registered external reviewers, including those that are temporarily prohibited from pursuing activities and whose registration has been withdrawn.
The EuGB Regulation will contain a suite of requirements covering the organisation, processes and documents concerning governance for external reviewers. It sets out the general principles by requiring the external reviewer to employ appropriate systems, resources and procedures and by requiring them to monitor and evaluate at least annually, the adequacy and effectiveness of its systems, internal control mechanisms and arrangements and take appropriate measures to address any deficiencies. There are also detailed requirements regarding the senior management; analysts, employees and other persons directly involved in assessment activities; compliance function; internal policies and procedures; assessment methodologies and used information; errors in assessment methodologies or in their application; outsourcing; record-keeping requirements; avoidance of conflicts of interest; and the provision of other services.
The EuGB Regulation will also set out requirements regarding pre-issuance and post-issuance reviews. Neither a pre-issuance review nor a post-issuance review will be permitted to refer to ESMA or any competent authority in such a way that could indicate or suggest their endorsement or approval of the relevant document or any assessment activities of the external reviewer. External reviewers will be required to make available certain information free of charge on their websites, including all pre- and post-issuance reviews.
Supervision and enforcement
The EuGB Regulation will give Member State national competent authorities certain powers to supervise issuers to ensure that the transparency rules are applied. It will also include several provisions that specify the administrative sanctions and other administrative measures that such competent authorities may impose, as well as rules on the publication and reporting to ESMA of those sanctions.
ESMA will have powers in relation to the supervision and investigation of external reviewers, including the power to request information by simple request or by decision, conduct general investigations and conduct on-site inspections. ESMA will also have the power to intervene in the market, for example, to suspend an offer of a green bond, and prohibit or suspend advertisements of green bonds. ESMA will also be able to impose fines and periodic penalties, as well as to charge registration and supervisory fees.
Now that the UK has formally left the EU, it is no longer bound by EU law and will have no obligation to implement the EuGB Regulation. The Financial Conduct Authority (FCA) is expected develop its own approach to the regulation of green bonds in due course, which is unlikely to be intentionally aligned to the EuGB Regulation. However, given that many of the principles underlying the EuGB Regulation have been influenced by the ICMA Green Bond Principles (GBP), and the FCA is considering formally endorsing the GBP in light of their wide application in the UK market, there is the possibility of broadly similar approaches being developed in the UK and EU.
In the UK, there is no set of binding rules to which market participants must adhere when issuing green bonds, and the FCA perceives this to have created some problems in the market. On 22 June 2021, the FCA published a consultation paper on a range of ESG topics which touched on issues around green, social, or sustainability labelled debt instruments. Following a review of prospectuses of UK-issued green bonds, the FCA identified that the contractual terms may not fully reflect information on the types of projects or activities for which the issuer will use the proceeds; the management of proceeds; the related reporting by the issuer; and details of any third party provider the issuer engages to provide a second party opinion. The FCA also noted difficulties around the definition of sustainable activities in the absence of regulatory and market standards stipulating which activities and projects should be considered ‘sustainable’; however, it is considered that the upcoming UK green taxonomy should resolve some of these issues.
The FCA is exploring the possibility of amending the UK prospectus regime to introduce specific requirements in respect of Use of Proceeds (UoP) bond frameworks and their sustainability characteristics, recognising existing standards such as the ICMA GBP, and requiring that the central elements of UoP bonds be reflected in contractual agreements and in the prospectus.
The end result will likely be that the UK and EU frameworks are driven by similar principles, but the UK takes a more high-level approach with targeted amendments to existing regulation, while the EU introduces an entirely new, prescriptive framework in the form of the EuGB Regulation. Market participants issuing green bonds in both jurisdictions will therefore need to ensure that both sets of regulatory requirements are met. As the UK and EU frameworks continue to develop, market participants should look to the voluntary ICMA GBP as a source of current best market practice as well as the basis of future binding standards in this area.