Sustainability Assembled
Legal and Regulatory Market Updates Q1 2024
Sustainability Regulation
EBA Report on Green Loans
On 15 December 2023, the European Banking Authority’s (EBA) report on green loans and mortgages (the Report) was published in response to a call for advice from the European Commission on green loans and green mortgages. Alongside the Report, the EBA also published an opinion on green loans and mortgages. In its call for advice, the European Commission specifically requests a voluntary definition of green loans which is based on the Taxonomy Regulation.
In the Report, the EBA:
- recommends the introduction of a voluntary common definition of green loans and a green loan label noting that the absence of such a definition has led to a fragmentation of the green loan market; and
- suggests that an EU green loan label should be consistent with the EU sustainable finance framework, including the Taxonomy Regulation. However, the Report also acknowledges the disadvantages of basing any such definition and framework solely on the Taxonomy Regulation, given the number of loans which would potentially be excluded as result (including “transition activities” and those currently identified by credit institutions are “green”).
The EBA outlines the following features which could be included in a definition of a green loan based on the Taxonomy Regulation:
- loan type and asset perimeter;
- use of proceeds;
- grandfathering of existing green loans in the application of technical screening criteria of the Taxonomy Regulation;
- treatment of newly originated loans and the loan stock; and
- reporting.
The Report recommends that the European Commission consider two options when introducing a definition for green loans:
- a recommendation for credit institutions on the processes and criteria to define green loans based on the Taxonomy Regulation; or
- a legislative proposal for credit institutions on the processes and criteria to define green loans based on the Taxonomy Regulation, mirroring the structure and features of the regulation on European Green bonds. This option is supported by the EBA, who provide further guidance on how a green label based on the legislation could be structured.
Additionally, the EBA recommends that green mortgages are included in the Mortgage Credit Directive (MCD) and, in recognition of the growing importance of sustainability features, that this is integrated into the MCD.
The EBA recognise the importance of the Green Loan Principles (GLP), developed by the LMA together with the LSTA and APLMA, which have become the leading framework in green lending among credit institutions. However, it acknowledges that the GLP do not define green projects, nor what can be counted as ‘green’.
Joining the Dots
The EBA’s Report recognises that bank lending plays a key role in achieving the goals of the EU Green Deal and Taxonomy Regulation aims to provide clear rules as to the economic activities which can be classified as green. At the same time, credit institutions are required to disclose the Taxonomy-alignment of loans in their green asset ratio in accordance with the EU Taxonomy Disclosures Delegated Act. Despite this, the EBA analysis indicates that the market for green loans remains fragmented and the lack of a common definition and rules is identified as a key obstacle to increasing green loan issuance.
The EBA Report acknowledges that whilst the market lacks a common standard or label, the Green Loan Principles (GLP) have become the leading framework for green loans. However, whilst further guidance is set out in the “Guidance on Green Loan Principles” and the “Introduction to Green Loan Frameworks”, it necessarily remains for the parties to a transaction to define eligible green projects as well as the criteria for evaluation and selection of green projects.
The GLP, “Guidance on Green Loan Principles” and the “Introduction to Green Loan Frameworks” (Green Loan Documents) provide the user with examples and additional resources for the purposes of structuring green loans and aligning with relevant regulation and ESG standards (including but not limited to the Taxonomy Regulation). Green Loan Frameworks may use Taxonomy-aligned criteria or alternatively use the Taxonomy Regulation to assist parties in defining the criteria and process for evaluation of eligible green loans and projects in a more flexible way. In addition, SFDR Article 8 and 9 disclosures, environmental standards and transition plans are also being used to frame the eligibility criteria and processes for green loans. The evolution of these practices is addressing the EBA’s concern that a framework based solely on taxonomy-alignment will fail to provide the flexibility needed and address the transition efforts of market participants and companies.
This flexibility is available in the form of existing market standards which use taxonomy alignment as one of a number of approaches. In the current market, banks, funds and companies have at their disposal a wide range of materials and resources to assist in the origination, structuring and documenting of green loans. As well as the Green Loan Documents, there is additional data and information resulting from the application and use of regulation (see below) which includes but is not limited to the Taxonomy Regulation. Reports such as the EBA Report and ESG standards (such as those outlined in later sections of Horizons) also provide additional information, resources and approaches to ensure the integrity of the green loan product, frame the eligibility criteria, ensure alignment with internal standards and safeguard against greenwashing. During 2024, the LMA will also begin work on draft model provisions for green loan terms.
The Report notes that the increase in volume of EEA currency-denominated green loans and sustainability-linked loans since 2015 with issuance reaching EUR 156 billion at the end of 2022.
Source and notes: (i) Bloomberg data and EBA calculations; (ii) extraction date is 28 June 2023 (loans and bonds) and 10 November 2023 (funds); (iii) yearly outstanding aggregate amount of EEA-currency denominated loans and bonds; (iv) yearly average Asset under Management (AuM) of EEA-domiciled ESG funds; (v) for non-euro currencies, average annual exchange rate corresponding to the year of issuance is applied for conversion; (vi) green product is self-reported by the issuer; (vii) ESG label is self-reported by the fund.
Corporate Sustainability Due Diligence Directive
On 15 March 2024, the Council of the European Union approved the Corporate Sustainability Due Diligence Directive (CS3D). This follows two failed attempts underscoring the controversies of the new CS3D which will create a new legal liability for companies relating to environmental and human rights harm within their supply chains. The final compromise text of the CS3D must now pass the European Parliament and following thereafter the EU Member States will need to transpose the CS3D into national law.
The CS3D is aimed at enhancing the protection of the environment and human rights within the EU and globally through the introduction of certain mandatory obligations on corporate sustainability, environment, and human rights due diligence. CS3D is considered to be one of the most important pieces of sustainability legislation for the EU’s goal of transitioning to more sustainable businesses practices and addressing issues such as deforestation, conflict minerals, and the import of goods made with forced labour. CS3D has drawn widespread support from across the business, finance, and NGO sectors - with many businesses already addressing supply chain due diligence on a voluntary basis.
The final text however represents significant departure from the original proposal including reducing the number of companies that will be captured by the new rules, new phase-in rules applying and removal of specific obligations on high-impact sectors for example. Companies in scope will need to comply with requirements including due diligence over upstream and downstream business partners, monitoring and assessing actual and potential adverse impacts of their and their value chain's activities, and introducing governance structures such as a stakeholder engagement processes, a complaints procedure open to third parties, and a transition plan for climate change mitigation.
The LMA’s response to CS3D amendments dated April 2023 can be accessed here.
Sustainable Finance Disclosure Regulation
On 4 December 2023, the European Supervisory Authorities (ESAs) issued a Final Report (Report) on draft regulatory technical standards (RTS) on the review of Principal Adverse Impacts (PAI) and financial product disclosures in the SFDR Delegated Regulation. The Report sets out feedback to the consultation paper issued earlier in 2023 along with an indication of adjustments that have been made. The draft RTS aim to broaden the disclosure framework, address the main technical issues that have been raised and reflect experiences shared by stakeholders covering the following:
- additional social PAI indicators (voluntary and mandatory);
- amendments to some existing PAIs (including definitions, applicable methodologies, metrics and presentation);
- introduction of a new financial product disclosure of GHG emission reduction targets (pre-contractual, website and periodic disclosures);
- enhances disclosures regarding compliance with the Do No Significant Harm principle;
- amendments to templates, including the introduction of a new dashboard of key information;
- revisions to provisions for products with investment options, such as Multi-Option Products; and
- certain other technical amendments, including changes to the calculation of sustainable investments and a requirement to produce the disclosures in machine-readable format.
The European Commission will decide whether to endorse the amendments within three months of publication. These draft RTS would be applied independently of the comprehensive review of SFDR.
The LMA’s response to the Commission’s Sustainable Finance Disclosure Regulation targeted consultation can be accessed here.
Corporate Sustainability Reporting Directive and European Sustainability Reporting Standards
Background
On 5 January 2023, the Corporate Sustainability Reporting Directive (CSRD) entered into force and from 1 January 2024, CSRD and the European Sustainability Reporting Standards (ESRS) will apply to the first group of companies (large EU listed companies, public interest entities and groups as well as large non-EU issuers and groups) for reports published in 2025.
The European Financial Reporting Advisory Group (EFRAG) is developing the ESRS, the reporting standards which set out the information that companies will need to disclose and report on in accordance with CSRD.
Below, we summarise the most significant developments relating to CSRD and ESRS.
Adjustment to size criteria
A Commission Delegated Directive amending the Accounting Directive was published in the Official Journal in December 2023 adjusting the size criteria for micro, small, medium-sized and large undertakings or groups by 25% to account for inflation. This criteria is used to determine the application and timing of CSRD.
European Sustainability Reporting Standards enter into force
In December 2023, a first set of sector agnostic European Sustainability Reporting Standards (ESRS) was published in the Official Journal of the EU. The ESRS are intended to apply to all companies falling under the scope of CSRD regardless of the sector that they apply to. An LMA summary regulatory alert relating to this can be accessed here.
EFRAG publishes ESRS Implementation Guidance
In December 2023, EFRAG released the first three draft ESRS Implementation Guidance (ESRS IG) documents to provide implementation support for organisations preparing their first statements according to ESRS. The following guidance has been made available:
- Draft EFRAG IG 1 - Materiality assessment implementation guidance: describes the reporting requirements on the materiality assessment and includes FAQs on the double materiality assessment and interoperability with other standards;
- Draft EFRAG IG 2 Value chain implementation guidance: describes the reporting requirements on the value chain within the materiality statement (setting out, relevant metrics and targets), considers the reporting boundary of the group for sustainability reporting and includes FAQs to provide further information and includes a 'value chain map' summarising certain value chain implications; and
- Draft EFRAG IG 3 Detailed ESRS datapoints implementation guidance: contains detailed ESRS data points as an excel spreadsheet along with an explanatory note. EFRAG indicates that IG 3 can be used to perform a data gap analysis.
The ESRS IG documents are non-authoritative and are intended to support ESRS. In the event of any contradiction, the ESRS shall prevail.
The draft ESRS IG are open for feedback until 2 February 2024 and responses received by EFRAG are publicly available.
ESRS: two year delay sector specific and general standards for non-EU Companies
Earlier this year, Parliament and Council negotiators agreed to a two-year delay with respect to the adoption of sector-specific sustainability reporting standards and those for non-EU companies. The delay is aimed at reducing the administrative burden on companies whilst also allowing EFRAG additional time to develop the relevant ESRS.
The two year delay for these specific standards affects the extent of reporting for relevant companies but does not affect the existing staggered reporting timelines under CSRD. Companies are still required to report on time against the sector-agnostic ESRS (see above).
Sector-specific reporting by Companies is considered an important source of information for investors, particularly in the context of “high-risk” sectors such as oil, gas, and mining. The Commission will therefore publish sector-specific sustainability reporting standards in eight areas as soon as they are available and before the deadline of June 2026. It is unclear at present which eight sectors the Commission prioritise.
The agreement needs to be formally adopted by the Council and the Parliament before it can enter into force (see EU press release).
"We will delay the deadline for sector specific standards under the Corporate Sustainability Reporting Directive (CSRD) by two years in order to give FRAG the time to develop quality standards and give companies the time to put them into practice."
Alex Voss, Member of the European Parliament
Taxonomy Regulation
EU Commission Guidance on EU Taxonomy
In December 2023, the European Commission published a Draft Commission Notice setting out guidance to FAQ on the interpretation and implementation of certain legal provisions of the EU Taxonomy Regulation (Taxonomy Regulation). The guidance is intended to assist financial market participants in preparing their first mandatory reporting in 2024 with the aim of facilitating compliance with the regulatory requirements in a cost-effective way and ensuring the usability and comparability of the reported information for scaling up sustainable finance.
The FAQs contain 71 questions and answers which, amongst other things, considers and clarifies: the reporting obligations of large financial undertakings and financial undertakings admitted to trading on EU markets, scope of entities which are subject to the reporting obligations, taxonomy assessment of exposures to individual undertakings and taxonomy assessment of groups and specific exposures and considers the rules regarding the verification and evidence of compliance with the Taxonomy Regulation. Additional guidance and specific FAQs relating to credit institutions, insurance undertakings, and asset managers are also included.
EU Taxonomy: Beyond regulatory compliance
In January 2024, the Platform on Sustainable Finance published a report “A Compendium of Market Practices” examining how the Taxonomy Regulation and other sustainable finance tools are being used by relevant stakeholders for purposes that extend beyond regulatory compliance. The report finds that corporates, credit institutions, investors, insurers, auditors and consultants are using the Taxonomy Regulation and the EU Sustainable Finance Framework more broadly in order to set transition strategies, structure financial transactions and report on sustainability efforts.
In this section, we summarise the findings of “A Compendium of Market Practices” as they relate to corporates, SMEs, credit institutions and investors and examine how this can support the development of sustainable loan products:
© European Union, 1995-2024
Joining the Dots
Under the Green Loan Principles (GLP), Sustainability-Linked Loan Principles (SLLP) and related Guidance, borrowers are required to provide lenders with green or sustainability-linked information which is positioned within a borrower’s overarching objectives, sustainability strategy, policy and commitments. The GLP also requires additional information (in the facility agreement or any related green loan framework) regarding the application of “use of proceeds” and the criteria for selection and evaluation of eligible green loans/green loan projects. The SLLP emphasise the need for key performance indicators (KPIs) to be material and relevant and for sustainability performance targets (SPTs) to be ambitious. These core components for sustainability-linked loans were also emphasised by the FCA in its 2023 letter as crucial for addressing greenwashing risk.
Challenges in structuring these loans have remained however, with lenders and borrowers highlighting the following:
- lack of timely and relevant sustainability information and data from borrowers;
- absence of sustainability strategy and/or policies;
- insufficient supporting detail relating to KPIs and SPTs (including benchmarks and defined terms);
- confusion around the use of ESG standards and relevant sustainability regulation;
- lack of awareness and understanding of the environmental issues required for structuring these loans; and
- cost of data collection, verification and second party opinions presenting a significant barrier to structuring these loans particularly in the case of SMEs.
In order to address some of these challenges, lenders are reliant on sustainability-related information and data from borrowers in order to assess sustainability risk and structure relevant loan terms.
There is evidence that compliance with the CSRD, SFDR and the Taxonomy Regulation has improved awareness and understanding of environmental and sustainability issues across the business and financial sector. In addition lenders, borrowers and investors are becoming increasingly aware of how information and data gathered for compliance with law and regulation can be used in a much broader context - to create strategies and policies, provide relevant data in a timely way and present the data in a form in which it can be verified and analysed. This will ultimately allow for greater rigour and transparency when structuring sustainable loan products and provide more cost-effective solutions to the challenges above.
“Information and data which has been prepared for compliance with sustainability regulation (including SFDR, CSRD and Taxonomy-aligned data) is more likely to be presented in a standardised and comparable form and can and should be used for broader purposes in order to increase efficiency and scale sustainable finance solutions. This same information can be used to structure SLLPs, Green and Social Loans, address timing and cost challenges and also be used by lenders for the purposes of their own sustainability disclosures and calculating the green asset ratio.”
This move from regulatory compliance to using data and information for broader transitional purposes will require financial professionals and their advisors to understand the extended sustainability landscape in order to identify multiple uses for sustainability information and data.
The LMA and Cadwalader, Wickersham & Taft (led by Sukhvir Basran (Partner and ESG Co-Chair, Cadwalader Wickersham & Taft) and Samantha Hutchinson (Partner and Head of Fund Finance, Cadwalader, Wickersham & Taft) will be leading the “ESG in Private Markets Project” in Europe which builds on this approach.
ESG Ratings: Greater Transparency and Trust
ESG Rating Regulation
On 14 February, a compromise text (6255/24) was published by the EU Council on the proposed Regulation on the transparency and integrity of environmental, social and governance rating activities (2023/0177(COD)) (ESG Rating Regulation) reflecting the provisional political agreement reached by the EU Council and the European Parliament.
The following key issues are covered by the proposed regulation:
E, S and G ratings: ESG rating providers are required to provide disaggregated E, S and G data and ratings or alternatively, indicate the weighting of each factor in an aggregated rating and disclose whether a relevant rating addresses “double materiality”.
Increased transparency: disclosures relating to methodology, models and assumptions as well as stakeholder engagement and indicate processes for dealing with incomplete, contradictory or subjective data. Additional disclosures are also required regarding alignment with international agreements such as the Paris Agreement.
Organisational requirements: additional organisational requirements on ESG rating including requirements aimed at ensuring independence and managing and preventing conflicts of interest including requirements relating to governance and the approach to rating methodology and requirements relating to employee independence as well as restrictions on certain financial services activities.
Competition: an entity looking for more than one ESG rating should ensure that at least one of those providers has a market share of less than 15 percent.
SFDR: The Sustainable Finance Disclosure Regulation will be amended to require additional disclosures relating to any relevant ESG ratings.
Enforcement Action: In case of non-compliance, ESMA can take a number of decisions including withdrawal of authorisation, prohibition or suspension of rating issuance, fines and public notices. A fine (of up to 10 percent of total annual turnover) must be imposed if ESMA finds that an ESG rating provider has negligently or intentionally infringed the regulation.
The provisional agreement remains subject to approval by the Council and European Parliament before going through a formal adoption procedure.
Code of Conduct for ESG Ratings and Data Product Providers
The International Capital Market Association (ICMA) and the International Regulatory Strategy Group (IRSG) launched a voluntary titled “Code of Conduct for ESG Ratings and Data Providers” in December 2023 (the Code). The code is intended to align with IOSCO’s recommendations and aims to promote transparency, good governance, management of conflicts of interest, and strengthening systems and controls in the sector. The Code is intended to be used internationally.
Joining the Dots
ESG ratings have grown in importance over recent years and are being used in range of different ways. Financial institutions and funds are using ESG ratings to structure and design financial instruments and investment products, set ESG rating targets and inform the investment process. As such ESG Ratings have become an important tool for market participants to assess the ESG credentials of a company, consider alignment of ESG performance with the criteria of banks, institutional investors and credit funds, assess risk and allocate capital and investment. Borrowers are also using ESG ratings to inform their sustainability strategies, select sustainability key performance indicators (KPIs) and targets and monitor their sustainability performance.
ESG ratings can be used as a KPI in a sustainability-linked loan, as part of the eligibility criteria for selection for green or social loan projects and for broader investment purposes including screening, due diligence and designing internal proprietary benchmarks, scoring and assessment processes. In addition, for SMEs which may lack the resources and internal infrastructure to deliver the information required for sustainable loan products, ESG ratings can be a useful tool with which to structure, compare and validate KPIs, targets and claims and therefore improve access to sustainable finance.
The use of ESG ratings to structure sustainable loan products has however attracted criticism. Over recent years, a number of issues have been raised about ESG ratings and the organisations providing them such as the lack of transparency regarding relevant methodologies (including weighting to different ESG factors, data sets and indicators used), quality of assurance, variation of rating for the same entity, risk of bias and potential for conflicts of interest. The use and application of ESG Ratings in sustainable loan products has declined as a result or, where used, additional information, KPIs and criteria are often added.
The ESG Rating Regulation aims to address the issues identified with ESG Ratings and ESG Rating Providers and it will be interesting to see whether this leads to an increased use of ESG Rating criteria and KPIs in loan terms.