The evolution of Environmental, Social and Governance (ESG) concerns in the market — from an abstract concept bandied about in white papers a decade ago to over $1.6 trillion in 2021 global bond and loan originations — has demonstrated the increasing viability and mainstream adoption of these specialized financial products. But how exactly are financial products tied to ESG metrics? Do regulators intend to standardize performance measures? Will the EU, with its sustained focus on climate change and related initiatives, offer a blueprint for future domestic regulatory endeavors? Finally, as practitioners consider how to translate these concepts into credible contractual rights, what nuances should they be aware of to perfect collateral securing ESG debt issuances?
ESG Trends in Debt Capital Markets & Heightened Regulatory Oversight
The volume of high-yield bond issuances and sustainability-linked loan originations continue to set records globally. For instance, the volume of these ESG products in 2021 was more than double the total volume of 2020. Furthermore, such growth has not been limited to certain sectors or jurisdictions. 2021 global ESG bond issuances reached a new threshold of over $948 billion, with sizeable volume from the EMEA region, followed by the Americas and Asia Pacific (excluding Central Asia). While the tech and financial services industries accounted for a majority of these 2021 issuances and originations, it should be noted that energy and power, and oil and gas companies, also availed themselves of these products to a not-insignificant degree.
Investor demand appears to be accelerating in tandem with regulatory scrutiny. As ESG products become more sophisticated, they are becoming subject to heightened oversight from the U.S. Securities and Exchange Commission (SEC). In fact, in July 2021, SEC Chairman Gary Gensler stated that the agency planned to propose rules by the end of 2021 to mandate that publicly traded companies disclose the risks they face from climate change. Proposed rules were issued by the SEC on March 21, 2022.
Accordingly, as a practical matter, it would be prudent for borrowers and issuers to verify any climate and other ESG data they are disclosing to the public or utilizing as metrics when accessing ESG credit. Additionally, use of proceeds provisions in ESG credit agreements and offering memorandums should be narrowly tailored to reflect a borrower’s or issuer’s verifiable activities rather than aspirational goals. Finally, another emerging structural trend in ESG financial products is the increasing use of racial equity and diversity and inclusion data when drafting use of proceeds provisions and formulating key performance metrics. As the use of D&I data in ESG products becomes more prevalent, companies should consult with counsel on data collection methods and review disclosure standards in their industry when making representations and warranties in credit documents based on such data.
Given the anticipated regulations, investors are being compelled to move from mere awareness into a more proactive posture. Asset management firms, proxy advisors, and ratings agencies are purchasing and partnering with climate data firms. Market participants are also incorporating climate-related information into assessment platforms. Certain activist investors are committing to vote against boards of directors that don’t address climate change and are requiring companies to disclose and make tangible commitments. Banks are also changing lending policies and reporting on their own climate impacts.
As the U.S. financial markets continue to digest the impact of the churning ESG regulatory environment, it is helpful to look to Europe, with its more established climate action framework, as a possible precursor for how regulations will develop and be implemented domestically.
In 2021, the European Union further accelerated its completion of the legislative edifice of sustainable finance. Notably, the European Union adopted the implementing legislation that allows it to put into practice the extraordinarily ambitious EU Taxonomy for sustainable activities adopted in June 2020. The EU Taxonomy covers the sustainability (or not) of all activities in all sectors of the EU economy by reference to the six EU environmental objectives: 1) climate change mitigation, 2) climate change adaptation, 3) protection of waters and marine resources, 4) the circular economy, 5) pollution prevention and 6) protection of biodiversity and ecosystems.
In order to be sustainable, economic activities must contribute to one or more of these six objectives (or to transitioning towards them) without causing significant harm to one or more of the other objectives. In addition, they must be compliant with social and governance protocols in accordance with strict, detailed criteria, which grants a full ESG dimension to the EU Taxonomy.
While the initial purpose of the EU Taxonomy was to determine the sustainability of investments by reference to the economic activities that they finance, the focus on the activities themselves has elevated the Taxonomy to a sort of overarching guide for the EU sustainability agenda. The more the EU economy will steer itself towards the Taxonomy, the more it will reach the EU environmental objectives, including climate change mitigation.
Hence, the Taxonomy plays a role in public policy (EU investment programs such as the COVID-19-pandemic-responsive Next Generation EU) and in finance policy; the ongoing EU green bond standard, for instance, will demand alignment with the EU Taxonomy of the green bonds issued in the EU.
The Taxonomy is science-based (technical screening criteria are developed for each activity) and hence subject to evolution, but it is also a legislative democratic process with opposing views within the EU legislative bodies (Commission, Parliament and Council (Member States)) when it comes to sensitive areas such as nuclear energy and natural gas. In February 2022, the EU addressed the taxonomy treatment of these last two areas of activity, which were still pending for the overall completion of the EU Taxonomy. The outcome, which attracted strong public attention, is that nuclear and gas-related activities are considered as EU Taxonomy-compliant under certain quality conditions.
The EU is also establishing clearer sustainability reporting obligations for all large companies, including financial companies, and all publicly traded companies, with the overall purpose of elevating sustainability reporting to the level of financial reporting. The revised Corporate Sustainability Reporting Directive, whose adoption is expected in Q2 2022, will establish clear and exhaustive sustainability reporting obligations for nearly 50,000 companies in the EU, compared with the current 11,000 companies subject to the previous, less demanding reporting requirements. The new EU sustainability reporting standards will be a “one-stop-shop,” providing companies with a single solution for the information needs of investors and stakeholders.
Also, the EU bank regulator (EBA) and the EU bank supervisor (ECB) are increasing the demands on banks concerning sustainability. On 24 January 2022, the EBA adopted its binding implementing technical standards (ITS) on ESG reporting covering Pillar 3 disclosures: how climate change may exacerbate other risks within institutions’ balance sheets, how institutions are mitigating those risks, and their ratios, including the Green Asset Ratio, on exposures financing Taxonomy-aligned activities and those consistent with the Paris Agreement goals. The EBA’s ITS has built on the Financial Stability Board Task Force on Climate-related Financial Disclosures (FSB-TCFD) recommendations, the European Commission’s non-binding guidelines on climate change reporting, and the EU Taxonomy.
The ECB will apply the EBA’s ITS. Since November 2020 the ECB was already applying supervisory expectations relating to risk management and disclosure. On 27 January 2022, the ECB also launched a supervisory climate risk stress test to assess banks’ preparedness for financial and economic shocks stemming from climate risk. The exercise will be conducted in the first half of 2022 after which the ECB will publish aggregate results.
Finally, the ECB’s fundamental climate-friendly monetary policy is being established. On 8 July 2021 the ECB adopted its action plan to include climate change considerations in its monetary policy strategy, covering, among others: implications of climate change for monetary policy transmission; disclosures as a requirement for eligibility of assets as collateral and for purchase programs; and climate change risks in the collateral and corporate sector asset purchase frameworks. With milestones in 2022 and 2023, the ECB sustainable monetary policy will be finalized in 2024.
UCC Issues for ESG Collateral
Finally, as the market adoption of ESG financial products continues to accelerate and regulatory disclosure standards continue to evolve in the U.S. and globally, practitioners need to confirm certain basic information to ensure that a security interest in any ESG collateral is properly created and perfected under the Uniform Commercial Code. The first consideration is whether the proposed collateral, such as carbon credits, can be made the subject of a security interest under UCC Article 9. ESG collateral is often in the nature of a government benefit. There may be statutory or regulatory limits on the ability of the holder of that benefit to transfer it, including creating a security interest in it. Next, counsel needs to determine how to perfect a security interest in the collateral. Again, statutes or regulations may displace the usual approach under the UCC of filing a financing statement. Finally, they need to examine how the security interest is enforced and whether a secured party or a buyer at a foreclosure sale can make use of the ESG collateral.
Source: Refinitiv Loan Connector ↑
Refinitiv Loan Connector ↑
Refinitiv LPC, Refinitiv Loan Connector ↑
Available at: https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en. ↑
See: https://ec.europa.eu/info/strategy/recovery-plan-europe_en. ↑
See: https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/european-green-bond-standard_en. ↑
Available at: https://ec.europa.eu/info/business-economy-euro/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en. ↑
Available at: https://www.eba.europa.eu/eba-publishes-binding-standards-pillar-3-disclosures-esg-risks. ↑
Available at: https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideonclimate-relatedandenvironmentalrisks~58213f6564.en.pdf. ↑
Available at: https://www.bankingsupervision.europa.eu/press/pr/date/2022/html/ssm.pr220127~bd20df4d3a.en.html. ↑
See: https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.pr210708_1~f104919225.en.html. ↑
The views expressed in this article are those of the authors, and they do not necessarily represent the views of their institutions.