Sustainable finance refers to the concept of making financial investments in projects with environmental objectives by taking into account environmental, social and governance (“ESG”) considerations. Predominantly to date, how we have seen this implemented has been through green or sustainability linked loans. Specifically, green loans are loans made available to borrowers to finance or re-finance green projects. Sustainability linked loans are loans which provide an incentive to borrowers if they achieve certain agreed sustainability linked performance objectives.
We have seen a significant increase in green and sustainability linked loans and would expect this trend to continue. At a macro level it is seen as being key in the EU’s efforts to deliver on their objectives under the European Green Deal and their international commitments on climate and sustainability objectives. At a micro level we have seen a willingness on borrowers to change how they do business and have put ESG considerations and initiatives to the forefront of their business.
One area of concern in this area is the risk of “greenwashing” which arises where a lender or borrower claims a loan is green or sustainability linked but such loan is actually not. The concern relates to:
- the risk for lenders of an inadvertent breach of bonds issued to finance green or sustainability linked loans;
- the potential reputational damage for both lenders and borrowers; and
- the risk of a perception of greenwashing which could undermine the integrity of green or sustainability linked loans, regardless of whether the greenwashing was intentional or not.
This will also come into sharper focus for lenders in the future as the EU has announced that it is considering lowering capital requirements for sustainable finance.
To try and bring some consistency to the sustainable finance market, there have been some industry-driven guidelines published, such as the Green Loan Principles and the Sustainability Linked Loan Principles. However, while these are a helpful reference point for borrowers and lenders it should be noted that these are to be applied on a voluntary basis as agreed between lenders and borrowers.
The EU’s Response
The EU has taken action in this area with the introduction of the EU taxonomy regulation (the “Taxonomy Regulation”), which was published in the Official Journal of the European Union on 22 June 2020. One of the drivers behind the Taxonomy Regulation is to encourage the integration of ESG factors into investment decision making.
The Taxonomy Regulation is designed to reduce the fragmentation in sustainable financing practices that exists throughout the EU and to prevent greenwashing in financial products. Prior to the introduction of the Taxonomy Regulation, there was no common language in this area.
The Taxonomy Regulation provides an EU-wide classification system which will enable businesses and investors to assess the degree of sustainability of economic activities. The main aims of the Taxonomy Regulation is to provide financial market participants with a common language for environmentally sustainable activities and to encourage financial investments to businesses engaged in or moving towards more sustainable activities.
On the borrower side, the Taxonomy Regulation provides clarity regarding green / sustainable obligations, which should, in turn, improve lenders’ confidence in offering loan terms that meet the criteria required under the Taxonomy Regulation.
What is “Environmentally Sustainable”?
The Taxonomy Regulation sets out a four-limb test that an economic activity must satisfy to be considered “environmentally sustainable”. The activity in question must:
(i) contribute substantially to at least one of the following six environmental objectives:
(a) climate change mitigation – the Taxonomy Regulation states that economic activities “should contribute significantly to the stabilisation of greenhouse gas emissions by avoiding or reducing them or by enhancing greenhouse gas removals”;
(b) climate change adaptation – the Taxonomy Regulation states that economic activities “should contribute substantially to reducing or preventing the adverse impact of the current or expected future climate, or risks of such adverse impact, whether on that activity itself or on people, nature or assets”;
(c) sustainable use and protection of water and marine resources - the Taxonomy Regulation states that economic activities “should contribute substantially to achieving / preventing the deterioration of the good status of bodies of water or achieving / preventing the deterioration of the good environmental status of marine waters”;
(d) transition to a circular economy - the Taxonomy Regulation states that economic activities should contribute substantially, for example, in the areas of waste prevention and recycling. An economic activity can contribute substantially by, for example, increasing the durability and reusability of products;
(e) pollution prevention/control – the Taxonomy Regulation states that economic activities should contribute substantially to environmental protection from pollution by, for example, improving levels of air, water or soil quality; and
(f) protection and restoration of biodiversity and ecosystems - the Taxonomy Regulation states that economic activities can contribute substantially by, for example, supporting services such as oxygen production,
(ii) “do no significant harm” to any of the other environmental objectives;
(iii) be carried out in compliance with minimum social and governance safeguards, which include the labour/human rights standards in:
(a) the Organisation for Economic Co-operation and Development’s Guidelines for Multinational Enterprises (e.g. support and uphold good governance principles);
(b) the International Labour Organisation’s Declaration Fundamental Principles and Rights at Work (e.g. complying with anti-discrimination principles);
(c) the United Nations’ Guiding Principles on Business and Human Rights; and
(d) the International Bill of Human rights (e.g. respect basic rights such as reasonable limitation of working hours); and
(i) comply with technical screening criteria to be adopted under the Regulation.
In Part 2 we will look in more detail at the technical screening criteria.