Antoine Corbin and Saga Rad of Sustainable Fitch dig into the details of the EU Green Bond Regulation, and what it means for issuers and investors
Environmental Finance: Sustainable Fitch carried out the review for the first issuance under the EU Green Bond (EU GB) regulation, from A2A. How did that process go?
Saga Rad: We conducted a pre-issuance review of the EU GB factsheet prepared by A2A ahead of its issuance of a €500 million ($520 million), 10-year EU GB, in January. The factsheet outlines four eligible project categories: renewable energy, energy efficiency, transmission and distribution networks, and pollution prevention and control.
It was a very engagement-based process, with frequent interactions between us and the issuer. We typically take two to three weeks to carry out this type of review but had a longer window due to the process starting early. We also had the advantage of knowing the issuer well, having reviewed A2A for an unsolicited rating. We arrived at an expected final review at the announcement date, which the issuer could use in its roadshow, followed by a final version once the terms of the transaction were fully defined. As the factsheet was transaction-specific, so was our review, but we also envisage that there are ways to adapt reviews to suit multiple transactions, using a type of 'master factsheet'.
EF: What requirements does the EU GB regulation place on issuers?
SR: The main thing is that EU GBs are regulated, so issuers need to comply with all the mandatory components of the regulation. The main requirement is that at least 85% of the proceeds need to be directed to activities that are not only eligible under the EU Taxonomy, but are also aligned with its substantial contribution, do no significant harm (DNSH) and minimum safeguard criteria. If the issuer has a transition plan, it needs to describe the link between the projects being financed by the bond and the entity-level transition plan.
EF: Which of these are likely to prove most challenging?
SR: Certainly the need to demonstrate not just eligibility but also alignment with the Taxonomy. In that process, DNSH is commonly the most challenging for issuers, because there is a range of different DNSH criteria. Some, such as Type A criteria, have very specific thresholds. Other more high-level ones, Types B and C, require companies to have specific policies or procedures in place or to comply with a particular EU directive or international framework: some can be onerous to demonstrate compliance with.
EF: Where does the EU GB regulation overlap with guidance from the International Capital Market Association (ICMA), and can they co-exist?
Antoine Corbin: The ICMA Green Bond Principles and the EU GB regulation share some core principles, such as an emphasis on use of proceeds' impact and reporting transparency. However, we see the EU GB as going a step further when it comes to disclosure and impact, while still being within the boundaries of the ICMA Green Bond Principles.
Under EU GBS, issuers have to demonstrate the environmental impact via an alignment or future alignment to the EU Taxonomy for the financed activities, accompanied by a strict duty to report and obtain an external verification, something that ICMA does not require for green bonds. While this can ensure that the use of proceeds of EU GBS would align with science-based thresholds, it also creates additional disclosure requirements and comes with difficulties to navigate some parts of the regulation, notably the Taxonomy.
The view is that those standards will coexist in the market. We can't expect all issuers to be in a position to issue EU GBs, or indeed to want to. On the one hand, there may be a 'greenium', due to rarity around EU GBs, and issuers might be able to attract more sophisticated investors with an EU GB. On the other hand, there could be challenges around scalability and reporting requirements.
ICMA-aligned bonds do not require use-of-proceeds alignment to science-based taxonomies, but they offer a good deal of flexibility. The ICMA approach is also deeply rooted in the market and is used worldwide.
EF: The EU GBS external review process is very much directed at the transaction level. What does this mean for larger issuers?
AC: The regulation partially addresses that issue with its reporting requirements, where issuers can report either at the bond level or on a portfolio basis, across a number of bonds with a similar asset pool. Such allocation and impact reports can be provided in a single document, akin to the current reporting practices of green bond issuers under ICMA.
But we come across questions from issuers and arrangers around the pre-issuance review and factsheet, and the approach that a company that is planning to issue a lot of bonds might take. We envisage the possibility of having a sort of 'master' factsheet, which is put in place before the first issue. It would analyse all the core elements of the regulation, and Taxonomy alignment, which is where most of the work has to be done. That master factsheet could be used by the issuer to gauge investor appetite and announce the transaction; once the issuer has defined all the terms of the transaction (i.e. the international securities identification number, price, issue and maturity date) as well as any specific features relevant to the specific bond and required to be disclosed by the regulation, when applicable, we would then produce a final factsheet at the moment of the transaction. That would minimise the amount of work required and make it easy for an issuer to swiftly access the debt capital market multiple times.
EF: The EU GBS provides for a 'flexibility pocket' for up to 15% of proceeds to go to activities that are not Taxonomy aligned. How does it work?
SR: The flexibility pocket was created to acknowledge that there are some activities that could be positive from an environmental perspective, but which are not yet covered by the Taxonomy. There are therefore specific criteria for that flexibility pocket under Article 6 of EU GBS: issuers cannot simply allocate the last 15% to anything they like. The main requirement is that these activities should still be considered positive from an environmental perspective. So, most likely, this would involve avoiding emissions or expanding a green technology. The other scenario is for activities which have received significant international support in terms of their sustainability. The final condition is that the activities meet generic DNSH criteria under the Taxonomy.
EF: It also allows for activities that are not fully aligned to be funded, if there is an associated capex plan. What does that involve?
AC: Under Article 7 of the EU GBS, issuers have the option to include assets that are not yet aligned to the Taxonomy, but for which the company has a plan to achieve alignment within five years, or up to 10 years for specific long-life assets, or those with a significant technological challenge to bringing them in line with the Taxonomy's substantial contribution criteria. For those assets, the issuer has to produce a capex plan, to be reviewed annually, to demonstrate how it is progressing in terms of bringing those assets into alignment with the criteria.
The reading behind Article 7 is that the regulation acknowledges that it may be difficult for some companies to demonstrate full Taxonomy alignment, so it's providing that extra flexibility. So far, neither Article 6 or 7 have been used. It will be interesting to see what sort of appetite there is for bonds that use either of them, because an investor buying into these bonds does not have the fully realised impact of an EU GB with 100% alignment at issuance. Having said that, the vast majority of green bonds issued under GBP equally don't provide that taxonomy alignment certainty, and they have proved to be quite appealing to investors.
EF: What feedback have you had from investors on EU GB issuance? What questions do they have?
AC: There is definitely a lot of interest from investors; the perception is that it offers more certainty with the external review, both pre-issuance and post-allocation. There's also the element of regulation from ESMA and the expectation that it's going to be a standardised product. Investors can also almost automatically assume that an EU GB will be compliant with whatever reporting they have to do against the Taxonomy.
One question we have frequently been asked focuses on the ability to use master frameworks for seamless access to the bond market and the level of detail issuers should expect to provide, either mandatorily or voluntarily, in their factsheets.
EF: What market potential do you see for EU GB issuance?
AC: The timing is interesting, because most large European financial and non-financial undertakings are now required to disclose their EU Taxonomy key performance indicators (KPIs); we believe that this can provide the right set-up for EU GB transactions, aligning company-level strategy and disclosure with a portfolio of EU GBs.
We cover just over 97% of green bonds larger than €250 million issued in Europe. We looked at entities with bonds demonstrating at least 25% alignment with the EU Taxonomy and found they accounted for approximately 26% of the European green bonds covered by Sustainable Fitch. If we narrowed the scope down to 100% alignment, they represented 21% of the green bond issuances in Europe covered by us. I would say that's a decent theoretical market for EU GBs.
But we have to keep in mind that there are extra requirements, particularly around disclosure, for EU GBs. Initially, we anticipate it will be the largest institutions that tap the market, to diversify their portfolio alongside more traditional green bonds. We would expect that, this year, many potential issuers will be assessing the market to gauge appetite and get familiar with the new standards prior to making a decision to issue an EU GB.
Antoine Corbin is co-head of EMEA ESG Ratings, and Saga Rad is an associate director, at Sustainable Fitch in London. For further information, see: www.sustainablefitch.com
Transition in the spotlight
Financing the transition of carbon-intensive companies towards net-zero business models remains a challenge for many investors. Use of proceeds bonds tend to favour discrete, deep green assets, while ESG ratings tend to score high-carbon businesses poorly.
To provide investors with a more nuanced perspective, Sustainable Fitch has introduced its Transition Assessment product. "It assesses how a company is aiming to transition its business through three main lenses," says Corbin. These are the emissions reductions the company has already achieved, its emissions reduction commitments, and the details of the financial efforts it is making to meet those commitments. Sustainable Fitch then offers a colour-coded assessment of the adequacy or otherwise of the company's transition strategy.
Corbin notes that the assessment can be used on a standalone basis to provide investors with an analysis of where a company stands in relation to transition, or it can be combined with raising green finance. "A company might have an SPO that focuses on the impact of a specific bond, alongside a Transition Assessment which places that green financing in the wider context of the corporate transition," he says.
Rad points to a recent such assessment produced for ContourGlobal, a UK-based power generation business which recently published a green bond framework ahead of planned issuance. The company combined that with a Transition Assessment from Sustainable Fitch, which rated its transition as 'Substantial Transition'.
"It's useful to combine the Transition Assessment with other products," she says.
"ContourGlobal has issued a green bond, and by also having a Transition assessment, this is a way to show its investors how the financed projects contribute to the company's decarbonisation."
