Since March 2020, a large number of relevant regulations on ESG (Environmental Social Governance) have been published at EU level. The publications primarily addressed the topics of climate and environmental risks. All of these sustainability regulations have significant relevance for the financial market. However, these EU regulations and their implications have not yet received much attention from the players.
First of all, these are the delegated acts on financial benchmarks as published by the EU in July 2020 and to be applied with effect from 01.01.2021.
In detail, these are the following documents:
COMMISSION DELEGATED REGULATION (EU) 2020/1816 of 17 July 2020
The regulation deals with the general application of ESG benchmarks and the annex regulates in detail how ESG factors are to be reflected in benchmarks and how the associated disclosure requirements are to be implemented.
Furthermore, it deals with a specific benchmark regulation on
„Minimum Standards for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks"
This underlines the importance the Commission attaches to climate protection in the context of ESG.
The role of ESMA
However, in a letter to the EU Commission dated 28 January 2021, ESMA also explained that in its view this is not sufficient. Instead, it demands that every institution in Europe that carries out ESG assessments be treated in the same way as a rating agency. I.e. on the basis of a generally applicable regulation, all would thus be subject to uniform supervision. The letter implies that ESMA would be suitable for this.
Extremely significant for all environmental regulation and monitoring is probably the REGULATION (EU) 2020/852 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088
This regulation will come into full force as early as 1 January 2022 and sets the criteria for when an economic activity is to be classified as environmentally sustainable in order to be able to determine the degree of environmental sustainability of an investment (Art. 1).
The six environmental objectives of the regulation at a glance
To this end, the regulation sets out the following six environmental objectives:
- climate protection: the activity avoids or reduces greenhouse gas emissions or increases their reduction. The means to achieve this objective include the generation, transmission or use of renewable energy, investment in the development of electricity grids and the more intensive and environmentally sound use of carbon capture and storage.
- adaptation to climate change: the activity includes adaptation solutions that either significantly reduce the risk of adverse impacts of climate change or significantly reduce the adverse impacts of climate change on that activity itself.
- sustainable use and protection of water and marine resources: the activity contributes to achieving good water status or preventing the deterioration of existing good status. Means to achieve these objectives include protecting the environment from the adverse effects of wastewater and of pollutants such as pharmaceuticals and microplastics, protecting human health from the adverse effects of contamination of water intended for human consumption, and improving water efficiency, for example by promoting sustainable water use based on long-term protection of available water resources.
- Circular economy, waste prevention, reuse and recycling: The activity contributes to improvements in, inter alia, efficiency in the use of natural resources, including resource and energy efficiency measures, water use efficiency, and water quality. The activity contributes to improvements in, inter alia, efficiency in the use of natural resources, including resource and energy efficiency measures; durability, repairability, upgradability or reusability of products, in particular in design and manufacture; recyclability of products, including individual materials contained in products, including through replacement or reduced use of products and materials that are not recyclable; and the useful life of products, including through reuse, design for durability, repurposing, dismantling, refurbishing, upgrading, repair and sharing.
- pollution prevention and control: the activity contributes, inter alia, to the prevention or, where not practicable, reduction of emissions of pollutants, other than greenhouse gases, to air, water and soil, the prevention or minimisation of adverse effects on human health and the environment from the production, use and disposal of chemicals, and the elimination of waste and other pollution.1. protection and restoration of biological
- diversity and ecosystems: The activity contributes, inter alia, to the conservation of natural and biological diversity, such as by achieving 'favourable conservation status' of natural and semi-natural habitats and species, to sustainable land use and management, to sustainable agricultural practices, such as by enhancing biodiversity or mitigating and preventing soil degradation, and to sustainable forest management, such as by enhancing biodiversity or mitigating and preventing ecosystem degradation.
Taxonomy of the EU Commission End of November 2020
Art. 8 of the Regulation on Facilitating Sustainable Investment contains a detailed obligation for real economy companies to publish non-financial information on each of the six areas. So far, however, only the first two objectives "climate change mitigation" and "adaptation to climate change" have been detailed in the subsequent legal acts in an extensive taxonomy for individual sectors and areas, covering several hundred pages. The EU Commission presented this taxonomy in a consultation paper at the end of November 2020.
The consultation comprises the following parts:
It can be assumed that these screening criteria will also gain regulatory significance for banks in their lending activities and for rating agencies in the future.
However, the regulation is initially aimed primarily at non-financial companies above a certain size (>500 employees). In addition to their financial results, they would also have to publish extensive non-financial data on the six environmental areas, starting with climate protection. In essence, the regulation amounts to the establishment of a second accounting and reporting system in addition to the financial system.
In order to meet their obligations, however, the larger companies will in future also have to know their entire value chain in their reporting. This will not be possible without approaching their suppliers and customers and demanding the relevant data from them. In this respect, the new sustainability regulation ultimately affects ALL companies.
The complexity of the project cannot only be deduced from the extensive taxonomy rules that have been put out for consultation. ESMA has received a mandate from the EU to specify various indicators that are only listed in general terms in the regulation (Art. 8 of the regulation) and has already launched a consultation on this.
Consultation of the EU Commission on the Taxonomy Regulation
The consultation paper Consultation Paper Draft advice to European Commission under Article 8 of the Taxonomy Regulation was submitted by ESMA on 5 November 2020. It not only shows the complexity of the project, but also goes significantly beyond the regulation in its core proposals by proposing to submit all reports for each individual economic activity separately and for each individual objective.
On page 68 et seq. of the consultation paper, ESMA outlines the consequences of the regulation for asset managers, who would consequently have to report accordingly for all their investment portfolios following the logic of the regulation. This means that the new requirements would not only apply to so-called sustainable investment funds, but ultimately to all funds regardless of the underlying asset.
Consultation Paper Draft advice to European Commission under Article 8 of the Taxonomy Regulation 5 November 2020
With REGULATION (EU) 2020/852 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088, the ESG regulation thus focuses on the environmental area - and here initially on the topic of climate protection. However, it can be assumed that the other four environmental objectives will still be worked out in detail.
The regulation is likely to have far-reaching implications for the real economy, as it would have to include
- set up a second, very complex reporting system;
- The EU would have to make its refinancing via the capital markets, but also via banks, dependent on this reporting to a considerable extent in the future.
Banks and financial markets will be affected by this regulation in several ways
On 29 May 2020, the EBA had already presented its final report "Guidelines on loan origination and monitoring". There it states in the introduction:
"In accordance with Article 8(1)(a) of the EBA Founding Regulation, the EBA, when carrying out its tasks, may take into account the integration of environmental, social and governance (ESG)-related factors. To this end, in accordance with Article 8(1)(a), these guidelines take into account environmental factors for loan origination and also put in place guidance for monitoring material ESG-related risks."
Accordingly, extensive obligations for ESG risks are already imposed on banks with regard to their lending conditions, their lending decisions and monitoring and risk management.
EBA document „Guidelines on loan origination and monitoring“
These obligations will also need to be considered against the background of the EU regulation of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, which sets out a detailed general scope.
Central bank policy guidance from the ECB
A foretaste of this is also provided by the ECB's Guidance Note on Climate and Environmental Risks - Supervisory Risk Management and Disclosure Expectations, published at the end of November 2020.
And the central bank policy side of the ECB will also have a corresponding effect on the financial markets, because the ECB's repeatedly announced consideration of sustainability and climate aspects in its monetary policy goes in the same direction.
Banks and financial markets are highly dependent on the ECB's refinancing function. Likewise, the ECB has a massive impact on the financial markets with its purchase policy.
Banks will therefore have to reckon with the ECB buying up in future
- prefer those ABS, covered bonds and corporate bonds in its purchasing policy that comply with the EU sustainability regulation and
- Repo transactions of banks with the ECB, which are preferably carried out with covered bonds and ABS as collateral, will be favoured in terms of interest rate and haircuts, provided that the products deposited as collateral comply with the EU sustainability regulation.
This also has a steering function on the credit policy of banks towards the real economy that should not be underestimated, as it indirectly determines their refinancing price and conditions.
Corona as a gamechanger
Now corona appears to be a gamechanger. Many industries are directly affected by Corona: their sales markets collapse and/or their financing conditions deteriorate. Although the consequences have not yet become fully visible due to the many state aids and legal and regulatory suspensions (e.g. of insolvency law), they are nevertheless foreseeable. The intersection of zombie companies, companies affected by Corona and companies negatively impacted by the new sustainability regulation could be high. All three factors taken together have the potential to trigger deeper structural change than previously assumed.
This brings us full circle:
Extensive environmental reporting is imposed on the real economy, based on a detailed taxonomy. This is not primarily result-oriented, i.e. only geared to the fulfilment of sustainability goals such as CO2 savings and pricing, but goes deep into the value creation process and thus, comparable to planned economy approaches, also claims to be a concrete technology assessment.
In the future, reporting will significantly guide the capital and financial markets and their institutions. The monitoring and risk management required for this will move along the EU taxonomy and the reporting of the real economy based on it. This in turn will reflect back on the real economy and its production lines as well as applied technologies and processes. Anything that is not rated as sustainable in the taxonomy will find it considerably more difficult to obtain corresponding financial resources in the future, which in turn will also have an impact on the creditworthiness of the companies that manufacture such products or use such processes.
Consequences for asset-based finance and securitisation
Asset-based finance and securitisations are likely to benefit from the new sustainability regulations. In our view, this is supported by the relatively specific purpose of such financing, i.e. its clearer and better distinguishability from general corporate financing. Moreover, originators, arrangers and investors in securitisation transactions are already used to dealing with extensive, detailed transparency requirements such as those now facing the entire financing market.