The new medal table: Gold, silver and brown

This is the third and final part in our series on “ESG Olympics”. In the first part we focused on directors’ duties in setting a green agenda and in the second part we explored the regulators’ response in the form of “brown penalties”. In this final part we turn our focus to the potential “greenium”.

Green finance

A report recently issued by the European Platform on Sustainable Finance noted that the EU needs to scale up its investment in sustainable finance by at least two-thirds by 2030 if the EU is to achieve net-zero goals.

Securitisation should be perfectly designed to make a substantial contribution to these goals by facilitating banks to free up regulatory capital and refinance lending to both wholesale and retail clients through access to the capital markets. In theory, lenders can use freed–up capital to reinvest in ESG lending, while capital markets investors can channel capital via securitisation directly to finance renewables lending.

So called “green” securitisations can take a few different forms. Where the underlying collateral is green (e.g. electric vehicles) these are known as green collateral deals.  Where the proceeds are used towards projects with green characteristics these are known as green use of proceeds deals. Most green securitisations to date have sought to combine both features. This reflects, perhaps, the difficulty companies face in being wholly green. To have a sufficiently large pool of green collateral is a challenge, and many companies will struggle to solely channel use of proceeds into green initiatives.

Enter stage right – the EU Green Bond Standard.

We should stop there for a moment. Those familiar with the theatre will recognise the “stage right” entrance as being reserved for that which is good, be it morally, socially or ideally both. This idea dates back to medieval times and whether we realise it or not, the audience is primed to understand whether this is a “good” or a “bad” character from where they enter the stage.

Now we’ve set the scene, we can go back to the EU Green Bond and look at it in a bit more detail. The provisional agreement on the EU Green Bond Standard was announced in February 2023.  The new regulations will apply from 21 December 2024.

Whilst voluntary, if issuers elect to label their bonds “EU GB” or “European Green Bond” they must comply with certain requirements set out in the regulations. Where the label is used, the proceeds of issuance must be invested in economic activities that are aligned with the Taxonomy Regulation (Regulation EU 2020/852).  What this means in practice is that the label will only apply to green use of proceeds transactions.

To use the EU Green bond label, issuers must provide exhaustive use-of-proceeds information which demonstrate how they align with the taxonomy. In addition, they must provide details of how the investment will help the sustainable transition to prevent green investments from being offset by unsustainable investments elsewhere. There is some relief, in the form of a ‘flexibility pocket’. This permits 15% of the proceeds to be applied towards economic activities which align with the EU objectives, but not with the Taxonomy Regulation.

Whilst the 15% flexibility is helpful, there will still be a large number of companies for whom this is too high a target. They simply cannot earmark 85% of issuance proceeds towards green assets. Whilst the “greenium” and high-profile nature of issuing an EU Green Bond is likely to be high, it may simply be out of reach.

The bigger picture

Green mortgages in the UK constitute a mere 0.4% of total lending. AFME have predicted that the green mortgage market could reach €125 billion annually by 2030 across eight RMBS jurisdictions (Belgium, France, Ireland, Italy, The Netherlands, Portugal, Spain and the UK). That would certainly provide support for the issuance of EU Green Bond Securitisations if it is, in fact, achievable.

Even if that scale of green mortgage market is achievable, we also need to consider the environmental impact of building new homes. A recent article in the Sunday Times highlighted water shortages in the east of England which are being exacerbated by new homes being built. Whilst these new homes may be energy efficient and meet many of the environmental targets, they still impact the environment by drawing on water supplies. The government’s response may raise questions – a £9 million investment in a water credits market, that allows builders to offset the development through purchase and sale of water credits.

Some of the answer may lie in expanding the definition of what a “green” mortgage includes. Traditionally it is used to refer to mortgages specifically targeted at green properties, to incentivise their ownership. However, as noted in the previous article, 95% of properties do not meet the energy efficiency criteria. Financing these homes to become more energy efficient must also be a target.

Green securitisations do not exist in a vacuum, but rather form part of the wider sustainable securitisation framework. Currently the main framework used by market participants are ICMA’s Green Bond Principles. These were first published in 2014 and provide a voluntary framework when issuing green, social or sustainable bonds. Notwithstanding this common market approach, it remains difficult for investors to identify positive sustainable impacts and compare the different instruments available on the market; for issuers, the lack of common definitions created uncertainty about which economic activities could be considered sustainable.

When announcing the EU Green Bond, the language that was used was that they were creating a “gold standard for green bonds”. That makes sense at first sight as you award a gold medal to those that achieve the highest standards.

To the extent issuers are unable to reach for the “gold” standard of EU Green Bonds, they can still make use of the voluntary best practice standards issued by ICMA. However, these are voluntary, and only best practice. They do not carry the weight of regulatory oversight and investors do not necessarily receive the same standard of disclosure. The key differences between the ICMA Green Bond Principles and the EU Green Bond standard are (a) use of proceeds; (b) disclosure requirements; (c) the role of external reviewers; and (d) regulatory oversight / sanctions.

If issuers are unable to satisfy the gold standard EU Green Bond they will continue to self-regulate, perhaps opting to apply ICMA’s Green Bond Principles. This may create a two, or possibly three, tier system, with EU Green Bonds at the top, bonds issued in line with ICMA’s standards in the middle, and everything else at the bottom. 

The medal table

At the upcoming Olympics in Paris we will likely witness phenomenal sporting success, with the gold medal awarded to the highest achievers. 

A “gold” medal green securitisation works in much the same way, it being awarded to the highest achieving issuers. To achieve this level of success, however, these issuers already need to be substantially green. If we are to reach the European Union climate and environmental targets, awarding gold medals to green issuers would seem to do little to assist with this.

Whether we like it or not, the world is not green and failing to properly manage the brown assets by striving for “gold” only risks increased costs in the future.

It is true that the gold medal at the Olympics is in each case awarded to the highest achiever. However, the Olympics is not a single sport; in Paris this summer we will witness 392 events across 32 sports, with different metrics of success. To achieve a gold medal in high jump for example, the winner will need to jump the highest. Running fast may help achieve this goal but the winning athlete may also have longer legs, more explosive power or a high strength-to- bodyweight ratio.  In the 100m sprint, by comparison, the fastest runner wins.

If we focus on a single “gold” standard we fail to recognise the inherent diversity of assets and underestimate the complexity of the problem we face.

Instead of striving for a gold medal for all (and, as they say, there can only be one winner) should we not instead be focusing on achieving silver, or even bronze?   As we all know, the Olympics come round every four years, and a small, elite group of athletes compete at the top of their game and countries produce their rankings of gold medals. The achievements are remarkable, inspire generations to come and are important in so many ways. Nobody is denying their value. Yet for the majority of people that level of achievement is out of reach.

The EU Green Bond most certainly deserves to enter “stage right”. It is inherently good, no one can doubt that.

The UK government announced its ambition to become the first net zero-aligned financial centre way back in 2021. The European Commission’s Green Deal plan shares a similar ambition. It aims to shift to a sustainable economy, with the EU becoming the “first climate-neutral bloc in the world by 2050”. The funding required for this is equally ambitious. To have any chance of success, it is crucial that sources of capital and liquidity are appropriately deployed.

Let’s go back to our Olympians. Their training takes years, with injuries and setbacks along the way. Train too hard or too quickly and you risk injury and potentially falling behind. They have their ultimate goal in mind but they break down their training plan into individual steps and take care to look at not just training but nutrition, hydration, sleep and mental well-being.

If we strive to achieve environmental targets in isolation, like an athlete vying for that one Olympic gold medal, we fail to recognise the inherent inter-relatedness of the problem. Environmental emissions do not respect country boundaries and the financial markets operate on a global scale. If we could get every country to bronze or even silver we would likely achieve a far better outcome than by one country achieving gold.

To echo the words of the ECHR in their recent ruling, “decarbonisation of the economies and ways of life can only be achieved through a comprehensive and profound transformation in various sectors. Such “green transitions” necessarily require a very complex and wide-ranging set of coordinated actions, policies and investments involving both the public and the private sectors. Individuals themselves will be called upon to assume a share of responsibilities and burdens as well”.

Whatever the parallels, the energy transition does not represent the Olympics in a number of crucial regards. After all, if a 100-metre sprinter were to run that event in 9.4 seconds, that would be a fantastic achievement for the Olympics – no one would care if the average speed of all the 100 metre contestants was lower than it had been at previous Olympics. But we will not decarbonise the planet by having one participant (or even one set of participants) achieve net zero in three years. We need to reduce carbon emissions across the entire economy. To that end, therefore, it is important that the most polluting businesses or sectors are still less polluting than they were last year, even if they have no hope of achieving the levels of greenness that the very “best” companies or sectors can reach. To that end, we need shades of greenness that suit and properly incentivise all sectors to become “more” green.  Unlike in the Olympics, the runners who come last still matter.