Recent UK, EU and globally significant policy developments and implications for investors, lenders, issuers, and borrowers

• US Inflation Reduction Act 2022
• European Central Bank (ECB) provides details on how it aims to decarbonise its corporate bond holdings

Other announcements and publications

• UK net zero strategy ruled ‘unlawful’ by High Court
• UK FCA published a review of the first mandatory Task Force on Climate-Related Financial Disclosures (TCFD) disclosures in the UK
• EU Parliament voted on EU Deforestation law
• Commission asked European supervisory authorities (ESAs) for input on greenwashing risks and supervision of sustainable finance policies
• PCAF launched public consultation on Capital Markets Facilitated Emissions methodology

What to look out for, for the rest of 2022 and Q1 2023

• UK Prudential Regulation Authority (PRA) to announce plans for climate risk prudential treatment
• Political agreement on EU Green Bond Standard (GBS) is expected to be reached
• Platform on Sustainable Finance to publish the second batch of recommendations on the technical screening criteria for the four remaining EU Taxonomy objectives
• The European Commission to provide responses to additional questions from ESAs on the EU Sustainable Finance Disclosure Regulation (SFDR)

US Inflation Reduction Act 2022

On August 16, 2022, President Biden signed the Inflation Reduction Act (“IRA”) of 2022 into law, representing the biggest package of climate investments in US history [1]. The bill will invest $369 billion in climate solutions, with the US Department of Energy estimating that actions taken through the IRA and the Bipartisan Infrastructure Law will decrease US greenhouse gas (GHG) emissions by 40% in 2030 vs 2005 levels [2].  

While the bill represents an historic step for the US on climate, it’s not a standalone piece of climate legislation; it is also aimed at reducing inflation, lowering healthcare costs, and creating jobs.

One of the main objectives of the Act is to lower energy costs while making cleaner technologies affordable. It further provides federal support in a wide range of economic sectors to encourage their decarbonisation efforts. The $369 billion package comprises a series of tax credits, grants, and subsidies for climate and energy-related purposes, with five key aims. The aims have been highlighted below along with some of the core areas of investment:

Lower consumer energy costs

• $9 billion in consumer home energy rebate programmes, 10 years of tax credits to make homes energy efficient and a $4,000 tax credit for purchasing used electric cars or $7,500 for new vehicles – all primarily for low- and middle-income households.

Increase American energy security through policies to support cleaner production

• Over $60 billion to onshore clean energy manufacturing in the US across the full supply chain of clean energy and transportation technologies.

Decarbonisation technology

• $27 billion clean energy technology accelerator to support deployment of technologies to reduce emissions, especially in disadvantaged communities.

Invest in communities and environmental justice

• Over $60 billion in environmental justice priorities to drive investments into disadvantaged communities.

Affirm the central role of agricultural producers and forest landowners in climate solutions

• $20bn to support more climate-friendly agriculture, $5bn to conserve forests and plant trees in urban areas and $2.6bn for protecting coastal habitats.

However, like much of what happens in Congress, the IRA is a compromise. The legislation also includes a provision that tethers offshore wind leasing to oil and gas extraction. Over a ten-year period, the Department of the Interior will be prohibited from issuing a lease for offshore wind development unless at least sixty million acres have been leased for oil and gas in the previous year. The bill also requires that the Department of the Interior offer to lease at least two million acres of public land for oil and gas drilling as a prerequisite for any renewable energy development on public lands.

While concessions, from a climate perspective were made, this new bill touches on almost every aspect of US climate policy and marks an important step to accelerate the transition to a clean energy economy. Overall, the IRA is an extraordinary monetary commitment from the US federal government focusing on climate and related areas.

Key considerations for sustainable finance market participants

Issuers / Borrowers

It should be noted that the IRA does not include any requirements for corporate issuers in terms of their disclosures, nor do the identified activities for federal investment form the foundation for any US taxonomy. However, companies in the renewables sector (and other relevant sectors such as low-carbon transportation [3]) that are active in the US will likely see increased investment opportunities in the US market. This can increase the scope for green finance issuance. Furthermore, the IRA raises awareness of key concepts around sustainable finance. For example, there is considerable focus on disadvantaged communities, and climate justice issuers may expect investor questions on these topics regarding the overall implications of their sustainability strategies or around projects including Use of Proceeds bonds. Corporates may also want to consider how their sustainability strategies and targets incorporate these ancillary considerations and confirm related disclosures are sufficient.

Investors / Lenders

The supply of investable “green” assets is expected to increase, providing greater diversification opportunities to investors and potentially leading to the tightening of the “greeniums” observed in the labelled bond markets to date. From a regulatory and compliance standpoint, multi-jurisdictional investors and investment managers, especially those with significant presence in the EU, will be facing a challenge of whether and how to classify the new third-country investment opportunities under the EU sustainable finance legislation, such the EU SFDR and Taxonomy, as well as ensuring that processes and procedures would be in place to comply with the forthcoming corporate sustainability due diligence requirements throughout the whole value chain.

ECB provides detail on how it aims to decarbonise its corporate bond holdings

On 19th September, the ECB announced [4] further details around the decarbonisation of its corporate bond holdings. The announcement follows the ECB’s July statement [5] (see also NatWest analysis [6]) where it outlined the intention to incorporate climate change considerations into its monetary policy framework and is in line with its goal to reduce Eurosystem’s exposure to climate-related financial risk, and to support the green transition of the economy.

The decarbonisation will be based on issuer-specific climate scores and will tilt corporate bond holdings towards issuers with better scores. It sends a strong signal to the market, however, impact is somewhat reduced given no new investments through the Corporate Sector Purchase Programme (CSPP) programme.

Issuer-specific climate score will be based on combination of 3 sub-scores:

i)              backward-looking emissions performance,

ii)             forward-looking emissions target, and

iii)            climate disclosure

A detailed scoring methodology has not been disclosed, however, issuers with self-reported emissions data, performing better vs peers, having ambitious decarbonisation targets and high-quality disclosures will receive a higher i.e., a better score. Scores of individual corporates will not be made public, however, aggregate climate-related information on corporate bond holdings will be published by the ECB annually, beginning in the first quarter of 2023.

Implications for issuers with higher climate scores will result in higher weighting and will be favoured in primary market bidding process. Implications for issuers with lower climate scores will result in lower weighting and no immediate sales to manage market stability, however, future purchases from such issuers will be reduced or even halted until improvement in climate scores is demonstrated.

Key considerations for sustainable finance market participants

Issuers / Borrowers

The ECB is saying it will buy more from companies with better scores and in theory support better-scoring issuers’ ability to borrow at lower rates. Issuers should also be aware that the measure does not affect the volume of corporate bond purchases but only the assets breakdown so the share of bonds from corporates with a better climate performance will be increased compared to those with poorer scores. Therefore, corporate issuers can consider becoming more transparent with carbon disclosures around their performance, targets, and other qualitative information, as this is one of the three ECB pillars. Corporate issuers can continue to evaluate their own reporting and performance and those of peers to check how they might rank in ECB’s scoring approach.

Investors / Lenders

As this approach currently only applies to corporate purchases, investors can review if their current ESG investment process to evaluate issuers should consider the ECB scoring pillars. Investors can consider if ECB’s new climate scoring approach may become a new market norm and if they then want to try to integrate a similar approach in their own evaluation and analysis. Regardless, investors may want to review their own corporate holdings’ carbon performance, targets and disclosures to evaluate steepening of the curve for potentially lower scoring names. 

UK net-zero strategy ruled ‘unlawful’ by High Court

UK has a legally binding commitment to achieve its net-zero target by 2050, and in 2021 the UK government developed a Net Zero Strategy (NZS) [7] setting out policies and proposals for decarbonising all sectors of the UK economy in line with the net-zero commitments.  

However, according to environmental groups like Friends of the Earth, ClientEarth and the Good Law Project, the NZS failed on multiple grounds such as providing a time scale for implementation of policies and detailing how the polices outlined in the NZS would reduce emissions enough to meet its legally binding carbon budgets. The groups legally challenged the NZS on the government’s failure to align the strategy with reporting standards under Sections 13 and 14 of the Climate Change Act 2008 ("CCA 2008") [8].

The High Court of England and Wales ruled in favour of the groups by stating that the NZS is unlawful and has ordered the UK Department for Business, Energy and Industrial Strategy (BEIS) to explain, by April 2023, the impact of the strategy on reducing emissions, using quantitative data [9].

UK FCA published a review of the first mandatory TCFD disclosures in the UK

On 29 July 2022, the FCA and the Financial Reporting Council (FCR) released a report [10] in which they reviewed the TCFD-aligned disclosures of a sample of listed commercial companies against the TCFD recommendations and analysed the consistency of companies’ disclosures per each core pillar (governance, strategy, risk management, and metrics and targets).

The key takeaways were that over 90% of companies self-reported that they had made disclosures consistent with the TCFD’s Governance and Risk Management pillars and 81% of companies indicated that they had made disclosures consistent with the seven recommended disclosure categories.

In 2021, 58% of the companies made disclosures that were consistent with at least 7 of the 11 TCFD recommendations, compared to 22% in 2020. The most common reporting gaps were in respect of the more quantitative elements of the TCFD’s recommendations e.g., scenario analysis and metrics and targets. The FCA is currently working closely with international partners to encourage progress towards a common global baseline sustainability-related reporting standard under the International Financial Reporting Standards (IFRS) Foundation’s new International Sustainability Standards Board (ISSB).

EU Parliament voted on EU Deforestation law

On 13th September the European Parliament voted to improve the draft regulation on the requirements for deforestation-free products, amending the legislation that has was introduced last November. Negotiations will now start between the European Parliament and European member states to finalise the text.

Last November saw the introduction of EU legislation that requires companies to collect information regarding deforestation on the products that they placed on the EU market. According to the WFF (World Finance Forum) [11], the EU is responsible for 16% of tropical deforestation that is linked to international trade. To ensure that the EU is not connected to deforestation or forest degradation, this legislation aims to put focus on coffee, cocoa, wood, palm oil, soy, and cattle products entering the EU market. This means that after the regulations are finalised, only products that are not linked to deforestation can be brought into the EU single market.  

EU lawmakers have now focused on updating certain elements of the legislation introduced last November namely:

• Updating the total list of commodities to include pigs, sheep and goats, poultry, maize, and rubber, charcoal, and printed paper products.
• Members of the European Parliament (MEPs) would also like financial institutions to be subject to additional requirements to ensure that their activities do not contribute to deforestation.
• Originally companies had to prove that their products had no contribution to deforestation and forest degradation but now this includes the human rights of indigenous people as well.
• Local communities and indigenous people near affected areas of deforestation can now present any non-compliance cases with these new regulations.
• Sturdier definitions of deforestation and forest degradation to provide protection to greater areas of forests.

According to the official press release [12], while no country or commodity will be banned, companies placing products on the EU market would be obliged to exercise due diligence to evaluate risks in their supply chain. They can for example use satellite monitoring tools, field audits, capacity building of suppliers or isotope testing to check where products come from.

Based on a transparent assessment, the Commission would have to classify countries, or part thereof, into low, standard, or high risk within six months of this regulation entering into force. Products from low-risk countries will be subject to fewer obligations.

Commission asks ESAs for input on greenwashing risks and supervision of sustainable finance policies

The European Commission issued a request to the European Banking Authority (EBA) (banking regulator), European Securities and Markets Authority (ESMA) (financial markets regulator) and European Insurance and Occupational Pensions Authority (EIOPA) (insurance regulator) (commonly known as European Supervisory Authorities or ESAs) to provide input on greenwashing risks and supervision of sustainable finance policies. Among other matters, ESAs are being asked to come forward with a consistent definition of greenwashing. They should also consider whether other current legal definitions aimed at addressing greenwashing are understood consistently by supervisors and market participants (e.g., ‘sustainable investment’ under the SFDR, as well as MiFID and IDD delegated acts on “customer sustainability preferences”).

Items on which input is requested are…

Definitions and sustainable finance policies review:

• Greenwashing and greenwashing risks both within the EU and internationally including third country firms providing financial services in the EU, assessing the scale and frequency of greenwashing and the risks that this could pose on financial markets.
• Implementation of sustainable finance policies and supervisory convergence across National Competent Authorities, with a focus on SFDR and the Taxonomy.
• Proposals for improvement of the regulatory framework and suggestions for amendments to the existing regulatory framework (e.g., Taxonomy, SFDR, EU Low Carbon Benchmarks Regulation, etc.)

Supervisory practice:

• Supervisory practices, experience and capacities including identification techniques and tools, prevention and remedial measures, data requirements to enable the identification of greenwashing, and practices to deal with greenwashing in the EU by third country firms.
• Supervisory measures to identify, prevent, investigate, sanction, and remediate greenwashing in the financial market by competent authorities.
• Assessment of supervisory obligations and powers to effectively monitor, address, deter and sanction greenwashing.

This is an important development for a few reasons.

EU Sustainable Finance legislation has been subject to some criticism for the lack of clear definitions and inconsistencies between the legislative frameworks and challenges around the usability and implementation. This will be the time for the financial services industry to feed back to the ESAs on the challenges it has been facing when implementing the laws and, more importantly, in using the laws in helping drive the re-allocation of capital towards sustainable investment.

The ESA’s request, which will likely feed into the future review of the existing sustainable finance legislation in the EU, may help to eventually rectify the inconsistencies and lack of clarity around some definitions (including the definitions pertaining to Art 6/8/9 fund “classification” under the EU SFDR. On a less positive note, this process will take a significant amount of time – at least 3 years from now. However, this exercise could still help form industry-wide approaches and best practice to be relied on before the formal adoption of any legislative changes.

PCAF launched public consultation on Capital Markets Facilitated Emissions methodology

The Partnership for Carbon Accounting Financials (PCAF) has launched public consultation on a methodology for the accounting and measurement of GHG emissions attributable to intermediated primary capital markets transactions (“facilitated emissions”). Whilst this not a government led or regulatory initiative as such, PCAF standards have widely been adopted and applied by the financial industry to report on financed emissions. Moreover, some voluntary industry led standards are beginning to become endorsed by regulators, and therefore the importance of this initiative should be recognised.  

The aim of the methodology is to enable the following:

• The ability to consistently define the quantum of GHG emissions associated with financial institutions’ facilitation of capital markets activities;
• Clearer comparison of issuers’ GHG emissions profile, allowing for more informed decisions; and
• More informed analysis and comparison of the financial institutions engaged in facilitation activity by their investors and other stakeholders.

NatWest contributed to the development of the methodology as part of a dedicated working group including eight global banks.

The public consultation will be open until October 21, 2022. Here is a link to participate in the consultation: https://form.typeform.com/to/fxQcVKJ8

UK PRA to announce plans for climate risk prudential treatment

As part of its 2022/2023 business plan, the UK PRA will work to determine whether broader changes are needed to the design, use and calibration of the capital frameworks for firms to better capture climate-related financial risks. Progress will rely on input from industry, academics and others, and a research conference is planned for 19 October 2022 where preliminary considerations are expected to be announced.

Political agreement on EU GBS is expected to be reached

Interinstitutional negotiations (commonly known as trilogues) between the European Commission, the EU Parliament and the Council of Member States have started on the EU Green Bond Standard (EU GBS), but the achievement of consensus on the final legislation is not expected until the end of the year and may extend into 2023 given the highly divergent positions of the three institutions. There are several points to agree on, particularly the degree of Taxonomy-alignment of the Use-of-Proceeds, grandfathering of the EUGB designation and the requirement to publish transition plans at issuer-level as part of bond documentation, as well as extending the reporting requirements to other types of sustainable bonds issued in the EU beyond green.

Platform on Sustainable Finance to publish the second batch of recommendations on the technical screening criteria for the four remaining EU Taxonomy objectives

Over the past 18 months, the Platform on Sustainable Finance worked to produce recommendations on the technical screening criteria for the four remaining environmental objectives of the EU taxonomy (sustainable use and protection of water and marine resources; transition to a circular economy; pollution prevention and control; protection and restoration of biodiversity and ecosystems). Following the publication of the initial recommendations and the respective public consultation in 2021, in March 2022 the Platform published an updated report [13]. The Platform is yet to publish the second batch of recommendations on the technical screening criteria followed by the Commission adopting the related delegated legislation to enshrine the criteria in the EU law.

The European Commission to provide responses to additional questions from ESAs on the EU SFDR

The ESAs have formally submitted [14] questions to the European Commission relating to the interpretation the EU SFDR. Among several technical questions, conceptual matters have been raised that the financial services industry has been grappling with over the past two years. For example, the ESAs have asked about how the definition of “sustainable investment” in Article 2(17) SFDR should apply to investments in funding instruments that do not specify the use of proceeds, such as the general equity or debt of an investee company; other questions related to the interpretation of an “investment in an economic activity that contributes to an environmental objective” or “investment in an economic activity that contributes to a social objective” (e.g. whether having a net-zero transition plan by an investee company would be enough for the related investment to be considered sustainable”). The Commission will be required to provide a formal response to these questions. As a reminder, the first set of clarifications on the application of SFDR was provided [15] by the Commission in May 2022. 

For those looking to discuss any of the above further, please reach out to our authors:

• Tonia Plakhotniuk, Vice President, Climate & ESG Capital Markets
• Daniel Bressler, Vice President, Climate & ESG Capital Markets, Corporates
• Tyler Mayzes, Analyst, Climate & ESG Capital Markets, Corporates
• Jaspreet Singh, Vice President, Sustainable Finance

References

[1] Summary of the Energy Security and Climate Change Investments in the Inflation Reduction Act of 2022 (PDF)

[2] US Department of Energy: The Inflation Reduction Act Drives Significant Emissions Reductions and Positions America to Reach Our Climate Goals (PDF)

[3] gov.uk/government/publications/net-zero-strategy

[4] mondaq.com/uk/climate-change/1225204/high-court-judgment-on-uk-government-net-zero-strategy

[5] Lexology: Where are we with Net Zero? A look into decarbonising the construction sector

[6] fca.org.uk/publications/multi-firm-reviews/tcfd-aligned-disclosures-premium-listed-commercial-companies

[7] ECB provides details on how it aims to decarbonise its corporate bond holdings

[8] ECB takes further steps to incorporate climate change into its monetary policy operations

[9] ESG Policy and Regulation Round up: July 2022

[10] EU consumption responsible for 16% of tropical deforestation linked to international trade - new report | WWF

[11] Climate change: new rules for companies to help limit global deforestation

[12] finance.ec.europa.eu/publications/call-feedback-platform-sustainable-finance-preliminary-recommendations-technical-screening-criteria_en

[13] JC 2022 47 - Union law interpretation questions under SFDR (europa.eu)

[14] c 2022 3051 f1 annex en v3 p1 1930070.pdf (europa.eu)