EU Taxonomy integration: the heavy lifting begins

On the issuer front, companies are expected to work on their “2nd generation” green finance frameworks embedding the latest recommendations of the EU Taxonomy/Green Bond Standard (GBS). Nuclear and gas will also continue to be a widely debated topic.

The EU published a number of reports with guidance and recommendations to support the implementation of the EU Taxonomy. The final text of the EU Corporate Sustainability Reporting Directive (CSRD) will be published in 2023, as well as guidelines on ESG risk management by the European Banking Authority (EBA).

Further climate stress testing

The findings from the initial rounds of climate stress testing by the Prudential Regulation Authority (PRA) and EBA have been reviewed, with more detailed requirements expected in 2023. Both regulators have asked ‘how’ banks are intending to overcome the gaps and consider the more complex risks on their balance sheets. Initial questions are already being raised regarding market risk and how to apply both physical and transition risk to the positions.

Competition law relief

Given the current state of competition law, it’s challenging to discuss details regarding data and modelling of climate risk. Therefore, having some ‘safe harbours’ would enable these discussions to accelerate the required change – there have already been some precedents (e.g. Authority for Consumers & Markets in the Netherlands) and other jurisdictions may follow.

Growing focus on biodiversity and natural capital

Biodiversity and natural capital were highlighted prominently during COP27 and of course, at COP15; as outlined in our article of December of last year.

European equity funds are incorporating biodiversity strategies into mandates, and it’s anticipated that fixed income will follow suit, initially focusing on climate adaptation or circular economy. In addition, Sovereign issuers may directly link their biodiversity ambitions to a sustainability-linked bond.

Rise of Scope 3 and its relevance

Scope 3 is becoming more relevant to fully assess the emissions’ impact across the value chain of companies, financial institutions and governments; as discussed in our Carbonomics series.

International Capital Market Association’s (ICMA) Sustainability-linked Bond (SLB) working group focused on Scope 3 for key performance indicators (KPIs), to be included into SLBs across industry sectors. However, there is still significant misunderstanding of what Scope 3 entails and what is material or decision relevant.

Increasing focus on Social and “Just Transition”

Given the energy crisis, rising rates and increased inflation, social matters are at the ‘front and centre’ for most organisations. Social and sustainable bond issuance may have a revival in 2023, as Governments, Supranationals, Agencies and Financial Institutions look to fill the gap.

Social components are likely to become an intrinsic parameter to analyse climate policies and issuers’ transition plans. The EU has incorporated Minimum Social Safeguards (MSS) which will be further defined and measured in 2023.

Transition finance: financial products and issuer journeys

Institutional investors and banks are actively considering the transition pathways of their investments and customers. This has given rise to the question of whether transition finance applies to the issuer or if particular instruments are utilised to support the transition activity.

Where 2022 was the year of transition guidance, 2023 will be the year of implementation where the role of transition finance will be defined across industries, for instance in real estate. The insurance industry has also been called out to increase their activity to decarbonise and transition their investments.

Carbon markets: improvements leading to expansion

In 2022, several market initiatives were launched to support the voluntary carbon markets; the Integrity Council for the Voluntary Carbon Market (ICVCM) and the Voluntary Carbon Markets Integrity Initiative (VCMI). In addition, Carbonplace completed a pilot trade with Climate Impact X (CIX) in December, a pivotal moment in helping take the carbon market to the next level.

2023 is expected to see the scaling of these developments to help accelerate the application of carbon credits and support the financing of climate mitigation and adaptation activities in the developing world. The increased transparency of the carbon markets should support further developments, such as digital green bonds, that will combine blockchain technologies to effectively and efficiently ‘price the carbon benefit’.

Financial institutions are accelerating the awareness of their customers’ understanding of emissions by incorporating ‘carbon planners‘ into their offering to actively track their carbon footprint.

Product development and innovation: Commercial Paper, Trade Finance and Securitisation

ICMA has established a working group on ‘Sustainable Commercial Paper’ to help define and develop the short-term fixed income market. Additional guidance is expected to be published in 2023 and more issuers are expected to explicitly reference Commercial Papers (CPs) in their sustainable financing frameworks going forward.

ESG securitisation has the potential to play a key role in financing the carbon transition.

Shift in Investor Preferences: back to basics (Use of Proceeds)

2023 is expected to be a pivotal year for SLBs as the first wave of targets begin to hit. Investors are also continuing to be cautious with SLBs and are showing a renewed interest in Use of Proceeds bonds.

The Loan Markets Association (LMA) and ICMA will review their respective guidelines concerning third party assurance, additionality, and materiality to increase the robustness of, and appetite for, sustainability-linked products.

Greenwashing vs Greenhushing: which will prevail?

Addressing greenwashing has become a priority for policymakers and regulators. Enhanced sustainability disclosure requirements are fast approaching across jurisdictions; CSDR beginning from 2024 in EU followed by similar regimes in the UK and US.

As a result, sustainable finance framework details may be incorporated more frequently into offering circulars / scope for enhanced ESG due diligence questions. Investors and issuers may also embrace “greenhushing” – effectively reducing sustainability disclosures to avoid allegations of greenwashing and potential litigation risks.

Finally, there may be a shift from Article 9 to Article 8 funds (e.g., Amundi, DWS, AXA IM) as investors are challenged to regularly monitor, track and measure tools.

ESG ratings scrutiny

ESG ratings and the underlying data is vital for the sustainable finance market; however, there is concern surrounding the respective approaches by the providers and collectors of data, as raised by the European Securities and Markets Authority (ESMA), International Organisation of Securities Commissions (IOSCO) and Financial Conduct Authority (FCA). As a result, the FCA has launched a Code of Conduct consultation with regard to ESG ratings to improve the ‘operating rhythm’ and transparency of the offerings.

Our specialists expect to see a number of drivers shaping the GSS/S market in 2023. These have been included below. 

Upward drivers

• Financial Institution initiatives to support green finance, especially retail financial products, such as green and refit mortgages or loans.
• Pressure on Supranationals to finance the transition in emerging markets sustainably or through sustainability development goals (SDGs).
• Social elements embedded to support the energy and inflation crisis i.e. the ‘cost of living’ narrative, may increase social bond issuance from agencies and FIs.
• Investor appetite for non-utility sectors, could encourage new corporate sectors to establish frameworks.
• Private finance could access the markets with structures that support their portfolio companies’ transition.
• There is a growing focus on natural capital and biodiversity evidenced through green or circular economy bonds.
• Guidance and transparency of KPIs and Sustainability Performance Targets (SPTs) to increase robustness of SLBs.
• Further product innovation is expected (e.g. CP, securitisation, trade finance).

Downward drivers

• Use of Proceeds structure will become more mature, with a natural cap on assets unless there is economic growth to finance expansion sustainably.
• Mixed “greenium” in the primary market given underlying volatility.
• Increased scrutiny on SLB structures could impact growth of the market, if without clear guidance and transparency.
• Pressure on sovereigns to finance energy and inflation crisis versus green expenditures.
• Recessionary pressures may reduce underlying issuance, therefore impacting GSS/S (reduction in the EUR market from 47% to 43% of total).
• 2023 debt issuance will likely affect GSS/S volumes (global issuance down ~28% in 2022 vs 2021).
• Reduced political pressure (e.g. new US president, geopolitical tensions).
• Increased regulatory pressure on greenwashing and reporting of impact of GSS/S labels.

For further analysis and information on how our specialists expect supply in the GSS/S market to progress in 2023, please do take a look at the full monthly newsletter on Agile Markets. If you do not have access to Agile Markets, please contact us here.

As always, if you would like to discuss any of the above further, please reach out to our authors:

• Caroline Haas, Head of Climate and ESG Capital Markets
• Doug Shuffman CFA, Vice President, Climate and ESG Capital Markets
• Jake Hallam, Associate, Climate and ESG Capital Markets
• Pulkit Khurana, Associate, Climate and ESG Capital Markets
• Siobhan Wartnaby, Analyst, Climate and ESG Capital Markets

*For any unfamiliar terms used within this article please refer to our Insights glossary.