In 2016 the European Commission introduced the Action Plan on Financing Sustainable Growth. This has been the start of new regulations that aim to realize the European Union’s ambitious sustainability goals in the areas of environment, social and governance (ESG). Through these regulations the European Union introduces classification and disclosure requirements in the area of ESG for financial market participants (such as investors, fund managers and pension funds). At the same time financial market participants are also increasingly incorporating ESG factors into their decisions-making process and disclosures in order to facilitate the growth in demand for investments that have a positive impact on ESG factors. These trends will continue to grow in the future and become a key theme within financial market.
The popularity of ESG aspects can be seen in today’s debt markets as both lenders and borrowers are looking at how to incorporate ESG factors into their financings. This is shown in the increasing popularity of Sustainability Linked Loans (SLL) in facility agreements as well as other forms of financing. These forms of loans include ESG linked margin ratchets which are triggered by key performance indicators relating to specific ESG goals made between the borrower and lender. As a consequence financial market participants and borrowers are willing to improve ESG disclosures to investors and borrowers, in particular ESG disclosures to inform investors on how financial market participants consider sustainability risks when making investment decisions, how investment decisions have adverse effects on sustainability factors and how they incorporate sustainability objectives into their investment processes. The lack of ESG guidelines has however caused inconsistent approaches when gathering ESG information from borrowers. This has resulted in it being unclear what information is required to be disclosed by borrowers to lenders and other relevant financial market participants.
Sustainable Finance Disclosure Regulation and the Taxonomy Regulation
As part of the action plan the European Union has introduced, as of 10 March 2021, Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector (the SFDR), which aims to improve the quality and transparency of disclosures provided in relation to sustainable investments. The technical regulatory standards that further define disclosure obligations will be in force as of January 1 2023. This means that borrowers and lenders will have to start collecting information on sustainability risks as of 1 January 2022 in order to be able to report on this in accordance with the SFDR in June 2023. The European Union has also introduced, as of 1 January 2022, Regulation (EU) 2020/852 of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment, and amending regulation (EU) 2019/2088 (the Taxonomy Regulation). This regulation aims to introduce clear guidance on what constitutes a sustainable investment. It is partially effective as of 1 January 2022, but largely requires further regulation in the form of technical screening criteria which will be effective as of 1 January 2023.
By introducing the SFDR and Taxonomy regulation, the European Union aims to introduce a baseline for disclosures, making them more uniform, transparent and reliable. This will likely boost further interest in sustainable investments and make the market more accessible for new parties on both the lender and borrower side.
Disclosure and classification obligations
The SFDR introduces the obligation for all financial market participants to publish on their websites ongoing disclosures and provide pre-contractual information on (i) how sustainability risks are integrated into their decision-making process, (ii) the likely impact of sustainability risks on the returns of their financial products and (iii) how their remuneration policy aligns with the integration of sustainability risks. It is likely that these disclosure obligations will further increase in the future.
The SFDR also introduces clear classifications of what makes up a sustainable investment and introduces further disclosure requirements for such investments. These can be split up into two financial products: (i) a financial product that promotes environmental or social characteristics and (ii) a financial product that has a sustainable investment as its objective. When a financial market participant offers a financial product that falls within either category, it brings further disclosure requirements in which it has to state how the sustainable goal is achieved or promoted and what indicators are used to measure this.
It is clear that these regulations introduce further obligations for financial market participants in publishing more detailed disclosures when dealing with sustainable investments and also increasing the amount of due diligence that they have to do on their part in order to comply with these new regulations. To provide greater clarity to financial market participants, the LMA, APLMA, and LSTA recently issued three guidance documents, those being the following: Sustainability Linked Loan Principles, Guidance for Green, Social, and Sustainability-Linked Loans External Reviews and Guidance on Social Loan Principles. These aim to provide greater clarity for financial market participants on how to include ESG factors into their loans and how to monitor these ESG factors through an external reviewer.
Implications for financial market participants and lenders
Financial institutions, including lenders, will have to comply with new disclosure obligations on how to integrate ESG factors into their decision-making process and the effect that it has on their financial products, improving the ability of investors to compare financial products and incorporate ESG factors into their investment decisions. Furthermore, they have to substantiate why a financial product can be considered a sustainable investment whilst also having the obligation to monitor its contribution to the ESG factors. This will likely improve the information-asymmetry between possible investors and borrowers, but does burden financial market participants with further obligations.
Implications for borrowers
Whilst borrowers do not qualify as a financial market participant and thus do not fall within the scope of the SFDR, they will still be impacted by the new disclosure and qualification obligations. In order for financial market participants to comply with the new ESG disclosure and qualification requirements, they will have to gather reliable, measurable and consistent ESG data from borrowers. Thus, forcing borrowers to indirectly comply with these new ESG requirements.
It is clear that ESG factors will continue to play an important role in the future of financial markets. This is likely to result in further legislation that will have a noticeable impact on all parties involved in financing and will lead to further questions and affect future transactions. Therefore it is key to ensure that all ESG related obligations are met and properly disclosed to the relevant financial market participant. Moreover, by doing so the involved parties can also benefit from pursuing investments that have a positive effect on ESG factors.
Should you have any questions about the disclosure of ESG factors or how ESG factors can be incorporated into financings, please contact Jason van de Pol.