11 February 2020
A notable landmark in the evolution of the global green bond market was passed in December when European member states endorsed legislation on the Taxonomy of Sustainable Economic Activities. The passage of the new law is regarded as ground-breaking for the green capital market because it clears the way for the establishment of common definitions of sustainability which have long been regarded as the missing piece in the market's jigsaw.
The pressing need for a broadly recognised classification system for sustainable activities was clearly articulated in June 2019 with the publication by the EU Technical Expert Group (TEG) of a report clearly setting out the basis for a future EU Taxonomy to be enshrined in EU legislation. This advocated the establishment of technical screening criteria for economic activities that can make "a substantial contribution to climate change mitigation or adaptation", while safeguarding against "significant harm" to a range of other environmental objectives.
Few welcomed December's announcement with more enthusiasm than Aldo Romani, Head of Sustainability Funding at the EIB, who has been calling for more transparency and clarity across the market for green finance for several years. "Many people did not believe that it would be possible to establish consensus-driven criteria for an EU wide taxonomy," he says. "The agreement of December 18th makes it clear that one year from now, all market participants who want to benefit from an EU green label will be required to follow the same core technical screening criteria as the basis for analysing the contribution to climate change mitigation of all their activities and of the products used to finance them."
Romani says that he and his sustainability funding colleagues at the EIB (see picture) derive considerable personal satisfaction from December's agreement. Justifiably so, because since it launched its first Climate Awareness Bond (CAB) in 2007, the world's first green bond, the EIB has been at the forefront of the development of the global green, social and sustainability bond market, which has now seen total cumulative issuance of more than $1 trillion.
While issuance has been embraced since 2008 by an increasingly diverse range of sovereign, supranational, financial and corporate borrowers, the EIB has remained the standard-bearer for green bonds. Aside from issuing close to €29 billion in 13 currencies by the end of January, the EIB has won consistent recognition for innovation and best practice, acting – as Romani puts it – as "de facto ambassadors" for greener capital markets.
"The EIB has clearly made an important contribution to the market," he says. "We have consistently developed an explicit and externally verifiable link between use of proceeds and allocations to certain types of projects, giving substance and transparency to the market. This is developing into best practice."
The Private Investment Challenge
To grasp why the pursuit of transparency, clarity and commonly understood and accepted definitions are so critical for the green capital market, it is important to recognise the magnitude of the financing challenge that will need to be overcome to support the global transition to carbon neutrality.
According to the TEG report on EU taxonomy, Europe needs to attract an additional €175 to €290 billion annually of private investment to meet climate goals alone. "High levels of public debt constrain governments' investment capacity, which is why private capital is required," says Romani. "This in turn is why mainstream capital markets have a pivotal role to play in mobilizing this investment."
The problem, Romani adds, is not the sourcing of this capital, given that there is no shortage of private money hunting for sustainable investment opportunities. The challenge, he says, has been in ensuring that this capital is deployed effectively. As long as there is little consensus on the core definition of green or sustainable finance, capital markets are unable to fulfil their potential as a mechanism for responding to the demonstrable threats posed by climate change. "This is why the EC and the EIB have been so vocal in emphasising the need for a shared interpretation of core aspects of sustainability," says Romani. "It is impossible to sustain fair competition in the market if everybody is free to define what they regard as green or sustainable according to their own tailor-made requirements."
The introduction of rules-based definitions sweep away these inefficiencies by establishing a clear procedure for allowing the market to monitor what is compliant with the EU's core policy objectives using universally observed and therefore comparable criteria.
Linking the Capital Market and the Real Economy
Romani says that the practical impact of the taxonomy agreement will be significant at a number of levels. Perhaps the most important of these is that by establishing standards observed both in fund raising and investment, it will create a visible and quantifiable link between the capital market and the real economy.
From the perspective of the EIB, the link between financing and civil society is especially important; the new energy policy announced by the Bank in November 2019 commits the lender to phase out support for unabated fossil fuel projects from the end of 2021. In its capacity as the EU's climate bank, the new policy also pledges to unlock $1 trillion of climate action and environmental sustainability investment this decade, inter alia in support of the EU's objective of increasing the share of renewables in its energy mix to 32% by 2030.
Romani says that by endorsing taxonomy legislation to be applied uniformly across all product and market segments (e.g. green bonds and green loans), the agreement of December 18th strengthens a key pillar of the EU Green Bond standard by unequivocally linking a bond's proceeds to projects officially recognised as sustainable. Critically, this recognition applies at a cross-border level. "So if a national regulator is required to rule on what constitutes a sustainable project in Italy, say, it will have to do so in accordance with the EU-wide taxonomy," says Romani.
Fostering cross-border Capital Flows
Romani believes that this taxonomy will also increasingly win multinational support as legislators, investors, borrowers and intermediaries beyond the EU's borders recognize the benefits that are to be derived from cross-border comparability. "Perhaps the most useful component of the taxonomy is the structuring element that this classification system will bring to the dialogue on the green capital market and the green economy at an international level," Romani explains.
Within the capital market, there has been compelling evidence over the last 12 months that the existence of comparable definitions and a universally recognised taxonomy can be very powerful in greasing the wheels of cross-border capital flows. Building on its track record as a pioneer in the international green bond market, for example, in May 2019 the EIB issued a new A$400m five year climate awareness bond (CAB). This was the first time that the EIB had targeted Australian and Japanese investors with a new green transaction supported by documentation which had been revised to align the use of proceeds with the evolving EU sustainability legislation.
Another example came the following month, when the EIB returned to the Danish kroner market for the first time since 2009 with a Dkr3 billion 12 year CAB which broke new ground as the first green bond from a sovereign, supranational and agency (SSA) borrower in kroner. Local investors gave the transaction a very warm response, with ATP's Senior Portfolio Manager, Lars Dreier Kristensen, saying that ATP valued EIB's bonds for the "transparency and accountability" they generated in sustainable finance. "We acknowledge EIB's effort to align with the EU Green Bond Standard via linking to the EU Sustainability Taxonomy and the external verification of both allocation and impact reports."
A similarly significant CAB met with positive reception in the sterling market in July 2019, when the EIB sold its largest green transaction ever in the British currency, increasing the size of the five year bond from the initially targeted £500 million to £800 million in response to an order book that exceeded in £1.4 billion. With this deal, again the EIB became the first issuer to inaugurate documentation tuned on the upcoming EU Sustainability Taxonomy in the UK market. The exercise was repeated successfully in the USD market with an SEC-registered USD global CAB in October, which was close to four times oversubscribed.
A more recent milestone came in January 2020, when the bank became the first borrower in the CAD-market explicitly to align its issuance documentation with the EU legislative framework agreed in December. This was a C$500 million five year CAB, the proceeds of which will be allocated to activities contributing substantially to climate change mitigation. As the bank announced at the time, the EIB aims to extend its CAB loan eligibilities, so far focused only on renewable energy and energy efficiency, to other sectors in line with the upcoming EU taxonomy, which it will achieve "via progressive adaptation of eligibility criteria and establishment of the required procedures and IT infrastructure."
Supporting SDGs with SABs
In preparedness for the mainstreaming of EU policy objectives into a formal taxonomy, the EIB also ensured that explicit alignment between use of proceeds and evolving EU legislation was incorporated into the documentation supporting its first Sustainability Awareness Bonds (SAB), issued in September 2018. SABs are allocated to projects supporting a host of social and environmental objectives beyond climate change mitigation that serve the Sustainable Development Goals (SDGs). The EIB's maiden SAB was a well-received eight year €500 million bond, the proceeds of which were initially earmarked for high impact water projects contributing to two environmental objectives (water conservation and pollution prevention and control) and two social objectives (access to water and sanitation and natural disaster risk management). The scope has meanwhile been extended to health and education projects.
The momentum towards commonly accepted taxonomy across the EU and beyond, Romani adds, is also having a notable impact on the EIB at an internal level. This is especially relevant for the bank's issuance of SABs, where the allocation of proceeds is de facto open-ended, as the EC has is yet to establish a taxonomy for a range of environmental and social goals other than the fight against global warming.
"Whereas the EC has been discussing the issue of taxonomy with official authorities worldwide, on the capital market side we have been engaged in a dialogue with the technical side of the bank," Romani explains. "In other words, we have been asking the engineers within the bank's project directorate to map our activities not just in the area of climate change mitigation but also in areas of sustainability where taxonomy is not yet available and won't be ready for some time. This implies a commitment to knowledge development, which will be valuable because it will help these concepts to become better understood by the capital market."
Turning Energy into Light
Already, says Romani, this knowledge development is being applied to areas such as health and education. And as other sectors falling under the more general umbrella of sustainability follow suit, so the potential for further expansion and diversification of the green and social capital markets (e.g. sustainability funding and lending) will gather momentum. "As the taxonomy is adopted and applied to larger portions of our balance sheet, this will feed through to larger volumes of CABs and SABs," says Romani.
That will represent a notable personal achievement for Romani, who says that when the EIB kick-started the green bond market in 2007, he was disillusioned by the feedback he had from investors across the EU. Today, he says he is delighted to see theory on sustainability turning into practice - despite the challenges still associated with implementation, a process he describes as turning energy into light. Clean energy for sure. "The EIB is now acting as the core engine for delivering on the New European Deal on sustainable and inclusive growth that the Commission has been advocating and that public opinion is supporting," he adds. "That is the beauty of working for an institution that is able to turn political statements into reality."