In 2021, the European Union further accelerated its completion of the legislative edifice of sustainable finance. Notably, the European Union adopted the implementing legislation that allows it to put into practice the extraordinarily ambitious EU Taxonomy for sustainable activities adopted in June 2020. The EU Taxonomy covers the sustainability (or not) of all activities in all sectors of the EU economy by reference to the six EU environmental objectives: 1) climate change mitigation, 2) climate change adaptation, 3) protection of waters and marine resources, 4) the circular economy, 5) pollution prevention and 6) protection of biodiversity and ecosystems.
In order to be sustainable, economic activities must contribute to one or more of these six objectives (or to transitioning towards them) without causing significant harm to one or more of the other objectives. In addition, they must be compliant with social and governance protocols in accordance with strict, detailed criteria, which grants a full ESG dimension to the EU Taxonomy.
While the initial purpose of the EU Taxonomy was to determine the sustainability of investments by reference to the economic activities that they finance, the focus on the activities themselves has elevated the Taxonomy to a sort of overarching guide for the EU sustainability agenda. The more the EU economy will steer itself towards the Taxonomy, the more it will reach the EU environmental objectives, including climate change mitigation.
Hence, the Taxonomy plays a role in public policy (EU investment programs such as the COVID-19-pandemic-responsive Next Generation EU) and in finance policy; the ongoing EU green bond standard, for instance, will demand alignment with the EU Taxonomy of the green bonds issued in the EU.
The Taxonomy is science-based (technical screening criteria are developed for each activity) and hence subject to evolution, but it is also a legislative democratic process with opposing views within the EU legislative bodies (Commission, Parliament and Council (Member States)) when it comes to sensitive areas such as nuclear energy and natural gas. In February 2022, the EU addressed the taxonomy treatment of these last two areas of activity, which were still pending for the overall completion of the EU Taxonomy. The outcome, which attracted strong public attention, is that nuclear and gas-related activities are considered as EU Taxonomy-compliant under certain quality conditions.
The EU is also establishing clearer sustainability reporting obligations for all large companies, including financial companies, and all publicly traded companies, with the overall purpose of elevating sustainability reporting to the level of financial reporting. The revised Corporate Sustainability Reporting Directive, whose adoption is expected in Q2 2022, will establish clear and exhaustive sustainability reporting obligations for nearly 50,000 companies in the EU, compared with the current 11,000 companies subject to the previous, less demanding reporting requirements. The new EU sustainability reporting standards will be a “one-stop-shop,” providing companies with a single solution for the information needs of investors and stakeholders.
Also, the EU bank regulator (EBA) and the EU bank supervisor (ECB) are increasing the demands on banks concerning sustainability. On 24 January 2022, the EBA adopted its binding implementing technical standards (ITS) on ESG reporting covering Pillar 3 disclosures: how climate change may exacerbate other risks within institutions’ balance sheets, how institutions are mitigating those risks, and their ratios, including the Green Asset Ratio, on exposures financing Taxonomy-aligned activities and those consistent with the Paris Agreement goals. The EBA’s ITS has built on the Financial Stability Board Task Force on Climate-related Financial Disclosures (FSB-TCFD) recommendations, the European Commission’s non-binding guidelines on climate change reporting, and the EU Taxonomy.
The ECB will apply the EBA’s ITS. Since November 2020 the ECB was already applying supervisory expectations relating to risk management and disclosure. On 27 January 2022, the ECB also launched a supervisory climate risk stress test to assess banks’ preparedness for financial and economic shocks stemming from climate risk. The exercise will be conducted in the first half of 2022 after which the ECB will publish aggregate results.
Finally, the ECB’s fundamental climate-friendly monetary policy is being established. On 8 July 2021 the ECB adopted its action plan to include climate change considerations in its monetary policy strategy, covering, among others: implications of climate change for monetary policy transmission; disclosures as a requirement for eligibility of assets as collateral and for purchase programs; and climate change risks in the collateral and corporate sector asset purchase frameworks. With milestones in 2022 and 2023, the ECB sustainable monetary policy will be finalized in 2024.
UCC Issues for ESG Collateral
Finally, as the market adoption of ESG financial products continues to accelerate and regulatory disclosure standards continue to evolve in the U.S. and globally, practitioners need to confirm certain basic information to ensure that a security interest in any ESG collateral is properly created and perfected under the Uniform Commercial Code. The first consideration is whether the proposed collateral, such as carbon credits, can be made the subject of a security interest under UCC Article 9. ESG collateral is often in the nature of a government benefit. There may be statutory or regulatory limits on the ability of the holder of that benefit to transfer it, including creating a security interest in it. Next, counsel needs to determine how to perfect a security interest in the collateral. Again, statutes or regulations may displace the usual approach under the UCC of filing a financing statement. Finally, they need to examine how the security interest is enforced and whether a secured party or a buyer at a foreclosure sale can make use of the ESG collateral.