The HM Treasury’s Roadmap to Sustainable Investing: Overview and Key Considerations for Businesses

On 18 October 2021, the HM Treasury published a policy paper titled “Greening Finance: A Roadmap to Sustainable Investing” (the Roadmap) that sets out the government’s long-term strategy to green the financial sector.

The Roadmap outlines a three-phase strategy to achieve this goal. The first phase is “informing” where sellers of investment products, financial services firms and corporates will be required to report information on sustainability. The second  phase is “action” where this information is mainstreamed into business and financial decisions. The third is the “shift” phase; ensuring financial flows across the economy shift to align with the UK’s net zero commitment.

The Roadmap sets out the government’s strategy to achieve phase 1 through economy-wide Sustainability Disclosure Requirements (SDR), the UK Green Taxonomy and Investor Stewardship. Each of these are outlined below.

1. SDR: what will businesses have to report on?

The SDR’s aim is to combine existing and new sustainability disclosure requirements in one framework for corporates, asset managers / owners and creators of investment products. The framework will be implemented through legislation, with sector-specific requirements being determined by government departments and regulators. The Roadmap emphasises that these new requirements will go further than existing disclosure requirements (such as those required by the Task Force on Climate-Related Financial Disclosures) by requiring reporting on environmental impact. SDR will also go beyond the FCA’s existing ESG framework by requiring asset managers / owners and creators of investment products to substantiate ESG claims in a way that is both comparable and accessible. SDR will also require disclosure with reference to the UK’s Green Taxonomy. Certain firms will have to publish transition plans, detailing how they intend to align with the government’s net zero goal by 2050. 

Certain UK-registered companies and listed issuers, including financial services firms, will need to disclose information about how they identify, assess and manage sustainability factors arising from their global operations in their Annual Reports. Financial services firms that manage or administer money for investors will need to disclose the sustainability-related information that clients and end-consumers need to make informed decisions about their investments. Investment product firms will need to disclose, at product level, the sustainability-related information that consumers need to make informed decisions about their investments.

2. UK Green Taxonomy

The lack of commonly accepted definitions makes it difficult for companies and investors to clearly understand the environmental impact of their decisions and can lead to issues such as greenwashing. To address this, the government is implementing the UK Green Taxonomy (the Taxonomy) that outlines criteria that specific economic activities must meet to be considered environmentally sustainable and “Taxonomy-aligned”.

Reporting against the Taxonomy will form part of SDR. Certain companies will be required to disclose the proportion of their activities that are Taxonomy-aligned. Providers of investment funds and creators of investment products will have to do the same for the assets that they invest in and products they create.

The Taxonomy has six objectives: Climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems. Each of the environmental objectives will be underpinned by a set of standards known as Technical Screening Criteria (TSC). To be considered Taxonomy-aligned, an activity must meet three tests. It must make a substantial contribution to one of the six environmental objectives, do no significant harm to the other objectives (this aims to ensure that activities which support one objective do not have a significant adverse impact on another) and meet a set of minimum safeguards: these are minimum standards for doing business, constituting alignment with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

Although Taxonomy-alignment will be determined by reported data rather than projections, the Taxonomy also recognises companies that are working to meet environmental objectives in the future. For example, due to technological constraints, some economic activities cannot currently be conducted in a way which is aligned with net zero-ambitions. For a number of these activities, the TSCs will set the threshold for Taxonomy alignment at the “best-in-sector” emissions level. These are known as “transitional activities”. Secondly, some companies will report on the proportion of their capital expenditure that is Taxonomy-aligned. This will enable these companies to demonstrate their investment in producing green activities in the future.

3. Investor Stewardship in Green Finance

The Roadmap outlines the government’s expectation that the pensions and investment sectors should seek to integrate ESG considerations into investment decision-making, monitoring and engagement strategies, escalation and collaboration (with other investors) and voting practices. For example, when exercising their shareholder rights,  being ready to vote against directors, corporate actions or other resolutions.

Next Steps

The key dates and developments to look out for are:

  • November 2021 – discussion papers on SDR disclosures, consumer-facing product-level SDR disclosures and the sustainable investment labelling regime
  • Q1 2022 – consultation on two of the environmental objectives under the Taxonomy (climate change mitigation and climate change adaptation)
  • 2022 – consultations on SDR disclosures, consumer-facing product-level SDR disclosures and the sustainable investment labelling regime
  • End of 2022 – legislation on draft TSCs for climate change mitigation and climate change adaptation
  • End of 2022 – government expects pensions and investment sector organisations to have published a high-quality net zero transition plan
  • Q1 2023 – government to consult on expansion of TSCs and standards for remaining four environmental objectives under the Taxonomy
  • End of 2023 – government to assess progress on its expectations for stewardship within the UK pensions and investment sectors

Key Considerations for Businesses

Although companies will have adequate notice before becoming subject to disclosure requirements, in order to be prepared companies are advised to review existing disclosure practices and determine the additional information required to be disclosed and the processes in place for gathering that additional information. Companies are also advised to keep up-to-date with the key consultation and implementation dates outlined above.

If you have any questions about this post, please contact Drew D. Salvest, Natalie A. Stewart, Rebecca Green any of the attorneys in our Banking and Finance Industry Group or the attorney in the firm with whom you in regular contact.

Duane Morris has an active ESG and Sustainability Team to help organizations and individuals plan, respond to, and execute on Sustainability and ESG planning and initiatives within their own space. We would be happy to discussion your proposed project with you. For more information, please contact Brad A. Molotsky, David Amerikaner, Nanette Heide, Darrick Mix, Vijay Bange, Steve Nichol, or the attorney in the firm with whom you are regularly in contact.

Bank of England explores impact of climate change on the UK banking sector

With climate change an increasing political and policy concern, the Bank of England (BoE) is making moves to ensure UK banks and insurers measure and understand their exposure to the risks from climate change and adjust their business models and strategies in response. On 8 June 2021, the BoE published “Climate Biennial Exploratory Scenario: Financial risks from Climate Change” (CBES), identifying climate change as a financial risk with a view to exploring its impact on the banking and insurance sectors. It is the first time an exploratory climate-related stress test of UK banks and insurers has been undertaken.

The Regulatory Agenda

In 2021, banks face a number of regulatory and supervisory deadlines. The UK Prudential Regulatory Authority has set a 2021 deadline for UK banks (and insurers) to have strategies and business models to manage climate risks. The European Central Bank will require banks at the Banking Union to undertake a self-assessment of their compliance with its guidance on climate risks in 2021 before conducting a review in 2022. In the US, the New York State Department of Financial Services has set out climate-related standards for banks under its supervision. Rating agencies are also factoring in climate change to their assessments.

In this post we will provide an overview of the CBES and its implications for banks and borrowers.

CBES

The CBES participants are made up of the largest UK banking groups, building societies and insurers. Participants have until October 2021 to make initial submissions, with the results expected to be published in May 2022. The results will be published on a combined basis to reflect systemic risk.

The CBES is intended to be a learning exercise for both the BoE and participants in measuring climate risks based on different policy pathways that could be taken by the government to achieve its aim of net zero greenhouse gas emissions by 2050. The CBES states the exercise will not be used to set capital requirements, however it may inform future policy.

The three stated aims of the CBES are:

  1. measure the financial exposures of participants to climate-related risks;
  2. understand the challenges to participants’ business models from climate-related risks and the implications; and
  3. assist participants in improving management of climate-related risks.

The CBES asks participants to look at three climate scenarios – early policy action (with transition beginning in 2021), late policy action (where transition begins in 2031) and no additional policy action. Each scenario has different outcomes in terms of global temperatures and the economy over the period 2021-2050, a significantly longer time period than the traditional planning period for financial institutions. Participants will measure the impact of the three different scenarios on their year-end 2020 balance sheets.

Within each scenario, two key risks from climate change are identified. “Transition risks” are risks that arise as the economy moves to net zero emissions, such as carbon taxes and changes in technology, regulation and policy that could create credit exposures for banks and other lenders. UK financial institutions are exposed to a wide range of sectors worldwide, many of which will be affected by climate change and the transition to net zero. In addition, reputational risk could arise from shifting attitudes of customers and other stakeholders towards the UK banks response to climate change.

“Physical risks” are the risks that are likely to occur as a result of climate change if no further policy action is taken by the government, such as extreme weather events and rising sea levels. Physical risks could result in large financial losses, reducing asset values and the value of investments held by banks. Extreme weather events are likely to impact businesses, affecting their ability to repay loans and damaging the value of assets.

Opportunities

There are a range of opportunities that banks, borrowers and other lenders are considering, particularly in the green finance space that we have previously covered in posts here and here. It is likely that banks and borrowers will take advantage of the opportunities which arise in the transition to a greener and more sustainable economy, as illustrated by the inflows to green investment products and the growth in the green and sustainability-linked bond and loan markets. With banks looking at how their business models will be impacted by various climate change policies, borrowers will also need to consider how their business practices may need to change in light of the changes to the financing options that might be available.

If you have any questions about this post, please contact Drew D. Salvest, Natalie A. Stewart, Rebecca Green any of the attorneys in our Banking and Finance Industry Group or the attorney in the firm with whom you in regular contact.

Duane Morris has an active ESG and Sustainability Team to help organizations and individuals plan, respond to, and execute on Sustainability and ESG planning and initiatives within their own space. We would be happy to discussion your proposed project with you. For more information, please contact Brad A. Molotsky, David Amerikaner, Nanette Heide, Darrick Mix, Vijay Bange, Steve Nichol, or the attorney in the firm with whom you are regularly in contact.

Sustainability-Linked Private Placements

In this post we will be looking at sustainability-linked loan principles and their application to a recent sustainability-linked private placement by Trafigura Funding S.A. (“Trafigura”), a subsidiary of Trafigura Group Pte. Ltd., a market leader in the global commodities industry. Trafigura’s private placement of $203.5 million of Senior Guaranteed Sustainability-Linked Notes is believed to be the largest sustainability-linked financing on record in the US Private Placement market to date. Duane Morris previously represented Trafigura in its 2020 private placement of Senior Guaranteed Notes to institutional investors in the United States.

Industry Principles

The two primary sustainability products in the loan market are green loans and sustainability-linked loans. The Loan Syndications and Trading Association (“LSTA”), Loan Market Association (“LMA”) and Asia Pacific Loan Market Association (“APLMA”) originally established standards for these products (called the “Green Loan Principles” (“GLP”) and “Sustainability Linked Loan Principles” (“SLLP”)) in 2018 and 2019 respectively. On 5 May 2020 the LSTA, LMA and APLMA published guidelines that outline considerations for the market in structuring such transactions, as detailed in our alert here.

The key element of a green loan is that the proceeds are used for “green” purposes. A sustainability-linked loan can be any type of debt financing where a company is economically incentivized to achieve sustainability objectives. Unlike a green loan, the proceeds of a sustainability-linked loan can be used for general corporate purposes. The objectives are measured using sustainability performance targets (“SPTs”) that include key performance indicators (“KPIs”) and other metrics to measure improvement. The SLLP guidelines provide examples of SPTs with categories including energy efficiency, greenhouse gas emissions, renewable energy, water consumption and biodiversity.

The GLP and SLLP guidelines are increasingly being applied more widely than the loan market, with private placement issuers utilizing the guidelines for green or sustainable private placements. These products are not only intended for “green” companies; any company can access the green or sustainability loan market provided the transaction is structured in the right way. This means a broad range of industries can utilize the guidelines in a transaction provided there is an appropriate commitment to green projects or sustainability objectives.

Components of a Sustainability-Linked Private Placement

The SLLP guidelines outline four components of a sustainability-linked transaction that we will illustrate the practical application of with reference to the recent sustainability-linked private placement by Trafigura. These components are:

1. Relationship to the company’s overall sustainability strategy
2. Target Setting
3. Reporting
4. Review

1. Relationship to the Company’s Overall Sustainability Strategy

As sustainability-linked private placements are intended to improve a company’s existing sustainability strategy, there needs to be 1) a sustainability strategy in place and 2) a link between the sustainability strategy and the SPTs the company is seeking to achieve. Trafigura selected three KPIs in relation to its operations: reducing greenhouse gas emissions, developing its renewable energy portfolio and bringing its procurement program in line with international sustainability standards.

The SLLT guidelines also encourage companies to disclose sustainability standards or certifications to which they are seeking to conform. For example, Trafigura outlined its intention for full alignment of the business with the ISO standard 20400:2017, an international standard for sustainable procurement.

2. Target Setting

The SPTs need to be “ambitious and meaningful” to the company’s business. For Trafigura, the KPI for reducing greenhouse gas emissions is the same target as set in the company’s sustainability-linked revolving credit facility that closed earlier this year. This KPI will measure Trafigura’s performance in reducing scope one and two emissions by 30% by 2023 (compared to 2020 levels) as set out in its 2020 Responsibility Report.

The SLLP guidelines suggest SPTs should be determined using internal or external specialists so that they are “fit for purpose” with respect to the company’s business and industry. In order to set the KPI aligning Trafigura’s procurement program with international standards, an independent sustainability verifier, ERM Certification and Verification Services (“ERM CVS”), conducted a gap assessment of Trafigura’s management system framework against the ISO standards.

The SPTs and calculation methodologies are communicated between the company and the investors. Price incentives are linked to the performance of the company in achieving the pre-determined SPTs. These price incentives could be an upwards interest rate adjustment if an SPT is not met, an downward interest rate adjustment if SPTs are met, or a two-way pricing structure utilizing upward and downward interest rate adjustments depending on performance.

The Trafigura sustainability-linked private placement is structured with only an upward interest rate adjustment if an SPT is not met. The interest rate adjustment is structured in this way to work around any potential ERISA Final Rule issue, as a downwards adjustment in interest rate based on meeting the targets could be interpreted as a sacrifice of return on investment for a non-pecuniary goal. Although the Department of Labor has subsequently issued a notice it will not enforce the Final Rule, until further guidance is published an ERISA fiduciary must only consider pecuniary factors when making investments.

3. Reporting

A company will need to report up-to-date data in relation to SPTs. The SLLP guidelines suggest reporting should be on an annual basis at a minimum. Companies and investors may seek external opinions and reports with respect to methodologies and assumptions used in reporting.

In Trafigura, ERM CVS will undertake an assessment of the KPI performance on the relevant assessment date each year. The results will form the basis of the KPI report, produced and verified by ERM CVS which details performance with respect to the SPTs. The report is attached to a compliance certificate signed by Trafigura and delivered to the investors each year, stating whether SPTs have been achieved for that period.

4. Review

The SLLP guidelines suggest external review and verification is to be negotiated on a transaction by transaction basis between the company and the investors. External review is strongly recommended where information regarding SPTs is not publicly available. The SLLP guidelines strongly recommend verification by an auditor, environmental consultant or rating agency. Trafigura engaged ERM CVS to review and report on KPIs and SPT compliance for each relevant period.

Although sustainability-linked products originate in the loan market, particularly among European lenders, interest from issuers and investors in the capital markets is increasing as ESG issues move back up the public agenda as the impact of COVID-19 begins to recede. Moreover, application of the SLLP guidelines allow issuers across a broad range of industries to access capital from investors who are demonstrating growing support for businesses that incorporate sustainability into their business operations. Trafigura’s recent US private placement is an indication that US institutional investors are also supporting issuers committing to sustainability targets.

If you have any questions about this post, please contact Drew D. Salvest, Natalie A. Stewart, Rebecca Green any of the attorneys in our Banking and Finance Industry Group or the attorney in the firm with whom you in regular contact.