ESG and sustainable finance update: how to manage greenwashing risks in green and sustainability-linked loans and bonds

NL Law

With green, sustainable and sustainability-linked debt funding on the rise, how do financial market participants steer clear of greenwashing risks when they provide or attract such debt funding? The European supervisory authorities for the financial markets have published reports on greenwashing risks, and financial industry associations LMA and ICMA have published various updates and recommendations regarding their ESG principles and guidelines for loans and bonds, including the long-awaited draft provisions for Sustainability-Linked Loans.

Greenwashing reports

The European Banking Authority (EBA) published its progress report on greenwashing monitoring and supervision on 31 May 2023. The report is the outcome of a consultation with financial market participants and reports on various greenwashing risks. The report identifies high-risk areas within the banking sector that are exposed to risks of greenwashing and suggests preliminary remedy actions in this respect. The European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) have also published similar reports on greenwashing.

Defining ‘greenwashing’

The EBA report provides a high-level understanding of the term ‘greenwashing’. While the EBA uses references to greenwashing as currently presented in the EU regulatory framework as a starting point, these references no longer cover all potential forms of greenwashing under the ESA's respective remits. The EBA has therefore formulated a new definition of ‘greenwashing’:

"A practice whereby sustainability-related statements, declarations, actions or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product or financial services. This practice may be misleading to consumers, investors or other market participants."

In addition, the EBA has identified core characteristics of greenwashing and cases in which information/statements are deemed to be misleading, notably the omission of information or the mislabelling or misclassification of financial products as 'green'.

Examples of greenwashing

To illustrate these core characteristics, the report provides examples of greenwashing with respect to several areas within its remit, including corporate lending and bonds. The corporate lending examples of greenwashing mainly relate to sustainability-linked loans. Examples are:

  • sustainability-linked loans that are presented as having real-world impact while the borrower’s business is not necessarily able to provide such real impact (for instance due to the size of the borrower’s business); and
  • sustainability-linked loans that include contractual provisions that provide for an upside only (i.e. a reduction of the margin) and do not provide for a downside (i.e. a penalty) if targets are not met.

Examples of greenwashing with respect to bonds are similar:

  • If the key performance indications (KPIs) set out in the bonds relate to something the issuer would achieve anyway, or if the KPIs relate to only a tiny portion of the issuer’s CO2 emissions, this is insufficient for the bonds to qualify as sustainability-linked bonds. This also appears to apply to sustainability-linked loans.
  • Marketing bonds as green without ensuring that the proceeds are fully used towards a green project or green collateral.
  • Misleading references to an ESG bond label.

The European Securities and Markets Authority (ESMA) also identifies greenwashing examples with respect to sustainability-linked bonds and green bonds in its progress report on greenwashing:

  • Misleading claims about real-world impact in relation to sustainability-linked bonds or green bonds as a greenwashing risk. The ESMA finds that the main issues with respect to impact claims stem from the fact that there are currently no rules in the EU sustainable finance framework for the use of terms such as ‘impact’, ‘impact investing’ or other impact-related terms. Some of the most frequent misleading claims relate to exaggeration based on an unproven causal link between an ESG metric and real-world impact.
  • The omission or lack of clearly outlined date limitations or disclaimers with respect to environmental or social characteristics or objectives of the bond.
  • Selective disclosure or hidden trade-off (cherry-picking). Clear substantiation of sustainability profiles is required to ensure that disclosure is fair, clear and not misleading.

The EBA report and the examples of greenwashing are aligned with the various ESG principles (such as the LMA Green Loan and Sustainability-Linked Loan Principles and the ICMA Green Bond and Sustainability-Linked Bond Principles) that are considered market practice in the loan and bond markets.

The EBA is expected to publish its final greenwashing report in May 2024, which will include final recommendations on limiting greenwashing, potentially through changes to the EU regulatory framework. In the meantime, the current report provides financial market parties with tools to address and mitigate greenwashing.

The EBA progress report on greenwashing monitoring and supervision can be found here.

Provisions for Sustainability-Linked Loans

The Loan Market Association (LMA) published the long-awaited standard draft model provisions for Sustainability-Linked Loans (SLLs) on 4 May 2023. The SSL provisions aim to provide a starting point for the drafting of SSLs, while leaving room for parties to include customized features specific to their transactions. The SSL provisions therefore contain various square bracketed options, which may be deleted or included depending on deal-specific requirements and the negotiated position. The SSLs also provide for a template Sustainability Compliance Certificate and a KPI schedule. Like the SSL Principle and SSL Principle Guidance, the SSL provisions are non-binding and are non-prescribed model recommendations. Whilst the market practice for SSLs is ever-changing, the expectation is that these provisions will become a market standard in the SSL market.

The SSL provisions are designed as an add-on to the various LMA facilities agreements and easily fit into these agreements. One of the key features of the SSL Principles is that a breach of the provisions does not result in an Event of Default, but rather in an adjustment of the margin. The draft SSL provisions therefore include a ‘Sustainable Margin Adjustment’ mechanism based on which the pricing of the loan is adjusted depending on the borrower's performance, which is measured based on KPIs, Sustainability Performance Targets (SPTs) and published ESG standards/ratings. Such adjustment may include a reduction of the margin if certain SPTs are achieved. In the event of a breach, however, such a margin reduction will not be applied, or a margin increase may be imposed. Considering the EBA report on greenwashing risks, the option that a margin reduction is lost, without a margin increase being applied, could be considered indicative of a greenwashing risk.

In addition, the draft SSL provisions provide for a declassification of a loan as sustainability-linked by the lenders if the SSL provisions are breached and good-faith negotiations between parties have not resulted in amendments to the previously agreed KPIs or SPTs or to calculation methods (a declassification event). The LMA also specifically states that parties may consider additional declassification event in the context of the relevant KPIs and SPTs. Following a declassification event, the borrower may no longer disclose or refer to the loan as sustainability-linked, and all sustainability-linked provisions will cease to apply.

Although the draft provisions will provide parties with a practical framework for SSLs, there are a couple of points that parties should consider when negotiating the SSL provisions. 

  • Sustainability information – The definition of ‘Sustainability Information’ is limited to information provided in relation to the Sustainability Compliance Certificate, KPIs or SPTs and the calculation/verification methods. Although the SSL Principle Guidance states that KPIs should be consistent with a borrower's overarching sustainability strategy (assuming that the borrower has a sustainability strategy), this is not a hard requirement. As such, it does not necessarily enable lenders to request sustainability information that they may require in a broader context. The upcoming EU ESG legislation by the European Committee, including the Corporate Sustainability Reporting Directive (CSRD), for instance, will impose further reporting obligations, among other things. As a result, lenders may therefore require additional information from borrowers for reasons of their own compliance with CSRD and other ESG legislation, such as the overall ESG strategy and the borrower’s energy transition plan. Although the footnote in the draft SSL provisions states that parties should ensure that the definition of ‘Sustainability Information’ includes all information for ensuring ongoing observation of the SPTs and KPIs and compliance with the SSL Principles in general (and the respective LMA facility agreement may also include a general information undertaking), lenders could consider extending this definition to include information required for their own reporting under CSRD or other applicable regulatory legislation, or to include a separate information obligation in this respect.
  • ‘No misleading information’ representation – The SSL provisions include a representation that all sustainability information provided by the borrower is true, complete and accurate in all material aspects and is not misleading. Although this representation is a repeating representation, it is made only on the date of a Sustainability Compliance Certificate and is not made on interest payment dates or draw down dates. Lenders could therefore consider including this representation as a (full) repeating representation.

The LMA also recently published minor updates to its existing ESG guidance for documentation to further align the guidance with the Green, Social and Sustainability-Linked Loan Principles, which were recently updated by the LMA in February 2023.

Practical recommendations for High Yield Sustainability-Linked Bonds

Given the steady increase of issuance of high yield sustainability-linked bonds (SLBs) by borrowers, the International Capital Market Association (ICMA) has teamed up with the European Leveraged Finance Association (ELFA) to provide a set of practical recommendations in order to maintain a robust set of standards for high yield SLBs. The recommendations aim to provide practical guidance on applying the Sustainability-Linked Bond Principles to high yield SLBs, given its unique characteristics.

There are ten recommendations that are split between different areas: bond characteristics, disclosures, targets and reporting. A high-level summary of the recommendations per area is set out below.

  • Bond characteristics – Issuers are encouraged to demonstrate the ‘commensurate and meaningful nature’ behind the choices made in terms of (i) the variation of the financial and structural characteristics of the bond; (ii) the funding and how the funding needs relate to the achievement of selected SPTs; and (iii) integration of call prices.
  • Disclosure – In order to increase transparency to investors, issuers are encouraged to use publicly available sustainability strategies for purposes of selection of KPIs and to disclose broader ESG data, demonstrating the issuer's commitment to ESG, in line with applicable regulatory standards and guidance. The recommendation also applies to issuers that are not subject to mandatory ESG reporting standards, in order to support investors' analysis of SPTs. 
  • Targets – A key difference between investment grade bonds and high yield bonds is the generally shorter tenor and redemption schedule. It is therefore recommended that issuers set the SPT milestones before the call date/expiry of the redemption schedule. Issuers are also encouraged to seek external verification of interim targets where feasible, in addition to long term targets.
  • Reporting – High yield bonds should include a contractual obligation to report on and provide up-to-date information on the performance of selected KPIs, and should include a trigger event in case of lack of reporting. Issuers are furthermore encouraged to publicly present the reporting in quarterly/annual investor presentations.

The ICMA practical recommendations can be found here.

Please do not hesitate to contact the Stibbe Banking & Finance team if you have any questions on these or other matters.

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