UK: ESG and debt capital markets

FCA seeks views on ESG topics in capital markets

On 22 June 2021, the FCA published two consultation papers with proposals to extend reporting in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) to:

• issuers of standard listed equity shares; and
• asset managers, life insurers, FCA-regulated pension providers.

For more details on these proposals, see our blog posts here and here.

This forms part of the UK’s ambition to roll out mandatory TCFD reporting across the economy by 2025, with most of the measures expected to be introduced by 2023 (see here).

Why is this relevant for the debt capital markets?

The paper on extending TCFD reporting to issuers of standard listed equity shares includes a discussion chapter seeking views on certain ESG topics in capital markets

The FCA is focusing on the following topics:

• Issues related to Green, Social and Sustainable (GSS) labelled debt instruments, including (i) the prospectus and “use of proceeds” (UoP) bond frameworks and (ii) the role of verifiers and second party opinion (SPO) providers; and
• ESG data and ratings providers.

The FCA is not proposing current rule changes in this area but is seeking feedback from stakeholders on potential harms and possible future policy intervention.

Views sought on prospectus disclosure and contractual commitments

Traditional GSS bonds have been structured as UoP bonds. The structure of these bonds, and terms and conditions, are the same as any other bond save that the proceeds are intended to be applied by the issuer to finance or refinance green or social, or a combination of both green and social, projects as described in a green, social or sustainable bond framework established by the issuer. The intended use of proceeds is described in the prospectus alongside typically a brief description of the bond framework and eligible projects, and a link to/or details of where to find the framework. Failure by an issuer to use the proceeds as disclosed in the prospectus and in accordance with the issuer’s framework is not an event of default under the terms of the bonds. This is aligned with the now well-established, voluntary ICMA Green, Social or Sustainable Bond Principles which are followed by a significant part of the market.

The FCA notes that whilst these products are marketed as GSS bonds, there may be a disconnect between the disclosure and the information in the bond framework and a lack of corresponding contractual terms.

Views are sought on whether future changes to the UK prospectus regime should incorporate specific requirements in relation to UoP bond frameworks and their sustainability frameworks. The paper also asks whether the FCA should explore supporting the UoP bond market by recognising existing standards such as the ICMA Principles. Finally, the FCA is soliciting feedback on whether more significant measures should be considered such as requiring the central elements of UoP bonds to be reflected in contractual agreements and set out in the prospectus.

In this regard it is worth noting there is potential for UoP instruments to become more attractive given incoming reporting obligations for EU credit institutions under the EU Taxonomy and the development of the EU Green Bond Standard which aligns to the Taxonomy.

Oversight of verifiers and SPO providers

Investors in the GSS UoP bond market rely upon SPO providers and verifiers to provide independent assurance that the intended use of proceeds is aligned to market practice, or for example the relevant ICMA Principles, based upon the issuer’s framework.

Sustainability-Linked Bonds (SLBs) are a more recent innovation in the bond market (supported by the Sustainability-Linked Bond Principles). An SLB is a bond where the financial and/or structural characteristics can vary depending upon whether the issuer achieves predefined sustainability performance targets (SPTs) based upon key performance indicators (KPIs). This is built into the bond terms and conditions themselves. The most common structure currently used is where the coupon payable by the issuer increases if the issuer fails to meet one or more SPTs. As with a UoP bond, the issuer has a framework in place and an initial opinion on the framework is given by an SPO provider. In addition, an SPO provider or verifier provides regular verification and reporting on the issuer’s performance against the SPT(s), supporting the determination as to whether an SPT has been met and therefore whether the coupon step up is applicable.

The FCA considers that the role of verifiers and SPO providers needs to be carefully considered. These entities are currently outside of the FCA’s regulatory perimeter and there is a lack of transparency on the methodology used to support their opinions. The FCA also notes a risk of conflict of interest given that the issuer pays for the opinions relied upon by investors.

The FCA acknowledges the proposal in the EU for the Green Bond Standard, where bonds labelled as EU Green Bonds will require SPO providers and verifiers to be overseen by ESMA and asks whether a UK “green” bond standard should be developed.

ESG data providers

Finally, the CP includes a discussion of the role of ESG data providers, and in particular ESG ratings providers, given the increasingly important role they play in the capital markets and allocation of investment. Potential concerns in relation to the role of the, largely unregulated, ESG ratings providers are not new, with issues having been identified by a number of other regulators including the French AMF and Dutch AFM (in a joint position paper), and ESMA in recent months.

Concerns relate to diverse methodologies, lack of transparency and comparability, consolidation in the market and potential conflicts of interest. Comparison has been drawn with credit rating agencies which have been subject to increased regulation in many jurisdictions since the financial crisis. ESG ratings, however, provide different challenges, and to illustrate this the FCA provides a side-by-side comparison of policy issues and underlying problems for credit rating agencies vs ESG ratings providers.

The potential harm to market functioning identified by the FCA in relation to ESG data goes beyond the ESG ratings provision and the potential for investors in debt securities to be misled, and a number of different policy actions are proposed for consideration.

Next steps

The consultation is open until 10 September 2021 and feedback to the consultation proposals will be considered with a view to publishing a Policy Statement with the finalised rules by the end of 2021.

In relation to the debt capital markets aspects and questions on ESG data providers contained in the discussion chapter described above, the FCA expects to issue a Feedback Statement on responses separately. The feedback received will inform its further work in this area.