While this month’s COP 25 was considered a disappointment (The Economist called it a “cop-out”), here in Europe we have seen significant progress in the last few weeks with regards to climate action.
On 11 December 2019, new European Commission (“EC”) President Ursula von der Leyen laid out the details for her European Green Deal – calling for a massive re-think of the European economic system which would see Europe become the first climate-neutral continent by 2050. Less than a week later, trilateral negotiations on the EU taxonomy concluded with a deal despite a bit of headline ping-pong. And just on Thursday, the German Finance Agency publicly announced its plans to issue Green Bunds and establish a Green Bund yield curve in H2 2020 – a significant milestone in creating a green government benchmark in Europe.
Below we’ve outlined some of the key points from each milestone, as well as some of the potential implications.
European Green Deal: “tackling this generation’s defining task”
In July 2019, EC President nominee Ursula von der Leyen pledged to push through a Green Deal for Europe in her first 100 days, and on 11 December 2019 the European Commission published its roadmap for achieving this plan.
The European Green Deal promises not only a comprehensive transformation of the EU economy but also a strategy for growth. The deal will require significant investment – the Commission estimates EUR260bn+ in additional annual investment (equivalent to 1.5% of 2018 GDP), implying a real opportunity to jumpstart economic growth in Europe.
To ensure the transition to a low carbon economy is irreversible and provides investors the predictability necessary to unlock green investment, the Commission intends to put its 2050 climate neutrality objective into legislation through the first European ‘Climate Law’ (proposed by March 2020). The Commission also plans to strengthen its climate ambition by increasing the EU’s GHG emission reductions target to at least 50% (and towards 55%) by 2030.
Meeting these commitments will require a significant transformation of the economy and society, and as such the Commission intends to review and revise all relevant climate-related policies by June 2021. This review will cover a broad range of policy areas – clean energy, sustainable industry (i.e. circular economy), building and refurbishments, mobility, biodiversity, food systems and pollution – and notably includes a possible extension of the Emissions Trading System (“EU ETS”) to new sectors (e.g. shipping, aviation and buildings).
How will Europe pay for this deal? The Commission intends to introduce a ‘Sustainable Europe Investment Plan’ to meet the EUR260bn+ annual funding gap. The plan involves dedicated financing and an improved enabling network (e.g. via a renewed sustainable finance strategy centred around the EU Taxonomy). In terms of dedicated financing, the EU budget will play a key role, with 25% earmarked for climate mainstreaming; in addition, at least 30% of the InvestEU fund will contribute to combatting climate change; and the Commission also intends to work with the European Investment Bank, which recently launched a new climate strategy designed to unlock EUR1tn trillion of climate action and environmental sustainable investment by 2030.
The Sustainable Europe Investment Plan also includes a Just Transition Mechanism, including a Just Transition Fund, to make sure growth is inclusive and leaves no one behind. The Commission recognises that the transition to a low carbon economy affects regions and sectors differently. As such, the Just Transition Mechanism will focus on protecting countries, citizens and workers most vulnerable to structural changes in the economy, e.g. by providing access to re-skilling programmes, jobs in new economic sectors and energy-efficient housing.
The timeline for this ambitious deal sees significant regulatory and non-regulatory action over the next two years, beginning January 2020. This timeline from FleishmanHillard provides a sense of the extent of the Commission’s ambition and the pace of change expected.
EU Taxonomy
Despite some initial opposition – particularly around the inclusion / exclusion of nuclear energy and gas – the European Parliament, Commission and Council finally reached an agreement on 17 December 2019 on the establishment of a framework to facilitate sustainable investment – the EU Taxonomy. The Taxonomy is considered the centrepiece of the EU’s Sustainable Finance Action Plan and provides a common language for what activities are considered environmentally sustainable. It addresses a number of barriers to sustainable financing such as fragmentation of practices and standards, risks of greenwashing and a lack of clarity on the definition of green products/assets.
Whilst we will not get into the full details of the Taxonomy (a draft technical report is available here), there are five key points worth highlighting:
- The Taxonomy is not just about green bonds – as the Financial Times points out, the “criteria are likely to affect how both bonds and shares are treated by asset managers” with potential implications for asset allocation and capital flows. Large companies will be required to disclose 1) the proportion of revenues aligned with the EU Taxonomy and 2) CAPEX and OPEX aligned with the Taxonomy. Investors will be required to use this data to disclose how their financial products offered in the European Union reference the EU Taxonomy (requirements vary by fund type)
- As noted above, the Taxonomy is the centrepiece of the EU’s Sustainable Finance Action Plan: a number of other initiatives are centred around the Taxonomy, including the EU Green Bond Standard (“EU GBS”), new requirements under the Non-Financial Reporting Directive (“NFRD”) and updates to the EU Benchmark Regulation (“EU BMR”), amongst others
- We expect a greater focus from the buy side on the taxonomy in the next 12-24 months – whilst less than 20% of respondents in our recent ESG Global Investor Survey indicated that they are actively aligning or imminently planning to align their metrics with the EU Taxonomy/EU GBS, a vast majority (c. 70%) indicated that this may change in the future. Last week’s political progress and associated clarity around the timeline for implementation may lead to a more rapid alignment of definitions and metrics at the buy side.
- “Controversial sectors” will be considered at a later date – the decision on whether to include or exclude nuclear and gas has been assigned to technical experts rather than politicians. Solid fossil fuels, however, will be subject to mandatory exclusion
- The Taxonomy is a living document and a work in progress: according to the UN PRI’s Investor Briefing, technical screening criteria will be published and enter force in two stages – criteria for objectives 1 (climate change mitigation) and objective 2 (climate change adaption) will be published by December 2020 and enter force by December 2021, while criteria for objectives 3-6 will be published and implemented one year later (i.e., published December 2021, entering force by December 2022). Within the next two years, the Commission will also review whether the Taxonomy should be extended to cover “neutral activities”, “brown sectors” and social objectives
Lastly, it is worth highlighting that the taxonomy is ambitious. The implications for European financial markets will be significant – beginning 2020.
Green Bunds
The German Finanzagentur (DMO) is joining the Green (Bond) Party. In the second half of 2020, the German Federal Government intends to issue Green Bunds for the first time (press release).
We think that this decision makes a bold statement in support of sustainable finance in the euro area. We will be watching closely to see if the Green Bund curve trades through the conventional Bund curve (as witnessed by KfW), which could have pricing implications for other ‘Green’ issuers – that is, if these Green bonds are priced off a tighter-trading Green Bund, more issuers may be encouraged to take advantage of this market.
Germany is also not expected to be the only sovereign issuer in 2020 (e.g. Sweden, Italy, Spain), and we at NatWest Markets are excited to support the next issuers who join the Green (Bond) Party.
