Green bonds and blockchain
How technology may help navigate the increasingly complex world of sustainability regulation
Kandidatnummer: 528 Leveringsfrist: 25.11.20 Antall ord: 15 140
i Contents
1 INTRODUCTION ... 1
1.1 Setting the scene ... 1
1.2 Methodological challenges ... 3
1.3 Outline ... 3
2 SUSTAINABLE FINANCE – THE CURRENT REGULATORY LANDSCAPE .. 4
2.1 General regulatory efforts to support sustainable finance ... 4
2.1.1 EU Green Deal ... 4
2.1.2 EU Action Plan on Sustainable Finance ... 5
2.1.3 EU Taxonomy ... 6
2.2 Disclosure and reporting ... 7
2.3 EU Green Bond Standard ... 9
2.4 Summary – current state of sustainability reporting ... 12
3 TOKENISED GREEN BONDS ... 14
3.1 The case for tokenisation ... 14
3.2 Using smart contracts to prove Taxonomy alignment ... 15
3.3 Regulatory implications of tokenisation ... 18
3.4 Risks of using DLT ... 19
4 USE OF DLT TO ENHANCE REPORTING AND VERIFICATION ... 21
5 THE CHALLENGE OF REGULATING INNOVATION ... 25
6 CONCLUSION ... 28
7 BIBLIOGRAPHY ... 30
1 1 Introduction
1.1 Setting the scene
Even as the world is reeling from the effects of the current Covid-19 pandemic, there can be little doubt that we are facing another challenge with potentially even more far-reaching detri- mental effects, namely climate change.1 In 2015, parties to the United Nations Framework Convention on Climate Change (UNFCCC) therefore agreed to strengthening their efforts against climate change by signing the Paris Agreement.2 This followed on the heels of the cre- ation of the UN Sustainability Goals, which were adopted by all UN Member States in 2015.3 The main goal of the Paris agreement is to keep the global temperature rise well below 2 de- grees Celsius above pre-industrial levels.4 This will necessitate a hitherto unprecedented re- duction in emissions over the coming decades.5 In order to achieve these ambitious aims, the parties to the Paris Agreement must employ a wide range of tools across all sectors. The fi- nancial sector will play a vital role in helping to fund the necessary changes by diverting pri- vate capital to green projects, in order to close what has been called the “green finance gap”.6 The EU is therefore working to encourage financial players to invest in sustainable activities and to make it easier for investors to choose products that will contribute to the transition to a carbon neutral society.
Perhaps in response to the increasing awareness of climate change issues, the recent years have seen a growing trend of companies seeking to limit their environmental impact, contrib- ute to equality and show their green and social credentials.7 Often referred to as Environmen- tal, Social and Governance (ESG), this trend coincides with, and is probably caused in part by, a shift in consumer expectations. Consumers increasingly demand more transparency and greater awareness of broader societal issues from the companies whose products and services they buy. This also applies to financial products, and sustainable or socially responsible in- vesting is on the rise. The Covid-19 pandemic seems to have accelerated this movement, with investors injecting “record sums into sustainable investment funds”.8
A common concern regarding green investments is the risk of so-called greenwashing. The European Commission defines greenwashing as “the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact basic environmental standards have not been met.”9 In other words, companies may be tempted to
1 Rockström et. al. have created a framework based on planetary boundaries in order to measure how far human activities have pushed the limits of the earth. According to their research we have already crossed at least three of these boundaries, including climate change. Rockström et. al. (2009), p. 473.
2 Norway’s commitment to achieving the goals of the Paris Agreement is set out in the Climate Change Act, which states that greenhouse gas emissions will be reduced by at least 40% by 2030, and that Norway will become a low-emission society by 2050.
3 United Nations (undated)
4 United Nations Framework Convention on Climate Change (undated)
5 The Economist states that emissions must be reduced by 90% from current levels over the next 30 years. Scriven (2020)
6 D’Orazio and Popoyan (2019), p. 25. The authors have argued that there is an inherent “carbon bias” in current investment strategies, accounting frameworks and financial regulatory schemes.
7 Kell (2018)
8 Riding (2020)
9 EU 2020/852, recital 11.
2
label themselves or their products as “green”, in order to attract customers or investors.10 The sheer number of different label or certification schemes in itself attests to the marketing ef- fects of being associated with sustainability.11
When it comes to green bonds, it may be useful to differentiate between two kinds of green- washing. The first kind occurs if the company or entity issuing the green bond is itself deeply involved in non-sustainable activities. This is for instance why Teekay Shuttle Tankers were accused of greenwashing when the group issued a green bond in 2019. While the project’s aim of transitioning the fleet to use clean energy was in itself green enough, the fact that the ships would still carry oil and thereby contribute to the continued use of fossil fuels did not sit well with the public.12 It should be possible to remedy this issue through regulatory means by defining what exactly constitutes a green investment, activity or product. Until recently, this was not the case for companies wishing to either issue, or invest in, sustainable financial prod- ucts. Consequently, many businesses cited the lack of common standards as one of the main reasons they hesitate to participate in the green market.13 Much is left up to the regulated enti- ties themselves, which may result in divergent practices and lack of comparable data. The EU has responded to this need for standardisation with the Taxonomy Regulation14, which estab- lishes criteria for determining whether economic activities are environmentally sustainable.
Other regulatory instruments, like the proposed EU Green Bond Standard15, build on the defi- nitions of the Taxonomy, and allow issuers to show their projects’ alignment with the Taxon- omy.
A second kind of greenwashing happens if the project funded by the green bond does not de- liver on the promises made when it was issued, as illustrated by the case of Texcoco airport.
In 2015, construction began on a new international airport in Texcoco outside Mexico City, featuring, among other things, more energy-efficient airport buildings. The construction pro- ject was funded in part by $6 billion worth of green bonds issued by Mexico City Airport Trust. At the time of issuance, the bonds fulfilled all the requirements of internationally rec- ognised Green Bond Principles, and included approving opinions and evaluations from rating agencies and external verifiers. All seemed to be going well until the newly elected Mexican government decided to scrap the project in 2018, citing an unfavourable public referendum as the reason for the decision. This leaves the question of what happens to the green bond if the underlying project fails or if it turns out to be less green that was initially indicated.16 The ex- ample of the Texcoco airport highlights the need for on-going verification to ensure that “a green bond remains a green bond until the end of its maturity and that issuers’ reporting about the developments of their green projects is in fact true.”17 It is difficult to see how this
10 The Economist (2020a)
11 The website Ecolabel Index currently monitors no less than 456 ecolabels in 199 countries. See http://www.eco- labelindex.com/
12 Nauman (2019)
13 According to a survey carried out by the TCFD, 42% of companies see the lack of standardized metrics as a challenge in implementing the TCFD recommendations. See TCFD (2019)
14 EU 2020/852
15 In TEG GBS (2019)
16 In this case, the rating agencies lowered their green bond assessments or withdrew their reports. See Krebbers (2019). However, according to The Financial Times, the bond is still on the market. See Stubbington and Nauman, 2020.
17 Krebbers (2019)
3
problem could be countered through regulatory means alone. This thesis therefore seeks to an- swer the question: could this problem be solved with the aid of technology?
Greenwashing may not only result in reputational damage for the company in question, but also in the loss of credibility for the industry as a whole.18 It is therefore of vital importance that green products labelled as such really do live up to their promise. While both the problem of greenwashing and the lack of trust in sustainability disclosures are currently sought tackled through regulatory efforts, my thesis will argue that such efforts are likely not going to be enough unless the companies also find a practical way of dealing with the growing compli- ance demands that often follow increased regulatory scrutiny. It has been argued that the im- plementation of the GDPR placed a disproportionately large compliance burden on small and medium sized enterprises,19 and it seems probable that this might become the case for sustain- ability-related legislation also. In order to avoid “sustainability reporting fatigue” and related issues, technology might be used as a tool to operationalize the ambitious goals of the Paris Agreement and the EU Green Deal. The main argument of this thesis then, is that technology and regulation both have important, and complementary, roles to play in limiting greenwash- ing and promoting sustainable finance.
1.2 Methodological challenges
One methodological challenge in choosing this topic for my thesis is that there is relatively little research available on the relationship between technology and sustainable finance in general, let alone on its use in conjunction with green bonds specifically. This scarcity of di- rectly relevant sources therefore informs my choice of the inductive approach as a research method. The inductive approach is characterised by the fact that it incorporates data and input from a variety of sources and uses these to look for patterns and trends. Instead of starting with a general theory and then testing this theory on specific cases, the inductive style of rea- soning often moves from the particular to the general. I have chosen to draw upon sources that deal with similar issues in different contexts and examining whether these would also apply to the scenarios I wished to explore. A possible drawback in using this method is that it does not necessarily produce any hard and fast results or answers. However, I think it lends itself well to research like that of this thesis, where the topic of study is relatively new and constantly evolving, thus in many ways presenting a moving target. In such cases it is often difficult to draw decisive conclusions or to make confident assertions to start with.
1.3 Outline
Chapter 2 provides an overview of the current regulatory landscape as it concerns sustainable finance, focusing on the EU, while also accounting for some of the more important interna- tional, non-governmental standards and recommendations. Chapter 3 introduces the technol- ogy available and outlines how it may be used to operationalise regulatory requirements by focusing on green bonds as a test case. Chapter 4 explores another, related, use case of block- chain technology in enhancing the transparency and efficiency of sustainability and impact reporting. Chapter 5 takes a step back and looks at the broader role of regulation in relation to innovation in general, and how this may come to bear on innovative uses of technology in green finance specifically.
18 TEG GBS (2019), p. 21.
19 Espinoza (2020)
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2 Sustainable finance – the current regulatory landscape Before the financial crisis of 2007-08, financial regulation was mainly concerned with trans- actional protection: interventions by public regulation in order to correct certain market failures such as information asymmetry or the agency problem.20 After the financial crisis, the objectives shifted to include a greater emphasis on financial stability.21 Post-crisis reforms have generally allowed for more regulatory prescription, intervention, and enforcement.22 Fi- nancial stability has increasingly come to be seen as a public good, which in turn warrants greater regulatory oversight. Some argue that the challenges posed by climate change are also a threat to financial stability, and as such they must be included in the regulatory frame- works.23 The recent shift towards including climate risk in reporting requirements could be seen as a response to this fear.24
The following overview does not intend to cover all existing regulatory and non-regulatory initiatives in the sustainable finance sector, as that would go beyond the scope of this thesis. I have chosen to focus on the EU, as any new legislation in this area will most likely be consid- ered relevant for the EEA and thereby for Norway. The EU is seeing a high level of activity in the sustainable finance sector at the moment, with many new developments on the way.
2.1 General regulatory efforts to support sustainable finance 2.1.1 EU Green Deal
The EU Green Deal, presented in December 2019, proposes to make Europe the first climate- neutral continent by 2050.25 In order to achieve this ambitious goal, the EU economy must be- come sustainable, which entails a shift to clean energy. The Green Deal will see changes to all areas of the economy, including the energy sector, public transport, buildings, investments and industry innovation.26 In order to enforce these changes, the EU is relying on regulation.
To this end, the European Commission has proposed a new EU Climate Law, in the form of a Regulation detailing the EU's political commitment to be climate neutral by 2050,27 in addi- tion to a number of other regulatory instruments and policy initiatives supporting the Green Deal.28
The Financial Times calls the Green Deal a “serious shift in European policy”, likening it to the Common Agricultural Policy of the 1960s.29 There are bound to be challenges when im- plementing such far-reaching changes. As the reforms are highly centralised, the move to- wards a sustainable economy will likely encounter and possibly exacerbate the inherent
20 Andenæs and Chiu (2014), p. 4.
21 Andenæs and Chiu (2014), p. 18.
22 For instance, the fourth Capital Requirements Directive which implements the Basel III reforms, the Markets in Financial Instruments Directive (MiFID) and the Alternative Investment Fund Managers Directive (AIFMD).
23 Carney (2015); Dafermos (2018), p. 219; D’Orazio and Popoyan (2019), p. 26.
24 Carney (2015); Ilhan et. al. (2020), p. 1.
25 COM(2019) 640, p. 2.
26 COM(2019) 640, pp. 6-12.
27 COM(2020) 80
28 Among these are the EU Taxonomy Regulation, the Action Plan on Financing Sustainable Growth, the Circular Economy Action Plan, the EU Biodiversity Strategy, the Sustainable Finance Disclosure Regulation (Regula- tion EU/2019/2088).
29 Butler (2020)
5
differences in attitudes and use of resources between various Member States. Some are more dependent on fossil fuel and non-renewable resources than others and will therefore probably be more resistant to a transition to clean energy. This is especially apparent in the Eastern Eu- ropean coal market.30
Anticipating this issue, the EU has introduced the “Just Transition Mechanism”, which aims to offer financial support to the regions and industries most adversely affected by the green deal changes.31 There is however a concern that this will not be enough, and that the transition will suffer from a lack of funds. Most of the funding for the Just Transition Mechanism is di- verted from social and regional development funds, so that only 7.5bn Euro of the promised 100 bn Euro is actually new money.32 The JTM is part of the European Green Deal Invest- ment Plan, which will mobilise at least 1 trillion Euro for the transition. The plan also in- cludes Invest EU, through which the European Investment Bank (EIB) works to achieve a higher degree of cooperation between the public and private sector.33
Despite these efforts by the EU to secure funding for the Green Deal, private capital is needed if the goal of a sustainable future is to be achieved. It is therefore essential that as a comple- ment to public money, private investors are encouraged to invest in projects that support “the transition to a climate-neutral, climate-resilient, resource-efficient and just economy.”34 The Sustainable Finance Action Plan plays a key role in this effort.
In addition to proposing specific regulatory instruments designed to support the Green Deal, the EU has also incorporated sustainability objectives into existing financial regulation. The worry is that investment firms are not taking sustainability factors into account in their selec- tion processes. Proposed changes to the Markets in Financial Instruments Directive (MiFID II) and the Alternative Investment Fund Managers Directive (AIMFD) are meant to remedy this. In essence, the amendments mean that those offering financial and investment advice must take environmental and sustainability factors into account when assessing the investment profile of their clients.
2.1.2 EU Action Plan on Sustainable Finance
The action plan on financing sustainable growth was adopted by the European Commission in 2018 and is based on the recommendations of the high-level expert group on sustainable fi- nance (HLEG). The action plan contains ten key actions divided into three main categories:
reorienting capital flows towards a more sustainable economy, mainstreaming sustainability into risk management, and fostering transparency and long-termism.35 Some of the actions are meant to result in specific legislation, while others are less tangible and function more like recommendations or overarching goals. Commentators have lauded the recommendations as being “the most far-reaching attempt to use law to embed sustainability within the decision- making processes of companies and institutional investors.”36
30 Butler (2020)
31 COM(2020) 22
32 Butler (2020)
33 COM(2020) 21, p. 1-2.
34 European Commission, “Overview of sustainable finance”.
35 COM (2018) 97
36 Sjåfjell and Johnston (2019), p. 13.
6
The action plan in itself is not a binding legal instrument, but the Commission has adopted a package of measures implementing several of the key points of the action plan.37 Perhaps the most important of these is the EU Taxonomy, which is discussed below in more detail. There is also the regulation on sustainability-related disclosures (SFDR) 38, the newly amended cli- mate benchmark regulation39, and a proposal for a new EU Green Bond Standard (see below).
Of the new delegated acts, only the climate benchmarks regulation has so far been incorpo- rated into Norwegian law, following its incorporation into the EEA Agreement on 7 February 2020. The SFDR is currently not incorporated into the EEA Agreement or Norwegian law, but the Ministry of Finance is currently preparing for its incorporation via a new legislative act on sustainability disclosures (lov om opplysninger om bærekraft).40
In order to support its work on the action plan the Commission formed the Technical Expert Group on sustainable finance (TEG) in July 2018. The TEG has published several reports and guides containing technical screening criteria and details on how to use the new regulatory in- struments. The work of the TEG will officially be over in September 2020, and further devel- opment of the Taxonomy and related instruments will be carried out by a new advisory body:
the Platform on Sustainable Finance.41
The Commission recently announced a renewed sustainable finance strategy which will align with the objectives of the Green Deal, while also taking in the context of recovery from the impact of the COVID-19 pandemic. Consultations for the renewed strategy closed on 15 July 2020.42
2.1.3 EU Taxonomy
The Taxonomy Regulation (EU 2020/852) entered into force on 12 July 2020. The Taxonomy is marked as EEA relevant, and is currently being considered for incorporation into the EEA Agreement by Iceland, Norway and Lichtenstein.43 The Norwegian Ministry of Finance and the Financial Supervisory Authority of Norway is currently asking for feedback on a proposal on the incorporation of the Taxonomy via a new legislative act on sustainability disclosures.44 The taxonomy applies to financial market participants that make available financial products, actors who are required to publish a non-financial statement and to Member States in public procurement proceedings.45
The aim of the regulation is to create a common system of classification for sustainable activi- ties which will apply to all businesses within the EU. The Taxonomy sets out six environmen- tal objectives, and for an activity to be considered green it must make a substantive contribu- tion to one of these, while at the same time doing no significant harm to the other objectives.
Finally, the activity must meet certain minimum safeguards, such as the OECD Guidelines on
37 Directorate-General FISMA (2020)
38 EU 2019/2088. The Regulation aims to reduce information asymmetry by requiring financial market participants and financial advisors to make pre-contractual and ongoing disclosures to end investors when they act as agents of those end investors.
39 EU 2019/2089
40 Finanstilsynet (2020b)
41 TEG (2020), p. 9.
42 Directorate-General FISMA (2020)
43 EFTA (undated)
44 Finanstilsynet (2020b)
45 EU 2020/852, art. 1(2)
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Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.46 The Taxonomy will function as the foundation for all EU regulatory instruments on sustaina- bility, and will most likely become the main ESG-standard for companies that are based in Europe, or that wish to do business there. The Commission plans to develop several delegated acts in conjunction with the Taxonomy Regulation. These will contain the technical screening criteria for each of the environmental objectives of the Taxonomy, such as climate change mitigation and climate change adaptation.47
It is important to note that while the Taxonomy sets out criteria for green activities, it does not mean that activities which are not considered green according to the Taxonomy are neces- sarily detrimental to the environment. Some activities may be neutral, in that they do not con- tribute significantly to any of the Taxonomy goals, while at the same time not doing any harm to the environment. The Taxonomy is highly ambitious in this regard, and it is not enough for example to simply reduce greenhouse emissions, if the business seen as a whole is more harmful to the environment. This signals an important change in attitude regarding how far regulators expect companies to go in contributing to a sustainable economy. It is no longer necessarily enough to simply transition to slightly more climate friendly versions of existing business practices, especially if in doing so, the companies in question contribute to carbon lock-in.48 In the future, we may perhaps see a system of green, neutral and brown categories.49 The Taxonomy is meant to function as a living classification and that companies must take an active approach in ensuring they stay aligned as the criteria change. An important first step is to be able to compare financial and non-financial companies on their taxonomy alignment, while the next step will be to adjust and calibrate the various thresholds contained in the Tax- onomy today. It will therefore need to be adjusted on a regular basis.50
2.2 Disclosure and reporting
The Non-Financial Reporting Directive (NFRD)51 entered into force before the Green Deal was announced, but is relevant to achieving the transition to a sustainable economy. The di- rective applies to large public-interest companies with more than 500 employees and requires these to include non-financial statements in their annual reports from 2018 onwards. Compa- nies must report on their policies related to environmental protection, social responsibility and treatment of employees, respect for human rights in addition to bribery and anti-corruption, among other things.52 The European Commission has since published guidelines to the NFRD which integrate international frameworks like the TCFD guidelines and takes account of the Taxonomy.53
The Directive is considered relevant for EEA adoption, and is currently subject to parliamen- tary processing in Lichtenstein. Most of the material requirements are already implemented in
46 EU 2020/852, art. 3; TEG (2020), p. 2.
47 European Commission (undated), “EU Taxonomy for sustainable activities”.
48 The carbon lock-in effect refers to practices that contribute to the dependence of industrial economies on fossil fuel-based energy systems. See Unruh (2000), p. 817.
49 Lowzow (2020)
50 EU 2020/852, recital 41.
51 Directive 2014/95/EU
52 Directive 2014/95/EU, art. 1, which adds the new article 19a in Directive 2013/34/EU.
53 The guidelines were published before the Taxonomy entered into force. See C/2017/4234, supplemented by 2019/C 209/01.
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Norwegian law through the Accounting Act §3-3c.54 This clause states that large enterprises must report on a variety of ESG and Corporate Social Responsibility (CSR) measures, includ- ing the external environment55 as part of their annual report. It only applies to large enter- prises whose stocks, bonds or other proofs of ownership are listen on a stock exchange or sim- ilar marketplace.56 The Accounting Act does not prescribe a certain method of reporting, but lets the regulated entities decide how to present the information. It could be included in the annual report or made available in a separate document. The reporting requirements set out in the Accounting Act § 3-3c go further than those of the Global Reporting Initiative (GRI) and UN Global Compact, but it is unclear whether they will cover all the requirements of the pro- posed EU regulation.
Earlier this year the Commission announced plans to review the Directive, seeking feedback and suggestions for improvements from the industry. The revision period closed May 14 2020, and a summary of the feedback was published on 29 July 2020. If and when the new SFRD and the changes made to the NFRD are to be incorporated into Norwegian law via the EEA Agreement, it will be necessary to consider how these changes will interact with existing legislation. Finanstilsynet, the Financial Supervisory Authority of Norway, has for instance suggested that the Accounting Act § 3-3c be moved to the proposed legislation on sustainabil- ity disclosures because of the strong links between the non-financial reporting duties of com- panies and the disclosure requirements of financial market actors in the SFDR.57
In addition to the legal instruments and guidelines of the EU, there are a number of recom- mendations and frameworks provided by international organisations. Many of these are devel- oped with the aim of helping companies comply with the regulatory requirements described above.
The Global Reporting Initiative (GRI) is an independent international organisation that has worked on sustainability reporting since the late 1990s. The GRI Standards are the first and most widely adopted global standards for sustainability reporting.58 The standards are divided into different modules, where some are general in nature and some are topic specific, like en- vironmental or social standards. According to a survey of 209 listed companies carried out by Finanstilsynet the GRI standards is the most commonly adopted framework among Norwe- gian businesses.59
Traditionally, companies have taken a CSR-driven approach to risk reporting, placing more importance on the risks posed by the company and its activities to the environment.60 More recently, companies are encouraged to also consider the risks climate change poses for their activities and business model. It can be argued that unsustainable practices create financial risks, which means it is in the board’s fiduciary duty to consider the financial implications of climate change.61 Such risks may be of a physical nature, like flooding or hurricanes
54 Regnskapsloven. See also Europalov (undated)
55 In the Norwegian text: “det ytre miljø”
56 Regnskapsloven § 1-5
57 Finanstilsynet (2020b), p. 15.
58 GRI (undated)
59 Finanstilsynet (2020a), p. 12.
60 Mähönen (2020), p. 7.
61 Sjåfjell and Johnston (2019), p. 12.
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threatening to disrupt production.62 However, there are also risks related to the transition to a green economy, not least as concerns new regulatory demands.63 Companies should also take into account how such transitional risks may affect their business. Both physical and transi- tional risks may be addresses through scenario modelling and planning. Whereas climate im- pact reporting is ex post in nature, climate risk reporting takes an ex ante approach, compel- ling companies to consider the risks before they materialise.64
The Task Force on Climate related Financial Disclosures (TCFD) was established by the Fi- nancial Stability Board (FSB) in 2015 with the aim of developing “voluntary, consistent cli- mate-related financial risk disclosures for use by companies in providing information to in- vestors, lenders, insurers, and other stakeholders”.65 The TCFD framework has so far been adopted by a number of regulators and industry players. Finanstilsynet has stated that the TCFD framework provides a solid foundation for climate risk reporting. Rather than creating procedures for reporting that are particular to the Norwegian market, Finanstilsynet recom- mends waiting for the results of the ongoing regulatory processes in the EU.66 In a recent re- port, around 25 of the businesses surveyed reported using the TCFD framework.67
The Climate Disclosure Standards Board (CDSB), an international consortium of business and environmental non-governmental organisation, has created its own framework for report- ing environmental and climate change information in mainstream corporate reports, such as the annual report. It is meant to align with the NFRD and the TCFD recommendations. The framework is being used across the world and aims to provide consistency and comparability for investors and other stakeholders.68
2.3 EU Green Bond Standard
As mentioned above, one of the challenges of the Green Deal is the lack of funds available for the transition to a sustainable economy. Thus, an important aspect of the work of the EU in this area is to steer more private capital into green projects.69 One way of raising such funds is to encourage companies and other entities to issue green bonds70, and to this end the EU has proposed its own Green Bond Standard (EU-GBS).
A bond is in essence a loan, where an investor buys the bond from an issuer, and the issuer promises to repay the loan with interest after a certain time. It is often used as a refinancing instrument.71 Exactly how the loan is spent by the issuer is normally of little importance to the
62 Ilhan et. al. (2020), pp. 3-4.
63 D’Orazio and Popoyan (2019), p. 26, Finanstilsynet (2019)
64 See Baldwin (2012), p. 243.
65 TCFD (undated)
66 Finanstilsynet (2019), p. 2.
67 Finanstilsynet (2020a), p. 12.
68 CDSB (undated)
69 COM (2019) 640, p. 22, EU 2020/852, recital 11.
70 Some have questioned whether green bonds really do contribute to decarbonisation (see for instance The Economist (2020b)). Others debate whether green bonds actually offer any clear financial benefits for issuers.
For more on this discussion, see for instance TEG GBS (2019), pp. 21-22; Gianfrate and Peri (2019), p. 128;
Lebelle et al. (2020), p. 16. I will not attempt to answer these questions here, as that would go beyond the scope of this thesis. For the purposes of this paper, I will therefore assume that green bonds have a role to play in the shift to a sustainable economy.
71 Rennison (2020)
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investor; they are mainly concerned with the interest payments.72 However, green bonds differ from traditional bonds in that the funds raised can only be allocated to green projects.73 This is why those issuing green bonds are often required to report on their use of proceeds. External reviews and second opinions are usually recommended in order for a bond to be classified as green.74
Issuing a green bond could potentially improve a company’s reputational capital with clients and the public, as it signals a commitment to environmental and climate related goals (virtue signalling).75 This may be especially true if the green bond issuance aligns with the com- pany’s overall mission. It could also give the issuer access to a larger and/or more diverse in- vestor base, as some investors are primarily interested in investing in sustainable instruments.
Such investors might not otherwise consider a traditional bond. Institutional investors, too, may benefit from the positive associations of eco-friendly debt, as clients are increasingly de- manding green or sustainable investment strategies.76
The proposed EU-GBS builds on the Taxonomy and the recommendations of the TEG, which published its final report and a useability guide on the EU-GBS in March 2020. The standard will be voluntary, but the TEG predicts that “the EU-GBS would rapidly gain a large market recognition as issuers and investors would naturally push for the adoption of a standard sup- ported by the EU and its implied reliability and integrity.”77 The European Commission is ex- pected to reach a decision by the end of 2020 on how to take the EU-GBS forward; including deciding if it should be made binding rather than voluntary. It is currently being reviewed as a targeted consultation, and the responses to the consultation were published on 26 October 2020.
The goal of the EU-GBS is to encourage market participants to invest in green bonds, and thereby contribute to a sustainable economy. Since the first green bond was issued by the World Bank in 2007, the market has grown substantially, especially in the last couple of years.78 However, green bonds still only make up a small portion, maybe as little as 1-2%, of the bond market in general.79 In the European bonds market, green, sustainable and social bonds make up approximately 10 % of the total bonds issued, excluding government issu- ances.80 According to Moody’s, a credit ratings agency, green bond issuance will reach $300
72 TEG GBS (2019), p. 18.
73 Deschryver and de Mariz (2020), p. 2. Green bonds are for instance often used to finance infrastructure invest- ments.
74 In addition to green bonds there are also other sustainability-linked financial instruments such as social-themed bonds and transition bonds. The latter are designed to promote the transition of brown industries to cleaner production methods and are less stringent about the criteria applied than green bonds. See BNP Paribas (2019).
These instruments all belong “to the broad universe of socially responsible investing (SRI) - defined as an investment strategy that considers both financial returns and social good”. Deschryver and De Mariz (2020), p. 5. See Kell (2018) on the difference between SRI and ESG investing.
75 Deschryver and de Mariz (2020), p. 5-6.
76 The Economist (2020a)
77 TEG GBS (2019), p. 23.
78 Deschryver and de Mariz (2020), p. 1; The Economist (2020)
79 Deschryver and de Mariz (2020), p. 4.
80 TEG GBS (2019), p. 17.
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billion in 2020, with another $100 billion in social and sustainability bonds.81 Moody’s also expects growth in issuance from alternative sustainability-linked labels, such as transition bonds.82 Green bonds have a significant tradition in Norway, and in 2015 the Oslo Stock Ex- change (acquired by Euronext in 2019) became the first stock exchange in the world to offer a separate green bond list.83 The Norwegian Ministry of Finance has urged Norwegian market actors and other interested parties to submit responses to the EU-GBS proposal.84
The EU-GBS uses the criteria of the Taxonomy to determine if bonds are to be considered green or not, and companies are required to have an external verifier confirm alignment with the Taxonomy.85 It also proposes that an accreditation scheme for external verifiers be imple- mented. Furthermore, the standard will compel issuers to report on the use of proceeds, to help ensure that projects actually remain green and deliver on their promises. The proposed standard is not meant for European issuers of green bonds alone, but aims to become an inter- national standard based on market best practices. The TEG recommends that the standard be open to corporate issuers, all types of financial institutions as well as sovereign, sub-sovereign or agency issuers.86 The EU-GBS contains elements of both ex ante and ex post measures, in that issuers of green bonds must provide certain information and show they fulfil certain criteria before they issue the bond. There are also on-going reporting requirements that demand transparency on the allocation of the proceeds of the bond.87 The EU-GBS may be said to use a compliance-approach to enforcement: a style of enforcement that emphasizes
“the use of measures falling short of prosecution in order to seek compliance with laws”.88 In addition to the EU-GBS, there are several existing green bond frameworks published by in- ternational organisations. Perhaps the most well-known of these is the International Capital Market Association (ICMA) Green Bond Principles, which are a set of voluntary process guidelines for issuing green bonds that are updated regularly. The latest version was published in 2018. The principles focus on the use of proceeds, where issuers are encouraged and ex- pected to report on how proceeds were used to fund green projects.89 Another widely adopted standard for green bonds is the Climate Bonds Standard and Certification Scheme, created by the Climate Bonds Initiative (CBI). The initiative describes the standards as “a FairTrade-like labeling scheme for bonds.”90 In order to achieve the certification, issuers must seek third party verification, choosing from a list of approved verifiers. Standards such as these function as tools for investors that assists them in selecting and prioritising investment products that support sustainability. For issuers of such products, they may also serve as a marketing ad- vantage.
81 Whereas green bonds used to belong to the domain of institutions like the World Bank and the European In- vestment Bank, today, green bonds are being issued by a diverse collection of companies. For instance, British fashion brand Burberry recently launched its own sustainability bond to support sustainable projects like “build- ing energy efficient warehouses and ensuring its cotton comes from the right sources”. Burgess (2020).
82 Moody’s (2020)
83 Oslo Børs (undated)
84 Finansdepartementet (2020)
85 TEG GBS (2019), p. 57.
86 TEG GBS (2019), p. 23.
87 TEG GBS (2019), p. 60.
88 Baldwin (2012), p. 239. This is distinguished from the deterrence-style of enforcement, which is penal in nature and aims to discourage future breaches through prosecution.
89 ICMA (2018)
90 Climate Bonds Initiative (undated)
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2.4 Summary – current state of sustainability reporting
Despite the regulatory efforts made to provide definitions of what is to be considered “green”
and to strengthen corporate reporting on sustainability issues, there is still scope for improve- ment. The NFRD has been criticised not achieving its goals, and especially for its lack of en- forcement of the reporting requirements and verification of the information provided by the regulated entities.91 Additionally, since the regulated entities are able to choose how they wish to report on climate issues, it is difficult to compare the performance across companies. Other points of criticism include the perceived lack of a scientific approach to sustainability and the weak link between financial and non-financial reporting.92
Several reports on the reporting practices of large companies have found that many, if not most, companies are lacking high quality disclosures, and often lag behind in implementing the TCFD guidelines.93 An interesting finding from the EY report is that Scandinavian coun- tries scored lower than other mature economies like UK, France, Germany and Switzerland.
This indicates that having had mandatory reporting requirements for some time does not auto- matically result in better reporting of climate risk information.94
Using information to motivate investors to choose green products like green bonds could be seen as a form of market-based approach to achieving the aims of the Green Deal and the Paris Agreement. Such mechanisms may function as another alternative or supplement to tra- ditional regulation.95 Non-financial reporting has been said to represent a compromise solution “between those wishing to regulate companies’ environmental and social
performance more strictly and those who do not”.96 The idea is that if investors want green products, companies that provide green products will do better. It is therefore supposed to be in the economic interest of a company to “go green”.
However, it is not certain that such market mechanisms will in themselves be enough. Be- cause of the norm of shareholder primacy, some commentators have pointed to the “risk that weak enforcement means social and environmental standards will not be followed by
companies concerned with profit, which most may be presumed to be”.97 Some regulated enti- ties may for instance take a cost-benefit approach to the consequences of regulatory non- compliance: some companies may ignore regulatory requirements if the potential economic benefit of non-compliance outweighs the cost of fines. They may also be able to pass the cost of fines on to consumers.98
91 CDSB (2020); Mähönen (2020); Sjåfjell and Johnston (2019) p. 20.
92 Mähönen (2020) p. 8, calls this “weak sustainability», an approach characterized by business as usual-thinking and techno-optimism (the belief that technology and innovation will solve the environmental problems) reli- ance upon reporting and transparency. The CDSB recommends making certain changes to improve the Di- rective’s efficacy, such as embedding the TCFD recommendations directly into the Directive. This may help to emphasise the link between financial and non-financial reporting. CDSB (2020), p. 3.
93 CDSB (2020); Nelson (2019). According to the CDSB report, “Only 3 in 10 companies fully disclose the envi- ronmental and climate-related aspects of their business model”.
94 Nelson (2019), chapter 2.
95 Lodge (2010), p. 208.
96 Sjåfjell and Johnston (2019), p. 20.
97 Sjåfjell and Taylor (2015), p. 16.
98 Baldwin (2012), p. 242, 250.
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The shortcomings of current reporting efforts have been sought remedied by the Taxonomy, the SFDR and the EU-GBS. Whether this marks the beginning of a new era of legislative ef- forts, or is simply more of the same remains to be seen. In the latter view, efforts to increase transparency and rework reporting requirements do not go far enough, this will only be a form of “window-dressing” to make companies appear more eco-friendly and socially responsible than they really are.99 Such doubts notwithstanding, the Taxonomy is meant to act as a link between the other regulatory instruments, binding them together through a common set of standards and definitions.100 The aim is to create a system which allows for comparison be- tween companies, products and industries, making it easier to identify those that are truly making an effort towards a sustainable economy and more difficult to get away with green- washing.
Through the Taxonomy and its related instruments, regulators are asking the industry players to provide feedback and input on how they manage reporting on sustainability metrics.101 As such, it is a dynamic instrument, constantly evolving. Even if the Taxonomy does not achieve total unity of standards, it pushes the businesses to actively consider and engage with sustain- ability issues and their own climate impact to a much higher degree than before. The boards of affected companies will likely be expected to be quite hands on and to deal with the tech- nical minutiae of such reporting, instead of the more overarching sustainability reporting most companies have relied on until now.102 This new regime of measuring and reporting will be more difficult to outsource. As such, regulatory instruments like the Taxonomy may help to further the process of transforming the economy to achieve the goals of the Paris Agreement.
As regulation becomes increasingly more complex, and reporting requirements demand an ever-higher level of technical detail, the burden placed on companies increases.103 For in- stance, tracking the proceeds of green bonds can be difficult, and it is important that issuers are transparent so that the capital raised by issuing green bonds do not mix with other funds.
Regulators are aware of this, and other, problems and have explicitly stated that they wish to avoid “overly burdensome compliance costs” for the regulated companies. This is to be achieved by creating “technical screening criteria that provide for sufficient legal clarity, [and] that are practicable and easy to apply”.104
Though having clear criteria will indeed help businesses in fulfilling the requirements of the Taxonomy, it is likely not going to be enough, even for companies with large compliance de- partments. This may in turn function as a barrier to entry as compliance costs are so high that only established companies are likely to be able to bear them. It is difficult to see how this challenge is to be overcome without the use of technology. The next chapter will outline how technology can build on and help realise the Taxonomy and the EU-GBS in a way that is more manageable for the regulated entities, thus making it more likely to have the effect in- tended by the regulators.
99 Mähönen (2020), p. 8. Instead, Mähönen argues in favour of “strong sustainability”, which “questions the exist- ing dominant market structures and pleads for more radical transformations”.
100 See for instance EU 2020/852, recital 19, on the link between the Taxonomy and the SFDR.
101 A (current) weakness of the Taxonomy is that many areas of commercial activity have not yet been mapped, for instance international maritime shipping.
102 CDSB (2020) p. 3; Deloitte (2019b) p. 13-14.
103 Baldwin (2012), p. 301.
104 EU 2020/852, recital 47.
14 3 Tokenised green bonds
As mentioned in the introduction, some of the problems associated with green bonds, such as greenwashing and lack of on-going verification may be tackled through regulatory and policy initiatives. However, it is possible, perhaps necessary, to use technology as a to enable and ac- celerate such efforts. While technology will not in and of itself help create consensus what constitutes a green activity and the criteria that should be used to measure such activities, it can be used to operationalise these definitions and goals. I have chosen to focus on green bonds as a test-case to examine how this might be achieved. There is a growing interest in green bonds in general, and the (green) bond market is where many see the use of blockchain technology becoming more mainstream.105 For instance, Germany has created a draft law that introduces the concept of a digital bond which no longer requires a physical certificate that represents the claim.106
According to a report by HSBC, “the blockchain based bond market is most mature in using the technology for structuring, registration, sales and distribution”.107 The sustainability bond issued by the World Bank and Commonwealth Bank of Australia, for instance, uses block- chain technology for structuring and issuance, and to provide an audit trail.108 In a similar vein, global financial group BBVA recently issued the world’s first blockchain supported structured green bond, where “the terms of the bond were negotiated on BBVA’s internally developed blockchain platform”. According to BBVA, the use of blockchain technology al- lowed the bank to streamline and simplify the process.109 In addition to such efficiency gains, I propose that the process of tokenisation and the use of smart contracts may also be used to increase transparency and to demonstrate alignment with the Taxonomy and the EU-GBS.
3.1 The case for tokenisation
Tokenisation refers to the process of replacing real-world or financial assets with digital rep- resentations called tokens, using Distributed Ledger Technology (DLT), like blockchain.110 DLT may be described as “a class of technologies which support the distributed recording of encrypted data”.111 The core feature of DLT and blockchain then, is that that there is no cen- tral database that controls the information. Instead, the stored information is distributed among multiple nodes, creating what is often referred to as “decentralised consensus”.112 This makes it difficult to alter the information without gaining access to the entire chain, and the information stored on a blockchain is therefore often described as being immutable.
105 HSBC (2019)
106 Clifford Chance (2020)
107 HSBC (2019), p. 9.
108 HSBC (2019), p. 43.
109 Farina (2019)
110 Popov (2019). I use DLT and blockchain technology interchangeably throughout the thesis. However, it is important to distinguish the underlying technology, DLT/blockchain, from assets or services that run on it, like Bitcoin and other cryptocurrencies. Furthermore, there are variations among blockchains, though they all share some common features. Ethereum, for instance, is another blockchain, most often used as the primary founda- tion for smart contracts, Hamilton (2020), p. 8. See also Deloitte (2019a), p. 4 for a general overview.
111 COM (2020) 593/3, p. 34. The Financial Conduct Authority (FCA) describes DLT as “a set of technological solutions that enables a single, sequenced, standardised and cryptographically-secured record of activity to be safely distributed to, and acted upon by, a network of varied participants”. FCA (2019), p. 9.
112 Cong (2019), p. 1755, 1761; Hamilton (2020), p. 8.
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The token represents the rights and obligations of the token holder. Tokens may for instance be used as a means of exchange, for investment purposes or to support capital raising.113 In the case of a tokenised green bond, the underlying asset would be the bond, and the resulting token would contain information about the investment, such as the principal paid, the interest and the annuity, in addition to information about ownership of the token. This would be what is often referred to as a tokenised security: “the digital representation of a security asset in the form of a digital token on a blockchain platform”.114 The token represents an existing invest- ment product, the green bond, and “therefore, legally, the primary record in many
jurisdictions is still paper-based or stored in a government- owned, centralized database.»115 Thus it is not a new type of asset, but rather a new distribution channel for traditional securi- ties, in this case a green bond.116117 According to ESMA, “the frontier between crypto-assets and traditional financial assets is blurring as some traditional financial assets are starting to be issued and transacted on DLT and the business models are evolving.”118
Because of the costs involved in issuing bonds in general119 many smaller companies are ef- fectively excluded from the green bond market. Such high transaction costs and minimum in- vestment size may make it especially difficult for emerging markets to support a thriving green bond market.120 Many companies will most likely struggle to find projects that are large enough to warrant issuing green bonds. This may lead to a lack of green projects for investors to invest in.121 Issuing tokenised bonds using blockchain is less costly,122 and more wide- spread adoption of the technology would perhaps open up the market for more projects to be financed in this way. Tokenisation can also help issuers reach new investor bases by allowing companies to list their green bond on a cryptocurrency exchange in addition to a regular list- ing on a traditional marketplace.
3.2 Using smart contracts to prove Taxonomy alignment
The EU-GBS formalises what needs to be included in the Green Bond Framework which issu- ers use to convey information about their project to potential investors. One key element is that the project being financed by the bond must be aligned with the Taxonomy. By requiring alignment, there will be less room for doubt as to whether the underlying project really is
113 Based on their respective core features, tokens are therefore often divided into three categories: exchange/cur- rency tokens, security/investment tokens, and utility tokens. See FCA (2019), Hacker and Thomale (2018), p.
652.
114 Schletz et. al. (2019), p. 2.
115 Lambert et. al. (2020), p. 26.
116 A securitised token, on the other hand, is a new asset class. They function as a financial asset (a security), but may also have utility features in the distributed economy. See for instance Kaplan (2019).
117 When discussing tokens, it is also important to identify which processes take place entirely on the digital plat- form (on-chain), and which take place outside the digital environment (off-chain). For many token instru- ments and other crypto assets, parts of the process still take place using traditional methods.
118 ESMA (2019), p. 13.
119 “For a green bond to make financial sense for issuers and investors, and ensure liquidity and index inclusion, it must have a critical size, which can hardly be below the USD 300–500 million mark.” Deschryver and De Mariz (2020), p. 9; see also TEG GBS (2019), p. 18 on the high costs associated with bond issuance.
120 Schletz et. al. (2019), p. 1.
121 TEG GBS (2019), p. 21.
122 See table comparing the cost of issuing a traditional green bond vs the cost of issuing a green bond using blockchain in HSBC (2019), p. 17. According to this estimate, the price of the latter comes in at around a tenth of the price for a traditional issuance.
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green.123 However, evaluating the degree to which a project aligns with the Taxonomy can be challenging. The technical screening criteria call for detailed information about the project and its potential impact. Collecting this data and presenting it in a meaningful way will likely require significant use of human resources by the company issuing the bond.124
Technology may help reduce the burden on companies through the use of blockchain and to- kenisation in combination with so called smart contracts.125 Smart contracts may be defined as
“the ability to use programmed automation to affect the exchange of money, property, or other items of value without conflict in a transparent method that requires no trust services of a middleman, such as a bank or attorney.”126 These are essentially computer programs embed- ded in the blockchain designed to execute specific actions automatically based on the data in- put they receive on-chain.127
Taxonomy-alignment could potentially be calculated automatically based on input data pro- vided by the companies seeking alignment and the technical screening standards of the Tax- onomy itself. Due to its highly technical nature, the Taxonomy should lend itself to coding, but this concept has not been widely discussed yet. If a green bond is meant to finance a pro- ject developing new housing for instance, a smart contract could contain criteria for the mate- rials to be used, and the way the materials have been transported to the building site. The in- formation needed to determine whether the criteria have been met could (ideally) be collected via sensors in the physical world, or through manual recording and input. The energy effi- ciency of the finished building could be measured and recorded on a DLT database and made instantly available to the investors. If the issuer fails to deliver on agreed-upon metrics, such as achieving a specific Taxonomy-alignment percentage, this could trigger the smart contract to automatically execute a corresponding action, such as higher interest payments to the in- vestors.
The EU-GBS makes the use of external verifiers to confirm Taxonomy alignment manda- tory.128 However, if issuers are able to calculate and demonstrate their Taxonomy alignment automatically, it would perhaps make external verifiers less useful. Perhaps their role would transition into more of a tech-advisory one; providing software tools for companies who do not have the capacity or desire to develop their own solutions.
Having taxonomy alignment calculated automatically and presented in a clear manner would make it easier for direct investors to choose among different bonds. It would, however, be of perhaps even more benefit for institutional investors like asset managers and pension funds.
They are required to calculate the percentage of all sustainable investments underlying the fi- nancial product they are offering their clients.129 Asset managers will likely face increasing demands from investors regarding the “greenness” of their portfolios and will need to find
123 TEG GBS (2019), p. 24-25.
124 Deschryver and De Mariz (2020), p. 15.
125 The name “smart contracts” is misleading, in that they are neither contracts in the general legal sense, nor
“smart” as they do not make any independent analysis or decisions, but rather perform exactly as programmed.
See Cong (2019), p. 1762.
126 Hamilton (2020), p. 9.
127 The key is that enforcement of the contractual obligations happens automatically. Smart contracts have been used for instance in simplifying insurance claims processing, making mortgage approval and loan servicing more efficient, ensuring copyright protection. See Hamilton (2020), p. 10.
128 TEG GBS (2019), p. 57. Verifiers will also have to be certified, and a certification scheme is under development.
129 EU 2020/852, art. 5. Also see recital 18.
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tools and processes that can show investors that they really are investing in a truly green prod- uct. Several high-profile funds with “ESG” in the title have indeed been shown to invest in some rather unsustainable businesses. Vanguard’s ESG ETF, for instance, while claiming it does not invest in fossil fuel stocks, nevertheless had holdings in companies like crude refiner Marathon Petroleum and oil services company, Schlumberger. Passive ESG funds are not necessarily any better: the FlexShares Stoxx US ESG Impact Index Fund has a $1.3m holding in oil giant Exxon Mobil.130 It is clear that there is a need for more transparency on the under- lying investments of such funds, and the Taxonomy and the SFDR are meant to remedy this.
It is however, not enough to require asset managers to prove their taxonomy alignment, there must be a practical way of doing so. Otherwise managers may have to rely on proxy figures, leading to ambiguous results.
The UN Principles of Responsible Investment131 have published a series of case studies
demonstrating how asset managers are working to implement the Taxonomy in their practices.
Investment managers Royal London Asset Management (RLAM) found that one of the main challenges was the manual nature of the work, and the managers predicted that “application across a range of funds would be a significant undertaking potentially spanning months”.132 This burden could likely be lightened considerably by the use of technology, perhaps even en- abling real-time monitoring of portfolios. Likewise, another fund manager, Aberdeen Stand- ard Investments, viewed automating assessment of alignment for all companies as a top prior- ity in order to make calculating Taxonomy alignment more manageable.133
In another case study, asset owner AP Pension stated that “a critical element in effective im- plementation will be streamlining of data delivery to market participants. Indeed, a lack of streamlining and multiple data sources may lead to conflicting results.”134 This statement highlights the fact that financial managers rely upon data provided by the companies they in- vest in, and that if retrieving this information is difficult, then that will have a negative impact on the disclosures of asset managers.135 Other participants in the case studies noted the lack of third-party tools that can perform a full Taxonomy-alignment screening136 and the limited number of industries that have been mapped and given Taxonomy criteria as problems con- tributing to low alignment scores.
The case studies described above to support the statement made by Morningstar data director Tim Walton when he predicted that the majority of ESG funds would see very low alignment
130 Rennison (2019)
131 The Principles for Responsible Investment (PRI) were established in 2006, and are designed to help institutional investors incorporate ESG issues into their investment practices. The principles are voluntary, and aspirational in nature. The principles were developed by an international group of institutional investors and is supported by the UN, through partnerships with the United Nations Environment Programme (UNEP FI) and UN Global Compact.
132 RLAM (2020)
133 Aberdeen Standard Investments (2020)
134 AP Pension (2020)
135 See O’Reilly (2020), in addition to the case studies mentioned in the text.
136 There are several ESG-related screening tools available, for instance by companies like Bloomberg, Sustainalyt- ics, MSCI ESG Research and Trucost. These are currently not able to perform a full Taxonomy alignment screening, however, and the managers participating in the case studies often had to use a combination of dif- ferent tools to find the data they needed. See BlueBay (2020) for a list of available tools.