ESG Debt Ratings Fuel Capital Markets Risk, Watchdog Says

(Bloomberg) — The rampant ESG debt boom has created accounting issues that require urgent regulatory attention, according to the European market watchdog.

Companies are accounting for the value of so-called sustainability bonds and loans inconsistently, the European Securities and Markets Authority has found. The development has the potential “to adversely affect the decision-making of financial market participants and therefore the efficient functioning of capital markets,” ESMA told Bloomberg in an email response to questions.

Demand for these debt products has exploded in recent years and Moody’s ESG Solutions expects the ESG bond market alone to reach around $1.4 trillion in 2022 as issuers try to capitalize on demand. seemingly insatiable with ethical investments. But the accounting rules for determining their asset and liability values ​​are not keeping pace with market growth, leaving companies to apply different valuation models.

ESMA expresses concern that the International Accounting Standards Board’s existing plans to regulate the market are moving too slowly and is now asking the IASB to address ESG debt assessment as a matter of urgency. The board should establish specific guidelines for the valuation of instruments whose interest rates change according to environmental or social objectives, according to ESMA.

The IASB says it is reviewing the rule known as IFRS 9, which determines how financial assets are measured, and reviews comments it has received on accounting for ESG elements in loans, bonds and structured instruments.

The board says the review includes a more in-depth look at “market changes since the accounting standard was issued” in 2018, “and the accounting standard’s responsiveness to those market changes,” a doorman said. -word. “In this context, many stakeholders provided information on the development of loans with interest rates that vary depending on whether the borrower meets predetermined ESG objectives or not.”

But that review process — and any potential action based on its findings — risks being too slow, say bankers, companies and regulators.

Different ESG debt assessment models…

Most banks want the IASB to adopt a standard based on measuring an asset at a so-called amortized cost. They say using fair value, which is the model preferred by accountants, risks making profit and loss accounts more volatile. That could ultimately discourage a bank from “promoting sustainable funding,” Dominique Crowe, head of group accounting policy at UBS, said in a Jan. 27 letter to the IASB. His comments were echoed by BNP Paribas.

The lack of uniformity is also a concern for issuers. In a January 28 letter, Shell International urged the IASB to “ensure consistency in judgments made on debt instruments and other lending arrangements with ESG-related features.”

This is not the first time that sustainability debt, which bears an adjustable interest rate based on compliance with key ESG performance indicators, has been questioned. In September, Bloomberg published an analysis of more than 70 sustainability-linked revolving lines of credit and term loans entered into in the United States since 2018, which showed that more than a quarter contained no penalties for not meeting the stated goals, and only a tiny discount if the goals are met.

When it comes to valuing sustainability-related debt in financial accounts, Europe’s market regulator is not alone in worrying. Regulators, banks, pension funds and accountants from Brazil to Australia are calling on the IASB to recognize the need for prompt action. The accounting problems do not stop at banks, but also affect pension funds and other sectors of the investment industry.

“As the volume of these financial assets is growing rapidly, we believe there is an urgent need for the Board of Directors to issue guidance on how ESG characteristics should be analyzed to determine whether financial instruments with these characteristics meet the SPPI criterion. “, KPMG IFRG Ltd. said in the letter of January 28.

The issue is of particular concern for banks in Europe, where governments and regulators are moving faster than other jurisdictions to create a framework that channels capital into environmentally and socially sustainable activities.

“Given the pressure on banks to promote this type of instrument and the implications on the economy of the banking sector, we consider that the examination of this project should be the top priority,” said the European Banking Federation. in a letter of January 27.

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