While the term “ESG” was actually more familiar to fund managers and compliance/CSR officers in larger companies before the Corona pandemic, since the beginning of 2022 at the latest, the turnaround scene can no longer avoid dealing with this terminology and the concepts behind it. Banks ensure compliance with ESG standards as an additional criterion when granting loans already, and this stance also applies to restructuring loans. The following article sheds some light on the background of ESG, the implementation of this rather cloudy terminology in supra-national and EU law and the already clearly recognisable concrete effects on the German economy and corporate finance.
1. Background
Even though the term “ESG” (“Environment, Social and Governmental“) is not specifically defined, it is generally understood to mean the ecological and social areas of corporate management that cannot be measured by financial indicators. It is therefore an assessment standard of the capital market for the sustainability of a company that goes beyond the financial aspects (see here for more details).
In recent years, various national and supranational institutions have launched projects to implement ESG assessment standards as globally as possible. In 2015, for example, the United Nations agreed on an “Agenda 2030” (here), which defines 17 Sustainable Development Goals (SDGs) (here), which – at least according to the Deutsche Bundesbank (here, p. 10, in German) – can be assigned to the ESG criteria. The European Commission – also as a consequence of the aforementioned UN agenda – first published an “Action Plan: Financing Sustainable Growth” (COM(2018) 97 final, here). In this action plan, it was determined to introduce an “EU classification system for sustainable activities” with the declared aim of reorienting capital flows towards a “sustainable economy”.
2. Concrete steps in the European Union
a) On the basis of this action plan, the EU on 18 June 2020 issued the so-called “Taxonomy Regulation”, which is directly applicable in the member states and – in relation to the “E”(nvironment) in “ESG” – is intended to “incorporate” the ecological aspects into financing and investment decisions (see more details on the structure and background here).
The taxonomy categorises (“assesses”) the economic activities of major industries that are responsible for a large amount of CO2 emissions and defines threshold values to assess whether they can be classified as ecologically sustainable. The taxonomy is intended as a source of information and a means of control and is thus the key to directing public and private financial flows towards sustainable, in particular CO2-neutral investments (for more details, see the explanation by the Scientific Service of the German Bundestag, here (in German)).
According to Art. 1, this Regulation applies to Member States and the EU in the case of “measures laying down requirements for financial market participants or issuers in relation to financial products or corporate bonds provided as environmentally sustainable”, to “financial market participants providing financial products” and to such companies that are covered by the so-called Accounting Directive of the EU (Directive 2013/34/EU, current version here) as well as the corresponding national implementing law, insofar as they are required to submit a so-called “non-financial statement” as part of their annual financial statements. According to the size class definition in Art. 3 of the Accounting Directive, this obligation in turn generally applies to entrepreneurs who exceed two of the following three characteristics during the reporting period: Balance sheet total Euro 20 million, net sales Euro 40 million and average number of employees above 250 (in Art. 19a EU Directive 2013/34/EU, the limit for the purposes of the Accounting Directive is only drawn at 500 employees).
According to Art. 8 of the Taxonomy Regulation, the addressees of the Regulation, insofar as they are obliged to provide the aforementioned “information of a non-financial nature”, must indicate to what extent “the activities of the enterprise are linked to economic activities that are to be classified as environmentally sustainable economic activities pursuant to Article 3 and Article 9 of this Regulation.” In other words, companies of the above-mentioned size class definition must supplement their annual financial statements with statements showing the extent to which the company is engaged in environmentally sustainable economic activities (Art. 3) and achieves the environmental objectives (Art. 9) of the Taxonomy Regulation. The Directive entered into force in large parts twenty days after promulgation (cf. Art. 27), i.e. it is applicable as direct Union law in all Member States since 12 July 2020.
b) Following the publication of the “Final Report on Social Taxonomy” (here) by the “EU Platform on Sustainable Finance”, the EU institutions are now also likely to tackle the “S”(ocial) in “ESG” quite quickly. At the end of February 2022, the EU Commission presented a proposal for a “Directive on corporate sustainability due diligence” (see here for more details), which seems to set higher requirements than the German Supply Chain Due Diligence Act (LkSG), at least in parts.
3. Impact – unintended consequences?
Parallel to the EU’s taxonomy efforts, the flood of events (see here, in German) and publications, including newly published journals (e.g. here and here, in German), is swelling considerably. This is probably not without reason, as these regulations – which have not even been fully “developed” yet – are already having a considerable influence on current economic development. This “impact” can be clearly seen in the fact that the restructuring industry – traditionally rather at the end of the development cycle of economic sectors and topics – already has to deal with this topic (see only here, in German). This is because banks are increasingly taking sustainability criteria into account when granting loans, and a corresponding framework has probably already been set by BAFin in 2019 with the “Merkblatt zum Umgang mit Nachhaltigkeitsrisiken” (“Leaflet on dealing with sustainability risks”) (here, in German).
a) (Sustainable) energy production
The broader public is probably also familiar with the current discussion about the classification of gas and nuclear power plants as climate-friendly from the media. The EU Commission has initially – against considerable resistance (see only the statement of the German Federal Environment Agency here, in German) – classified such power plants as climate-friendly under certain conditions (here, in German). The German government intends to veto this classification (here, in German). However, given the restrictions to generate energy resulting from the exclusion of this base-load-capable (albeit risky) type of energy generation, the possible halt in the supply of natural gas from Russia at any time as a consequence of the war in Ukraine and the backlog in the expansion of renewable energies, the risk of a large-scale blackout would increase considerably (see here and currently here, in German) if nuclear and/or gas power plants were not classified as sustainable. This is because the removal of the sustainability criterion for these types of energy production would at least make it more difficult to finance the respective companies.
b) Arms production and arms trade
At the latest since Russia’s attack on Ukraine and the decision of Nato and the EU to provide generous support to Ukraine, including large-scale arms deliveries, the arms industry has once again come into the public eye. And while the share values of these companies have risen dramatically in (joyful) anticipation of good business (here, in German) and some politicians are already calling for taxation of the expected “crisis profits” (here, in German), for many companies the question of how to finance the start-up or increase in production is probably more in the foreground at the moment. Admittedly, reports in the German newspaper Die Welt indicate that the relevant EU bodies have meanwhile distanced themselves from the original plan not to designate arms manufacturers as sustainable under any circumstances (here, see also here, in German). However, at least some banks (e.g. DZ Bank, here, or LBBW, here, p. 19, in German) already severely restrict lending for arms production and trade on their own initiative – i.e. without regulatory requirements.
c) Combustion engine
Even before Corona, the pressure for transformation in the automotive industry was high, so that even then banks were critically questioning their credit commitments in this area (see only here, in German). This meanwhile advanced transformation process will finally end the use of combustion engines in vehicles . It is true that the taxonomy criteria do not explicitly mention “petrol” or “diesel” (but only “solid fossil fuels”, i.e. coal, see e.g. Art. 10 para. 2 of the Taxonomy Regulation). However, this is not (any longer) necessary, because the EU Commission – in agreement with the EU member states – has already determined within the framework of the so-called “Fit for 55” programme (see more details here) to reduce the annual CO2 emissions of new vehicles to zero from 2035 (see also more details on the plans of individual countries here, in German). Accordingly, plans for the financing of projects in the (CO2-intensive) combustion engine sector will relatively quickly raise the question of the company’s creditworthiness.
4. Consequences for restructuring
The issues briefly outlined here already illustrate the problems that even healthy companies can find themselves in when they operate in a sector critical from the point of view of sustainability criteria. Especially in the automotive industry, which has been in transformation for years anyway, the EU regulations are likely to cause additional headaches. And companies from this sector falling into an individual crisis will have difficulties financing themselves out of such crisis.
Some voices also assume that the ESG criteria could lead to a revival of the question of so-called “restructuring worthiness” (“Sanierungswürdigkeit“), which was shelved with the introduction of the InsO, i.e. it might no longer be solely a question of a company’s “(economic) ability to be restructured” (“Sanierungsfähigkeit), but the ESG criteria will have to be fulfilled as a separate (non-financial) point of examination. The ESG criteria will nevertheless have financial effects, too, because a company in crisis will also have to finance investments in the ESG area in order to ensure a sustainable restructuring.
Conclusion: The EU itself assumes that additional investments of 180 billion euros per year will be required by 2030 to achieve the sustainability goals in the area of climate and environmental protection alone (see here). The taxonomy is intended to ensure that these funds are used efficiently. The effects of the Taxonomy Regulation, which has been in force for almost two years, already extend into concrete financing decisions for individual companies. ESG criteria thus will foreseeably have an increasing influence on corporate restructuring decisions.
Although there are isolated critical voices on the ESG concept in general (see here) and on the taxonomy in particular (see here again, in German), the chorus of critics is generally rather quiet, which is basically understandable, because who wants to be accused of being against ecologically sustainable management? The German thinktank iwd speculates that the conception of the taxonomy could lead to black-and-white thinking, be more inefficient than market-based instruments such as trading in emission certificates and warns of the financial consequences for companies (here, in German). The German Federal General Accounting Office (“Bundesrechnungshof“) is much clearer in its criticism and warns against “greenwashing” as well as the far-reaching options available to the EU Commission in implementing the taxonomy. It could thus “classify entire industries as unsustainable and thus help shape the industrial policy landscape in the EU member states“. According to the Office, such powers go too far and the member states should be given more say (here, in German). The justification for this criticism can be vividly demonstrated by the discussions on the classification of nuclear and gas power plants as sustainable.
The above examples also illustrate that conflicting goals – such as climate protection vs. security of energy supply or climate protection / social responsibility vs. external security of the EU (defence) – were either not recognised or not taken into account when the regulation was created. Climate and environmental protection are prioritised absolutely by this taxonomy regulation. Admittedly, these conflicting goals are currently still being resolved more or less “manually”, i.e. with typical EU compromises. It remains to be seen whether NGOs will try to enforce the prioritisation of environmental and climate protection over such improvised measures by taking legal action.
From the point of view of the affected companies, the increase in complexity and costs due to the increased reporting requirements is likely to be the first thing to be considered, if one is not already active in an area identified as “non-sustainable” or will not be in the foreseeable future. Accordingly, from a restructuring perspective, it is to be expected that the Taxonomy Regulation may, if not cause, then at least intensify individual company crises.