The agreement among EU leaders for a €750 billion Covid-19 Recovery Fund — at the end of a marathon summit on 21 July — was a landmark for EU integration. For the first time, the European Commission will issue bonds in the capital markets at scale on behalf of the whole EU — a mutualisation of financial obligations that was resisted throughout the EU’s 2010–12 sovereign debt crisis.

But the move by the EU also has major implications for ESG investors — promising to create a new sovereign debt ESG benchmark, boost the green bond market and extend green taxes.

The EU Recovery Fund will provide €390 billion in grants and €360 billion in loans to EU member states hit hardest by the Covid-19 pandemic. In line with the wider EU budget, at least 25% of the fund will be allocated to climate action.

Agreed alongside a new €1.1 trillion, seven-year budget, which will be funded as usual directly by member states, the Recovery Fund is to be financed by EU borrowing. To repay that debt, the EU has committed to introduce a range of new taxes and levies, including new environmental taxes.

An ESG safe asset?

Considerable comment has been made about how EU sovereign bonds could help boost the role of the euro as a reserve currency, by creating an effectively risk-free asset that can be used as collateral in financial markets. Such a development would be particularly welcome given the willingness of the current US president to threaten to use the US currency as a political weapon.

Some analysts, such as those at S&P Global, have suggested that the European Commission could simultaneously create a “green safe asset”, by issuing long-duration green bonds to finance a considerable portion of the recovery fund.

As S&P Global’s analysts note, the issuance of €225 billion of green bonds to fund 30% of the Recovery Fund would make the EU the largest supranational provider of liquidity for a green safe asset, dwarfing the $33.7 billion of green bonds issued by the European Investment Bank since 2007, and the $53 billion of sovereign green bonds issued to date.

New green taxation

In addition, the European Commission is mulling new green taxes to underpin its Recovery Fund borrowing. In addition to the long-discussed EU digital tax and, longer-term, a potential financial transactions tax, the Commission will:

- Introduce a new levy on non-recycled packaging waste (from January 2021, to raise around €7 billion/year);

- Create a carbon border adjustment mechanism, based on the emissions of imported products (from the end of 2022, raising €5–14 billion/year). We wrote about this topic of ‘outsourcing’ carbon emissions in a blog postearlier this year; and

- Tap the existing levy on the EU Emissions Trading System, and possibly extend it to aviation and maritime emissions (with no timeline, but raising an estimated €10 billion/year).

Of perhaps broader significance is that the EU is showing how environmental negatives — specifically plastics pollution and the under-pricing of carbon emissions outside the EU — can be taxed, and therefore discouraged, to fund positive environmental action. These are lessons that other sovereigns might learn as they seek to fund the low-carbon transition.

ESG bonds as an intermediate step

Green, social, impact and other ESG-related bonds have received a lot of attention recently, not least because these types of instrument can help asset owners — private and institutional alike — to ‘green’ their portfolios. Certainly, this is a step into the right direction.

Ultimately, at CountryRisk.io we believe that ESG risk factors should become standard in any risk analysis. Subsequently, ESG bonds should also become the standard, making prefixes such as ‘green’, ‘social’ or ‘ESG’ unnecessary. The steps by the EU in relation to the EU Recovery Fund, as well as statements by large asset managers like Blackrock, suggest that we are heading in this direction.