The position as set out in this article is correct as at 13 December 2021. An updated version of this article can be found here.
The level of ESG issuance is staggering: global ESG bond issuances have reached nearly US$500 billion in the first half of 2021 alone, and an estimated 65% of European syndicated leverage loans contained ESG-linked margin ratchets in the second quarter of 2021. However, despite these figures, the securitisation market is seriously lagging behind on ESG transactions: AFME found that 2021 was only the second time that European ESG securitisation issuance had passed through the €1 billion barrier. In comparison, and echoing the global numbers above, the financial markets saw approximately US$700 billion in ESG bond issuance in 2020 and issuance in the first half of 2021 has reached over US$229.9 billion in green bonds alone. ESG issuance has risen above US$100 billion in the EU alone.
So why is securitisation lagging behind? Are securitisation market participants less interested in ESG products than other financial actors? This doesn't seem to be the case: originators in the securitisation market are very keen to issue ESG securities and a vast majority of securitisation market participants (86%) have reported they have ESG programmes in place at the enterprise level. Nearly half of structured finance market participants report that they have an ESG programme in place at the structured finance level. But then the numbers take a dive: whilst 43% of issuer respondents indicated they are developing an ESG focused securitisation programme, only 13% currently sponsor one. Our own clients indicate that there is significant demand for ESG securitisations on the investor side. In fact, investor respondents have indicated that ESG is now an urgent focus in the context of capital markets offerings, including for securitisation transactions. So if there is interest from originators and investors what is holding back ESG securitisations? There seem to be two main constraints: (i) uncertainty as to what constitutes an ESG securitisation; and (ii) a lack of eligible assets.
Why the uncertainty as to what constitutes an ESG securitisation?
Unlike conventional debt and loans, there is considerable uncertainty as to what qualifies as an ESG securitisation. The lack of clarity as to what is a green or social investment makes it harder for issuers and investors to create a marketable product. It is estimated that there are currently more than 200 ESG frameworks available worldwide, although we tend to mainly see the ICMA principles used in the securitisation market to-date. The lack of consistent data and available reporting of that data makes it harder for investors to determine whether a product is suitable for them. Of course, there is some benefit in having a degree of flexibility and adaptability in any set of principles, particularly as a market develops. At the moment this can be provided through industry-led principles and the use of second opinion providers although market participants need to take care that flexibility does not amount to "ESG-washing".
Also, unlike what we have seen for instance in the sustainability-linked high yield market this year, whilst it seems that ESG securitisation structures gain a lot of interest, there is not a sufficiently clear "greenium" (a green pricing premium) at the moment to make an ESG-themed securitisation more appealing from a financial perspective. We would note however that a "greenium" did not really emerge in the corporate bond market until recently so there is still potential for this to develop down the line.
Lack of eligible assets
There is a lack of eligible assets for ESG securitisation; this is clearly an issue of scale but also reflects lack of clarity as to criteria that accurately determine what is meaningful when looking at ESG assets today. Some industries might be heavily regulated and therefore have inherently strong green credentials without having a green label. Many firms have positive green and social policies (such as diversity policies, cycle to work schemes etc.) but how can the market differentiate between those entities that have a serious commitment to green and social policies and those that do not? Sophisticated investors are honing their due diligence questionnaires to deep-dive into ESG issues but originators report that not all investors raise the same kinds of questions or to the same level of detail, resulting in inconsistent information requests. There is a tension here as originators and arrangers may wish to see material information included in the prospectus, which is driving pressure to include ESG information in a prospectus even for transactions not marketed as such. The market is struggling to get to grips with these complexities and could benefit from an agreed framework for data and reporting to overcome some of these hurdles. This has led to calls for consistent regulated requirements but these calls should be approached cautiously as over-burdening the securitisation market with further disclosure requirements at this stage could risk stifling its initial attempts to align to ESG principles. Once the ESG securitisation market is more developed further comfort could be provided by recommending clear disclosure guidance, particularly with regards to impact reporting and data disclosure.
We take a broader look below at these issues and the ESG securitisation market in general, including the current regulatory framework, the various forms an ESG securitisation can take, and possible policy solutions to stumbling blocks in the market.
ESG-related matters have been relevant to securitisation transactions since well before the adoption of the European Green Deal and the Action Plan on Financing Sustainable Growth. Notably Regulation (EU) 2017/2402 (the "EU Securitisation Regulation") requires the provision of environmental performance metrics (where available) in respect of residential and auto portfolios for STS transactions.
The EBA, in close cooperation with ESMA and EIOPA (together, the "ESAs"), are required to publish a report on developing a specific sustainable securitisation framework. One of the key items to be considered in this framework is disclosure of information on environmental performance and sustainability (the "Draft Sustainability RTS"). The ESAs must also provide draft regulatory technical standards on the content, methodologies and presentation of sustainability indicators relating to adverse impacts on the climate and other ESG-related adverse impacts of residential loan or auto loan or lease securitisations which qualify as STS. The ESAs have been delayed in producing these items which are now keenly awaited by the market and which we hope will be available early next year.
Since the EU Securitisation Regulation came into force, a number of further ESG-related rules and regulations, directly or indirectly affecting securitisation transactions (to the extent that the applicable regimes apply to relevant investors), have started to proliferate. The most prominent examples are:
- Regulation (EU) 2019/2088 ("Sustainable Finance Disclosure Regulation"). This imposes disclosures on financial market players and on finance products (e.g. both pre-contractual and on-going), as well as disclosures relating to sustainability risks and sustainability downsides of financial products. The Sustainable Finance Disclosure Regulation came into force on 10 March 2021. It applies to financial market participants but does not apply to banks, which are governed by the Non-Financial Disclosure Regulation (see below);
- the combined provisions of Regulation (EU) 2020/852 ("EU Taxonomy Regulation") and Directive 2013/34/EU ("EU Non-Financial Reporting Directive"), impose disclosures on how and to what extent economic activities of large corporates (including banks) are linked to activities that qualify as environmentally sustainable. A proposal published in April 2021 for a Corporate Sustainability Reporting Directive ("CSRD"), would significantly amend and extend the existing reporting requirements of the EU Non-Financial Reporting Directive including introducing audit (assurance) requirements and more detailed reporting requirements according to mandatory EU sustainability reporting standards. On 9 December the Council approved the text of a delegated regulation supplementing the EU Taxonomy Regulation; this will be effective from 1 January 2022 and specifies the technical screening criteria under which certain economic activities qualify as contributing substantially to climate change mitigation and adaptation and for determining whether those economic activities cause significant harm to any of the other relevant environmental objectives, including criteria for areas such as renewable energy and car manufacturing;
- the combined provisions of the Commission Delegated Regulation (C/2021/2800 final) ("Taxonomy Climate Delegated Act") and the proposal for a regulation on European green bonds, requiring that all bonds labelled as "European Green Bonds" or "EuGBs" be aligned with the provisions under the EU Taxonomy Regulation ("European Green Bonds"), comply with transparency and reporting standards and be audited (assurance) and registered with ESMA; and
- the provisions set forth in the proposal of Art. 449a of Regulation (EU) No. 575/2013 (as amended, the "CRR"), based on which listed banks will need to provide quantitative and qualitative ESG risk disclosures, quantitative disclosures of physical climate risk and ESG policies, KPIs and a green capital allocation ratio (Green Asset Ratio) which will incentivise banks’ investment decisions toward green assets.
There are various other legislative items that might be relevant in the capital markets more generally and different jurisdictions have, or are developing, their own requirements.
The United Kingdom on-shored the EU Securitisation Regulation with effect from 1 January 2021 with minimum changes (the "UK Securitisation Regulation" and together with the EU Securitisation Regulation, the "Securitisation Regulations"). As such, the same requirements noted above under the EU Securitisation Regulation apply through the UK Securitisation Regulation. Any subsequent amendments or technical standards do not however form part of this onboarding and the UK Securitisation Regulation does not currently provide for the drafting of any sustainability technical standards. On 24 June 2021, HM Treasury issued a call for evidence for a review of the UK Securitisation Regulation, which will examine environmental disclosure requirements. It is unclear whether the UK would seek to draw from the Draft Sustainability RTS once published or lay out its own set of technical standards. It is also unclear what the approach will be on social and governance aspects.
The UK taxonomy regulation will be modelled on the EU Taxonomy Regulation and will apply to both financial and non-financial firms (the "UK Taxonomy Regulation", together with the EU Taxonomy Regulation, the "Taxonomy Regulations"). The UK government established the Green Technical Advisory Group ("GTAG"), set up for an initial period of two years to oversee the Government’s delivery of the UK's green taxonomy framework and determine whether investments can be defined as environmentally sustainable or not. The GTAG is currently reviewing EU metrics and assessing their suitability for the UK. We look forward to publication of the GTAG's technical screening criteria soon in order to get more clarity on the compliance obligations of financial institutions and corporates – the UK Taxonomy Regulation is intended to launch by the end of 2022.
The UK government's green finance strategy aims to "green" the financial system, mobilising finance for clean and resilient growth, and capturing the resulting opportunities for UK firms. In the 2019 Green Finance Strategy the UK government established a working group, chaired by HM Treasury and made up of regulators and government departments, to explore the most effective approach to implementing the recommendations of the TCFD1. On 9 November 2020 the Chancellor of the Exchequer announced that the UK will become the first country in the world to make TCFD aligned disclosures fully mandatory on a phased basis across the economy by 2025, going beyond the ‘comply or explain’ approach. A key point of HM Treasury's decision is the inclusion of an obligation to publish consumer-focused disclosures showing the impact, risks and opportunities of the activities companies finance on sustainability. In October 2021, the Chancellor of the Exchequer also announced that the UK will set new standards for environmental reporting to weed out greenwashing and support transition to a greener financial system.
Types of ESG Securitisations
Based on industry-led initiatives, various forms of ESG securitisations have been taken to market in recent years. Of these forms, the most transparent transactions are those involving the securitisation of assets which are themselves seen as being "ESG" and therefore qualify as ESG collateral, with the proceeds of these transactions typically being used for the origination of more of these assets ("ESG Collateral Securitisations"). These transactions require a clearly identifiable portfolio of homogenous ESG assets. In recent years, asset classes such as green residential mortgages and, in the USA, auto loans for electric vehicles have largely been used for these purposes.
A model in the market, Green Storm 2021 (the fifth of its name) involved the issuance of green RMBS consisting of properties with a high EPC rating where proceeds are allocated to the origination of further "green" mortgages. Also noteworthy as a first in the Continental European market, auxmoney recently issued a social ABS in its Fortuna 2021 debut with assets consisting of loans to consumers who are typically excluded from the traditional consumer banking space. ESG Collateral Securitisations will typically follow the green bond or social bond principles outlined above, with Green Storm 2021 based on the ICMA Green Bond Principles (the "ICMA GBP") and Fortuna 2021 on the ICMA Social Bond Principles (the "ICMA SBP").
For investors, the advantages of ESG Collateral Securitisations are clear: there is less risk of ESG-washing, the link to ESG is intuitive, and repayments under the bonds directly come from "ESG" cash. This view is also shared by AFME, which holds that the underlying assets are key in determining whether a securitisation could be considered "green".
There are some disadvantages however. Chief of these is the fact that there is still a limited volume of ESG collateral available. There is a distinct shortage of sufficient ESG assets in the real estate and automotive sector, and the market has limited experience with other asset classes such as social loans or domestic solar energy products. Looking at RMBS for example, the share of buildings across Europe with an EPC rating is still small, and EPC class A properties are rare. The definition of ESG Collateral Securitisation under the various principles currently in place in the market is also quite strict. This means that, for example, the finance company of an automotive manufacturer securitising financial products for conventional vehicle stock with the intention of using the proceeds for the manufacturer to invest into the research and production of electric vehicles would likely not qualify as a ESG Collateral Securitisation.
Whilst ESG Collateral Securitisations therefore provide the most transparent and clear-cut link to ESG for a securitisation, the strict view regarding the nature of the underlying assets coupled with a lack of availability of these assets is likely to restrict the number of ESG Collateral Securitisations coming to market in the near future. This is unsurprising, particularly for green assets, as economies globally need to transition to net zero. We believe securitisation could support this transition through use of proceeds securitisations with clear accountability and impact reporting, as set out below.
Use of Proceeds
There is, in our view, great scope for use of proceeds securitisations to contribute to a growing ESG share in the industry and to support the transition of economies globally. As the name suggests, a "use of proceeds" securitisation is one where the underlying assets may not be ESG linked, but the financing raised by the transaction is used for ESG objectives ("ESG Proceeds Securitisations").
Within the securitisation industry, a noteworthy transaction in the sustainability space was the River Green Finance 2020 CMBS deal, which securitised the real estate acquisition loan for the River Ouest building in France and used the proceeds to enable environmental initiatives around the site, such as encouraging low carbon transportation among employees through the inclusion of multiple electric charge points and the provision of electric cars. In the social space, Yorkshire Building Society recently launched its Brass 10 RBMS, exclusively applying proceeds to finance or refinance new and existing social projects, including social housing and underserved segments of the market such as first-time-buyers, self-employed borrowers, as well as early and later-life lending. Both River Green Finance and Brass 10 follow the ICMA GBP and ICMA SBP, respectively.
ESG Proceeds Securitisations have some distinct advantages to offer, including the fact that they are less prescriptive than ESG Collateral Securitisations and are not restricted to a pool of homogeneous ESG assets. On public transactions, ESG Proceeds Securitisations can attract larger financing volume and enable the origination of further ESG assets going forward, supporting the transition of a business and the wider economy. This can become an important solution to the lack of ESG eligible assets currently plaguing the industry.
A key risk to investors remains the potential for ESG-washing within a ESG Proceeds Securitisation: if originators base a transaction on "brown" (or non-ESG assets) investors will be keen to confirm that sufficient comfort is in place to ensure proceeds are properly applied, particularly as limited post-closing control is available to investors once the funds have been passed on from the issuer SPV to an originator. Reputational risk plays a key role for investors in a world of enhanced social, political and media scrutiny, and where accusations of ESG-washing are rife. We acknowledge some investors may look for greater clarity as to whether an ESG Proceeds Securitisation is appropriately designated as ESG aligned and that well-crafted regulation may help in this regard. However, we would suggest that, initially, the market should be allowed to develop with a number of industry-led principles and guidance, and that these may ultimately be subject to further overarching regulation. Care would need to be taken to ensure that this regulation is proportionate and targeted to ensure that the growth of an ESG segment in the market, which is already subject to a heavy regulatory, transparency and compliance burden, is not stifled.
We believe ESG Proceeds Securitisations could be key in jumpstarting the ESG securitisation market and enabling it to reach the same deal volumes as ESG loans and straight debt bonds, a view shared by the ECB. Originators with balance sheets which are simply not yet big enough to accommodate an adequate amount of green collateral (assuming they could even source a sufficient amount) are offered the possibility to raise finance for the origination of future ESG assets. It also plays an important role in supporting the transition of businesses and the wider economy.
For the ESG Proceeds Securitisation format to thrive investors may require greater transparency and improved impact reporting. The securitisation market is already used to data reporting and high levels of asset transparency. The challenge will be to ensure that any ESG reporting requirements work well within existing infrastructures, without creating additional burdens that would disadvantage ESG securitisations.
Investors also need to trust that the companies involved in these structures are committed to ESG. Those companies that invest now in establishing their ESG credentials may see dividends later on.
One way in which ESG Proceeds Securitisations could address some of the concerns raised above is through the use of margin ratchets linked to ESG key performance indicators ("ESG KPIs") (akin to what is already common in the loans market and the corporate debt market). If the ESG KPIs are met, the margin under the senior notes would decrease, and the return to the originator under the subordinated notes or deferred purchase price would increase. Conversely, if the ESG KPIs are not met the margin under the senior notes would increase and the return to the originator would decrease. This would clearly align the interests of the originator with delivery of the ESG KPIs through the use of proceeds from the transaction. Of course, applying this approach to a securitisation would have its own challenges, including requiring fairly limited tranching involving only senior and junior noteholders, with the originator retaining all of the junior pieces, failing which the upside and downside risk of ESG KPI performance would not sit with the originator. From an investor perspective, the market seems keen to support ESG deals but meaningful ratchets and KPIs may need to be offered to encourage alignment of the originator with delivery of the ESG KPIs. In turn this would mean investors, potentially, foregoing part of their return and debt stacks having to be sized to take into account rating agency modelling at the potentially higher level of return to the senior noteholders if ESG KPIs are not met. In addition, significant margin adjustments may trigger requirements for investors to re-value assets depending on applicable accounting rules. Nevertheless, this structure could offer interesting opportunities for investors and originators alike, particularly with regards to increasing accountability for how originators use proceeds, and rewarding those originators who stick to their promises.
Greenwashing is at the forefront of every ESG investor's agenda (it is the biggest concern for over 44% of investors). There is currently some lack of consistency in instrument labelling and post-issuance disclosure which leads investors to fear that claims made by originators in relation to their securitisation may be overstated or unreliable. As mentioned above, it is estimated that there are currently more than 200 ESG frameworks available worldwide, which may lead to framework arbitrage and a search for the most convenient set of requirements for originators. This concern may be alleviated through clear industry-led standardised principles which may be supplemented by a regulatory framework down the line, an ESG label, increased reporting and disclosures, and prudential capital relief.
Third party verifiers such as Sustainalytics and credit rating agencies providing investors with reports and certifications have done a great deal to alleviate investor concerns about ESG-washing, and offer tools to compare different types of ESG transactions in the market. Substantial steps have been taken in recent years to provide more clarity on what can be considered a "green" asset, and initiatives such as the voluntary European Green Bonds Standards (which advocate for green collateral as well as green use of proceeds) and the Taxonomy Regulations are certainly welcome additions. Of course, whilst the Taxonomy Regulations provide a framework for what can be considered "green", they mostly impose obligations on funds managers and large corporates. The scope of representations and covenants in transaction documents for ESG transactions vary significantly and we expect to see these become more standardised going forward. We also look forward to further developments in industry-led principles to steer the market towards more standardisation, including perhaps the consolidation of various existing principles to create a more harmonised set of guidelines. In time, and once the market has matured, these principles could be supplemented, where required, with well-crafted and proportionate regulation, but regulation should not over-burden the market and suffocate growth.
Most of the focus so far has been on the "E" of ESG and less to address standardisation issues within the "S" and "G". As noted above however, the EBA has been mandated to prepare the Draft Sustainability RTS including all elements of ESG. With input and support from industry bodies, we hope that this will go some way to providing further clarity.
ESG securitisation label
We believe the creation of an ESG label similar to the current STS label could provide the market with much needed clarity and a sound voluntary regulatory framework for ESG securitisations. This label could include ESG Collateral Securitisations and ESG Proceeds Securitisations (or a combination of the two). Such a label would be one way to address transparency concerns raised by some investors. It would also support further standardisation, potentially strengthening investor demand and further alleviating ESG-washing risks. We understand that the EBA is looking into a possible green securitisation label which would be separate from STS but offer synergies between both frameworks – a position which is also supported by AFME. It would be important that (as with STS) the label remains voluntary and the requirements under it are proportional.
Reporting and Disclosure
Additional disclosure requirements are always a burden on originators but have the benefit of providing investors with reliable and standardised information, particularly within the realm of public transactions where the ultimate beneficiaries of asset-backed notes are unlikely to have a direct commercial relationship with the originators in question. This is particularly true in ESG Proceeds Securitisations where the underlying assets are not ESG and investors must be reassured of ongoing compliance with pledges or obligations made by originators and the note-issuing vehicles. We note that annual reporting is already embedded in some of the industry standards such as the ICMA GBP and compliance with these reporting requirements is voluntary. We would note that it is also possible that the Taxonomy Regulations will never be specific enough to cover the vast array of securitisation assets and it might be that a well-structured framework with guidance and some flexibility will be required to promote innovation in the market.
Issuers and investors appear to acknowledge that improved availability of more standardised data would be welcome and help to move the market forward. A balance needs to be struck however to ensure that a level playing field is maintained and that ESG securitisation is not put at a competitive disadvantage compared to other ESG products. It is important that securitisation, in trying to meet its ESG potential, is not over-burdened by new rules, on top of heavy existing reporting requirements. Regulation on this front could ensure periodic reporting is accurate and relevant, but there is a risk that too much regulation could stifle a growing market in its infancy. In our view reporting should include details and evidence of how proceeds have been used and performance of assets to which proceeds have been allocated (impact reporting), but should initially grow organically out of market demand rather than regulatory requirements. Proportionate and targeted regulation may be effective down the line once the ESG securitisation market has matured in order to align principles-based disclosure guidelines. By granting access to reliable information in this way, investors can verify whether their investments comply with ESG requirements and, to the extent required, hold originators accountable where this is not the case.
Beneficial capital treatment could have a significant impact in aligning lending and investment decisions of financial institutions to ESG criteria. There could be substantial scope for regulators to introduce certain forms of capital relief for originators in relation to ESG securitisations, as is currently the case with STS, and on the basis that ESG linked assets should be more resilient to environmental and social risks. This would enable banks to securitise ESG assets and free up capital to be used for new ESG securitisations. Such capital relief would be tied to stringent requirements, alleviating potential risks of ESG-washing. We note that the EBA already touched upon this point and that they would welcome a call for advice to assess the potential benefits from a differentiated prudential treatment for green bonds, which the EBA would consider particularly relevant for green securitisations. Article 501c of the CRR already mandates the EBA to assess prudential treatment for assets associated substantially with environmental and/or social objectives, but that report is only due by 2025. The EBA is also considering a "Green Asset Ratio"; which could be very relevant for securitisations as banks would be incentivised to invest in green assets and divest themselves of brown assets. It is possible that brown capital penalties could also be considered. It remains to be seen whether the UK would consider taking a similar approach.
The securitisation market has a long history of innovation and has unique potential to drive forward ESG developments. Significant attention has been given in recent years to both the climate emergency and social exclusion around the world, the latter only exacerbated by Covid-19. COP26 has made clear that the private sector has a pivotal role to play in the transition to a fairer and more environmentally friendly world. Substantial capital will be required and the securitisation market is well placed to be one of the pillars of this transition. Despite this, figures show that the market is lagging in terms of deal volume compared to other ESG debt instruments. In our view, a broader acceptance of ESG Proceeds Securitisations is crucial to jumpstart the market and finance the ramp-up required to originate more ESG assets. Whilst we acknowledge that ESG-washing is a risk, ESG Collateral Securitisation alone may not be sufficient to move the dial towards a financial system which more fully aligns to ESG criteria and excluding ESG Proceeds Securitisations risks cutting down on the potential for ESG deals in the future. The inclusion of ESG Proceeds Securitisations is therefore key as a transitional step, and an approach which seems broadly supported by market participants and certain regulators. We would therefore expect to see ESG Proceeds Securitisation (or a combination with ESG Collateral Securitisation) as an accepted mainstream form of ESG securitisation in the near future.
In our view, well-crafted regulation has a part to play in alleviating investor concerns about ESG-washing but this should be approached cautiously as over-burdening the securitisation market could risk stifling its initial attempts to align to ESG principles. We would welcome further developments in industry-led initiatives with regards to standardisation and disclosure during this initial phase of the ESG securitisation market instead. Once ESG securitisation is more developed further comfort could be provided by recommending clear disclosure guidance, particularly with regards to impact and data reporting, and supporting best-in-class transactions with an ESG label akin to what is provided for STS. Finally, regulatory capital reliefs should be adjusted to better align to ESG criteria.
The nature of securitisations is complex and issuances will always be time-consuming. Well-crafted and proportionate ESG regulatory initiatives potentially have a role to play in ensuring that the market remains not only safe and secure, but also attractive for investors and originators alike who seek to contribute to a more sustainable and fairer world. There seems to be regulatory support for these initiatives, at least in the EU, and we look forward to seeing how this develops in the coming months.
- Task Force on Climate-related Financial Disclosures ("TCFD"), a task force set up by the Financial Stability Board.
Authored by Julian Craughan, Andrew Carey, Jane Griffiths, Steven Minke, and Andrea Salsi