Securitisation and sustainability
A few days from the start in Glasgow of COP 26, the focus on sustainability across Europe has never been as strong. But, beyond the political wrangling and the lofty declarations we are accustomed to, Europe has moved into the phase where actual laws and rules are starting to roll off the production line. In July alone, the European Commission adopted the proposed Carbon Border Adjustment Mechanism (CBAM) and the European Green Bond Standard whilst the European Union passed the EU Climate Law turning the 2019 EU Green Plan into a legally binding obligation on all member states.
At the same time, global capital market investors have raised substantial sums specifically for sustainable investments. In the first quarter of 2021 alone inflows into European “sustainable” funds totaled €120 billion according to Morningstar. Last year, over 700 sustainable funds were set up globally. All indications are that this trend is accelerating.
All this is welcome for anyone who cares for the future of our planet and the living organisms that depend on it, including homo sapiens. Time is extremely short and the time for lofty declarations probably passed a while ago already.
Between the sustainability requirements of global investors and the legal framework falling into place it is increasingly clear that if European securitisation cannot find, practically and legally, a niche within the green capital market ecosystem, it faces a bleak future.
Therefore, PCS thought it useful to issue this Special Edition of the STS Newsletter to canvass the rules relating to sustainability that will directly or indirectly affect securitisations. One should not believe that this is just an issue coming towards us fast. Some of these provisions are already in force.
To ensure that our industry can find its niche we collectively will need to pay close attention to what is being discussed not just around securitisation regulations specifically but around the full spectrum of capital markets and financial regulation.
This Newsletter is divided into sections:
- The background – what is Europe committed to achieve?
- The backbone – what are the two key overarching rules for sustainable finance?
- The disclosure rules – what disclosure rules applicable to finance generally, do impact securitisation?
- The securitisation rules – what existing and proposed securitisation green rules will affect the market?
- The battlegrounds – what are the issues that have already emerged as key discussion points in the coming legislative process?
THE BACKGROUND – the Green Plan
To understand detailed regulatory provisions, it is always useful to go back to the underlying reason for their introduction. What were the legislators and regulators trying to achieve?
All European legislation on sustainability is designed to allow the continent to achieve the European Green Plan. This ambitious program was adopted in 2019. In July 2021, the Green Plan was turned into a law (the EU Climate Law) thus transforming it from a statement of ambition to a legally binding obligation on European Member States.
The Green Plan contains two commitments:
- To reduce emissions by 2030 to 55% of their 1990 levels
- To achieve net zero carbon emissions by 2050
The UK has declared a yet more ambitious set of targets:
- To reduce emissions by 2030 to 32% of their 1990 levels
- To reduce emissions by 2035 to 22% of their 1990 levels
- To achieve net zero carbon emissions by 2050
As with the EU, the UK’s commitments are legally binding through the Climate Change Act, originally passed in 2008 but regularly updated with new targets.
THE BACKBONE – the two EU laws that frame EU sustainable finance regulation
The Taxonomy Regulation came into force in July 2020.
Its purpose is to define what activities will be deemed by the European Union to be “sustainable” when passing rules (e.g. what is a “green bond” or what can banks count as “green assets” when they are required to report to regulators and the public).
The Taxonomy Regulation is very short and basically defines six types of activities as compliant with the EU’s sustainability principles. It then leaves the details to delegated legislation to be drafted by the European Commission.
That delegated legislation is not short.
The first piece of delegated legislation is the Taxonomy Delegated Act issued in July 2021. It deals with only two of the six categories and runs to 512 pages!
It does not even deal with all the activities in the two categories as two of them, nuclear and gas, generated so much controversy that they were left to a later delegated act. If you read in the press about political fracas around those energy sources, it was about this delegated act.
The UK government, for its part, announced that it would also create a green taxonomy by the end of 2022. To assist, a new advisory group was created in June of this year: the Green Technical Advisory Group (or, for those worried by a possible drying up of acronyms in this area, the “GTAG”).
The EU Green Bond Standard
The European Union Green Bond Standard (or “EU GBS”) is a piece of draft legislation adopted by the European Commission in July 2021. It is now placed before the European Parliament and the European Council for discussion and amendment and will likely become law sometime in 2022.
It defines a voluntary green standard for capital market instruments. Securitisations are explicitly mentioned as instruments that may achieve the standard. How though is not settled – see our paragraph below on the battlegrounds.
The current proposal is that EU Green Bonds are bonds whose proceeds finance activities compliant with the Taxonomy Regulation and whose sustainable credentials are certified by independent and regulated third parties. Note that non-EU bonds are allowed to qualify for the EU GBS.
Do not get too complacent about the word “voluntary”. Although the EU is unlikely to ban an issuer from describing their bonds as “green” or “sustainable” unless they meet this standard, rather than some other standard (e.g. ICMA or CBI) it is likely that the EU GBS will be used in all legislative and regulatory rules dealing with sustainability and the capital markets. It is also likely to underpin the actions of important public sector market actors such as central banks and multi-lateral financing entities.
It is therefore vitally important to ensure that the EU GBS allows securitisation fully to play a role in the financing of Europe’s transition to a sustainable economy. That battle is far from won – see “battlegrounds”.
It is not clear at this stage whether the UK will opt to pass similar legislation defining green capital market instruments.
THE DISCLOSURE RULES – the rules that indirectly affect securitisations
A number of rules of general application, some already in force, will have an indirect but powerful impact on the securitisation market. These rules require various capital market participants to disclose how green are their activities.
SFDR – the Sustainable Finance Disclosure Regulation
The SFDR came into force in March 2021. It imposes mandatory disclosures on “manufacturers of financial products” and financial advisers.
This is not the place to go into the multiple levels of disclosure required by the regulation. The key point is that “manufacturers of financial products” covers pretty much all asset managers and those asset managers are mandatorily required to disclose the sustainability standards of their funds. This applies even to funds that do not claim to be green.
Not only is the disclosure mandatory, but the level and format of the disclosure will be made mandatory through a delegated act. A draft of the delegated act issued by the Joint Committee of the ESAs already exists.
The disclosure requirements do not kick in until June 2022 but – like accountancy periods – this looks back. PCS knows of a number of European funds already asking originators to provide the information required to fulfill their SFDR obligations come next year.
As SFDR came into force in 2021, it was not binding on post-Brexit UK. The UK chose not to apply the SFDR opting instead, in line with its apparent new policy, to leave this type of matter to the regulatory authorities rather than to legislative acts.
In June 2021, the FCA published a consultation paper on new climate-related disclosure requirements for asset managers, life insurers and pension providers, with a phased-in approach starting 1 January 2022 for the largest firms.
Although the content and timing will be different, the set-up in the UK is not likely to be fundamentally different to that in the EU.
NFRD – Non-Financial Reporting Directive
In 2013, the EU passed two directives: the Accounting Directive and the Non-Financial Reporting Directive. The aim was to standardise company reports across the union.
In 2020, the Taxonomy Regulation (remember that one) required the European Commission to amend the NFRD to add sustainability information to the non-financial disclosure required of large and listed companies. In July 2021, the Commission did just that.
The NFRD applies to both banks and insurance companies. It imposes companywide disclosures. But to compile and publish the necessary sustainability information, those banks and insurance companies will need to put in place internal reporting processes to capture the relevant data, for example from investments made by the bank or insurer.
Today, the bank bid represents around 30% of primary securitisation issuance.
Article 449a of the CRR
Supplementing the NFRD obligations of banks, article 449a of the Capital Requirement Regulation (CRR) is a Pillar 3 requirement.
The article will require all large, listed EU banks, as of June 2022 to provide the following:
- quantitative disclosure of ESG risk
- qualitative disclosure of ESG risk
- quantitative disclosure of physical climate risk
- the bank’s ESG policies, KPIs and GAR
The EBA is tasked with defining exactly what those disclosures will need to contain. It consulted on the matter in March of this year and launched a survey in September.
Note the last three letter acronym in the list – GAR – as this will become very important.
Green Asset Ratio – GAR
A new bank metric has now been endorsed by the EBA for both Article 449a and for NFRD disclosure: the Green Asset Ratio or GAR.
As its name indicates, the GAR will be a percentage of “green” assets in a bank’s total assets.
Why should the securitisation community care about these disclosure rules?
There are two reasons these disclosure rules matter for securitisations.
First, bank treasuries and asset managers together form most of any publicly placed securitisation’s investor base. As these disclosures are or will be mandatory, both banks and asset managers will set up internal compliance procedures to gather and process the sustainability data relating to their investments so that they may summarise them for their regulatory filings. If this information is not provided to potential investors by the originator (directly or through some third party), these investors will have to do their own digging to be able to meet the internal compliance information requirements. That is likely to be very unattractive. Therefore, selling a securitisation without attendant sustainability information is likely to become challenging.
Second, all this disclosure – so far – is designed to put moral pressure on investors. It is assumed that no asset manager will wish to report that their funds have a negative impact on the planet. Most banks will probably compete to show the highest GAR amongst their peers. If a securitisation cannot report at least no negative green impact, it will be that much less attractive to most reporting investors. We saw a similar effect in relation to the Liquidity Coverage Ratio rules: securitisations that could not qualify for LCR pools could still be purchased by bank treasuries but de facto lost all or most of the bank bid.
THE SECURITISATION RULES – the green rules that directly affect securitisation
Currently, the only green rule specific to securitisation, is the requirement for STS securitisations backed by auto or mortgage assets to report available information on environmental performance (article 22.4 of the Securitisation Regulation).
A helpful EBA interpretation of “available” has ensured that originators only had to report information that was centrally available rather than conduct expensive and time-consuming research of their securitised pools.
In the April 2021 amendment to the Securitisation Regulation – which opened STS status to synthetic securitisations and made the rules on NPL securitisations more sensible – the EBA was also required to produce a report on the way this information was presented. The report was due in July 2021 but has yet to be published.
More important, in the same regulation (article 45.a), the EBA was also mandated to produce a report on how sustainability disclosure should be made in the context of securitisations generally. This report is due by November 2021 but likely to be delayed.
This second report on general green disclosure contains potential dangers for the securitisation market:
- excessive requirements: if the requirements are unreasonable and would, for most originators, necessitate exorbitant costs in time or money, it will effectively close the possibility of their participation in the securitisation market.
- more unlevel playing fields: the fact that the EBA has been requested to produce a report on securitisation alone rather than on any bond claiming to meet the EU GBS means that there is a real possibility that securitisation issuers will be required by law to produce different and considerably more onerous information than issuers of any other EU GBS capital market instrument. This would intensify the legal discrimination against securitisations versus other instruments of similar risks and characteristics and be diametrically opposed to the EU’s oft stated goal to promote a safe European securitisation market.
- indirect pre-empting of the EU GBS debate: As we will see in “Battlegrounds” below, there is a debate on exactly what a green securitisation looks like. It would not be helpful if the conclusion of this debate were pre-empted by the EBA selecting disclosures that are only compatible with a certain approach to green securitisation (e.g. green assets only)
Finally, and obviously, although the EU GBS debate is not a securitisation debate, the final standard will cover and therefore directly impact securitisations.
THE BATTLEGROUNDS – the emerging issues for securitisation
Green assets versus green proceeds
The first issue to have emerged as a point of contention is whether a green securitisation must be a securitisation of “taxonomy compliant assets” or whether it can be a securitisation where the proceeds are used for lending to green projects.
On the one hand, the draft EU GBS legislation is clear: a green bond is a bond whose proceeds go to fund sustainable, taxonomy compliant activities. A green bond is one that finances the transition to a sustainable economy. Therefore, it follows logically that if the cash raised by a securitisation is used to transition the European economy to a sustainable state, like for any other capital market instrument, that securitisation qualifies as a green bond under the EU GBS.
Some voices have been raised in the market and regulatory communities to suggest that only securitisations of green assets should count as green securitisations. This approach has a superficial intuitive attractiveness, but in our view is wrong both as a matter of logic and green principles.
- Logic: If a company issues a five-year corporate bond to fund a six-year project to build an off-shore wind farm, the investors accept that they will be paid interest and principal on this bond from that company’s brown income. But a wind farm is funded and there is zero doubt that this bond meets the EU GBS. If the same company securitises the brown assets that otherwise would generate the cash to pay the corporate bond and so funds the same wind farm with a securitisation, it makes no sense to deny that securitisation green status. The same wind farm is built with the same money and in both cases the investors get paid by the same cash generated by the same brown assets. The only difference is the balance sheet on which those assets can be found.
- Green Principles: The climate emergency worsens every year and the amount of per annum funding required to achieve the green plans increases as nations and unions fall behind. It is essential that any safe and legitimate financial channel able to contribute to the green transition be fully mobilized. There are reasons – which PCS will go into in a longer paper we intend to publish soon – to believe that certain types of green projects and transformations may not obtain finance (or will obtain less finance) without securitisation. To impede the securitisation channel from funding the green transition on a logically weak formalistic argument runs counter to the overwhelming need to green our economies fast.
The legislative and regulatory debate around capital markets, green finance and sustainability in both the EU and the UK is proceeding very fast and has many moving parts. Although we believe that objectively, securitisation has an important positive role to play in the greening our economies, it will only be able to do so if it can find a niche in the green finance ecosystem. To do this, the final regulatory framework must be holistic, fair and workable.