Sustainable securitisations: tapping into the ‘old’ to catch the wave of new opportunities
Massimiliano G Danusso
Bonelli Erede Lombardi Pappalardo, London
massimiliano.danusso@belex.com
Ilaria Parrilla
Bonelli Erede Lombardi Pappalardo, Milan
Sara Pirri
Bonelli Erede Lombardi Pappalardo, London
Financing that takes into account environmental, social and governance (‘ESG’) factors has been gaining prominence for several years now, so much so that ESG assets are expected to represent a third of global assets under management by 2025.[1] Indeed, investors are increasingly seeking products that are not only financially appealing but also aligned with the broader ESG agenda.
The ESG financing figures for 2021 published by the Association for Financial Markets in Europe (‘AFME’)[2] show that new ESG bond and loan issuances peaked at EUR 749.8bn for the 2021 financial year, up significantly from EUR 396.4bn in 2020. ESG securitisation issuances also increased in 2021 to EUR 8bn (up from EUR 2.1bn in 2020) with a variety of asset classes, mostly consumer asset-backed securities and residential mortgage-backed securities. However, ESG securitisation volumes remain relatively modest as they only account for around two per cent of European Union ESG bond issuances and around six per cent of EU securitisation issuances. This is likely due to the lack of a commonly agreed, clear definition of securitisation that meets ESG standards.
How to best adapt securitisations to address ESG concerns has in fact been an issue for some time and was recently looked into by the European Banking Authority (‘EBA’) in its report of 2 March 2022 on ‘Developing a Framework for Sustainable Securitisation’ (‘EBA Report’).
The EBA Report, which shows that it would be premature to establish a dedicated framework for sustainable securitisations, offers insights on how to get the most out of the already available or upcoming tools as an intermediate step to allow the sustainable securitisation market to develop to its full potential.
Background and state of play of the EU ESG securitisation market
As mentioned, the volume of financing to support the transition towards more sustainable economies has increased in recent years, and the development of various sets of regulations related to sustainable economic activities has been steadily embraced by the financial sector.
However, although sustainability is becoming an increasingly important matter for market participants, the development of the EU sustainable securitisation market is lagging behind compared to equity and corporate debt finance (eg, green bonds, social bonds and sustainability-linked bonds), and only a limited number of securitisations labelled as sustainable have been seen in the EU.
Certain intrinsic characteristics of securitisations, for example, the variety of products, parties and types of underlying assets and structures, and the complexity of the EU securitisation regulation, have curbed their development and limited their attractiveness on the market.
Furthermore, as the EBA noted in the EBA Report, there is a clear lack of ESG-aligned assets to collateralise and originate. Indeed, even when clear indicators exist for how securitised assets can meet ESG criteria (eg, low emissions/electric cars for auto ABS, or sustainable infrastructures for corporate ABS), the stock of these assets is currently insufficient to form the basis of a liquid ESG securitisation market.
What is already on the table: the building blocks of ESG/sustainable securitisations
At present, there is neither a market standard nor a label exclusively applicable to ESG/sustainable securitisations. Moreover, the major pieces of legislation developed in the sustainable finance market to date, that is, Regulation (EU) 2020/852 (the so-called ‘Taxonomy Regulation’) and Regulation (EU) 2019/2088 (known as ‘SFDR’), do not directly apply to securitisation transactions.
Therefore, based on market practice, the following three elements are usually considered when evaluating the sustainability credentials of a transaction:
- whether the assets that back the transaction fully or partially comprise collateral that positively impacts ESG factors;
- whether the assets’ sales proceeds (or the capital relief in cases of synthetic securitisations) are used to fully or partially finance or refinance assets that positively impact ESG factors; and
- whether the key parties to the transactions (including the originator and the servicer) undertake to achieve certain sustainability-related key performance indicators (KPIs).
The above elements are usually combined, which results in a wide range of transactions that can in principle qualify as sustainable securitisations.
Market participants can also rely on the non-binding frameworks developed by the International Capital Markets Association in relation to sustainable bonds,[3] which apply to all types of bonds, including securitisation bonds.
Furthermore, the proposed regulation for an EU green bond standard (‘EU GBS’), which is currently making its way through the European legislative process, applies, to a certain extent, to securitisation transactions. Indeed, under the proposed draft, the requirement for a securitisation bond to be eligible for the EU GBS label is to be a security issued by a securitisation vehicle. Therefore, while true sale securitisations fall within the relevant scope of application, synthetic securitisations are de facto excluded from the eligibility under the EU GBS as they typically do not envisage a bond issuance.[4]
Market concerns and the EBA Report output
Despite the relative under-development of the ESG securitisation market, investor demand is increasing steadily. This trend creates two main challenges:
- the lack of eligible collateral and verifiable, easily comparable, high-quality information regarding existing portfolios creates risks of greenwashing and associated reputational concerns; and
- the understandable request from investors for greater standardisation, transparency and verification pushes for more regulation to reduce, at least to a certain degree, the risks of investing in something that is an ESG securitisation only on the surface. This could, however, trigger the risk of overregulation with overlapping and conflicting frameworks, and the associated potentially prohibitive compliance costs.
Finding a balance between these opposite factors is probably the main challenge currently faced by the ESG securitisation market. Indeed, leaving the area completely unregulated and relying solely on market initiatives does not appear a viable option, given the relative complexity of securitisations as a financing tool and the multiple regulatory frameworks in the pipeline and already in place. Conversely, creating too much regulation – especially at this early stage of the market’s development – would work against the objective of unlocking its full potential, particularly in sectors in which other funding tools are unavailable or commercially unattractive.
The EBA shares these very concerns in the EBA Report. Indeed, the EBA – based on the assumption that designing a dedicated regulatory framework for sustainable securitisations is desirable for the future but inappropriate at this stage – recommends that the EU GBS be applied to true sale securitisations, subject to certain adjustments, to ensure a level playing field across all types of green bond instruments.
The EBA’s view is that a use-of-proceeds paradigm might initially be the best way for the market to prioritise ESG concerns. Hence, the EU GBS requirements should apply at originator level (instead of at issuer/securitisation special purpose entity (‘SSPE’) level). This would allow securitisations not backed by a portfolio of green assets to meet the EU GBS requirements, on condition that the originator undertakes to use all the proceeds from the green bond to generate new green assets.
If the use-of-proceeds requirements were to shift from the SSPE to the originator level, additional EU GBS disclosure requirements would be necessary to ensure investors are made aware of the ‘green’ features of the underlying portfolio. More specifically, adjustments to the EU GBS disclosure framework would need to comply with the disclosure requirements under Art 7 of Regulation (EU) 2402/2017 (‘Securitisation Regulation’).
The EBA Report also flags the need to improve the availability of data on the principal adverse impact (‘PAI’) of securitisation investments on sustainability factors. It thus recommends amending the Securitisation Regulation to extend the application of voluntary PAI disclosures to all type of securitisations (not only to ‘simple, transparent and standardised’ (‘STS’) securitisations, as currently envisaged) in the short term, as well as introducing mandatory PAI disclosures in the medium term.
The EBA’s analysis is currently limited to green securitisations, but the approach and findings could be easily extended to other areas of sustainability once equivalent standards are developed.
The case for engaging in ESG/sustainable securitisations
The benefits of and reasons for engaging in ESG/sustainable securitisations include the following:
- business growth and diversification: Investing in sustainable securitisations creates new business opportunities and can be growth-enhancing for investors;
- diversification of the investor base: Setting up sustainable securitisations can be a great opportunity for originators/issuers to diversify their investor base;
- brand and reputation value: Engaging in sustainable securitisations provides involved parties with the chance to brand themselves as forward-thinking, innovative, and sustainable; and
- ESG risk management: Institutions that enter the sustainable finance market are also incentivised to conduct a risk assessment on their sustainable products and could be more resilient to economic changes and financial risks associated with the transition towards a low-carbon economy.
Furthermore, embracing the use-of-proceed at the originator level, as put forward by the EBA, appears to offer other distinct advantages: it is less prescriptive than the use-of-proceeds at the SSPE level, and it is not limited to a pool of homogeneous ESG assets. In fact, it appears to be the most pragmatic approach during a transition phase in which the availability of green assets is rather limited, as it also allows non-so-green originators to enter the sustainable market.
A glance through the Italian legislation: where do things stand?
The EBA’s analysis also provides an opportunity to shed light on the instruments already available under Italian law and how they could be used in a more efficient manner.
Indeed, as a result of the amendments introduced by Law No 160 of 27 December 2019 to Art 7.1 of Law No. 130 of 30 April 1999 (‘Law 130’) relating to non-performing loans (NPLs):
- the scope of Art 7.1 of Law 130 has been extended to receivables transferred at the debtor’s request in securitisation transactions of social value[5] under which a real estate owner company (a so-called ‘ReoCo’) leases to the debtor the real estate asset operating as collateral to the portfolio of NPLs acquired by the securitisation vehicle; and
- a wide range of tax breaks and exemptions has been introduced in favour of market participants that engage in securitisation transactions of social value.
The scope of the Italian regulation is clearly rather limited at this stage, as it is restricted to NPLs and the ‘social’ dimension of sustainability, and operational issues remain open, including what ‘social value’ means in practice. As a result, the relevant market is currently underdeveloped.
However, the instrument available under Law 130 is certainly valid and, although future clarification and regulatory actions are certainly desirable, it represents a good starting point for embedding sustainable securitisations at a national level too.
Furthermore, it appears likely that ongoing developments at the EU level can have a positive impact in this respect. Indeed, the use-of-proceeds approach encouraged by the EBA, if applied to assets securitised by banks, among other players, and the inclusion and enhancement of certain KPIs, might well enable the social securitisation market to develop faster and in a more structured way also at national level, regardless of the lack of a clear ‘social’ label.
Conclusion
There is little doubt that ESG securitisations are becoming an increasingly important segment of the financial markets.
Overcoming existing challenges and balancing demands and objectives will be key to unlocking the full potential of ESG securitisations. This is crucial not only to benefit from all the opportunities ESG securitisations offer on the financial markets but also to achieve broader goals, such as those concerning the climate crisis.
While establishing a dedicated regulatory framework for sustainable securitisations is desirable for the future but inappropriate at this stage, embracing an approach which takes the most out of the instruments we already have on the table and, at the same time, is more tailored to the needs and specificities of the sustainable securitisation market, appears the most pragmatic and efficient way to achieve such a balance in the short-medium term.
Even if certain amendments to existing instruments are required, these can be implemented more quickly than creating a new specific framework for sustainable securitisations from scratch.
This will contribute to making the financial market more consistent and aligned in its development towards sustainability and, ultimately, can also have a positive impact on national legislations where, as shown by the Italian case, the available instruments are often rather limited, and the market is consequently underdeveloped.
Notes
[1] Adeline Diab and Gina Martin, ‘ESG assets may hit $53 trillion by 2025, a third of global AUM’ (Bloomberg, 23 February 2021); available at www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum/.
[2] Julio Suarez, ‘ESG Finance Q4 and Full Year 2021 - European Sustainable Finance’ (AFME, 23 February 2022); available at www.afme.eu/Publications/Data-Research/Details/-ESG-Finance-Q4-and-Full-Year-2021---European-Sustainable-Finance.
[3] Reference is to the Green Bond Principles (‘GBP’), the Social Bond Principles (‘SBP’), the Sustainability Bond Guidelines (‘SBG’), and the Sustainability-linked Bond Principles (‘SLBP’).
[4] Similarly, credit linked notes issued under a synthetic securitisation are also deemed to be outside the scope of the proposed EU GBS as they are primarily credit protection instruments, though they are issued by a special purpose vehicle.
[5] Law 130 specifies that a securitisation is to be considered of ‘social value’ if a social promotion association registered for at least five years takes part in it and assists the debtor in entering into the lease agreement with the ReoCo.