The green mortgage-backed securities market prepares for take-off

A lack of labelling and benchmarking standards has hampered the development of green asset-backed securities – but change is coming

Green asset-backed securities (green ABS) look set to thrive, with standard ESG criteria finally on the horizon. The absence of such labelling and benchmarking information – for measuring product performance and customer risk – has proven to be a real challenge for the securitization industry thus far.

But November 2021 will see the launch of the European Banking Standards Green Product report. It was the subject of much anticipation at the Global ABS conference recently held by the Association for Financial Markets in Europe (AFME) and Information Management Network (IMN).

Many of the speakers were hopeful that the report would lead to an environmental, social and governance (ESG) labelling mechanism within the securitization market.

Such a development could offer issuers and underwriters alike some concrete guidelines on how to base products and risk assessment. This in turn could accelerate the much-awaited green mortgage-backed securities marketplace.

But many questions remain. The most pressing of these is fundamental: just what should a green ABS actually look like? Most of us have a vague sense of the answer to this – even without standards or product labels to work from. But how can we be sure we are all in tune?

Identifying the challenges for integrating ESG criteria into green ABS

A key barrier here is the lack of existing green products from which to build. There is not a lack of interest though: consumers and corporations do mostly want to be green; investors are asking for ESG investment opportunities and governments are pushing for zero-carbon initiatives. There’s even preliminary research from the IMF that suggests green bond, green loan and sustainability-linked-loan borrowers should lower their emission intensity over time at a faster rate than other firms.

So what’s the hold up?

Arguably, securitization lags behind other fixed-income asset classes (e.g. cash, loans and bonds). That may be due to the complexity of some of the assets and the structures. But given that we are dealing with a relatively fixed pool of assets, it should be possible to judge and monitor once green parameters are established.

Government incentives and zero-carbon deadlines are in train in the UK already. The country’s independent Climate Change Committee (CCC) has already stated that by the early 2030s every new car, van and replacement boiler must emit no carbon, with all UK electricity production following suit by 2035.

If ESG criteria integration into financial products works only in a binary way – with products either meeting ESG compliance or not – there may be social implications of green ABS progress. Affordability could become an issue for green mortgages, electric vehicles and green home-improvement loans.

This possible social dilemma further highlights how hard it is to set about labelling products without a consensus on performance and risk.

Understanding Energy Performance Certificates (EPCs)

Focusing on residential mortgages, the environmentally friendly aspects are based largely on Energy Performance Certificates (EPCs). Recently there has been much debate over their accuracy and benefit to the environment. This also applies to the buy-to-let market.

A landlord in the UK can rent out a property as long as it is above an E rating on its EPC. This is just two above the worst efficiency rating, leaving little incentive for investment in energy-efficient improvements.

The issues with EPCs raise more questions for investors and providers. Clearly there are different shades of “green”. So what proportion of assets in a pool must meet ESG compliance or have a certain EPC rating? And how can this be monitored over time?

Europe’s housing stock highlights this challenge, with only 4.6% of European buildings built after 2010. (The EU legislative framework includes the Energy Performance of Buildings Directive 2010/31.) Beyond the commercial mortgage field (with its own regulations), residential mortgage-backed securities (RMBS) have only the EPC to go on.

So will green homes reduce the cost of capital for mortgage lenders? Issuers will need to be confident that they are funding residential or commercial assets that will achieve zero-carbon goals in budget and on time. Energy improvements could be factored into the transaction and monitored if the data was captured at the underwriting stage.

Third-party verification to validate ESG credit ratings

The securitization segment operates in a highly regulated market with extensive reporting obligations for compliance. Yet there is a gap in the capture and reporting of ESG data. Third-party verification will be needed to address that.

The regulation does mean the industry is already on top of the “S” (social impact, for instance building customer credit and upward mobility through home equity) and the “G” (for instance in rules against excessive servicing) in ESG. Ensuring that the “E” (the environmental element) is as reliable will require expert verification.

This could provide transparency and impose mandatory ESG disclosure obligations. Investors and issuers will need granularity in the static assets they’re buying. For example, assets shouldn’t lose their ESG status due to increasing technology standards over time. Standards should be fixed from the start.

There must be room for transitioning assets (typically defined as a 30% improvement in the property quality). Risks may need a regulatory treatment, which would appeal to both investors and issuers. The EU’s sustainable finance directive regulation, issued earlier this year, is certainly trying to do just that to avoid greenwashing.

Assuming we get to the promised land, with an agreed framework and a way forward, third-party independent verification agents make sense. They give something on which the industry can hang its hat – and could validate creditworthiness of issuers based on ESG practices and risk assessments.

Why Intertrust Group?

• Intertrust Group is at the forefront of securitization regulation in key markets including Luxembourg, Irelands, the UK, the Netherlands and the Channel Islands.
• We have on-the-ground securitization experts across major financial centres with track records in traditional and alternative funding structures.
• Our experts are in tune with emerging asset classes (including green mortgages, supply-chain and enterprise value financings, and NPLs) and the needs of NFBIs to structure them to appeal to a pan-European investor base.
• We can help clients meet growing KYC reporting requirements in multi-jurisdictional products.