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EXECUTIVE PERSPECTIVE: A Powerful New Engine For Green Finance

Michael Sheren

06 Dec 2017

In this important post by Michael Sheren, he proposes a new twist on securitization, or pooling of credit, that aims to accelerate the rate at which global capital markets can participate in green finance.

The message sent following the ratification of the Paris Agreement on climate change was clear, the world must urgently transition away from a high carbon, polluting and resource intensive economic model. Rapidly advancing this transition should help mitigate the worst effects of climate change and facilitate new sustainable economic growth. This growth will range from sustainable infrastructure to innovative battery technology and act as an engine for new future-facing jobs. However, financing these opportunities at the necessary scale and pace will be more difficult without reviving and then accelerating the issuance of green securitized bonds within the global debt capital markets.

Leading up to the financial crisis, securitization[1] was an important work-horse within the global debt capital markets helping banks to free up balance sheets to underwrite more loans by selling assets into the capital markets. Standardized debt products such as car loans and credit card receivables were repackaged into asset based securities. Larger and more complex debt such as leveraged loans were sold into collateralized loan obligations. Other than US residential mortgage backed securities (“RMBS”), the vast majority of these pooled structures held up very well during and after the financial crisis[2]. However, all securitization was tainted by the US sub-prime RMBS that brought the market to a screeching halt and in the process, almost took down the global financial system. That said, even RMBS is looking for redemption as Fannie Mae has printed $US 19 billion worth of green residential mortgages as of Q3 2017.  The recovery of the global securitization market has been slow. However, it is gaining momentum and despite its tarnished reputation, it’s time to re-exam, restructure and accelerate securitization so it can play its part in significantly mitigating the risks anticipated from climate change.

The amount of global capital in play to finance the green transition in the global economy is staggering; over the next fifteen years sustainable Infrastructure alone will demand over $90 trillion.[3]  Currently most infrastructure and other assets such as electric vehicles and green mortgages are funded by bank loans[4]. The enormous task of financing the transition is too big to be achieved solely off the backs of commercial banks[5].  Further, many sustainable investments require long tenors, often fixed rate that are miss-matched with the short-term floating tenors of wholesale borrowing and on-demand deposits that make up bank balance sheets. Hence, the highly liquid debt capital markets must be major part of the sustainable solution. To release balance sheet capacity for new sustainable companies and assets, illiquid bank loans must be repackaged into a liquid format that appeals to long term investors.

Globally, there is nearly $US 100 trillion[6] under management between insurance companies, pension funds, sovereign wealth funds and other institutional investors; however, currently less than 1%[7] of their holdings are in green investments.  Most institutional investors can only purchase public, rated and freely tradable investment products such as bonds.  Bank loans largely do not meet the investment criteria of institutional investors; however, repackaged loans could qualify, thereby opening up trillions of new liquidity to fund the transition. A transfer mechanism to move sustainable loans from banks to the capital markets is needed and securitization is that mechanism.

In 2016, a total of $US 95.1[8] billion of green bonds were issued but only $US 5.0 billion of this volume was asset backed securities(ABS).[9]  Despite a continued increase in volume over the last five years, green bonds of all types remain a small fraction[10] of the $US 90[11] trillion global bond markets.  To increase deal flow and achieve the potential volumes calculated in Figure 1, the securitized path from bank balance sheets to the capital markets must be accelerated.  In doing so, not only will green assets migrate to institutional investors, bank balances will be freed up to underwrite NEW green loans.  Thereby recycling the funds and creating a green circle.

Figure 1: Green ABS/CLO has the potential to scale to USD 280-380 billion in annual issuance by 2030

Source: OECD (2016) Analyzing potential bond contributions in a low-carbon transition[12]

Accelerating green finance through securitization would see banks, in scale, identifying and tagging eligible loans on their balance sheets.  Loans tagged as green would be eligible for green securitization. Once the green loans are identified, tagged and pooled, the securities would be structured to meet the investment preferences of global institutional investors. Essential structuring work would aim to obtain an optimal credit rating, tenor, currency and coupon, among other investment preferences to maximize liquidity. In some cases, a bond may not achieve one or more of the desired preferences and in such cases, financial structuring tools could be employed. These tools include credit tranching, first loss guarantees, insurance and over-collateralization.  The importance of these tools and their ability to attract liquidity by structuring bonds in a way that crowds-in private institutional investors cannot be overstated.

Structuring bonds to attract international institutional investors in emerging markets can pose challenges around country risk, illiquid currencies and rule of law. However, some of the financial structuring tools mentioned above can be applied to support asset based green bonds in these markets.  The most important tool is creating a subordinated portion of debt that will take the first loss over the senior debt in the event of default. By structuring a subordinated tranche or by providing insurance or a guarantee over a portion of the bond, the credit of the senior portion of the bond is enhanced and can bring in private sector investors.  Further, transferring the first loss or guaranteeing this risk in respect of green financing will reduce the capital to allow the bank to originate more green loans.  Alignment of interests can be achieved through a requirement that originating banks retain an ongoing interest in the loans.

On the regulatory side, there has been significant progress in reviving securitization, however, challenges persist.  In the EU, efforts to structure Simple Transparent and Standardized (STS) securitization as a stronger and safer asset class that would carry lower capital requirements is progressing. However, EU Insurance companies remain mostly locked out of securitizations by challenging capital requirements under Solvency II.  In the US, lack of clarity on the accounting treatment on risk retention rules that define what qualifies as a true sale have surfaced causing confusion in the market. Clarity on these issues could meaningfully increase the volume of green securitization in the EU and United States.  Finally, an effort to identify and adjust the regulatory friction to securities in areas around sustainable infrastructure would be a positive signal to the markets.

Green securitization is not a silver bullet but it is an important tool to manage the global balance sheet by matching long term investors with long term sustainable assets. Further, empirical evidence is emerging that sustainable investments perform better and default less than other investments[13].   Hence, financing the transition to a sustainable world is not just essential for the planet, it’s also smart investing. Banks remain on the front line of financing sustainable projects and infrastructure represents the biggest need for green growth; therefore, the acceleration of green loans to the debt capital markets is essential drive the transition and provide long term assets to institutional investors. But, green securitization, unlike the other financing solutions above, allows banks that originate green loans to recycle the capital they dedicate to green financing.

A big challenge calls for big, bold action.  There is no challenge bigger than the threat to humanity posed by climate change.  Support for the accelerated development of green securitization should be part of the solution. This initiative could be an important step in moving the trillions required by growing a sustainable global green capital markets product of scale that will help put the world on the path to a sustainable future.

Michael Sheren is an Honorary Research Associate at Oxford University’s Smith School of Enterprise and Environment as well as the Co-Chair of the Academic Committee of the International Institute of Green Finance at the Central University of Finance and Economics, Beijing China.  Mr. Sheren has over twenty-five years of experience in the debt capital markets in London and New York. This article was written in a personal capacity and does not reflect the policies or opinions of any organization affiliated with Mr. Sheren. 

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[1]Securitisation defined across all pooling structures: asset based securities, collateralised debt obligations and covered bonds, residential/commercial mortgage backed securities etc…

[2] https://www.spratings.com/documents/20184/1393097/SF10Years/b0f1300a-5ed5-407d-8d3b-77fdc3b1f20c

[3] http://newclimateeconomy.report/2016/

[4] http://cfi.co/finance/2017/07/otaviano-canuto-world-bank-matchmaking-finance-and-infrastructure/ ; According to IJGlobal and Thomson One Banker, 66%-90% of global project finance are funded by bank loans from 2007-2015. Sources: Q1 2016 League table Analysis (April 15 2016), IJGlobal; Project Financial International, Thomson One Banker

[5] Total on balance sheet assets of  the world’s largest banks are less than the US$ 90 trillion needed just for sustainable infrastructure http://www.snl.com/web/client?auth=inherit#news/article?id=40223698&cdid=A-40223698-11568;

[6] http://www.worldbank.org/en/news/feature/2015/06/18/institutional-investors-the-unfulfilled-100-trillion-promise

[7]http://www.oecd.org/cgfi/resources/Progress_Report_on_Approaches_to_Mobilising_Institutional_Investment_for_Green_Infrastructure.pdf

[8] https://about.bnef.com/blog/green-bonds-2016-review/

[9] https://www.climatebonds.net/files/files/March17_CBI_Briefing_Green_Securisation.pdf

[10] Total cumulative green bond issuance stood at USD 221 billion as of January 2017; a minute but rapidly growing fraction (0.25%) of the USD 92.7 trillion global bond markets. Green bond issuance accounted for 2.1% of global debt capital markets underwriting volume in 1Q17 up from 1.4% YoY. Source: SEB & Bloomberg

[11] http://europe.pimco.com/EN/Education/Pages/Everythingyouneedtoknowaboutbonds.aspx

[12] http://www.oecd.org/cgfi/quantitative-framework-bond-contributions-in-a-low-carbon-transition.pdf

[13] https://www.bofaml.com/content/dam/boamlimages/documents/articles/ID17_0028/equityStrategyFocusPointADeeperDive.pdf

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