Regulation in the ESG securitization market: what are the needs of the industry actors when it comes to sustainability? In this article, we will review the evolution of the market in regards to ESG from a regulatory perspective. We will also look at EBA’s recommendations concerning the dedicated framework for sustainable securitization.
Considering that the overall market mainly focused on the Environmental aspect of ESG, in this article we are going to dive into green securitizations and its related standards.
An overview of the European Securitization Market
Before looking at the role of regulation in the ESG securitization landscape, let’s review the market evolution in the last few years. Looking at the performance of the EU sustainable securitization in 2021, you might think that the market boomed. The issuance of EUR 8bn resulted in a +273% increase in volume compared to 2020 (when it was only EUR 2.1bn).
However, sustainable issuance volume was only 3% of the total of EUR 233.1bn securitizations executed. In the same period, EU sustainable loans represented 25.4% of the total loans market, while sustainable bonds accounted for 20.2% of the total bonds market.
While US green securitization market volume is staggering compared to its EU equivalent (USD 115.5bn at the end of Q1 2021), the share out of the total securitization market is very similar, standing at 1%. As a matter of comparison, the Chinese green securitization market recorded, by the end of 2020, 85 ABS deals totaling RMB 115 bn (~EUR 17.5bn), representing less than 1% of the overall Chinese securitization market (RMB 4.3 tln).
These numbers suggest that the depth of the US and Chinese green securitization markets is, therefore, more related to the dimension of the overall “domestic” securitization market rather than to factors directly impacting the sustainable issuances. However, the EU green securitization market represents only 1.7% of the overall EU ESG bond market. If we compare this ratio with the US market (above 10% in 2021) and the Chinese Market (11% in 2020), the European market seems to miss something versus its international peers.
Challenges in the development of the EU sustainable securitization market
The differences between US/China and Europe can be explained by two main factors:
- In the US the most active players in the market have set their own standards for sustainable securitizations. For example, the issuance programs for green securitization of two mortgage loan companies Fannie Mae (USD 100bn of cumulated green multifamily mortgage-backed securities) and Freddie Mac (over USD 600m).
- In China, green finance policies focused on securitization have been developed, providing definition, eligibility criteria, verification, and disclosure requirements for green ABS.
As also confirmed by an assessment made by the EBA, the main challenges affecting the development of the EU sustainable securitization market are linked to:
The lack of a market standard
As already highlighted, the European market misses an “official” (or at least a widely accepted) definition and related disclosures for sustainable securitizations. This generates an asymmetry of information between market participants and poses a reputational risk in case transactions do not meet ESG requirements and incur in being labeled as green/social washing.
The lack of available sustainable assets to colateralise and originate
The lack of common definitions and indicators of which assets have to be considered ESG makes it difficult for originators to identify the sustainable assets within their balance sheets.
One of the options to identify sustainable assets is to use the EU Taxonomy, which is in place from January 2022 (even if some reporting requirements will be applied from January 2023). Even if the taxonomy is relatively new for market players, it is estimated that, currently, only 7.9% of the total assets of EU banking institutions are represented by EU taxonomy-compliant assets. In the absence of a reliable alternative, the potential pool of sustainable assets is therefore very limited and holds back the market from potential development.
Lack of technology
In addition to the lack of assets, the existing internal reporting and data management systems of most institutional lenders have not been adapted yet to track sustainable assets and provide proper monitoring and reporting.
Based on the evidence from the US and China, and as also confirmed by EBA, a dedicated framework would address the lack of standard definitions and criteria to be met by a securitization to be labeled as ”sustainable”, reducing the greenwashing risk and improving the market transparency.
What standard is currently available in the EU Market?
Looking at the available sustainable standard in the EU market, the only one currently “in place” is the so-called EU Green Bond Standard (hereinafter “EU GBS”).
In July 2021, the EU Commission published a legislative proposal for a Regulation on green bonds (2021/0191 COD) aiming at creating a voluntary, high-quality standard for green bonds (‘EU GBS’) to support the financing of green investments while addressing concerns around ‘greenwashing’. Its main objectives are:
- Improving the ability of investors to identify high-quality green bonds
- Facilitate the issuance of green bonds by specifying the eligibility conditions to obtain an EU green bond label, thus reducing potential reputational risks for issuers.
The main characteristics of the EU GBS are:
- 100% of proceeds to be used to finance EU Taxonomy-compliant investments by the maturity of the bond;
- Compliance with the EU GBS disclosure framework which includes the publication of
- EuGB factsheet together with a pre-issuance review of the factsheet by an external reviewer;
- An allocation report every year until the full allocation of the proceeds;
- A post-issuance review by an external reviewer of the first allocation report following full allocation of the proceeds;
- An impact report after the full allocation of the proceeds at least once during the lifetime of the bond;
- Control by an external reviewer supervised by ESMA
The EU GBS is intended to be applied to any type of bond instrument, including securitizations.
Is the EU GBS applicable to securitizations?
Even though securitizations fall within the scope of the EU Green Bond Standard, their application might have significant drawbacks.
In particular, the use of proceeds criterion in the original EU GBS applies at the issuer level, that in the case of securitization would be the SPV (or Securitisation Special Purpose Entity), therefore resulting in a collateral-based approach, since it would have the effect of imposing the purchase of a portfolio made up of 100% EU taxonomy-aligned assets.
Furthermore, the application of the EU GBS requirements to an SPV would not ensure the effectiveness of administrative sanctions and other measures (including material pecuniary sanctions) in case of breach of the regulation, given the limited legal and economic substance of SSPEs.
Regulation in the ESG Securitization market: EBA’s recommendation on a dedicated framework
Following the mandate provided by the EU Capital Markets Recovery Package in the context of the amendments introduced to the Securitisation Regulation (SECR), on the 2nd of March 2022, the EBA released the Report on Developing a framework for sustainable securitization, with the goal of assessing:
- the main challenges that affect the development of the EU ESG securitization market;
- how to define and implement sustainability-related disclosures and due diligence requirements for securitisation products;
- how to establish a specific framework for sustainable securitisation products drawing upon the EU Taxonomy Regulation and the SFDR;
- the potential impact of a sustainable securitisation framework on financial stability, the scaling-up of the EU securitisation market and bank lending capacity;
Even if EBA performed an analysis of the market status and the viable options, with regards to the definition of a dedicated framework, it has decided not to move ahead at full steam.
The decision was taken considering, on one side, the limited availability of “pret-a-porter” green assets and on the other, the limited experience of the market so far.
The regulator has concluded that too little experience has been gained on the application of ESG factors so far, not only for securitizations but also in the wider bond market, where the EU GBS has not been applied yet, since it is still being examined by the Council of the European Union. The EBA has therefore decided to allow the market to self-develop before taking a definitive stance, in order not to stifle innovation by promoting a solution that doesn’t suit investors’ and issuers’ needs.
Given the early stage of development of the EU green securitization market and the insufficient amount of green assets, the EBA deemed as too early the definition of a dedicated green securitization framework for both the true-sale and synthetic securitization.
In the meantime, the EBA has suggested the application of the EU GBS to securitizations with some adjustments aimed at solving the identified drawbacks:
Application of the use of proceeds criterion at the originator level rather than at the SPV level
This requires the originator to invest the transaction’s proceeds in the origination of EU-Taxonomy compliant assets. This approach is not as obvious as it might appear, considering the typical ring-fence structure of securitizations, since its effect is to create obligations on the originator, which would be liable towards the noteholder (and eventually the Regulator).
Definition of additional disclosure requirements
This should allow investors to perform proper due diligence and monitoring of securitization transactions and assess their compliance with ESG criteria (e.g. green assets ratio and the banking book taxonomy-alignment ratio and similar KPIs for non-financial institutions). Additionally, disclosure needs to cover the originator in order to make sure that the use of proceeds goes in the right direction and that there is no adverse selection on the securitized assets (i.e. selling the non-green part of the portfolio to keep the high-quality green assets);
Compatibility between EU GBS and transparency requirements
The reporting of the EU GBS disclosure framework should be compatible with the transparency requirements for originators, sponsors, and SPVs foreseen by Article 7 of the SECR. This will ensure that investors have access to the securitization-specific information and prevent the EU GBS and the securitization disclosure requirements from being fragmented between different sources.
The EBA considers the above just as a temporary interim measure in order to support the development of the EU market up until it will be ready for a collateral-based approach. Therefore, the re-evaluation of a dedicated framework for green securitizations should be performed at a later stage.
Disclosure’s requirements applicable to green securitisation
As we have seen, one of the key elements to support the development of a sustainable securitization market is the disclosure concerning the performance, in terms of ESG metrics, of the different parties involved (such as originator, issuer, assets, etc.).
Sustainability disclosure is not just a matter of supporting the potential development of the market. There are already several sustainability disclosure frameworks that affect, or are going to affect in the near future, the securitization transactions issued in the European Market:
The Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088, SFDR)
The regulation introduces, for financial market participants, periodic and pre-contractual disclosures requirements on how a specific financial product “promotes environmental or social characteristics or “has sustainable investments as its objective”. Moreover, it introduces the obligation of providing dedicated disclosure on principal adverse impacts on sustainability (hereinafter “PAI”) of investments. The PAI can be defined as indicators for assessing the potential impacts on sustainability factors that are “caused, compounded by, or directly linked to investment decisions and advice performed by the legal entity”.
The EU Non-financial Reporting Directive (Directive 2013/34/EU, NFRD)
The directive introduces disclosures requirements for large financial and non-financial undertakings with regards to environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters;
The Regulation on EU GBS
This regulation will introduce the obligation to publish several reports concerning, inter alia, the allocation of the proceeds collected.
The Capital Requirement Regulation (Regulation – EU 575/2013)
Especially with regards to Article 449a and the EBA’s Implementing Technical Standards on prudential disclosures on ESG risk, that require the banking institutions to provide quantitative and qualitative data on ESG Risk and on “green” capital allocation.
Once the pending disclosure regulations for EU-Taxonomy-aligned products will be finalized, the EBA deems that the above-mentioned regulations should be complemented with additional disclosure requirements for green securitization transactions.
However, ensuring that both investors and asset managers take into consideration the ESG factors also in securitization transactions that are not labeled as “sustainable”, is vital.
In this sense, the amendment to the Securitisation Regulation pushed towards the integration of the sustainability-related disclosure set forth by the SFDR.
The importance of standardised data in sustainability-related disclosure
In October 2021, the European Supervisory Authorities’ Joint Committee has published the final draft Regulatory Technical Standards, which introduces specific indicators to determine the PAI of investment products on ESG factors.
Ensuring standardized data for the assessment of the principal adverse impacts of securitization investments is key to improving the sustainability of the overall EU securitization market since it would:
- Allow originators and issuers to provide better disclosure on ESG factors
- Enhance investors ability to perform their due diligence on ESG factors
However, the securitization products, and therefore their originators/issuers, do not fall directly within the scope of the SFDR. This has a two-fold negative impact:
- It does not ensure a standardised source of data for the investors, which under the SFDR have to collect “principal adverse impact” data in order to determine whether the securitisation transaction is aligned with their ESG target;
- It makes the securitisation products less attractive to investors since they cannot be included within their ESG investment strategies, unless an independent evaluation is carried on;
Having acknowledged the issues above, the Securitisation Regulation (“SECR”) amendments included in the Capital Market Recovery Package and published on the 31st of March 2021, have involved also the Articles 22(6) and 26d(6). These articles attribute to the ESAS a joint mandate to develop dedicated Regulatory Technical Standards on the disclosures concerning the sustainability indicators in relation to the adverse impacts on climate and other environmental, social and governance-related dimensions. Such RTSs shall mirror or draw upon the other RTSs already prepared with regards to the SFDR framework.
Thus, it is likely that the PAI indicators and other disclosures requirements identified by the ESA’s RTSs, and applicable to financial products currently falling within the scope of the SFDR, could be extended also to the securitization products and their originators.
The EBA’s recommendations don’t just refer to STS transactions currently in scope for ESAs’ RTS, but also involve non-STS transactions in order to unleash the full potential of the sustainable market. Additionally, the EBA deems it appropriate to adjust the ESMA templates in order to ensure that the loan data provided are adequate for the PAI calculation at the transaction level.
It is therefore evident that in the near future, originators and issuers will have to be able to gather a wide array of ESG data in order not to lose access to investors needing that information to comply with the disclosure requirements set forth by the SFDR.
Regulation and the ESG Securitization Market: Conclusions
There is ongoing turmoil in the ESG world, and securitizations are not excluded, even in good old Europe. Notwithstanding the European market still lags behind international peers when it comes to numbers and volumes of transactions, the attention that sustainability matters have attracted from practitioners and regulators signals that something is going on.
EBA’s recommendations on how to apply EU GBS to securitizations have been widely welcomed since they are in line with market needs in terms of supporting its expansion without introducing too many regulatory overheads (at least for the moment). The recommendations also would potentially leave space for the development of independent labels or standards. While there are several directions the market and its participants could take in the future on ESG matters (self-definition of a sustainable standard or adaptation to regulatory requests), it is clear that new needs will emerge in terms of data, monitoring, and reporting infrastructure.
On one hand, the Securitization Regulation is already set to be implemented with new disclosure requirements on PAIs with the upcoming JC RTSs. On the other hand, investors are developing more and more sophisticated approaches to assess the investments’ sustainability risks and impacts.
Both of the above require a new and dedicated set of data that will have to prove to be solid and reliable. Originators and services will be requested to disclose ESG data in their periodic reporting and, therefore, a dedicated framework for the retrieval and management of internal and external data will be needed.
The new solutions that will emerge as “best practices” will not only support new issuances but will also allow originators and investors to assess and disclose the sustainability credentials of their legacy assets and existing securitizations.