Tag: esg

ESG INCORPORATION IN SECURITISED PRODUCTS: THE CHALLENGES AHEAD

PRI (Principles for Responsible Investment – the world’s leading advocate for sustainable investing, founded on a United Nations initiative) has recently published an interesting report on the incorporation of ESG in securitization products.

On one side regulators are increasing transparency requirements on sustainable related information on investment products. On the other, client demands and risk management are driving demands for considering the long-term impact and sustainability of investment choices. As a result of these forces, investors and asset managers are widening and improving ESG policies, but few of those are tailored for securitization products.

ESG information wanted by investors

Source: PRI

For ESG incorporation in securitized products to be effective, a holistic, multi-pronged approach needs to be developed. Compared to other asset classes the securitization market shows some additional complexity though including:

Transaction structure: which implies a multi-level assessment of practices and policies including Sponsor and/or Issuer, Originator, Servicer, Deal structure, Loans, Collaterals or Guarantees. This is further complicated by the fact that parties can occupy multiple roles (e.g. servicer and originator) or involve private entities, which tend to be less transparent.

Adequate data: Practitioners consider the ESG information in current deal documentation, marketing materials, and underlying portfolio disclosures insufficient to comprehensively analyze most securitized products.

– No ESG reporting standards for servicers/originators: Relevant ESG information on collateral often lacks uniformity and is not comprehensive.

– A diverse pool of underlying assets: the complexity and diversity of underlying collateral (and the sectors covered) make it difficult to build proprietary ESG frameworks that can be used for assessment.

– A lack of coverage by third-party ESG information providers: ESG information providers have limited coverage of securitized products. This is not surprising given that responsible investments originally developed in equities and only recently expanded to debt capital markets. Moreover, the leveraged finance market includes a high proportion of privately owned and smallcap companies that tend to disclose less information

– Lack of a clear ESG premium: differently from the so-called greenium that typically applies to green bonds, securitization transactions do not show meaningful price differentiation when incorporating ESG criteria[1]

As a result, of the 2,000 signatories that reported on their investment activities to the PRI in 2020, only 215 indicated how they incorporate ESG factors into their securitized product investments.

ESG incorporation in securitized products is at a very early stage

Source: PRI

To find a solution to the complexity above and sustain more ESG driven securitizations, PRIs have identified data quality, availability, and consistency as the main solution: a combination of robust in-house and third-party data sources is likely to drive investor confidence in ESG incorporation across securitized credit markets.

For further information please refer to the following link: https://www.unpri.org/fixed-income/esg-incorporation-in-securitised-products-the-challenges-ahead/7462.article

[1]Based on European ESG CLOs that were issued between March 2018 and August 2020 versus traditional CLOs

EU Taxonomy: A tool for ESG transition or a nightmare?

A practical guide on main steps and cases study results on how to comply with the EU Taxonomy

The EU Taxonomy is one of the most significant developments in sustainable finance and will have wide-ranging implications for investors and issuers working in the EU and beyond. This tool helps investors navigate the transition to a low carbon, resilient and resource-efficient economy by assessing to what degree investment portfolios (both equity and fixed income) are aligned with the European environmental objectives:

  1. Climate change mitigation
  2. Climate change adaptation
  3. Sustainable use and protection of water and marine resources
  4. Transition to a circular economy
  5. Pollution prevention and control
  6. Protection and restoration of biodiversity and ecosystems

As with all other regulations, nothing comes easy. Applying the taxonomy requires a five steps approach that in reality becomes seven or eight steps depending on the data availability, internal ESG readiness and the disclosure level of the invested companies.

One of the key disclosures that investors need to make is the definition of the proportion of underlying investments that are Taxonomy-aligned, expressed as a percentage of the investment, fund, or portfolio – including details on the respective proportions of enabling and transition activities.

Source: Cardo AI analysis

To do that, investors need to go through the following steps:

Step 0 – Translate every sector/industry classification system to NACE economic activity code

To determine eligible economic activities in the Taxonomy, investors need to map the current classification system in use: e.g. NAICS or BICS (already mapped by the Taxonomy), GICS, ICB, SIC, TRBC, etc. with the European industry classification system (NACE).

Step 1 – Break-down invested company’s sectors by turnover or capex, and if relevant opex to determine if these activities are listed in the Taxonomy

Starting from the turnover, investors need to be able to break down the sectors of activity in which the company’s funds are allocated (both equity and fixed income). Successively, map these sectors to the list of taxonomy and flag those sectors that are present.

Step 2 – Validate if the companies meet the substantial contribution criteria

Every company in the portfolio is required to validate whether or not each economic activity meets substantial contribution criteria to climate mitigation and/or adaptation objectives. Substantial contribution is assessed through different screening tests carried out based on a collection of thresholds by sector.

To do that, investors need to have ready the data reported from the companies. In case data is not available – due to lack of reporting – an estimation of the data point or an approximation of the threshold could be a solution to determine the significant contribution.

Step 3 – Validate if the companies meet the “do no significant harm” criteria

The third step requires investors to conduct a due diligence-type process to verify the company’s activities meet the “do no significant harm” to the other environmental objectives using a set of qualitative and quantitative tests. They are typically applied at the company level looking at the production process or in the use phase and end of life treatment of the products produced.

Step 4 – Control if there are any violations of the social minimum safeguards

Investors need to conduct due diligence to control any negative impacts on the minimum safeguards related to UNGP (United Nations Guiding Principles on Business and Human Rights), OECD (Organisation for Economic Co-operation and Development), and ILO (International Labour Organization) conventions. OECD guidelines for MNES (Multinational Enterprises) ensure compliance with qualitative DNSH and minimum safeguards are recommended to be followed for the due diligence process.

Step 5 – Calculate the alignment of investment with the Taxonomy and prepare disclosure at the investment product level

Once the previous steps have been completed and the aligned portions of the companies in the portfolio have been identified, investors can calculate the alignment of their funds with the taxonomy (as an example, if 10% of a fund is invested in a company that makes 10% of its revenue from Taxonomy-aligned activities, the fund is 1% taxonomy-aligned for that investment, and so on).

Assessing a portfolio for Taxonomy alignment

Source: Taxonomy: Final report of the Technical Expert Group on Sustainable Finance (March 2020)

A great initiative has been the case studies around how to use the EU Taxonomy shared by PRI’s (Principle for Responsible Investment: The PRI is an investor initiative in partnership with UNEP Finance Initiative and UN Global Compact). Starting in late 2019, over 40 investment managers and asset owners worked to implement the Taxonomy on a voluntary basis in anticipation of upcoming European regulation.

Here is a summary of some of the cases studies:

For more details on these case studies and practical EU taxonomy implementation recommendations click here!

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