Current status of green ABS market discussed

Representatives from Clifford Chance, TMF and Ygrene Energy Fund recently discussed the current status of green ABS during a live webinar hosted by SCI (view the webinar here). This Q&A article highlights the main talking points from the session, including the established asset classes, those that are developing, and what is next for the sector.

Q: As the most developed jurisdiction, what is the current state of green ABS in the US?
Rasool Alizadeh, head of capital markets at Ygrene Energy Fund: Green ABS is growing and evolving at a rapid pace. Solar ABS and PACE bonds have noticeably grown in 2017 through its issuance, but we also see green auto ABS - for example from Toyota - making headway. Growth and confidence in PACE is only expected to continue in 2018 as the investor base continues to diversify.

PACE in particular has evolved tremendously over the last couple of years. PACE is a state and local government community initiative providing innovative solutions for property owners to finance energy efficient upgrades, and at Ygrene we have done five deals, three of which have been public.

The three public deals have all had a GB1 assessment from Moody's, which is the highest green bond assessment. This assessment focuses on the applications of the proceeds and also the assets at are being originated.

Q: How does the state of green ABS in Europe compare?
Kathryn James, senior associate at Clifford Chance: Green securitisation activity has been lower in Europe than in the US, but we certainly expect it to grow. With the environmental commitments that various European jurisdictions have made, we see securitisation as being a useful tool to help finance those initiatives.

There has been the Green Storm 2017 RMBS deal in the Netherlands, which was the first public green securitisation in Europe in the RMBS space. More recently we have seen a whole business utilities issuance from Anglian Water.

We are starting to see public deals come through, and in the private space there are lots of warehousing deals. While these are not big, publicly known deals, we are aware of a lot of clients looking at putting warehouse facilities in place and perhaps terming those out in the future.

Q: Have there been any green ABS with SME loans as assets? How would you propose to expand the concept of green ABS to SME loans?
KJ: Not in Europe, so far as I am aware. The SME market is less developed generally in Europe than other asset classes, however, it is foreseeable that you could have green SME securitisations as well. By way of example, loans to waste cycling plants tend to be quite granular and homogenous and could be a potential green collateral asset class.

Q: How does an ABS qualify as 'green'? Are there agreed criteria?
KJ: An ABS can either have green underlying collateral or it can have non-green collateral but use trade proceeds to invest in green technologies.

For green collateral deals, auto ABS really stands out. A lot of jurisdictions have committed to moving away from petrol in the next couple of decades so we should see auto ABS move quite seamlessly into the ABS space. For RMBS, one of the challenges will be whether or not there is a large enough pool of green mortgage loans. There could also be new asset classes, for example solar finance is more common in the US, but has significant room to grow in Europe.

There is a lot more flexibility for deals with non-green collateral but where the proceeds are used for green technology or research. The main issue there is how you label those transactions as being green, because the scope of those transactions is so wide. Structurally, those transactions should not look any different from existing securitisation deals; it is more about how you use the proceeds.

Q: PACE is one of the best-established green ABS asset classes. How has that market developed?
RA: PACE is one of the best-known green asset classes and has been extremely well-received. Investors are turning to green ABS and we have met investors who can buy 25% more bonds if there is a green bond assessment present. As spreads compress in PACE issuance (even with benchmarks widening), opportunities for financings will only grow as we diversify our investor base. States that are eligible for PACE financing cover roughly 90% of the US population, so that gives some perspective of how the market can expand.

Mike Lemyre, government affairs svp at Ygrene Energy Fund: We are just scratching the surface in terms of the market. The estimated addressable market in the US is US$200bn in terms of measures and projects that would be eligible for financing or fit within a green ABS.

Almost all origination so far has come from California and Florida, although Missouri emerged last year in small volumes. PACE is possible in 33 states and the District of Columbia, so the sky's the limit in terms of where the market can go, but we are seeing enormous interest from a legislative and policy perspective in most of these states. That is pairing nicely with not only investor demand but also the market demand within both residential and commercial sectors for the underlying projects that fill those securitisations.

Q: There has been talk of lack of performance data on PACE bonds in the US because investors must rely on the municipalities to report defaults. Is access to performance data an issue and how can it be improved?
RA and ML: The best way to address data is for independent firms to work with top originators to standardise data where investors and industry can grow over time and understand the trends within the asset class.

Q: Commercial PACE is developing alongside the more established residential version. How is it different and what are its prospects?
ML: Commercial PACE is one of the most exciting developing markets. At Ygrene we have folded commercial PACE transactions into our public securitisations, making those mostly residential but also diversified, but more recently there has been pure commercial PACE.

Given PACE is a legislative and regulatory based product, there is also the popularity of commercial PACE even in jurisdictions where residential PACE has not taken off yet. That could be because of more sophisticated building owners and buyers of the financing and it takes out the consumer aspect of it. You also do not see the same headline risk in commercial.

RA: In transactions we have had about 5% of small balance commercial feathered into large residential transactions. That has been a good tool for diversification and has been well accepted by the marketplace.

A pure commercial PACE deal closed last year and we believe another two or three could be completed in the next year or so. There will be some refinement around underwriting practices and it will take a bit of time to build scale for these deals, but it will be a very exciting space in terms of growth for the next five years or so.

Q: Why has commercial PACE been slow to gain market share?
RA and ML: Market efficiency in the commercial PACE has been challenging. The opportunity to grow came in residential and commercial has taken time to catch up as the addressable market is still grappling with the benefits. In a rising interest rate environment, this will be more relevant and may benefit commercial PACE the most.

Q: While commercial PACE is capturing the imagination in the US, which markets are developing in Europe and what needs to happen to develop them further?
Huub Mourits, global head of structured finance services at TMF: Solar is well established in the US but not in Europe. Ticket sizes are small and we typically see terms of 15-20 years. Lease contracts are pretty well standardised. The originator or seller of the panels is often also the servicer and responsible for the more technical reporting and making sure that the maintenance on those panels does actually happen.

In Europe we might have monetary union but we do not have fiscal union. That makes things more difficult. However, the EU needs to invest €100bn per year in building renovations to meet energy and climate goals. On the one hand this can result in green mortgages but it can also offer separate financings for energy efficiency improvements, which can be bundled and securitised like PACE bonds. However, those transactions would need to sit within the STS framework.

The European Parliament and Commission should actively support green ABS PACE securitisation and even green CLOs, for example by reducing risk retention for qualifying transactions. CLOs are excluded from STS, but static CLOs should be able to apply for STS treatment.

Green bonds and securitisation will be the new gig in the fixed income markets as we anticipate it will be a trillion-euro market in a few years (2020). For example, OECD estimates annual issuance of green ABS/CLO somewhere between US$280bn-US$350bn by 2031-2035, which is 44-52% of annual issuance.

However, this is not all additional issuance; over time investments/loans will be taken for LEVs instead of non-hybrid/electric vehicles, hence shifting from high-carbon to low carbon, or in other words transitioning towards a green or greener economy.

Standardisation of tech and agreements will pave the path for pooling bundles of loans or leases and securitising them as ABS/CLOs are more efficient tools or vehicles for aggregating pools.

Q: Is solar ABS feasible or desirable in Europe, at least in the short term, considering a number of recent non-rated, non-listed privately placed capital markets solutions being issued with institutional investors?
RA and ML: Ultimately yes, if the markets are to be efficient then the ABS term markets will enable that to happen.

KJ: In the short term we would expect the solar finance market to continue to develop primarily in the private placement/institutional investor market. Long-term we could start to see public securitisations but this is dependent on there being sufficient stock of relatively granular and homogenous loans/leases to support a public deal. It would be more difficult to securitise more bespoke solar financing designed for particular businesses.

Q: Harmonising regulations has often been cited as a worthy aim for green ABS. What are the current regulatory definitions and what progress has been made on harmonising them?
KJ: Agreeing common definitions is a challenge and no doubt there will be evolution as the technology advances. There are standards at the asset level, for example energy performance certificates for properties or emissions information for cars. The Green Storm 2017 deal also had a third-party to verify the energy performance certificate requirements that were set for that transaction. Quantifying and verifying the 'green-ness' of these transactions is key.

An interesting question from a legal perspective is what happens if assets that you thought were green actually turn out not to be, or if you lose that green status after you close the deal. Should there be repercussions for that? It might not impact the credit quality at all, but it might affect the value of the security.

On the Green Storm deal the originator gave certain representations that the properties involved had a certain EPC certificate. There were certain repercussions if it turned out that that was inaccurate; there was an obligation to buy back assets. If the certificate is removed at a later date, then there were no economic repercussions. That is an interesting distinction.

The development of standard terms, in solar for example, will be important to build sufficiently large homogenous pools of assets. There are a couple of interesting legal questions there as well, such as what security will you have with solar panels, because the solar equipment itself has debatable value in the secondary market. Could you get them off the property? If there is no real value in the security there, could you get security over the property itself? That brings up inter-creditor issues where you have got mortgage loans and solar panel loans on the same property.

HM: When you look at the labelling of green bonds, it is a labyrinth. There are a number of competing standards, but investors do want independent certification. Investors want to avoid green-washing.

China's entry into the market with their own standards has not helped the matter. We have seen Chinese bonds with respect to the coal industry classified as green, which is hard to understand.

The most widely referenced standards are the ICMA Green Bond Principles and the Climate Bonds Initiative. We also see guidelines from the European Investment Bank and the People's Bank of China. India and Japan have guidelines. Luxembourg has a label for green bonds, because the Luxembourg stock exchange lists more than 50% of the green bonds worldwide. There is also the EMAP initiative for green mortgages and rating agencies are also involved.

There is a lot of overlap but there are differences as well, so a more unified approach would be helpful. We need more universal clarity on what qualifies as 'green', as we have seen some bond issuers using the green label perhaps only for PR reasons, which we call green-washing.

The good thing is that we have seen the EIB and Green Finance Committee China Society for Finance and Banking working together.

Q: How do risk retention rules impact green ABS deals?
KJ: Green ABS deals would be treated the same way as non-green ABS.

RA and ML: They would be mo different than any other asset classes. Issuers have been known to do vertical and horizontal retention.

Q: What is the regulatory outlook in the US?
ML: PACE in particular is a market that is legislatively enabled, which is why state legislation in Florida has allowed the market there to flourish while other states are still building. Regulation gives the market structure and form as it grows and standardises.

Mature markets are putting in place regulatory guardrails to bring the asset into the mainstream. At the Federal level the key is to rationalise PACE assets within the overall consumer finance regulatory framework. To that end, we see activity in the House and Senate in Washington, the latest development being the proposed PACE regulatory legislation being folded into the banking finance bill. It is still many steps away from becoming law, but it has started some very helpful discussions in the market about making this asset class more mainstream - and we are pleased to have a seat at the table for those conversations.

Q: In relation to Solvency II, is there a favourable capital charge for insurers when investing in tranches of securitised green PACE credits?
KJ: Having a green label would not alter the regulatory capital treatment. Under the draft STS regulations relating to transparency there is an obligation on the originator and sponsor to disclose any data available on the environmental impact of the assets underlying the securitisation so this quality is starting to come into reporting requirements.

Q: What might be the impact of continued Federal de-emphasis on green energy, and how do Trump's tax reform proposals affect the landscape for green ABS?
RA and ML: There will still be appetite, only less if this path continues in the US which can make it a buyers' market.

There is still appetite, but available funds may be less due to the reform. This can crowd the markets with more projects and not enough capital. It is still too early to tell, though.

Q: How does a US$20m-US$80m transaction support the costs of a securitisation?
RA and ML: It is difficult, but achievable if terms and market conditions are factored in the ahead of time, it can be done. Most likely a private deal with one buyer the best starting point though.

Q: As rating agencies are not doing the due diligence, who is checking green credentials independently? Is it something that the rating agencies should be doing?
RA and ML: Rating agencies are collecting information and focusing on use of proceeds. Over time this will evolve as the industry starts understanding the impact of these projects in a standardised way.

KJ: Moody's and S&P provide green bond ratings distinct from any credit rating. Moody's Green Bond Assessment is intended to "assess the relative likelihood that bond proceeds will be invested to support environmentally friendly projects". S&P's green evaluations assess "the environmental net benefit of projects financed by the bond's proceeds over a lifetime, relative to a local baseline". There are also a number of third-party verifiers who will provide reports or certificates as to the compliance with particular green bond principles. By way of example, Sustainalytics provided a verification of the Obvion's Green Storm 2017 with reference to compliance with the Climate Bonds Standard.

JL