In brief...

The general focus on environmental, social, and governance (ESG) related investments has led to a rise in the ESG securitisation market and the potential for ESG specific CLOs.

What constitutes ESG or “green” investments?

In this growing market, there is little regulatory clarity as to what constitutes ESG or “green” investments. Although ICMA has published its Green Bond Principles (based on the similar LMA Green Loan Principles), the Climate Bond Initiative has established a Climate Bonds Standard & Certification Scheme, and Rating Agencies have started their own green evaluation ratings, there is no one widely accepted definition or criteria for ESG assets. Working definitions such as that suggested in the G20 Sustainable Finance Study Group piece on sustainable infrastructure1, “sustainable loans, sustainable debt and sustainable bonds as specific financial products or debt linked to assets or investments that target environmental and social sustainability...”, are helpful until a market consensus is developed.

In the realm of securitisations, the market has fallen into two main categories of ESG securitisation, which follow similar lines to the G20 definition:

  1. Where the underlying assets directly relate to green activities; and
  2. Where the underlying assets are ‘non-green’ assets, however the proceeds of any securitisation or resultant capital that is freed up is used for green initiatives.

The second category in practice is more like traditional securitisation save for the stipulations on the use of proceeds or balance sheets. In the first category there are a variety of asset types that could fulfil these requirements. They can include sustainable energy loans (e.g. loans for solar energy projects), sustainable auto loan (e.g. leases for electric vehicles), Property Assessed Clean Energy loans (public loans used to fund sustainable retrofitting of commercial and residential properties), and commercial and residential mortgages for energy efficient properties.

All of these sustainable loans can be removed from the originating bank’s balance sheets through purchases by SPVs as part of a sustainable CLO. Such freed up capital can then be used for further sustainable loans, creating a ‘sustainable finance loop’ and simultaneously achieving similar aims to the second category identified above.

Asset pipeline

An obvious concern, aside from the previously mentioned issues around defining the assets, is that in such a relatively new market there is potentially insufficient ESG compliant assets to currently sustain a market of ESG CLOs. Having a ‘green bucket’ of only sustainable loans is perhaps not yet commercially viable for collateral managers. The current solution has been to invert the obligation. Rather than making it a positive requirement to invest in only sustainable assets, managers are being prevented from investing in ‘non-ESG’ assets. This negates the issues around the lack of sustainable loans as well as limiting the concerns around the definition of ESG compliant assets.

The current market

The Financial Times recently picked up on the ESG trends in the US market2, but the same trends are being played out in the European CLO markets.

The restrictions mentioned in the US CLOs referenced in the FT article are similar to those included in what has been recognised as the first ESG European CLO, Providus CLO I. These CLOs have included restrictive language around the eligibility criteria for selecting assets (Providus CLO I also includes an ongoing commitment to assess ESG issues). We have also seen in our recent deals specific language which restricts the ability to invest in weapons and/or thermal coal production. Removing exposure to certain fossil fuel based assets goes towards the overarching ESG aims. There still remains the risk that such restrictions become a credit negative for CLO investors.

However, in reference to five recent deals in 18 months underpinned by these ESG principles, “Moody’s saw no discernible difference in performance between those five deals and the rest of the market”3, whilst they also noted that in the short term there may be an imbalance between supply and demand for ESG assets.

Using restrictions in CLO documentation, instead of making positive requirements at this stage deals with the lack of sustainable assets in the market. In time, with a more defined ESG lexicon, it appears likely that CLOs of only green assets may soon be in the market.