Sustainable Finance, another door opens?

By Jim Rusagara

Politics provides opening

First, let us lay out the dots: US retreats, EU and China lead, EU institutions agree on securitization…another door opens. Now let us connect the latter, cautiously.

On June 1st 2017 US president Donald Trump announces that the world’s leading nation will quit the Paris Agreement on climate change, citing a recurrent mercantilist argument compatible with the current administration’s “America First” mantra: “the bottom line is that the Paris Accord is very unfair, at the highest level, to the United States”[1]. The latter is especially ‘interesting’ when one considers the fact that the US is the largest cumulative greenhouse-gas emitter in the world. But we can’t let facts (alternative or not) get in the way of a good story.

In the immediate aftermath of President Trump’s announcement, EU leaders criticized the decision and vowed to lead despite the US’ retreat. This intent to lead was arguably best summarized in President Macron’s paraphrasing of President Trump when he ended his press conference with the troll comment: “Let’s make our planet great again”[2]. More surprisingly however was China’s response to the announcement. Often derided as enabling and being overly dependent on fossil fuels, the Chinese, in providing their support for the Paris Agreement, provided an answer worthy of a soon to be world leading economy.

On Tuesday May 30th, in a somewhat unexpected turn of events, the European Parliament and the Council finally agreed on the standardized transparent securitization (STS) file[3]. The decision is what we’d like to direct attention to. The two institutions have yet to iron out all of the details but the message to the markets is clear – securitization (albeit a more transparent and simple kind) is back. So what does this have to do with climate change you ask?

 Lead and scale

European leaders having signalled their intent to ‘fill the [Paris Agreement] vacuum’, securitisation oddly enough has a key role to play. The market seldom waits for politics and thus has already started fulfilling the promise of the Paris Agreement with sustainable finance products and investment approaches of various nature (green bonds, fossil fuel divestment strategies, renewable energy only funds, etc.). These have been offered to investors for some time now (ex: leading market participant Triodos Bank has been offering sustainable finance products and advice for the past 20 years). But the offering remains comparatively small.

Let us take green bonds as an example. The Climate Bonds Initiative estimates that there are currently $694 billion worth of climate aligned bonds (labelled or otherwise) outstanding[4]. The latter not only pales in comparison with what institutions such the New Climate Economy[5] believe should be invested cumulatively by 2030 to reach our goals ($93 trillion) but it is also dwarfed by the size of the current global bond market ($100 trillion)[6]. But encouraging and intensifying signals are also coming from the market. More recently, investors representing $10+ trillion formalised their commitment to sustainable finance (through green bonds)[7]. Large insurers followed suit with a pledge to increase climate aligned investments 10 fold by 2020[8]. Public private initiatives like the principle for positive impact finance have also garnered momentum[9].

However, much like other growing markets, crucial issues remain on the road to a more mature market. Challenges include labelling, asset assessment, the lack of worthy debt markets in Europe, tax incentives, supply and demand disparities etc. But more importantly, sustainable finance needs to scale to reach its objectives over the next 20 years. This is where the securitisation agreement comes into play.

Securitization and its capacity to pool individually illiquid assets (energy friendly building mortgages, electric vehicles loans, wind farm loans, etc.) into more appealing securities creates an opportunity to scale sustainable finance cannot afford to squander[10]. The opportunity securitization offers to sustainable finance is three-fold: 1) it will allow product originators to scale assets to a level they find economically viable; 2) provide a larger number of investable assets for investors to finally meet demand and 3) allow for more risk distribution and diversification of funding sources. Giving in turn issuing institutions more flexibility in terms of capital for other lending activities.

Next Steps

We expect the European Commission (FISMA led) and recently appointed High Level Expert Group (HLEG) to produce recommendations further enhancing the call for more to be done to boost sustainable finance by the end 2017[11].An interim report is currently being drafted and should be presented on July 18th. The recommendations will however fall short of suggesting the use of securitization to tackle the issue of scale as the process of boosting debt markets in the EU through securitization will not fully materialize before the second half of 2018 at the earliest. More importantly we expect the recommendations to focus initially in defining clear standards, labels and assessment processes for sustainable assets (CRAs to be early focus). Furthermore, we anticipate the work to focus on disclosure and transparency issues and to also include the integration of more ESG assessment (potentially through non-financial reporting legislation) metrics across assets types. Finally, the European Commission will certainly look to follow-up on the stakeholder recommendations provided in its recent CMU mid-term review[12].

Individual member states on the other hand can move significantly faster if they chose to. To name a couple of examples: France’s Energy and Ecological Transition for Climate Label (TEEC)[13] has enabled its financial institutions to lead in green bond issuance this year[14] and Luxembourg is home to the world’s first platform dedicated to sustainable assets: the Luxembourg Green Exchange[15]. We anticipate this member state trend to both intensify and continue for the foreseeable future. Naturally, these national disparities can only further complicate the cross-border availability and attractiveness of sustainable assets.

The US created a vacuum, EU and Chinese leaders immediately filled it. EU institutions agreed on securitisation to boost capital markets in the EU and by doing so opened another door for sustainable finance. The stars seem to be aligning, making this a potentially great story.

[3] European Commission Press Release.

[4] Climate Bonds Initiative; Bonds and Climate change – the state of the market in 2016. See here.