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Europe's CLO Market, Already Red-Hot, Looks to Go Green

The world’s first green CLO is on its way amid a growing sustainable finance market and a push from regulators to scale up green investments to tackle climate change.

While the private sector has already been developing markets for green assets, such as green bonds and loans, increased global regulatory coordination is in the offing to support further growth of green financing, in particular the creation of a sustainable securitisation market.

One European manager, which focuses exclusively on investment in clean energy infrastructure, is working on the first green CLO, according to sources. It will also be the manager’s first CLO issue.

global CLO 1Permira Debt Managers took an initial step in March towards creating a sustainable CLO market by making its €362.5 million Providus I vehicle compliant with environmental, social, and governance (ESG) criteria. The manager’s future CLOs are also going to be ESG compliant, sources say.

ESG criteria calls for socially responsible investments and prevents a fund from investing in certain industries (such as speculative extraction of oil and gas, weapons and firearms, tobacco, gambling, and payday lending, among others).

A green CLO focuses on the “E” in ESG. Sources say the upcoming vehicle will invest solely in green sectors and projects that have a positive and so-called “global cooling” environmental impact, such as renewable energy and energy efficient transportation.

A revolution
Sustainable (or green) CLOs, along with other sustainable structured products “are set to turbocharge sustainable finance,” wrote White & Case partners Chris McGarry and Debashis Dey and counsel Mindy Hauman in a client alert in May. “CLOs will be a pillar of the sustainable securitisation revolution,” they added.

The green finance market is still at a nascent stage, but it’s growing rapidly and will benefit from certain accords. Indeed, to reduce climate risk in line with the Paris Agreement, the United Nations estimates that $90 trillion of investments are needed in the next 15 years to build out sustainable infrastructures that include everything from energy to public transport, buildings, water supply, sanitation, and so on. The Organisation for Economic Co-operation and Development (OECD) estimates annual issuance of sustainable asset-backed securities (ABS) could reach $350 billion by 2035 and notes that it is the fastest growing product under the sustainable finance umbrella.

Other forms of sustainable securitisations include ABS made up of sustainable auto loans, solar loans, and Property Assessed Clean Energy (PACE) loans, as well as mortgage-backed securities for green residential and commercial properties.

“We are pushing hard for green securitizations because the scale of investments around the world to achieve low carbon is so vast that the balance sheets of banks are not going to be able to cope, especially as the banks need to recapitalize,” says Sean Kidney, CEO of the Climate Bonds Initiative (CBI), an organization which aims to develop a liquid green and climate bond market and which partners with banks, bond issuers, institutional investors, law firms as well as ratings agencies and other institutions.

Global issuance of green bonds totaled $160.2 billion in 2017, up 85% versus 2016. The CBI forecast for 2018 calls for the global green bond market to grow to $250–300 billion. The U.S., China, and France accounted for 56% of 2017 issuance. U.S. government agency Fannie Mae was the largest issuer of Green MBS in 2017 at $24.9 billion.

Some existing CLO managers are somewhat skeptical about the green securitisation market though, given that it remains relatively niche, but they say the theme is becoming more and more topical.

“We haven’t written ESG criteria into our CLO documentation, but we have ESG watch flags in our investment processes. Lots of institutional investors are stressing the importance of it, but it needs to be clear that this should not only be a marketing strategy to boost reputation,” says one CLO fund manager.

It is not just specialist investors, but also global managers that follow sustainable investment strategies. “Asset managers like Amundi and BlackRock, but also several commercial banks’ treasuries invest in green bonds,” says Tanguy Claquin, head of sustainable banking at Credit Agricole CIB, which ranked as the top arranger of green financing in 2017, according to various league tables. Claquin also sees large potential for growth in the green securitisation market.

A lack of clarity remains around the definition of green/sustainability. The two phrases are often used interchangeably for investments that have a positive environmental impact.

So far there is no universal agreement on a definition. “Should nuclear energy be considered green? Given the diversity of opinions, it can be challenging to establish ‘standard’ definitions of green,” according to a report on green bonds published last December by The World Bank, Zurich Pension Fund, Amundi Asset Management, and Actiam.

A number of initiatives have been put forth though to set standards. In March, the Loan Market Association launched the Green Loan Principles (GLP) to help growth of the global green loan market. The GLP builds upon the Green Bond Principles (GBP) of the International Capital Market Association (ICMA) and sets voluntary guidelines to promote transparency and disclosure, along with second-party opinions. S&P Global Ratings has the Green Bond Evaluation service, while Moody’s provides the Green Bond Assessment. CBI also provides an extensive taxonomy and certification for green bonds.

global CLO 2While certifications can create extra costs and operational efforts, fund managers like them as they help with due diligence processes to assess a bond’s use of proceeds. “We and our clients want a lot of transparency so that we know how the proceeds are spent, even for future projects that an issuer—at the time of raising a green bond—has not yet selected. We want to make sure we know how the money really is spent,” says Foppe-Jan van der Meij, portfolio manager at Actiam, a €54 billion-plus Netherlands-based fund manager that complies with the Green Bond Principles for investing in green bonds as well as ABS.

The firm‘s investors are insurance companies, pension funds, and wholesale distribution partners like banks. “We are seeing a lot of demand. More and more investors are incorporating green goals and ESG criteria into their strategies. Retail investors are very keen to put money to work towards green bond funds. Returns are in line with non-green bonds, but their [secondary market] performance in a volatile market is more stable,” van der Meij adds.

CBI’s Sean Kidney also notes that while there is growing demand for green bonds, they pay similar spreads to comparable non-green bonds with the same tenor and currency and rating. “Investors don’t do it for the price benefit, they do it for the diversification benefit,” he says.

Asset sourcing
Sourcing enough assets to fill a green fund though is one major challenge for investors, they say, because the number of issuers active in the green bond market is still limited. Actiam said that for its mainstream €3 billion fund, 10% is invested in green bonds, including sovereign and corporates, while the remainder is invested in conventional bonds, although those still need to meet a minimum proprietary ESG score that is better than the benchmark.

White & Case argues this issue can be overcome, saying that there is a critical mass of assets available. “It is just a question of market education and re-examining potentially eligible assets for sustainability,” the law firm wrote in its May client briefing. Moreover, it adds that sustainable securitisations will help free up bank’s balance sheets, enabling them to arrange more deals.

For example, Credit Agricole last year transferred the risk of $3 billion-worth of project finance loans to Mariner Investment via a so-called green capital note (Premium Green 2017-2). As part of the transaction, it committed to use $2 billion of the $3 billion of freed-up capital for new lending in green sectors, such as renewable energy and energy-efficiency loans for commercial real estate and public transportation, among others.

This creates a “sustainable finance loop” that generates more assets on a rolling basis, White & Case says.

Regulatory landscape
The regulatory landscape is also starting to become more supportive of green investment, with a long list of legislative initiatives on the way to help drive investments. For example, under the simple, transparent, and standardised (STS) framework of European securitisation regulation, sponsors and originators will be required from January 2019 forward to disclose information on the energy efficiency of underlying assets in RMBS and auto loan securitisations in order to receive beneficial regulatory capital treatment.

The European Commission has also set up a “High Level Expert Group on Sustainable Finance” to address funding shortfalls and create plans for sustainable finance as part of the European Capital Markets Union. In its action plan published in March, the EC said it would establish a unified EU classification system or taxonomy to define sustainable investments, identify areas where sustainable investments can make the biggest impact, and clarify the duty of asset managers and institutional investors to take sustainability into account in the investment process and enhance disclosure requirements.

On a global level, the Bank of England and the People’s Bank of China as co-chairs of the G20 Sustainable Finance Study Group (SFSG) are currently developing plans to mobilize private capital for green investment, according to SFSG reports. This includes further research into the securitisation of sustainable assets, as approved in a meeting in February. The SFSG will hold its second meeting in early June and then submit a new report to the G20 Finance Ministers and Central Bank Governors Meeting in July and the G20 Leaders’ Summit in December. — Isabell Witt

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