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COMMENTS

Environmental, Social, And Governance: ESG Credit Factors In Structured Finance


Environmental, Social, And Governance: ESG Credit Factors In Structured Finance

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Environmental, social, and governance (ESG) credit factors have long been considered within our structured finance analytical framework. In most cases, ESG credit factors are not key rating drivers and are captured by other aspects of our analysis. Even in cases where, in our opinion, ESG credit factors could be material enough to become direct considerations, most ESG credit factors generally pose indirect benefit or risk to structured finance transactions, and structural features can mitigate risks. Hence, there have been limited cases where ESG credit factors were a primary rating driver in our analysis.

S&P Global Ratings' issue credit ratings on structured finance transactions incorporate an analysis of ESG credit factors when, in its opinion, they could affect the timely payment of interest or ultimate repayment of principal by the legal final maturity date. In our view, material ESG credit factors could have an adverse or positive impact on the credit quality of the securitized assets, and the related operational and administrative risks, legal and regulatory risks, and payment structures in structured finance transactions. ESG credit factors may also have an impact on our counterparty risk analysis if the ratings on dependent counterparties change due to these credit factors, which, in turn, could affect the ratings on the related structured product.

We believe structural and legal mechanics already embedded in structured finance transactions can, to some extent, mitigate potential risks posed by ESG credit factors. These include credit support levels to absorb losses, amortization and deleveraging, concentration limits, eligible collateral requirements, shorter tenor of the rated securities relative to longer-term risks, replacement and performance triggers, and isolation of assets from the bankruptcy of the originator, among others.

How Do Credit Ratings Differ From ESG And Green Evaluations?

S&P Global Ratings' 'Credit Ratings', 'ESG Evaluations', and 'Green Evaluations' are separate types of opinions that apply different analytical frameworks. As a result, something that we view as a strength under an ESG Evaluation or Green Evaluation may not have a significant impact or carry the same strength in our credit rating analysis, or vice versa. Table 1 summarizes what each opinion type addresses.

Table 1

Comparing S&P Global Ratings' Credit Ratings, ESG Evaluations, And Green Evaluations
Credit ratings ESG evaluations Green evaluations
What does it address? A forward-looking opinion about the capacity and willingness of a borrower to meet its financial commitments on an obligation in accordance with the terms of the obligation. A cross-sector, relative analysis of an entity's capacity to operate successfully in the future. It is grounded in how ESG factors could affect stakeholders, potentially leading to a material direct or indirect financial impact on the entity. Our analysis also includes our opinion of the entity's long-term preparedness, which reflects our qualitative view of its capacity to anticipate and adapt to a variety of plausible long-term disruptions and therefore support its long-term sustainability. Provides a relative green impact score on instruments that finance environmentally beneficial projects. It is an asset-level environmental credential leveraging Trucost environmental data, which aims to provide investors with a more comprehensive picture of the environmental impact and climate risk attributes of their assets and portfolios.
How are they related? Incorporates an analysis of ESG credit factors when, in our opinion, they could impact the likelihood of timely payment of interest or ultimate repayment of principal by the legal final maturity date. However, in most cases, exposure to ESG credit factors in structured finance transactions is indirect or mitigated by legal and structural features already embedded in typical transactions. Offers a deeper analysis of ESG factors beyond those that are relevant to credit quality. Our ESG evaluation is not part of our credit rating methodology. Not a credit rating and does not consider credit quality or factor into our credit ratings. Please refer to the Appendix for a summary of the Green Evaluations we've assigned to structured finance transactions.
Where is more information available?

For further information see "S&P Global Ratings Definitions," published Sept. 18, 2019.

For further information see "Environmental, Social, And Governance: How We Apply Our ESG Evaluation Analytical Approach," published April 10, 2019.

For further information see "Green Evaluation Analytical Approach," published April 26, 2017.

How Relevant Are ESG Credit Factors To Structured Finance Credit Ratings?

When assessing a structured finance transaction, our analytical framework includes five key rating factors (or "five pillars"; see "Principles Of Credit Ratings," published Feb. 16, 2011).

  • Credit quality of the securitized assets;
  • Legal and regulatory risks;
  • Payment structure and cash flow mechanics;
  • Operational and administrative risks; and
  • Counterparty risk.

When, in our view, an ESG factor can influence an obligor's capacity and willingness to meet its financial commitments when due, it becomes an ESG credit factor. If we believe that an ESG credit factor is material enough to influence our opinion of the risk or benefit to any pillar, the credit factor may be relevant in our credit rating. However, in most cases, ESG credit factors are not key rating drivers. Instead, they are indirect risks captured by other aspects of our analysis. Even in instances where ESG factors are directly relevant to credit quality, structural mitigants such as increased credit enhancement levels or additional structural protections can offset the impact of ESG risks. In these cases, ESG factors will generally not affect the credit rating (see "What Are Some Examples Of ESG Credit Factors In Structured Finance Transactions?" below).

As a result, rating actions on structured finance transactions driven by ESG credit factors have, so far, been limited. In our view, however, structured finance ratings would be susceptible to change due to major ESG event-driven risks.

What Are ESG Credit Factors?

An ESG credit factor is an environmental, social, or governance factor that, in our view, could impact the likelihood of a structured finance transaction making timely payment of interest or ultimate repayment of principal by the legal final maturity date. In structured finance transactions, ESG credit factors are typically indirect risks already captured in other aspects of our analysis.

If we believe material ESG credit factors pose direct risk or benefit to a transaction then we may explicitly address these in our analysis. How and where the factors are precisely incorporated in the rating depends on the analysis of the rating committee, through the application of the relevant criteria.

Examples Of ESG Credit Factors

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What Are Some Examples Of ESG Credit Factors In Structured Finance Transactions?

Below we provide some examples of ESG credit factors in structured finance transactions. Even though we categorized these examples by the three ESG factors and the five pillars of our analysis, in practice many of these examples overlap, and the mechanics embedded in typical structures could mitigate more than one of the ESG credit factors. Many of these examples are already captured by other aspects of our analysis, so they are not explicitly considered as primary rating drivers. Even if we believe an ESG credit factor is material, typical mechanics in structured finance transactions means there may not ultimately be a rating impact.

How Does S&P Global Ratings Monitor ESG Credit Factors Over A Rated Transaction's Life?

We monitor for any changes in the risk profile of the five key rating pillars as part of our regular surveillance of structured finance transactions. In addition to monitoring the underlying collateral's performance, our surveillance includes event-driven risks and any developments with respect to the sector, country, or transaction participants that could have a material impact on our analysis. As such, the frequency, timing, method, and extent of surveillance are dynamic. At a minimum, we conduct a review of each credit rating at least every 12 months.

A transaction's exposure to ESG credit factors may evolve over time. A risk may become more visible or more certain, or the seller, servicer, or other transaction participant may take action to reduce or eliminate the risk exposure. As a result, the effect of ESG risks and opportunities on a transaction's creditworthiness may change. A major ESG-related event that in our view has a material impact on one of the five key rating factors could prompt a surveillance review.

What Are Some Examples Of ESG-Related Events In Structured Finance?

Environmental
  • Credit FAQ: Questions Over Electric Vehicle Residual Values In European Auto ABS, published May 31, 2019

Summary of ESG risks:  In our view, an increase in electric vehicles in lease transactions would raise the uncertainty of future residual values, which is the risk that the residual value of the vehicle stated in the lease contract exceeds its market value. This is a result of limited historical performance data, reliance on fiscal incentives, the strong link to the manufacturers and suppliers, and technological factors for electric vehicles. The increased popularity of electric vehicles, particularly in Europe and Asia, could also negatively impact the secondary market values of diesel and petrol vehicles. We believe electric vehicles pose a medium- to long-term risk to the sector, and we may adjust our residual value assumptions and stresses if we believe they affect the ultimate payment of the rated securities.

  • German Diesel Ban Brings Bad Air For Carmakers And Auto ABS, published Feb. 28, 2018

Summary of ESG risks:  There is a high likelihood that cities with nitrogen dioxide emission levels significantly above the European Commission's threshold will impose bans on diesel vehicles. This could cause used values for diesel cars to deteriorate and impact recovery proceeds and performance on transactions.

  • Impact Of Major 2017 Hurricanes On Rated U.S. RMBS: Potential Exposure To Maria Totals $555 Million, published Oct. 4, 2017

Summary of ESG risks:  In residential mortgage-backed securities (RMBS), the total exposure across all securitizations to hurricanes Harvey, Irma, and Maria based on the current pool balance was $9 billion out of $147 billion of loans in the affected counties (6.2%). We took no rating actions, but we are monitoring the deals. Geographic diversification in collateral pools mitigates the risk that a natural disaster will affect a significant portion of the collateral.

Social
  • Marketplace Lending And The True Lender Conundrum, published Feb. 22, 2019

Summary of ESG risks:  Questions have been raised regarding the legality and enforceability of marketplace loan contracts originated through partner banks, along with concerns about breaches of state usury limits. Securitizations could be impacted if collections are delayed from the loans in dispute, yield may be reduced if the interest rates are lowered due to usury limits, or interest and/or principal may be annulled if loans are declared void. We will continue to monitor legal developments as they relate to the sector and, meanwhile, we will maintain a cautious approach to the industry, evaluating each platform on a case-by-case basis and considering the nuances, if any, specific to the platform.

  • Credit FAQ: How Will New Persistent Debt Rules Affect U.K. Credit Card ABS?, published Jan. 21, 2019

Summary of ESG risks:  Customers considered to be in persistent debt will be encouraged to change payment behaviors via increasing monthly payments or transferring balances to a lower interest loan. We expect this rule to increase the payment rate, positively impact charge-off rates, and reduce yield rates.

Governance
  • Marketplace Lending Securitization: Operational Risk Is Declining As The Sector Evolves, published June 3, 2019

Summary of ESG risks:  With the rapid increase in marketplace lending, regulations have also increased in most jurisdictions. The regulatory environment as well as the lenders' business strategy and operating history, management, revenue and financial performance, funding, and partner bank relationships and incentives are all key considerations in rating marketplace lending transactions. As the regulatory environment continues to mature, many lenders have adapted by increasing their compliance and control functions, which has often resulted in stronger alignment of interests. Given the diversity of the sector, we assess whether a cap on our ratings is applicable case-by-case, and we may update the cap periodically.

  • With A LIBOR Phase-Out Likely After 2021, How Will Structured Finance Ratings Be Affected? published Oct. 19, 2017

Summary of ESG risks:  The proposal to phase out the London Interbank Offered Rate (LIBOR) in favor of alternative rate references by 2021 could affect deals with floating-rate assets and liabilities. Transactions including fallback language could experience difficulties implementing new rates, and there would likely be basis risk between existing references and a potential replacement. Those with no fallback language or requiring a majority class approval could be subject to dispute risk since achieving a consensus could be difficult. In the end, we don't currently expect bond cash flow disruptions, and the impact for structured finance products will depend on several factors coming into play.

What Are Some Of The Challenges Related To ESG Credit Factors In Structured Finance?

ESG credit factors in structured finance, while not new, are evolving. We have primarily included this type of risk analysis in our qualitative assessments, including potential impact from an event risk. Because our opinions on creditworthiness are based on relative rankings, we continue to benefit from an increasing volume of case studies, which can help categorize the risks and their potential impact on the securitization. The case studies can also help establish benchmarks that may serve as a base for our discussions about relative rankings.

We've also been approached by issuers proposing securitizations backed by assets viewed as having strong ESG credentials. However, some hurdles need to be overcome in these initial stages, including a lack of capital market standard or market consensus of the definitions of "ESG" and "green", confidentiality, inconsistent disclosures and data reporting, and varying views on how to score and weigh ESG factors. It is also important to note that while certain assets may be viewed as having strong ESG credentials, this does not mean they would have a positive impact in our credit rating analysis. In fact, it is possible that assets with strong ESG credentials may have increased risk characteristics that result in either higher required credit enhancement levels or lower credit ratings. We do not opine on whether a transaction has strong or weak ESG credentials in our credit ratings. Rather, our focus is to identify and increase transparency around those ESG credit factors that in our view are material to credit quality under our five pillars framework.

Appendix

Solar and property assessed clean energy financing (PACE) ABS

In the U.S., we have rated five distributed generation solar ABS securitizations, which we now surveil according to our global solar methodology published in May 2019. In addition, we have rated two PACE securitizations using our principles of credit ratings criteria. For more information, see "Presale: GoodGreen 2019-1" published on Jan. 16, 2019, and the related criteria section below.

Green securitizations and Green Evaluations in structured finance

Green Evaluations can be performed on structured finance transactions, which help to finance technologies within the scope of our Green Evaluation. To date, we have assigned Green Evaluations to three structured finance transactions, which securitized PACE loans on green building, water, and energy improvements to commercial (and some to residential) properties in a variety of U.S. states. All three transactions scored an E1 score, the highest score possible on the E1-E4 quartile scale. The E1 scores were supported by strong governance scores enabled by the defined green project eligibility requirements found in the relevant PACE legislation and through the provisions of the securitization structures (see Ygenre 1, Ygrene 2, Pacewell 2).

There have also been some inroads into green bond securitizations in Europe, the Middle East, and Africa and Asia-Pacific. For example, the Green STORM Dutch RMBS transactions only securitize assets that comply with the "green" eligibility criteria of the originator. These criteria relate to the residential properties having certain energy performance certificates (see "New Issue: Green STORM 2019 B.V.," published July 18, 2019). In Asia-Pacific, certain assets identified as green have been included within a larger pool and a corresponding tranche of "green" notes has been issued.

Other asset classes that may eventually have green credentials include auto ABS collateral pools comprising electric vehicles, ABS and RMBS with underlying solar panel financing, and CMBS, given the established framework regarding energy efficiency. For example, projects driven by political initiatives, such as the Energy Efficient Mortgages Initiative (EeMAP), will likely increase growth in green covered bonds and ABS. EeMAP is a mortgage-financing mechanism that promotes the green tagging of mortgages, incentivizes building owners to improve their building efficiency or acquire new green properties at preferential interest rates, and collects data through a systematic framework.

Related Criteria

  • S&P Global Ratings Definitions, July 5, 2019
  • Global Methodology For Solar ABS Transactions, May 16, 2019
  • Environmental, Social, And Governance: How We Apply Our ESG Evaluation Analytical Approach, April 10, 2019
  • Green Evaluation Analytical Approach, April 26, 2017
  • Principles Of Credit Ratings, Feb. 16, 2011

Related Research

  • The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis, Sept. 12, 2019
  • Credit FAQ: Are Covered Bonds Becoming More Sustainable?, Sept. 6, 2019
  • New Issue: Green STORM 2019 B.V., July 18, 2019
  • Marketplace Lending Securitization: Operational Risk Is Declining As The Sector Evolves, June 3, 2019
  • Credit FAQ: Questions Over Electric Vehicle Residual Values In European Auto ABS, May 31, 2019
  • Greenworks Lending LLC's Pacewell 2 LLC Term Notes, 2017-1 Score E1/78 On Green Evaluation, May 3, 2019
  • Environmental, Social, And Governance: How We Apply Our ESG Evaluation Analytical Approach, April 10, 2019
  • Credit FAQ: How Will New Persistent Debt Rules Affect U.K. Credit Card ABS?, Jan. 21, 2019
  • Ygrene Energy Fund Inc.'s GoodGreen Series 2019-1 Notes, Jan. 16, 2019
  • Presale: GoodGreen 2019-1, Jan. 16, 2019
  • Ygrene Energy Fund Inc.'s GoodGreen Series 2018-1 Notes, April 19, 2018
  • German Diesel Ban Brings Bad Air For Carmakers And Auto ABS, Feb. 28, 2018
  • How Does S&P Global Ratings Incorporate Environmental, Social, And Governance Risks Into Its Ratings Analysis, Nov. 21, 2017
  • With A LIBOR Phase-Out Likely After 2021, How Will Structured Finance Ratings Be Affected?, Oct. 19, 2017
  • Impact Of Major 2017 Hurricanes On Rated U.S. RMBS: Potential Exposure To Maria Totals $555 Million, Oct. 4, 2017

This report does not constitute a rating action.

EMEA:Matthew S Mitchell, CFA, EMEA, London (44) 20-7176-8581;
matthew.mitchell@spglobal.com
Americas:Ildiko Szilank, New York (1) 212-438-2614;
ildiko.szilank@spglobal.com
APAC:Kate J Thomson, Melbourne (61) 3-9631-2104;
kate.thomson@spglobal.com
Greater China:Aaron Lei, Hong Kong (852) 2533-3567;
aaron.lei@spglobal.com
Sustainable Finance:Corinne B Bendersky, London + 44 20 7176 0216;
corinne.bendersky@spglobal.com
Thomas Englerth, New York (1) 212-438-0341;
thomas.englerth@spglobal.com
Global Head of SF Analytics & Research:Winston W Chang, New York (1) 212-438-8123;
winston.chang@spglobal.com
Research Contributor:Jenna Cilento, New York (1) 212-438-1533;
jenna.cilento@spglobal.com

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