An environmental think-tank has suggested that covered bonds backed by renewables could help alleviate a shortage of funding for the greening of the world’s energy resources. Chiara Francavilla explores the issues and challenges surrounding the Climate Bonds Initiative’s proposal.
This feature originally appeared in the January-February 2013 issue of The Covered Bond Report magazine.
Covered bonds are one of the few areas of the capital markets to have emerged with little damage from the crisis. Indeed, their resilience has, if anything, polished their reputation. As a result, policy-makers have touted the instrument as a solution to all sorts of the world’s economic woes.
But the latest claim to be staked on behalf of the asset class is perhaps the most heroic yet: covered bonds can help make the world a greener place.
The Climate Bonds Initiative argues that the financial instrument could be used as a tool to channel funds into the renewable energy sector, conciliating the interests of environmental advocates and bankers.
The proposal is not yet at the stage where Occupy Wall Street are likely to lay down their banners and make peace with their erstwhile banker enemies, but last December a group of 30 finance experts and investors sat together for a roundtable in London with representatives of environmental organisations to discuss the feasibility of the proposal. They brought with them expertise, experience and vision, but also scepticism to examine whether the project could be market viable, rather than just socially desirable.
Funding could drop
Covered bonds could be — among other financial instruments such as asset-backed securities that the initiative is looking at — a way to boost the availability of funding for renewable and energy efficiency projects, which the think-tank says are suffering from scant attention in the world of the capital markets.
New investments in renewable energy have increased significantly in the last decade, growing from $39bn in 2004 to $257bn (Eu195bn) in 2012, according to a recent report, “Global Trends in Renewable Energy”, published by the Frankfurt School of Finance & Management and the United Nations Environment Programme (UNEP).
However, some observers say that there is still a significant shortfall in the availability of funding for renewable energy projects. A 2012 policy paper from the German Advisory Council on Global Change (WGBU) says that if the world sets itself the goal of deriving its entire electricity supply from renewable sources by 2050 — excluding nuclear but assuming a substantial increase in energy efficiency — the amount of funding necessary annually would be $1.1tr now, rising to $2tr in 2030 and $3.5tr in 2050.
Sean Kidney, co-founder and chief executive of the Climate Bonds Initiative (pictured), says that capital availability for renewable energy projects is limited, especially in Europe after the financial crisis, and could decrease further.
This is because the renewable energy sector is highly reliant on project finance, which will be particularly vulnerable to new liquidity standards included in Basel III, as renewable energy projects are usually serviced by income-generating assets that may not have ready secondary markets during economic shocks, so banks holding those assets would need additional liquidity buffers.
“Existing loans will not be eligible under Basel III, so we could see further recapitalisation drop,” says Kidney.
“But if renewable energy assets became eligible as collateral for covered bonds, then we would have another financial instrument to enhance funding availability for renewable energy projects,”
Capital is available in Europe for clean energy projects that are well structured, but it often comes at a high cost, according to Alexandre Chavarot, managing partner at Clean Infra Partners, a financial consultancy specialised in renewable energy markets. Chavarot was one of the participants in the London Climate Bonds Initiative roundtable.
“If new instruments to finance renewable energy projects were introduced, this could add more diversity to the pool of capital, therefore reducing the cost of such capital,” he says.
“Covered bonds might be an interesting instrument to fund energy efficiency investments,”
Gaia & Mammon
Covered bonds are being advocated because of their dual recourse nature, says Kidney. Investors would be attracted by the strength of the issuer in the first place, and this would contribute to overcoming the high risk perception associated with renewable energy projects.
Another reason is that investing in renewable energy could help in mobilising resources against climate change, which is ultimately an issue related to the public good, he says. Covered bonds have been historically used to raise funding for socially desirable outcomes, such as affordable housing, and could now also be used to fight climate change.
Kidney says that it would be misleading to look at covered bonds “merely as a financial instrument that happens to have macro-economic benefits”.
“Covered bonds have been used to direct funds into an area of significant policy importance,” he says. “They are policy-promoting tools.”
Some covered bond specialists agree on this political and financial nature of covered bonds.
“Ultimately covered bonds are at the intersection between public policy and financing tools,” says Julia Hoggett, managing director and head of covered bonds, FIG flow financing and short term fixed income origination, EMEA at Bank of America Merrill Lynch, and also a member of a steering committee for the Climate Bond Initiative’s covered bond project.
“Green energy finance and the greening of the global economy, and the further integration of environmentally efficient measures in the way we invest in the decades to come are important issues of public policy,” she says.
“If you have an instrument that has been used both as a financial tool and a mechanism of public policy,” she adds, “then it is wholly appropriate that it be considered as a tool for the greening of the market as it was and still is useful for financing home mortgages.”
Beyond responding to the public good, renewable energy covered bonds would also be beneficial for the banking sector, claims the Climate Bonds Initiative.
Christoph Anhamm, head of covered bond origination at RBS and also a member of the steering committee, says that renewable energy covered bonds could help issuers in matching assets and liabilities on their balance sheets.
“Loans to renewable energy projects are long dated,” he says. “Usually they have 10 or even 20 year tenors, which are quite hard for banks to fund on maturity-matched basis. Senior unsecured hardly ever goes beyond a certain maturity, so 10 years is a rare tenor.
“Any security that could offer long term funding, such as covered bonds, should be of great interest for the institutions holding these loans.”
Anhamm says that not only would renewable energy covered bonds help in funding existing loans, they could also help promote the origination of new ones, increasing the amount of money going into the renewable energy sector.
To be economically viable however, covered bonds would also need to be seen as attractive by investors.
A buy-side representative said that covered bonds backed by renewable energy projects would be less appealing for investors than residential mortgages backed ones.
“Residential mortgage covered bonds are products that investors know well,” he says. “Investors are comfortable with them because the mortgage cover pool is perceived as less risky and more granular than how a renewable energy projects cover pool would appear.”
However, he adds that the investor community is very diversified, so at the “right pricing” renewable energy covered bonds may become appealing for some.
“The pricing of those bonds may make them more or less attractive for investors,” he says. “If banks were to offer covered bonds of that type, they would need to give investors a relatively good return compared to covered bonds backed by residential mortgages.”
The Climate Bond Initiative has not yet presented a plan on how to introduce renewable energy covered bonds in the market. Some participants believe that the first step should be taken by existing covered bond issuers.
“The structure for establishing a new covered bond market always has been and will have to be that the initiative comes from the issuer side,” says RBS’s Anhamm. “This product will never go live before an issuer is willing to take action.”
Bank of America Merrill Lynch’s Hoggett elaborates three possible solutions for the introduction of renewable energy covered bonds that could be implemented in the short, medium and long term, “all together constituting pieces of the same puzzle,” she says.
A short term solution could be to include renewable energy projects in existing public sector covered bonds by providing guarantees for the loans from public entities or multilateral institutions that are eligible as counterparties to public sector cover pools.
“If the bonds are fully guaranteed, they could become eligible as cover pool assets, as are pieces of public sector debt guaranteed by an export credit agency,” she says.
A medium term solution could be to create a new category of mortgages for loans that are used to purchase more environmentally friendly houses or to upgrade the energy efficiency of a property, according to Hoggett.
“It would not necessarily be a huge stretch for regulators and banks to provide beneficial pricing on mortgages that deliberately have a green element to them,” she says.
Those mortgages could be used as collateral for covered bonds alongside traditional ones.
“There is no reason why with a few adjustments to regulations such green mortgages would not be eligible as cover pool assets, without any massive change to the nature of covered bonds themselves,” she says.
Finally, a “much, much longer term solution”, says Hoggett, would be to establish a new asset class for renewable energy projects.
“But that’s a long way away from being reality,” she says.
Hoggett highlights how in all three options for the introduction of climate bonds there is an element of government initiative, and it should be in governments’ interest that the true cost of environmental investments is properly priced and properly incentivised.
“The introduction of renewable energy covered bonds can be seen as tripartite effort,” she says, “the issuer push, the investor push and the regulatory push, or the latter can be substituted by the regulator recognising and accepting the pragmatic utility of doing this.”
According to Anhamm, more than incentives such as public guarantees or tax exemptions, the best push that governments could give to the initiative would be putting in place a legal framework for renewable energy covered bonds. Ideally, these bonds should then also benefit from the same favourable regulatory treatment as existing covered bonds.
“If you are looking for public support, I think that a legal framework is the greatest support you can have,” he says.
Too green to fit
However, including renewable energy projects in cover pools could present obstacles that are difficult to overcome, especially if dedicated cover pools are created. Loans to renewable energy projects are by their nature very different from the types of loans that have been used in cover pools until now — namely mortgages, public sector loans, and aircraft and ship loans — and some of their features may not be compatible with the covered bond structure.
Georg Grodzki, head of credit research at Legal & General Investment Management, says that many renewable energy projects would not satisfy the quality requirements to be included in cover pools.
“Covered bonds have an impeccable default record mainly because they tend to be collateralised by high quality assets, he says. “For this reason, regulators have decided to give them preferential treatment in terms of risk weightings and concentration limits, and investors feel safe.
“Renewable energy projects do not have a long enough performance record and not all of the transactions in this sector have met expectations. So it would be difficult and too early to justify their inclusion in the collateral pool for covered bonds unless project cashflows are underpinned by government support or other means, such as legislated feed-in tariffs.”
Grodzki suggests that more time is needed to thoroughly evaluate the risks for debt investors in renewable energy projects.
“In the meantime, we should either refrain from using them as collateral, as we don’t have enough information on their performance over time, or apply very steep haircuts, with overcollateralisation of something like 200%,” he says.
Another issue seen as problematic is that renewable energy projects are usually formed by long dated and large loans, as acknowledged by Hoggett.
“The high granularity of mortgages is not something we would have in the relatively lumpier public sector renewable infrastructure projects,” she says.
Renewable energy cover pools may also not enjoy the same degree of homogeneity as mortgage cover pools. In order to avoid excessive complexity for investors, similar loans should be assembled, and a single institution may not have enough of them.
“In our experience, we have observed that there is a strong preference for homogeneous pools,” says RBS’s Anhamm, “so we would need to put loans to wind farms with wind farms, solar panels with solar panels, so that it could be easier for investors to understand and assess the risk and potential of those assets.”
In terms of investor perspectives on cover pools, the buy-side representative also points out that in recent years investors have shown a tendency to invest directly in renewable energy projects.
“As we are in a relatively new technological era,” he says, “some of the investors I have spoken to actually prefer to be closer to the investment rather than having a second hand relationship.
“They want to have enough information on the assets, which you may not have through a covered bond structure.”
Another issue to consider is that covered bonds are highly protected products that some fear could lose their privileged status if assets other than conventional ones are included in cover pools. This is an issue that has already been cited in relation to covered bonds backed by other new classes of assets, such as loans to small and medium sized enterprises.
“There is a very understandable community of covered bonds advocates which feels that covered bonds are most successful and best protected by having a very clear discipline about the nature of the eligible assets,” says Hoggett. “The inclusion of renewable projects themselves would be a significant step away from that.”
The Climate Bond Initiative’s Kidney acknowledges this, but says that the scale of the initiative would not be so large as to damage the covered bond product itself.
“We don’t want to make a proposal that would see a dilution of the protected covered bond label,” he says. “At this stage the scale of investment in the renewable energy sector would be relatively small compared to the housing market.
“The amount of issuance would not corrupt the brand.”
But some others, like Grodzki, say that using the covered bond brand to make renewable energy appear less risky would be against the principle of covered bonds themselves.
“It defeats the purpose of covered bonds,” he says. “Covered bonds are meant to be the safest debt asset class, which means only high quality loans should qualify for the collateral pool.”
He adds that other funding sources may be better suited to finance green investment projects, pointing out that equity should provide the bulk of the funding for projects with high construction, technology or revenue risks.
“It would be more useful to call upon equity investors,” he says. “If there is a significant cushion of equity, then the risk for debt investors would also decline and could be carried by banks or investment funds directly.
“If debt is not available right now, it’s because some of those assets are too risky,” he adds. “But the return upside for many of them should be good enough to attract equity investors.”
A long way to go
Kidney says that the steering committee has taken on board all the observations made during the London roundtable, including criticisms and challenges, and will engage in talks with institutions by the end of this year. Officials from some public entities, such as the European Investment Bank, joined the roundtable, he notes.
Kidney says that the initiative is still in the consultation phase, but will be pushed forward.
“The gestation process will be long, but in five years from now the first issuance may take place, probably via a first demonstrative issuance with the European Investment Bank to set the example,” he says.
Hoggett says that the introduction of a renewable energy project into a covered bond pool in the form of a guaranteed public loan may not be far away, but the establishment of pure renewable energy project cover pools would require a great deal more time.
However, at the roundtable Stuart Clenaghan, co-founder of the green investment projects consultancy Eco System Services and a member of the steering committee, put a positive spin on the possibilities ahead with a quote from Bill Gates: “Most people overestimate what they can do in one year and underestimate what they can do in 10 years.”