The use of renewable energy assets as covered bond collateral under a proposed Luxembourg framework would bring extra risks versus traditional collateral, according to Moody’s, but the rating agency highlights various mitigants and says the law is overall credit positive for funding such assets.
The Luxembourg ministry of finance announced in January that it has produced a draft law to create a framework for green covered bonds backed by renewable energy assets. The law is the first green covered bond law proposed anywhere in the world.
In a report published on Tuesday, Moody’s said the proposed law is credit positive, because once implemented it will allow renewable energy projects to be funded with a dual recourse structure, while also reducing legal complexity and increasing standardisation among covered bond programmes.
However, Moody’s highlighted that renewable energy infrastructure financings (abbreviated to REIFs by the rating agency) pose higher and more complex credit risks than a traditional residential mortgage cover pool.
“REIF cover pools will be exposed to the operating risks and economic success of a potentially diverse range of renewable energy projects and would also likely be significantly more concentrated than traditional cover pools made up of residential mortgages,” said the rating agency.
These risks, Moody’s said, include the variability of renewable energy generation, which can influence the revenue generated by renewable energy assets.
“REIFs are based on independent forecasts for the energy that will be produced by the underlying assets, but renewable energy generation is nevertheless variable,” said Moody’s.
The rating agency adds that the majority of REIF assets it rates in Europe benefit from the underlying renewable energy projects receiving government subsidies, typically in the form of a feed-in tariff. The potential for changes in such subsidies are another credit risk for existing renewable energy projects, Moody’s said.
“The risk of retrospective changes to existing subsidies is related not only to a government’s track record, but also to political and popular support for renewable energy and the burden on electricity consumers of funding the above-market compensation for renewable power,” it said. “In some cases, such as Spain and Italy, governments have retrospectively changed subsidy levels to the detriment of renewable energy projects.”
However, Moody’s notes that dependence on such subsidies is declining and newer assets are less exposed to this risk than older assets, supported by the introduction of competitive bidding.
Moody’s also cites technological risks, where technology is unproven over a long period or untested or in a sector where technology rapidly advances, and that REIFs tend to be less liquid assets than traditional covered bond assets – although it expects the number of prospective purchasers for a pool of REIFs to expand over time.
“If an issuer of covered bonds backed by REIFs were to fail, refinancing risk would likely materialise, because the natural amortisation of the long-dated REIFs in the cover pool may not be sufficient to repay principal under the covered bonds at the scheduled maturity date,” said Moody’s.
“As a consequence, investors are exposed to the risk of later than scheduled repayment of the covered bonds or face the risk of losses due to a fire-sale of the REIF assets to raise the necessary liquidity for the bond repayment.”
The structures used in REIFs typically include features designed to address some of these risks, Moody’s said, adding that the dual recourse structure of covered bonds also reduces such risks.
Mitigants in proposed law
The law proposed by the Luxembourg ministry of finance also includes various features that mitigate credit risks associated with the collateral, said Moody’s.
Among these are leverage limits that cap the amount of a REIF that may be counted as a cover pool asset at 50% to 80% of the estimated realisation value (ERV) of the renewable energy project that collateralises the REIF. Moody’s notes that the ERV must, according to the law, be based on prudent valuation standards and that valuation principles are to be further defined by Luxembourg’s financial services supervisor.
Moody’s cited other mitigants in the law as including comprehensive rules on asset eligibility, a mandatory overcollateralisation requirement of 2% of the nominal value and net present value of the covered bonds, and a 180 day liquidity buffer.
It highlights that the eligibility criteria also allow for REIFs that are being managed through an enforcement process to remain in cover pools, which is deemed a credit positive feature of the framework.
However, Moody’s noted that the framework does not require further collateral to be added to cover pools if REIF assets become nonperforming, and that set-off rights and interest and currency risk are also not addressed.
Under current European Union legislation, bonds issued under the new Luxembourg framework will be classified as covered bonds, said Moody’s. Should REIFs not be considered of sufficiently high quality to collateralise covered bonds once European covered bond laws are harmonised via the European Commission’s Directive and associated Regulation, Moody’s suggests that bonds backed by REIFs may be classified under European Secured Notes (ESNs), a proposed product that would share dual recourse features with covered bonds but would remain distinct and may eventually be issued under a separate regulatory framework.
Photo: Topaz Solar Farms, a solar project cited by Moody’s as an example of one of the renewables projects it has analysed; Source: Pacific Southwest Region of the US Fish and Wildlife Service/Flickr/Wikimedia Commons