Navigating the ESG covered bond market
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Navigating the ESG covered bond market

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At the Euromoney Asian Covered Bond Roadshow in Singapore in March, DZ BANK led a session looking into recent policy and market developments in ESG covered bonds.

The session was held soon after the announcement of the provisional agreement on the European Union’s (EU) green bond standard which, as it is based on the Green Bond Principal’s ‘Use of Proceeds’ model, has raised some concerns for the green covered bond market. This is because the market is traditionally based on the nature of the green security underlying the bonds as opposed to the proceeds being chanelled towards the funding of new green assets.

Carmen Muñoz, global head of resources at Sustainable Fitch, started the conversation on this point by saying that, for example, in China, many green collateralized bank bonds were “double green,” being both secured on green assets, such as loans to buy electric vehicles, and committing to use the proceeds of the bond to originate more of the same type of loan.

However, for issuers who can’t use both approaches, there were differing views. Sanna Eriksson, managing director of OP Mortgage Bank, and others, argued that by their very nature, the identity of a covered bond was the identity of the collateral. This comment was echoed by Sascha Kullig, member of the management board of the Association of German Pfandbrief Banks (VDP), who emphasised the importance of the close link between a covered bond and the cover pool and the importance of keeping that linkage, which has underpinned all of the existing “green Pfandbrief”.

Several of the panellists argued that as long as you define and communicate the outcome that you are trying to achieve, it isn’t so important to investors if you advance a green loan then refinance it via a green bond issue or raise the finance then grant the green loan. The outcome is the same, they argued.

The bottom 85% 

Matthias Ebert, head of DCM FIG origination at DZ BANK, pointed out that the use of proceeds approach in the green covered bond market would remove the requirement that bonds are only backed by green assets – in particular loans secured on the 15% most energy efficient houses in the mortgage book – and allow the bond proceeds to be used to advance loans that are transformative across the loan book.


This echoed two points, made by Jennifer Johnson, deputy secretary general of the European Covered Bond Council. She pointed out that the least efficient buildings were the biggest problem in terms of their energy consumption and that renovations, although they might make significant progress in terms of their energy efficiency, don’t necessarily bring these mortgages into taxonomy compliance or eligibility as collateral for green covered bonds.

In addition, mortgages on the most energy efficient properties are typically advanced to wealthier families and there is a very real risk that the focus of the taxonomy and green bond market on these properties will make it more difficult for more vulnerable families to access credit.

This risk could exacerbate social exclusion and energy poverty for the most vulnerable members of society. From the point of view of the banks, it could also generate another class of stranded assets. The EU taxonomy’s ‘do no significant harm’ rule – that in pursuing one objective you must cause no significant damage to other parts of the taxonomy – could clearly be breached by a focus on the ‘top’ mortgages. Yet, according to Johnson, this is something of a black box and there is a need for further clarity from European Commission. She also pointed out that in the European Parliament nuances such as the ‘do no significant harm’ considerations are sometimes overlooked given the focus on the green outcome of legislation.

What is green? 

In response to a question about the potential for legislation to disrupt the existing, green bond market, Johannes Trautwein, ESG origination at DZ BANK, pointed out that the green covered bond market was growing strongly, and more so last year than other areas of sustainable finance. This growth, he said, has depended very heavily on clear definitions and labels and that the EU’s taxonomy of green activities poses a major challenge for many issuers.

For example, few existing green covered bonds apply eligibility criteria aligned with the taxonomy. Johnson pointed out that the taxonomy is currently far from complete, with only two of the six sections – climate change adaptation and mitigation – having been defined and that these definitions were controversial, despite the clarity and objectivity of the overarching goal of reducing carbon dioxide emissions. In contrast, the covered bond sustainability label has been developed by the industry and is a clear example of a market-led initiative guaranteeing standards and protecting investors from accusations of ‘greenwashing’.

The green covered bond market was growing strongly, and more so last year than other areas of sustainable finance
Johannes Trautwein, DZ BANK

The panel discussed whether the taxonomy’s ‘top 15%’ approach is the right one given alternative, more objective, ways to define green assets, such as referring to near zero emission building standards or energy performance certificates (EPCs). However, as Eriksson pointed out, the EPC ratings vary widely between countries with, for example, Finland (which objectively has relatively efficient buildings only rating 1% of all houses in the A category) a ‘top 15’ approach would require the inclusion of properties with EPCs of A, B and even C under the Finnish system. 

The search for a perfect definition of green assets was, according to Eriksson, potentially demotivating, as long as the asset quality is progressing it is not necessary to have a perfect definition and that shares of green are necessary for progress. As Johnson pointed out, “Perfection is the enemy of good’.

What is social?  

The problem of defining eligibility is even more apparent in the field of social covered bonds. According to Johnson, it is necessary to avoid accusations of ‘social washing’ when compared to ‘greenwashing’. As Trautwein described it, the efforts to define the social chapters of the taxonomy have effectively stalled at an EU level.

However, as with the EU’s green bond standard, some features created by the market have been included in the EU’s definition. This creates hope that market-led rules would help steer the EU legislation and avoid the potential disruption from a mismatch between regulation and market practice.

Echoing Johnson’s comments about market-led definitions in the green covered bond market, Ebert referred to the Pfandbrief market where there are now minimum standards for "Social Pfandbriefe” based, among others, on the UN’s Sustainable Development Goals. While they offer a degree of flexibility to issuers, they provide transparency requirements and call for an external assessment and impact reporting. Furthermore, proceeds may only be used for the financing and refinancing of assets that serve a social added value. This approach is necessary as, for example, several panellists commented that the definition of social housing varied widely country-by-country within Europe and would be even more difficult to define consistently on a global scale.

Show me the data 

Whatever definition applied, the problem of identifying sufficient eligible assets meeting the criteria is an ongoing concern of issuers and with more focus on greenwashing, data and credibility in general is attracting more attention.

In Finland, as Eriksson pointed out, data protection rules even apply to a property’s energy performance rating and, in order to launch Finland’s first green covered bond, OP Mortgage Bank had to use artificial intelligence instruments to identify the greenest loans in their portfolio.

Whatever definition applied, the problem of identifying sufficient eligible assets meeting the criteria is an ongoing concern of issuers and with more focus on greenwashing, data and credibility in general is attracting more attention.

In contrast, according to Muñoz, green characteristics of properties in the US are reported on a loan-by-loan basis by Fannie Mae in their portfolio reporting. In Europe, disclosure standards have been in place for some time in specific markets. For example, requirements on Dutch pension funds to report ESG metrics. However, the introduction of common standards on an EU basis such as the green asset ratio from mid-2023 for institutional investors, will require greater analysis of pools.

Why green?  

In response to a question from the audience, Ebert suggested that the initial focus of the European green bond market on a ‘greenium’ – a cost saving for labelled green bonds – was increasingly less important than the recognition of the greater credit quality of green assets by lenders and in turn by regulators, which would influence capital consumption. In addition, ESG instruments were increasingly important to be able to access the widest possible investor base.

Johnson explained the correlation between energy efficiency and credit risk for mortgages on the basis of numerous studies undertaken by the European Mortgage Federation and expects that, in the context of the final Basel 3 framework, the European Banking Authority is looking at the potential for a dedicated prudential framework for ESG exposures to reflect the assets superior risk behaviour.

Trautwein said that, based on analysis of the order books for ESG covered bonds, Ebert’s comment about a wider investor base was more important to deal execution in more challenging market conditions. Green bonds are increasingly purchased by investors that DZ BANK considers ‘dark green’ – frequently reaching 20% to 25% of the order books of green bonds.

The role of explicitly green investors will, if anything, increase as a result of the Mifid requirement that banks need to ask retail investors about their sustainability objectives when offering them investment products, holding out the prospect for further economic benefits to help continue the growth of the green covered bond market.

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