Covered bonds are not the answer to the UK’s renewable revolution
Labour: don’t change the covered regime, look to secured notes instead
UK shadow City minister Tulip Siddiq said last week that the Labour Party would look to use covered bonds to unleash £10bn a year of renewable energy infrastructure investment if it were in government.
Plans to reform the country's covered bond law would allow UK lenders to include renewable energy products in their collateral pools and to issue paper secured against these projects. But getting the projects to fit into Capital Requirements Regulation-compliant asset pools might prove a problem.
Furthermore, Luxembourg has had a legal framework for covered deals secured against renewable energy loans since January 2018. But to date, only one issuer has made use of this, Nord LB Luxembourg, which raised €300m with a Lettres de gage énergies renouvelables in early 2020.
In the case of Nord LB Luxembourg’s renewable energy bond, the assets used did not comply with the needs of the CRR.
CRR-compliant covered bonds can only be secured on mortgages below a certain loan-to-value ratio that are regularly valued or state guaranteed public sector loans. Unsecured bank lending to renewable energy infrastructure projects does not fall into either category.
And as the UK covered bond regime still incorporates Article 129 of the CRR, the same would be true of any UK attempt at renewable energy-backed paper.
The UK may no longer be in the EU and it is free to tear up the rule book if it wanted, however, doing so would be ill-advised and would risk undoing any attempts at equivalence with the bloc's covered bond regime.
Unless a prospective Labour government wants banks to sell renewable energy-backed sterling covered bonds to UK accounts only, then it needs to ensure that any products keep the support of European investors.
To get this support, UK originated covered bonds need CRR-compliant assets so that investors can include the paper in their Liquidity Coverage Ratio portfolios.
Of course, there are ways around this. Banks could secure the bonds on a mortgage tied to the underlying real estate of a renewable energy product, or get some form of public sector guarantee for the project. But these are merely workarounds.
There is an alternative in the shape of the European Secured Note (ESN), however. Although a rebrand might be needed for it to pass the anti-European contingent in the UK legislature.
ESNs sit between covered and senior funding, offering banks a chance to fund unusual assets via a dual-recourse instrument.
Commerzbank pioneered the format when it sold a secured bond backed by SME loans in 2013. However, since then no bank has issued an ESN.
A UK Secured Note regime might prove a valuable middle ground. On the one hand, it would allow UK banks to continue issuing CRR-compliant covered paper (until the EU decides otherwise). While on the other, it would allow banks to finance these products at a lower cost than through senior unsecured debt alone.
But secured notes are not just for banks. A well rated and well regarded corporate could issue one if it had a ring-fenced pool of assets — like, say, a wind or solar farm.
The Labour Party has the right intentions. The bond market can help unleash the renewable energy revolution in the UK. But covered bonds are not the answer. Instead if Keir Starmer and co win the next UK election, then should look towards supporting a new secured note regime instead.