ESG securitisation has the potential to play a key role in achieving sustainable finance objectives in the European Union. There have been a number of regulatory developments and other advances in this area, including the joint consultation paper recently published by the European Supervisory Authorities regarding the draft regulatory technical standards with respect to certain sustainability disclosures for simple, transparent and standardised securitisations.
There is a strong drive towards sustainable finance in the European Union. It has been recognised that securitisation could play a significant role in achieving this objective. Amid increasing investor demand for sustainable investments, market participants are considering how to incorporate environmental, social and governance (ESG) and sustainability principles in their securitisation transactions. In addition, rating agencies may take ESG factors into account where this has a material impact on their credit analysis.
The European ESG securitisation market is still in its early stages and lags behind that in the United States. However, there have been a number of sustainable securitisations issued in the European Union, including green and social residential mortgage backed securitisations (RMBS), green securitisations backed by commercial mortgages (CMBS) and auto loans and leases, and green synthetic transactions.
There is as yet no standard approach to sustainability disclosures for securitisation transactions, and a range of approaches has been seen in the market to date. The International Capital Market Association (ICMA) have published various voluntary sets of principles, and some transactions have been aligned with the ICMA Green Bond Principles or the ICMA Social Bond Principles, and also in some cases certification under the Climate Bonds Standard. Rating agencies and third party verifiers may provide evaluations, second party opinions and/or certifications based on assessments of ESG and sustainability principles and other considerations. ESG considerations are also increasingly relevant in the context of CLOs, with investors seeking disclosures to facilitate their compliance with certain requirements under the SFDR (as defined below).
There are a number of key pieces of EU legislation and other proposals which relate to sustainability. While some of these are not directly applicable to securitisation transactions, they are nonetheless relevant in the broader context. They include the following:
The Non-Financial Reporting Directive
The Non-Financial Reporting Directive (Directive 2014/95/EU) (NFRD) requires disclosure by certain large undertakings of information relating to environmental, social and employee matters, respect for human rights, and anti-corruption and bribery matters.
The application of the disclosure requirements is expected to be expanded to include certain other companies, under the proposed Corporate Sustainability Reporting Directive (CSRD).
The EU Taxonomy Regulation
The EU Taxonomy Regulation (Regulation (EU) 2020/852 of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088) sets out a classification system in order to assess the extent to which an economic activity is environmentally sustainable (under Article 3) and sets out certain environmental objectives (under Article 9).
It also contains requirements (under Article 8) for certain undertakings that are within the scope of the NFRD to disclose information on how and to what extent the activities of such an undertaking are associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9 of the EU Taxonomy Regulation. This has been followed by a Delegated Regulation (Commission Delegated Regulation (EU) 2021/2178) specifying the content and presentation of such information, and the related methodology (the Taxonomy Disclosures Delegated Regulation). In particular, certain key performance indicators (KPIs) will need to be reported. For banks, the main KPI is the Green Asset Ratio (GAR), being the proportion of their assets which are invested in economic activities aligned with the EU taxonomy as a share of their total covered assets (as described therein).
The Sustainable Finance Disclosure Regulation
The Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088, as amended) (SFDR) requires certain financial market participants and financial advisers to make various sustainability-related disclosures, including principal adverse impacts (PAIs) on sustainability factors. It does not apply to securitisation as this is not within the definition of a “financial product”. Regulatory technical standards will be put in place by way of a Delegated Regulation (the SFDR RTS) to provide more details in relation to the required information.
Article 449a of the Capital Requirements Regulation
Under Article 449a of the Capital Requirements Regulation (Regulation (EU) No 575/2013, as amended) (the CRR), from 28 June 2022 certain “large institutions” (as defined in the CRR) which have issued securities that are admitted to trading on a regulated market of any EU Member State will be required to disclose information on ESG risks, on an annual basis for the first year and biannually thereafter. This has been supplemented by implementing technical standards.
The EU Green Bond Standard
Following the publication of a proposal by the European Commission (the Commission), a green bond standard is expected to be put in place in the European Union (the EU Green Bond Standard). The objective is to enhance the effectiveness, transparency, comparability and credibility of the green bond market and to encourage market participants to issue and invest in EU green bonds.
The EU Green Bond Standard is expected to be available on a voluntary basis and to require the use of proceeds from the bonds to be allocated to projects aligned with the EU taxonomy, detailed reporting, and verification by a third party, which would be supervised by the European Securities and Markets Authority (ESMA).
Under the EU Securitisation Regulation (Regulation (EU) 2017/2402, as amended), the European Banking Authority (the EBA) was mandated to prepare a report on developing a framework for sustainable securitisation. This was published by the EBA on 2 March 2022 (the EBA Report). This is to be followed by a report by the Commission, accompanied, if appropriate, by a legislative proposal.
The EBA Report notes that only a limited number of securitisations categorised as sustainable have been issued in the European Union. It identified the shortage of sustainable assets and the lack of standards and data as particular challenges.
In the EBA Report, the EBA expressed the view that the EU Green Bond Standard should apply to securitisation. However, it recommended that the EU Green Bond Standard be adjusted in order to apply the use of proceeds approach at the originator level rather than at the level of the securitisation special purpose entity (SSPE). This would require additional disclosures, including the GAR (or similar KPIs for non-bank financial institutions).
While the EBA considered that there is a rationale for establishing a dedicated framework for sustainable securitisation in addition to the EU Green Bond Standard in the case of green true sale transactions, it concluded that it would be premature to establish such a framework at present. In the case of synthetic securitisation, more time would be needed to assess how this should be reflected in a green framework. With respect to social securitisation, the EBA also considered that it would be premature to establish a dedicated framework at the moment. In each of these cases, a framework may be developed in the future.
In addition, the EBA considered the question of sustainability-related disclosures and due diligence for securitisations, and concluded that the application of the PAI disclosures for simple, transparent and standardised (STS) securitisations backed by residential loans and auto loans and leases (as discussed further below) should be extended to non-STS securitisations in these asset classes. It also recommended that there should be mandatory PAI disclosures for all securitisations in the medium term, once the sustainable securitisation market has matured further and more experience of sustainability-related disclosures has been obtained.
The EU Securitisation Regulation sets out the criteria for a securitisation to be considered STS. Among other things, this enables certain investors to benefit from improved regulatory capital treatment with respect to asset backed commercial paper (ABCP) and non-ABCP securitisations. While synthetic securitisations were originally excluded from the STS framework, it is now also possible for on balance sheet synthetic securitisations to be STS in the EU following the amendments to the EU Securitisation Regulation which came into force in April 2021 (the EU Securitisation Regulation Amendment).
The STS criteria for non-ABCP true sale securitisations and on balance sheet synthetic securitisations provide that, in the case of securitisations of residential loans or auto loans or leases, the originator should publish available information related to the environmental performance of the assets financed by such residential loans, auto loans or leases, as part of the reporting required under Article 7 of the EU Securitisation Regulation. This requirement applies only to these types of asset classes and only to non-ABCP STS securitisations.
The EU Securitisation Regulation Amendment added some wording to give originators the option, instead of publishing such information on environmental performance, to publish available information related to the PAIs of such assets on sustainability factors. The European Supervisory Authorities (the EBA, ESMA and the European Insurance and Occupational Pensions Authority (EIOPA) (together, the ESAs)) were required to develop, through the Joint Committee of the ESAs, draft regulatory technical standards on the content, methodologies and presentation of such information, in respect of the sustainability indicators in relation to adverse impacts on the climate and other ESG-related adverse impacts (the Draft Sustainability RTS).
The ESAs published a consultation paper on 2 May 2022 with the Draft Sustainability RTS and including a summary of the related background and rationale. The ESAs considered the Taxonomy Disclosures Delegated Regulation in preparing the Draft Sustainability RTS, and in addition aimed to ensure a high degree of consistency with the SFDR and the SFDR RTS.
Below is a summary of some of the key aspects of the Draft Sustainability RTS.
Format of Disclosures
The consultation paper indicates that, in the case of “public” securitisations, disclosure of the relevant information would need to be made available via a securitisation repository. However, it was decided not to build these disclosures into the existing reporting templates put in place under Article 7 of the EU Securitisation Regulation for the time being, although such templates may be revised in the future. Instead, it is proposed that disclosure will initially be achieved by way of a stand-alone “principal adverse impact statement”, which would be closely aligned to the template developed for the purposes of the SFDR RTS. The information would be required to be provided quarterly as part of the information disclosed under Article 7(1)(a) of the EU Securitisation Regulation.
The Draft Sustainability RTS contain mandatory PAI indicators for loans backed by residential real estate and are aligned with the draft SFDR RTS. These are exposures to energy-inefficient assets and the proportion of non-green exposures (i.e., 100% - GAR). There are also some additional environmental indicators relating to greenhouse gas emissions, energy consumption, waste, resource consumption and biodiversity. No indicators have been included with respect to social or governance aspects.
Auto Loans and Leases
In the case of auto loans and leases, there are no specific PAI indicators in the draft SFDR RTS and so the indicators have been drawn from other sources. The proposed mandatory indicators relate to greenhouse gas emissions, air pollution, water, waste and material emissions, the non-green asset ratio, and social and employee matters. There are some additional environmental indicators and indicators for social and employee, respect for human rights, anti-corruption and anti-bribery matters.
Other Types of Securitisation
While the Draft Sustainability RTS are required to cover non-ABCP STS securitisations of residential loans and auto loans and leases, the ESAs are also of the view that originators should have the option of providing information on the PAIs on sustainability with respect to securitisations with other underlying exposures.
Consequently, the Draft Sustainability RTS set out proposed PAI indicators based on the SFDR RTS for securitisations of commercial real estate loans (although it is worth noting that CMBS transactions are not generally capable of obtaining STS treatment) and for corporates including SMEs (although there would be a reduced number of indicators for SMEs) and trade receivables.
The ESAs found it difficult to develop PAI indicators for securitisations backed by consumer loans and credit cards and so did not include these in the Draft Sustainability RTS.
Next Steps for the Draft Sustainability RTS
The ESAs have asked for feedback on the Draft Sustainability RTS via responses to a set of questions. The closing date for responses to the consultation is 2 July 2022.
Market participants will want to consider the extent to which the disclosures will be beneficial, as a result of increased standardisation and provision of information to investors, but at the same time will want the disclosures to be proportionate and not unduly burdensome on originators, both in terms of the amount of information to be provided and the frequency of reporting. This is particularly key given the possibility, as indicated in the EBA Report, that such disclosures will be extended to non-STS transactions and to other asset classes, and may become mandatory at some point in the future.
The regulatory framework in relation to sustainable securitisation is complex and is still in the process of being developed. It seems likely that disclosure of sustainability-related information will become increasingly important, and that the development and use of standardised principles will become more prevalent. Furthermore, given the increased focus on sustainability and the level of interest in ESG securitisations, the number of these securitisations is likely to increase. Sustainable securitisation will certainly be an area to watch.
Sharing insights and resources that help our clients prepare for and address evolving issues is a hallmark of Morgan Lewis. To that end, we maintain a resource center with access to tools and perspectives on timely topics driven by current events such as the global public health crisis, economic uncertainty, and geopolitical dynamics. Find resources on how to cope with the globe’s ever-changing business, social, and political landscape at Navigating the NEXT. to stay up to date on developments as they unfold. Subscribe now if you would like to receive a digest of new updates to these resources.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact the author, Merryn Craske, or any of the following Morgan Lewis lawyers: