ESG Focus: Green Finance Offers Reprieve For Banks

ESG Focus | Jul 22 2021

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ESG Focus Green mortgages a reprieve for banks

As big capital extends green financial nets into the retail, SME and corporate markets, banks are likely to be sheltered from the worst ravages of competition behind anti-trust legislation.

– EU launches sustainable finance strategy
– Global anti-trust and anti-big-tech sentiment given a voice
– Green mortgages on the way
– Capital questions: who gets what when stress strikes
– The Australian scene – property is the easy target

By Sarah Mills

Sustainability-linked finance is about to sweep the world, and property investors will be among the first in its path. 

Banks globally have been preparing for the new lending paradigm, which is forecast to incorporate green priorities into all property-secured lending and issuance within a decade.

As with most things green, the European Union (EU) is leading the charge and this week ushered in the new financial year with its Sustainable Finance Strategy.

The big takeout was that the EU and the European Banking Authority are exploring supporting a taxonomy-aligned uptake of green mortgages and green loans – ready by 2022.

This will be part of an inclusive finance framework that is likely to provide a blueprint for other nations. 

A strategy highlight was the suggestion that mortgages will become the first asset class in the world to receive preferential capital requirements, to encourage the finance sector to take carriage of the green transition.

As part of its roadmap, the European Central Bank says that over the next 18 months, it will develop indicators for banks' carbon footprints and exposure to physical climate risk.

Banks globally are preparing for the new ratings and assessment regimes and are already creating their own green lending frameworks.

While the EU’s sustainable finance strategy addresses both GSS use-of-proceeds and sustainability-linked bonds and loan markets; this story focuses primarily on the sustainability linked market and the banks. 

Not so brave new banking world

Big capital is placing carriage of the green transition into the hands of banks, which will mobilise capital towards a sustainable future.

In return for accepting this baton, it is highly likely that the banking industry will be protected from online retail behemoths like Amazon for at least the next decade.

The capacity of the banks to take carriage of a task the scale of the green transition, while fighting tooth and nail against disruption, would be compromised.

The retail/investment banking nexus has proved a powerful tool for big capital to exert global control through the process of financialisation.

Banks have essentially turned to investment banking market for greater profits, while offsetting losses through its retail oligopilies.

Retail banking is to the banks what classifieds were to the press. Without it, they would face a precarious future, and one of big capital's command and control mechanisms would be compromised, as would an escalation of financialisation through ESG finance.

So it is fair to say that banks are safe from serious competition for now.

So while smaller financial industry competitors will continue to nip at banks ankles, the banks will enjoy a double advantage:

Protection from major competition on one front; while the greater complexity of sustainability-linked retail products will help shore up their competitive moats in the sector on another front.

Banks will also gain extra fee income from deal-making in fixed-income markets; carbon-trading activities; potential funding advantages; and preferential capital treatment.

But let’s take a step back

The future of retailing is very different to the past.

Without regulation, the logical evolution of the online retail industry is for supermarkets, department stores, banks and media to merge into single-branded online portals, such as Amazon – or at the very least to sell their products through such portals. 

It then becomes a battle of the portals for supremacy.

Categories would still exist but market dominance would hold with the portals.

Already Amazon has been purchasing, building and experimenting with tools, systems, fin-tech buyouts and financial products that expand its merchant participation.

It has also contemplated partnerships with major US banks offering accounts in the online market place, and also has the option of plumping for a cut of financial products sold on its platform.

Amazon alone represents a serious threat to the global banking industry, let alone other competitors when the broader retail disruption gets under way.

For now, Amazon has played it very cool on the banking front, largely confining its activities to those surrounding core merchandising activities.

Amazon founder Jeff Bezos was bred on Wall Street and has no illusions of the scale of defence the global financial system would mount to a serious affront. 

Only fools go where angels fear to tread; and Bezos is no fool.

But just to be safe, the establishment sabres are rattling and big-tech is on the back foot: a signal that retail disruption is being sidelined in favour of green and Fourth Industrial Revolution disruption.

Anti-trust bills on the rise

Regulators are backing the banks – and other vulnerable industries. 

Last month, the United States House Judiciary Committee approved half a dozen bills with bipartisan support targeting the break-up of the nation’s tech giants.

The bills would create a framework to break up the big tech companies into smaller ones; break up businesses that use their dominance in one area to get a stronghold in another; and make mergers more expensive and difficult.

The big beneficiaries of such legislation would be the banks, supermarkets and department stores –generally some of the world’s largest employers.

Given green sustainability goes hand in hand with social sustainability and stability, this is telling. 

The trade-off for old-model retail industries is likely to be the provision of greater job security and stability during the transition; keeping in mind stable income is required to fund green mortgages, bonds and loans.

Expensive labour also creates barriers to entry.

Banks jostling for carbon-trading positions

Globally investment banks are chasing opportunities in the US$227bn carbon-credit market.

Greenbiz expects the market will need to rise ten-fold to meet the Paris Climate targets by 2030 and that the carbon price could rise to US$50 a tonne. Reuters estimates the increase at 15-fold.

Banks have three main sources of income from carbon credit markets: buying and selling emissions rights on behalf of corporations to profit from bid-offer spreads; investment in carbon offset development under the Kyoto Protocol's clean development mechanism; and proprietary trading.

This month, National Australia Bank, NatWest Group, the Canadian Imperial Bank of Commerce and Itau Unibanco launched a pilot platform for buying and selling voluntary carbon credits.

The platform is expected to record its first trade this August.

This will add to green income from bank retail arms, via green mortgages (see below) and other sustainability-linked lending.

Also this week, Washington State has just passed its cap-and-trade bill, joining California. More states are expected to follow.

Green mortgages first off the rank

The EU’s review of upcoming Mortgage Credit Directive will include means to support the uptake of green mortgages, and provide a blueprint for other nations.

The European Commission said in its Sustainable Finance Strategy this week that it plans: “to recognise that measures to enhance energy efficiency of a mortgage collateral can be considered as unequivocally increasing property values,” in the section on amending capital requirements.

This suggests the EU plans to lower capital charges on assets that support its 2050 climate goals.

The EU has been working on an Energy Efficient Mortgages Action Plan for about three years, in which the banks have been setting parameters for energy-efficient mortgages, developing a pool of complying assets upon which they can perform risk analysis.

The upshot was that it identified a link between sustainability and default: higher energy costs for non-sustainable buildings increased the likelihood of default.

This was a bit of a no-brainer given it would obviously affect disposable income. 

Another EU finding from various studies was that people who are more environmentally and socially conscious tended to be more conscientious in other life habits such as debt repayment. 

Turns out they’re better credits.

These findings lay the foundation for preferential capital treatment. 

The capital question

The EU’s next step is to explore whether ESG factors improve the risk profile of other asset classes. 

If so, it will “propose amendments to the prudential framework for banks to ensure ESG factors are consistently included in the risk-management systems and supervision.”

The European Commission (EC) is bringing forward the date to make these assessments from 2025 to 2023; and also has the insurance sector in its sights.

The EC is also planning on building climate stress tests into the Capital Requirements Directive that governs European banks.

Also on the agenda are plans to improve the “reliability, comparability and transparency of ratings agencies”.

Credit hierarchy – who gets what when stress strikes

As banks enter new waters, investors will have to navigate new risks. 

Other stories in this ESG Focus series cover the current lack of protection for bond investors associated with green “default”; and other risks associated for both equity investors and fixed-income investors with green finance. 

This section focuses on risks surrounding debt seniority.

Policymakers are considering whether a preferential capital regime can be justified for green financing to reflect transition risks to a low-carbon economy, keeping in mind that it will be an interim measure.

Over time, most assets will be underpinned by sustainable behavior; and become the new norm. 

Until then, a new class of green regulatory capital to support the financing of sustainable assets is likely.

But Fitch says this would only make sense if the taxonomy and classification were clear and consistent globally.

The capital issue is just as important for equity investors as fixed-income investors; given regulators could force green bonds to absorb losses and write-downs on all assets, including non-green assets. 

This has triggered a discussion on ring-fencing sustainable assets and liabilities.

But to do so, may set up a fight with the global bank prudential regulators. 

The EU taxonomy is one thing but doesn’t answer many technical considerations for complex green instruments beyond senior and unsecured bonds, says Fitch Ratings. 

There are no mechanisms in bank liquidation or resolution procedures allowing the ring fencing of assets other than those specifically pledged as collateral.

To ring-fence assets would firm up the green credentials of subordinated instruments and increase green asset expansion given the inherent leverage of green regulatory capital instruments.

But it would also weaken banks’ capital resilience as it weakens the ability of stronger parts of a bank to support weaker parts.

When it comes to tier one  debt, there is no regulation or market precedent beyond the usual creditor hierarchy for how the use-of-proceeds would be tracked if the instrument were required to absorb losses.

Meanwhile, Fitch Ratings notes green bond ratings will of course revolve around debt seniority; and like the early days of convertible bonds, the markets are waiting on more stress scenarios to clarify risk performance.

So far banks have largely issued green hybrid bonds, which qualify as additional Tier 1 capital; and subordinated Tier 2 bonds. 

Both instruments can be used to absorb losses through write-downs or conversion in the event of deep stress.

Banks have also toyed with green residential-mortgage-backed securitisation.

Not everyone agrees

Many critics argue that the EU’s measures focus too strongly on capital requirement reward for good green behavior rather than simply penalising polluters.

In other words, it means broader classes investors will be paying for the transition of brown companies rather than those who threw their lot in with fossil fuel companies in the first place.

Many prudential regulators and other industry bodies have qualms for other reasons.

The European Leveraged Finance Association (ELFA) is the latest of many, including the European Banking Authority, to voice concerns over coupon step-ups related to missed ESG KPIs and targets on sustainability-linked bonds (SLBs).

An ELFA survey cites issuers’ ability to game "greeniums", through high-yielding SLBs that are callable prior to penalties kicking in for ESG misses, taking advantage of the greenium while reducing the risk of step-ups. 

Half of respondents suggested the cost of calling the bond should 50% plus the step-up if the non-call period ends prior to KPI testing. 

Use-of-proceeds market has its own problems

When it comes to the use-of proceeds market, banks ask how can a green bond be perpetual if there are no perpetual green assets (keeping in mind the proceeds are earmarked for projects). 

Spanish bank BBVA suggests providing a portfolio of eligible assets that proves the bond’s reinvestment capacity; i.e. that the corporation has a reliable and robust capacity to generate more said assets.

That way bond maturity doesn’t have to match the maturity of the underlying assets. 

Others suggest simply securitising assets, or using the assets as collateral. 

BBVA suggests separating the capital buffer requirement from the commitment to devote the proceeds to fund new eligible sustainable products – as independent elements. 

It says it is also important to differentiate between the green target of the bond and the financial rationale of the operation.

Banks doing their own legwork

Banks are already setting up systems that certify that assets meet their frameworks; and that asset selection is carried out against these framework. 

A big issue for banks is to ensure issuance outpaces amortization.

Like the Climate Bond Initiative and other standards platforms, banks favour traceable assets; independent opinions; solid governance and certified environmental impact (we refer to the fallibilities of certification in earlier stories).

Australian banks ready to rock

The banks aren’t waiting until 2023. They already have their sustainability skates on, and this is already affecting capital markets.

At a Bloomberg panel earlier this year, the sustainability heads of all four Australian major banks predicted that sustainability finance would break from the gates in the second half of 2021.

In July 2017, the Climate Bond Initiative (CBI) released its first qualifying criteria under the Climate Bond Standard tailored to Australian residential mortgages called the low-carbon residential buildings proxy criteria.

The criteria specifies location-specific requirements that Aussie residential buildings have to satisfy to receive a Certified Climate Bond.

Again, like everything, the criteria are fairly loose and are expected to tighten over time.  The CBI will review prerequisites twice a year.

The proxy criteria are based on the minimum design standards for thermal efficiency and energy efficiency of Australian residential buildings within states. 

The criteria require buildings to be in the top 15% of residential buildings in a local market for emissions. 

National Australia Bank ((NAB)) issued Australia’s first green residential mortgage-backed securities (RMBS) in February 2018 – a $300m tranche of the bank’s 2018-1 $2bn securitisation.

NAB was the first bank to issue a sustainability-linked mortgage in January 2020 at a 2.44% interest rate.

Property market an easy target

As the largest holders of real-estate in Australia, the property market is an obvious target for banks’ sustainable finance arrows.

The Clean Energy Finance Corporation estimates that property accounts for about 23% of Australia’s emissions and residential property accounts for about a half of that. 

The main source of residential emissions is heating and cooling (40%) followed by appliances at 25% and water heating at 23%.

The average house emits about 7 tonnes of greenhouse gases per year.

From a carbon brownie-point of view, thermal performance of buildings is tipped to be favoured over renewable energy generation such as residential solar panels.

To increase the energy efficiency rating of a new-build home by one star translates to about 1% to 4% of construction costs (just to give an estimate of the likely flow-on affects into the construction industry and construction-industry suppliers).

Banks will issue rate discounts to borrowers linked to targets. 

At the moment, these range from as little as 10 basis points to 40 basis points for five years on a maximum LVR of 80%.

In some respects, it can be zero basis points given most building code requirements demand certain levels of efficiency and banks are already securitising assets based on the percentage of those assets that would likely conform to these standards (i.e. those built in the past 10 years).

Residential mortgages represent half of NAB’s balance sheet, for example, so the existing mortgage pool definitely represents low-hanging fruit.

Nonetheless, it is expected that banks will try to incentivise borrowers to perform above code.

As rates fall, the above basis-point discounts become more attractive. As rates rise, benefits to borrowers fall. It is likely financiers will adjust these rates accordingly.

The interesting thing for borrowers and investors, is going to be the extent of step-up margins and penalties in the event of missed KPIs and targets. 

If it is anything like credit cards, it could prove a lucrative business for the banks, although as with most things green, markets will be eased in gently.

Borrowers may increasingly be requested to fill out scorecards, thereby improving bank efficiency in the screening process. 

All of this also requires a lot more work on behalf of the borrower to prove eligibility. 

Policing appears loose at this stage of the game.

The EU’s Energy Efficient Mortgages Initiative has put an energy efficiency data protocol in place where it is collecting data among banks and sharing reporting on it to gauge performance.

The initiative’s 2020 study of 72,000 Italian mortgages between 2012 and 2020 demonstrate a -30% lower default rate of higher rated homes – obviously they have deeper pockets. 

This puts pricing into perspective and makes a 10 basis rate differential seem a bit stingy; although the profile of borrowers is likely to change over time as the transition gains pace.

Given the general lack of comparability of bank products, 10 basis points could easily get lost in translation.

Apart from thermal efficiency, banks are likely to fund the following inclusions in new builds and for retrofits:

– Solar and photovoltaic panels;
– Solar battery storage systems;
– Solar hot water systems;
– Gas hot water systems;
– Solar pool heaters:
– Solar hydroponic heat pump systems;
– Rainwater tanks;
– Water pumps;
– Grey-water treatment systems;
– Home insulation that meets government standards for geographic areas;
– Certified double glazing and triple glazing for windows;
– Split air-conditioning systems (that will muscle out gas over time);
– Evaporative coolers or zoned air-conditioning units with complying energy ratings;
– LED lights in more than 75% of the property.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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