Luxembourg wants to pioneer the green, social and sustainable financial scene. To materialise this ambition, the Luxembourg Stock Exchange launched the Luxembourg Green Exchange a year ago. Green and social bonds account for, at least, 50% of listed green transactions. Read on how Luxembourg is pushing further the boundaries of financial innovation to work towards achieving sustainable goals.
A new law to reinvigorate the Luxembourg market of covered bonds
In January 2018, Luxembourg published a draft bill to provide a legal framework for the Renewable Energy Covered Bond, RECB (Lettre de Gage d’Energies Renouvelables; LdG-RE). The draft bill is expected to be approved by the parliament and enforced in summer 2018.
This will be the fifth type of covered bonds the Luxembourg law considers. In addition to LdG publiques (public sector covered bonds) and LdG hypothécaires (mortgage covered bonds), the law also allows the issuance of LdG mobilières (secured by ship, aircraft or other movable asset loans for rolling stocks) and LdG mutuelles (secured backed by institutional guarantees).
The creation of the LdG-RE covered bond endows the Luxembourg’s financial centre with a high-standard product directly linked to the rapidly growing global renewable energy sector. The draft bill is also part of the strategy to diversify the Luxembourg financial centre. The law intends to:
Create a legal framework with clear criteria and standards that will increase the confidence of potential investors in related products;
Boost financing of environmental and climate protection projects (including renewable energy, waste, water treatment or e-mobility projects); and
Revitalise the Luxembourg Covered Bond market.
Who can benefit from this law?
Currently, the issuance of RECBs is intended solely for covered bond banks[1]. There are only four in Luxembourg. We expect the application of RECBs to span out to a wider audience of institutional and private investors.
There is strong appetite for private and structured debt among investors, a market that doubled since 2010 reaching USD 638b in June 2017[2]. Private debt investments provide an opportunity to diversify portfolios, yield higher returns and replace the role of banks which face stringer regulations.
In this context, RECBs are suitable for covering the needs of private and public pension funds, insurance companies and asset and wealth managers which ultimately target portfolio allocations for private and structured debt. Institutional investors (i.e. public and private pension funds and insurance companies) currently invest between 2.0% and 3.0% of their portfolio in private debt and are seeking to increase this allocation from 4.5% to 5.6%. In case of wealth managers, they are more exposed to debt by investing 6.3% of their portfolio, aimed to increase to 10.5%[3].
Prior to the draft bill, investors had the choice to either invest directly in renewable energy projects or to act as Limited Partners in funds. Now, RECBs offer an attractive solution to institutional and private investors at a marginal cost, where renewable energy assets are bundled in rated bonds through a regulated securitisation vehicle.
Most niches of returns in the European market are depleted. Yet, opportunities remain around certain geographies and sectors but traditional investors frequently suffer from the proximity bias and tend to be uncomfortable with unknown investment areas. RECBs become, therefore, an option of choice for most investors. They cover not only familiar geographies but a familiar industry as well.
RECBs don’t limit to issuing banks or investors looking for private debt allocations. In 2017, renewable energy investments reached USD 333 billion mainly through debt, showing market dynamism with solid opportunities. In this context, players seeking to finance renewable energy assets or a renewable energy portfolio may also consider partnering with covered banks. Their assets could be part of the cover pool and receive financing in the form of covered bonds a bank issues.
RECBs to ease fund valuation & administration
Another technical aspect to consider is the internal process investors have to go through when moving into different type of investments. Investors considering private and structured debt for the first time may find themselves struggling with the technical aspects of a debt-like or equity-like instrument in their balance sheet.
Topics like valuation, synthetic credit rating and impairment aren’t familiar to investment managers, as these represent radically different considerations and challenges, as opposed to equity investments.
It wouldn’t be surprising to see investors fully covering their debt allocation via RECBs. This will offer to them similar returns and generate alike risks as direct investment do, but at limited costs. It will also cut down the management time significantly.
Renewable Energy: What does it mean and which assets are eligible?
Green labelled bonds usually fund projects with a positive environmental or climate impact. While the bond structure and the underlying assets are similar to ‘classic’ bonds, the difference lies on the investments proceeds, typically financing green projects.
The promise of the draft bill is to provide for certain adjustments to the existing regime of covered bonds, authorising renewable energy projects as a permitted asset class. Banks issuing RECBs will have the opportunity to diversify portfolios and take advantage of a new asset class. Renewable energy sources cover non-fossil sources, namely wind, solar, aerothermal, geothermal, hydrothermal and ocean energy, hydropower, biomass, landfill gas, sewage treatment plant gas, biogases and energy from similar sources. For instance, based on the draft bill definition, eMobility storage and charging infrastructure would qualify as an eligible asset for the RECB if the majority of energy used comes from renewable resources.
RECBs will be the first law in the world explicitly regulating renewable energy bonds. They are bound to tackle the existing but insufficient standardisation of ‘green’ covered bonds under Green Bond Principles (GBP[4]).
What is different under RECBs?
RECBs fund renewable energy projects with the recourse to both issuers and a dedicated cover pool of assets. This leads to a dual protection, contrasting to unsecured bonds or asset-backed bonds.
In a recent report, Moody’s[5]highlighted the new framework is expected to include[6]
Eligibility criteria for renewable assets to be included in cover pools;
Leverage limits to restrict the amount of covered bonds to be issued against renewable energy assets;
Minimum overcollateralization requirements; and
A 180-day liquidity requirement to reduce risk.
Given the structure of RECBs, this asset class will certainly be of high interest to insurance companies and pension fund portfolio managers. By nature, RECBs will address more diverse credit risks than traditional covered bonds.
Typically, covered bonds’ market risks related to containerships or airplanes bring considerable operating uncertainties. RECBs, in turn, face the volatility of assets’ performance and local governmental regulation of feed-in-tariffs.
Wind, water and solar have become well established technologies, with a sustainable track record of over 20 years in project/asset finance. Nowadays, production forecasts are highly standardised and precise, and innovation is likely to further increase productivity and returns.
Assessing risk
Governments won’t guarantee feed-in-tariffs in the near future, equalling renewable energy production-costs with energy market/trading prices.
While real estate or shipping assets (i.e. traditional assets for covered bonds) represent a substantial market price risk, renewable energy assets increasingly become less dependent of market price. With the standardisation of the financing of renewable energy assets, its structuring will become more relevant for both, the asset developer and the finance industry.
The remaining risk under covered bonds is the relatively illiquid nature of renewable energy assets, compared to other covered bond classes. Managers’ role is to control/mitigate the cover pool portfolio risks (e.g. by blending liquid eligible bonds).
The draft bill provisioned for a number of RE-asset specific risks like production risk, market risk, sourcing risk and construction risk by defining what it relates to and specifying applicable reductions (i.e. up to 50%).
Loan to value regulation
Parallel to drafting and voting the law, the Commission de Surveillance du Secteur Financier(CSSF) is developing regulatory guidance applicable to cover pools of RE assets, or what is commonly called the Loan-to-Value approach (LtV). Given the novelty of RECBs, existing frameworks cannot be extended or applied to RECBs.
One of the specificities of RECBs is the reliance on cash flow models –as opposed to market prices- to determine the value of the assets. In doing so, the regulator is striving to develop a framework considering operational, financial, regulatory and market risks. This framework plans to openly communicate the risks factors applicable to assets, specific discount rates and equity, and capital structures.
Beside methodological aspects, further valuation-related topics become also relevant for the LtV approach. Triggering events for revaluation (materialised market risks), standard revaluation cycles, roles and responsibilities within the valuation process are highly relevant for any issuing bank and rating agency.
It remains key that RECBs are backed by a mature portfolio with a lean management of the cover pool. This fulfils regulatory requirements and investor transparency interests (i.e. banks which invests in covered bonds do not have to set regulatory capital as opposed to investing in other assets).
At the same time, European Union is harmonizing covered bonds
Earlier this month, the European Commission (EC) proposed an updated framework for covered bonds (amendment to Art 129 of CRR 575/2013). The legislative package is composed of a directive, which specifies the core elements of covered bonds and provides a common definition at EU level.
The directive defines covered bonds as “debt obligations issued by credit institutions to which bondholders have direct recourse as preferred creditors”. The proposal sets minimum standards but leaves the implementation to each country’s discretion. It will also influence the nature and structure of RECBs. The directive will likely come into force in first half of 2019, with a 12 month phase-in period to transpose the rules in national law.
What we think
Michael Hauer, Senior Manager
RECBs will be the first law in the world explicitly regulating renewable energy bonds. They are bound to tackle the existing but insufficient standardisation of ‘green’ covered bonds under Green Bond Principles.
Hind El Gaidi, Senior Manager Corporate Finance
Prior to the draft bill, investors had the choice to either invest directly in renewable energy projects or to act as Limited Partners in funds. Now, RECBs offer an attractive solution to institutional and private investors at a marginal cost, where renewable energy assets are bundled in rated bonds through a regulated securitisation vehicle.
For more details, please refer to theDraft Bill(French Version)
References
[1]Banks that issue covered bonds operate within a specific legal framework laid down in the law of 21 November 1997, as modified. This law established the covered bond issuing bank and reserves to them the exclusive right to do so.The covered bond is a debt security guaranteed by cover assets specifically allocated to this purpose.
