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05/16/2012

The Covered Bond: A Vehicle for the Shift to a Low-Carbon Economy?


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In our first two articles focused on the emerging climate bond market, we spoke with Nick Robins, Director of HSBC’s Climate Change Center for Excellence, and to Sean Kidney, Cofounder and Chairman of the Climate Bonds Initiative. Here, we look at how the covered bond might be adapted as an investment vehicle to catalyze the funding of the critical transition to a low-carbon economy.

The International Energy Authority now estimates that $1 trillion will be required in annual “low-carbon” project funding out to 2050 if the global economy is to avoid the most catastrophic impacts of climate change. Meanwhile, the fallout from the global financial crisis has left both governments and the capital markets severely constrained in their ability to support those funding needs.

A discussion paper issued this week by the Climate Bond Initiative—an international, investor-focused not-for-profit promoting large-scale investment in the low carbon economy—proposes a transition solution to this quandary. The authors, Frank Damerow, Sean Kidney, and Stuart Clenaghan, suggest that the covered bond structure could easily be adapted to help mitigate some of the risk of investing in the emerging market for renewables and cutting-edge climate mitigation projects. “The unfortunate coincidence of a deep financial crisis with the urgent need to invest in tackling climate change has highlighted the need for financial innovation,” the authors wrote. “Banks and energy companies need to find new sources of capital.”

Covered bonds offer a number of attractive features to institutional investors seeking exposure to climate mitigation and adaptation projects but who may have limited experience with the market. It could also serve bank lenders who seek to expand lending to projects in this sector because covered bonds often receive favored treatment from regulators in the determination of capital requirements and because they allow banks to access funds at relatively attractive rates.

Covered bonds are structured to provide investors with a dual recourse—an unsecured claim on the issuer and a preferred claim on the assets and cash flows of the cover pool. An additional comfort factor for investors is that issuers are required to over-collateralize the pool and replace any underperforming assets. Furthermore, the cover pool is required to be exceptionally transparent, which in turn affords investors and analysts the ability to gain experience with the underlying asset performance, without direct exposure to it.

Covered bonds are now issued in markets where explicit legislation has been created for them but can also be issued under general contract law in markets where no such legislation has been enacted. In markets where covered bond legislation exists for mortgage securities (in Germany, for example, where the Pfandbriefe market is governed by legislation that also includes covered bonds for the shipping and aircraft asset), the discussion paper suggests that legislation might be expanded and adapted to the covered bond market for climate bonds. The authors note such legislation would stipulate which institutions could issue covered bonds, how the market would be regulated and its rules enforced, how qualifying assets and standards would be defined, agreements on loan-to-value ratios, management standards, and the incorporation of international law. Perhaps most critical to the integrity of the covered climate bond market will be a requirement that bond issuers comply with recognized, rigorous climate mitigation standards, such as those being put forward by the Climate Bond Initiative.

Damerow, Kidney, and Clenaghan suggest a three-step process in the evolution of the covered climate bond market. First, would be to adapt existing covered bond legislation, where it exists, to include a relatively mature renewable energy technology like wind. This would be the first step in giving investors a degree of comfort with the underlying assets and an opportunity to monitor their financial performance. Once investors and analysts have sufficient experience in the market, specific legislation for renewable energy covered bonds might then be enacted. These initial steps would prepare the market for the final evolution of the market, the direct issuance of asset-backed corporate bonds by renewable energy companies. “It should be expected that as investors increase their understanding of renewable energy assets, so other forms of bond finance, such as corporate bonds and asset-based securities, would become more feasible,” the authors maintain.

–Susan Arterian Chang

Susan Arterian Chang is a contributing writer to The Finance Professionals’ Post and the director of the Capital Institute’s Field Guide to Investing in a Resilient Economy project.

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The Report gives a snapshot of the climate-themed bond markets’ size, the key investments themes and regional market, and finally identifies three key ways to accelerate market expansion.

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