ESG: Looking Under the Label

As many of our investors will know, we believe ESG risks can have a material impact on the value of our investments, and we have devoted a substantial amount of resources to developing a proprietary and active ESG integration model to help evaluate them. As we mentioned last week ESG-labelled debt issuance reached record levels in January, and this is a trend we expect to continue in 2021 and beyond.

The market for ESG-labelled securitisations in Europe is also small and still developing; we have seen a handful of ESG deals coming to the market over the past few years, mainly in the form of green RMBS from the Netherlands. Last year we saw the first Green CMBS (backed by a BREEAM-certified office building) from France, and a social housing RMBS from the UK. Both deals were positively welcomed by market participants and the very high subscription levels suggested there is pent-up demand for quality ESG products. 
 
We would reiterate our view that ABS is a naturally ESG-friendly asset class, chiefly because having exposure to a defined pool of assets with greater certainty on funding proceeds makes ESG factors easier to define for ABS than, for example, some green bonds from sovereign, corporate and financial issuers. This week the market took another step forward with the first conventional Social UK RMBS deal. The transaction, sponsored by Northview Group (owner of Kensington Mortgages), was structured to comply with the criteria for simple, transparent and standardised (STS) securitisations, CRR/LCR eligibility and to meet Kensington’s `Social Bond Framework’, which is aligned with the ICMA Social Bond Principles of 2020. The deal also contributes to meeting the United Nations Sustainable Development Goals and drives financial inclusion by providing mortgage finance to groups of the UK population who are underserved by the major high street mortgage lenders. These underserved groups are self-employed borrowers, first-time buyers, younger borrowers or contractors, in other words people that have a ‘complex’ income profile which requires a more tailored and manual underwriting approach. Kensington last year became the first specialist lender to define and publicly release its corporate ESG targets, showing its commitment not only at the lending level but at a corporate level too.  

This deal, backed by a £472m pool of owner-occupied mortgages partially securitised in a previous transaction, drew over £1.2bn of orders and was printed 10-30bp tighter than initial price guidance depending on the tranche, reaching pre-COVID tights. It is difficult to separate whether this popularity was driven by slower than expected ABS supply, the STS/LCR labels or the Social label, but the level of demand is nonetheless encouraging for issuers considering ESG linked transactions.

However, it is worth highlighting certain considerations related to ESG-labelled products in ABS more generally. Let’s imagine a CMBS backed by a property which is BREEAM-certified (an independent, international standard for building sustainability) with a strong BREEAM rating, but the sole tenant in the building is a business operating in the tobacco or the weapons industry. When it comes to ESG scoring, the deal would likely score high on the Environmental side but low on the Social side. Which factor is more relevant? Or let’s imagine a non-conforming RMBS deal from a lender providing finance to underserved borrowers (a positive for Social scoring) but charging high levels of interest likely leading to a higher loan default rate (a negative for Social scoring). Does the latter completely negate the positive Social impact of the former? How exactly do we define ‘underserved borrowers’? And when exactly do lending rates become high enough  to verge on predatory behaviour? Where is the boundary between “near-prime” and “sub-prime” lending? These are just a few of the important nuances we believe investors should consider when measuring ESG risks, and when looking at ESG linked issuance.

Coming back to Northview’s social RMBS, since the global financial crisis the lender (Kensington) has been targeting underserved borrowers and over the years has expanded its product offering. Given the complex income profile of its typical borrowers, bondholders could face a higher risk investment and this is why RMBS deals of this type are labelled as non-conforming or near-prime. But does that mean a near-prime deal can’t be ESG friendly? Not necessarily. For example, Kensington’s product offering is typically 0.5-1.5% higher than rates charged by high street lenders, but it is generally lower than other non-conforming lenders. The performance of its previous deals has been outstanding, with very low levels of defaults and low levels of complaints from customers. These are factors that would improve the Social score and decrease the overall risk of the transaction. On top of this, Kensington has contributed to improving ESG data transparency in the ABS market by disclosing Energy Performance Certificate (EPC) data for its pools. 

In conclusion, we think investors need to see through the veil of the ESG label and rely on deep due diligence and ongoing monitoring to assess ESG risks in looking to improve returns in the long term. As we see more ABS deals that are specifically labelled as being ESG and Sustainable, we need to make sure we are creating a baseline for the market that critically evaluated to ensure it is starting from a position of strength and integrity.