Despite its position as a public asset class with more than €400 billion of outstanding issuance in Europe, third-party ESG coverage of asset-backed securities is sparse. What opportunity does this offer asset managers who do mind the ESG gap in this asset class?
ESG investment analysis has rapidly transformed over recent years, as investors and regulators have recognised the importance of these considerations for potentially generating sustainable, long-term investment returns. Within traditional asset classes, this has led to a proliferation of third-party research from ratings providers, such as MSCI and Sustainalytics, which apply standardised, quantitatively-driven ESG scoring systems to hundreds of thousands of securities. Regulators have also begun to implement formalised, far-reaching ESG policies, such as the European Union’s Sustainable Finance Action Plan (SFAP), while in the UK, the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) is expected to introduce similarly robust ESG-related disclosure requirements.
In non-traditional asset classes, however, the development of standardised frameworks around both qualitative and quantitative considerations has proven more challenging due to the additional complexity of the securities involved. This includes asset-backed securities (ABS), for which third-party ESG ratings providers offer very limited coverage and regulators provide no specific guidance, despite ABS being a public asset class with €400+ billion of outstanding issuance in Europe1. We believe this places a strong emphasis on asset managers to drive the industry forward in improving and standardising ESG analysis of ABS.
Why does ESG analysis of ABS differ from corporate bonds?
A significant obstacle to developing standardised ESG frameworks is the multi-layered nature of securitisations. Whereas traditional corporate bond analysis primarily involves evaluating an issuer and its capital structure, the securitisation process involves several entities, which can include:
- the originator;
- sponsor;
- servicer; and/or
- asset manager.
This introduces various challenges from an ESG perspective. For instance, rather than investing or lending directly to a specific company, an ABS transaction is likely to involve purchasing securities issued by a bankruptcy-remote special purpose vehicle (SPV), which has no board of directors or other employees. Meanwhile, the corporate entity that originated the assets may not be involved in the transaction, or the deal may be backed by loans originated by lenders that no longer exist. Due to these fundamental differences, we believe ESG analysis of ABS requires careful evaluation of three core areas – the transaction, or deal structure; the underlying asset pool; and the counterparty.
Engagement is driving progress
Issuers are making steady progress in disclosing ESG-related information, with newer lenders leading the way. Recently, we were encouraged to see that an originator with which we had previously worked closely (a UK challenger bank) had significantly increased its ESG disclosure in its latest residential mortgage-backed securities (RMBS) transaction. Notably, the bank disclosed information on how its lending practices and day-to-day operations are aligned with the 17 United Nations Sustainable Development Goals (UN SDGs), alongside details of its own carbon footprint, staff diversity and measures it takes to avoid predatory lending.
Nevertheless, the securitisation industry still lags conventional fixed income markets in providing ESG transparency and disclosure. By developing in-house ESG frameworks and sharing these with issuers, we have found that we can engage with them more effectively to obtain additional relevant information in more standardised forms. In prospective auto loan transactions, for instance, we have begun to calculate in-house estimates of CO2 emissions for underlying vehicle collateral pools using publicly available data and proprietary tools that incorporate machine learning. We then share these estimates with the issuer, which in some cases has led them to disclose their own estimates.
Our sponsor engagement has also, in some cases, led to wider industry adoption of certain practices. In UK RMBS, for instance, our request for transactions to include a ‘payment holiday’ reserve to accommodate the Financial Conduct Authority’s Covid-19 relief measures for mortgage borrowers was implemented by several issuers in 2020. Combined with the greater disclosure we sought regarding the types of borrowers accessing mortgage payment deferrals, alongside more detailed information on how lenders would protect vulnerable customers, this helped to mitigate liquidity concerns for investors and effectively restarted UK RMBS issuance, which had slowed significantly following the introduction of UK lockdowns.
ESG provides a clear direction of travel
We believe the direction of travel for the securitisation industry is clear. Investors will increasingly scrutinise ABS transactions and investment portfolios, as ESG integration continues to gather pace across asset classes. Given our significant role in the European securitisation market, we believe this places a strong emphasis on asset managers such as M&G to help drive the changes that investors demand. In doing so, we believe this can provide us with a significant advantage in influencing positive developments within the industry and should aid our potential to deliver sustainable returns over the long term.
1Source: Citi Research, European Securitised Products Monthly Call, April 2021
