The controversial CLO asset class is being hailed as a “key tool” for climate finance in a new G20 report with APG, SEB, S&P Global and others.
The report, backed by some of the biggest brains in the ESG world, calls for the development of a ‘sustainable’ Collateralised Loan Obligation market, to offer investors access to more green projects through the capital markets.
Although there are only a couple of recognised green CLOs – both from China and neither cash-based – the report says that, already, “sustainable infrastructure CLOs are warming up to take their rightful place as a pillar of the sustainable securitisation revolution”.
The research was commissioned by G20 Sustainable Finance Study Group co-chairs, Bank of England Senior Advisor Michael Sheren and Ma Jun, who led China’s green finance drive during his stint at the People’s Bank of China.
“The goal of this White Paper is to understand how collateralised loan obligations (CLOs) and other securitised and structured financial products could play a critical role in financing global sustainable infrastructure investments at scale and pace,” according to the Executive Summary.
Among others, it has been penned by a who’s who in the field: Christopher Kaminker, former OECD climate finance specialist and current Head of Climate & Sustainable Finance Research at SEB; Michael Wilkins, Head of Sustainable Finance at S&P Global Ratings and member of the TCFD; and Chris McGarry, securitisation specialist at law firm White & Case. It has input from Joshua Linder, Credit Analyst at pension giant APG; Ulf Erlandsson, former AP4 bond trader; SEB’s Head of Sustainable Financial Solutions, Christopher Flensborg; and Nicholas Pfaff of the International Capital Market Association (ICMA).
CLOs have a bad reputation in many corners of the financial markets, as they strongly mirror the Collateralised Debt Obligations implicated in the 2007 financial crash. Typically, CLOs involve the creation of a Special Purpose Vehicle to provide loans to projects and in turn securitise those loans into bonds with various risk-based tranches for investors.
This year has seen the highest bond issuance in the CLO market since the financial crisis.Writing in the Wall Street Journal earlier this year, James Mackintosh pointed to the number of pension funds, insurance companies and investors now chasing CLOs, warning: “It’s easy to lend money. The trick to successful finance is getting it back—and lenders, egged on by politicians, are once again forgetting how hard it can be to recover debts in a downturn.”
Much like the Green Supporting Factor, proposed by the European Commission late last year, the concept of a CLO market focused on climate finance sees broader ‘responsible investment’ values – those centred on rejecting the triggers of the 2007 crisis and focusing on prudent decision making – butting heads with more deal-based innovations in ESG.
The White Paper argues that, despite their close association with the financial crisis, “the transfer of sustainable loans from bank balance sheets into CLOs will replenish bank lending capacity,” and it is therefore “imperative to create a sustainable CLO market” to deal with the risk of climate change.
“Currently most infrastructure projects are funded by bank loans. Infrastructure projects require long term financing which is sub-optimal from a risk weighting perspective; further, most banks are funded on short-term debt or on demand deposits thereby creating a maturity mismatch with longer term projects,” it says. “Therefore, a mechanism is needed to move project loans from bank balance sheets to bond market investors who are the natural long-term investors in sustainable infrastructure.”
A labelled ‘sustainable’ CLO market could be underpinned by the EU’s green taxonomy, it adds – a version of which is due to be released in 2019 – and should be supported by regulators to iron out any “friction”.
Despite the likely backlash from some market observers, the White Paper identifies the main challenges to the growth of green CLOs as lack of green collateral, not market sentiment. But, it says, the growth of interest in the green bond market and the continued rise of issuance from CLOs suggests that “2019 and beyond looks big for investor and issuer activism in green CLOs”.