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Green ESNs

27 July 2018
Richard Kemmish

ESNs backed by loans to SMEs and infrastructure projects are one thing. But ESNs backed by qualifying green loans has a real potential to generate benefits. It’s the next discussion that we should be having.


One of the big topics of discussion in the Euromoney Covered Bond Congress in Munich this September is bound to be European Secured Notes – bonds that use covered bond technology to fund non-traditional assets. The European Commission has, for the purposes of the studies that they have commissioned on the topic, defined the non-traditional assets as loans to small and medium sized enterprises and to infrastructure projects. The debate thus defined is an interesting one. But there is a parallel debate to be had about whether these are the only assets that should be eligible for ESNs.

Green covered bonds are a great development that has been intriguing to watch – even if there hasn’t been a proven price benefit relative to existing covered bonds yet. But as currently constituted, green covered bonds can only ever be the thin sliver of the venn diagram where one circle is all of the mortgages in Europe and the other circle is all of the loans with environmental benefits (or, more accurately for reasons that I will come on to, the potential universe of loans with environmental outcomes). 

As long as national covered bond laws continue to ignore the concept of green assets (Luxembourg being an honourable, if untested, exception), green covered bonds are necessarily the same credit, with recourse to the same pool of assets (green and regular) as the more traditional bonds. In many ways they mirror the problem in the wider green bond market. ICMA’s green bond principles are great – they channel funds raised into the sort of projects that investors want to fund - but a green bond launched by KfW will always be pari passu with a regular bond issued by KfW. As long as credit is the dominant determinant of a bond’s price they will always price at the same level.

We could question whether credit is the dominant determinant of pricing. Green bonds are realistically never going to be as liquid as regular bonds of the same issuer, so no benefit for that.  If a green imprimatur introduces new investors that implies that some investors were acting irrationally previously (they could have purchased the same credit/price trade-off in regular covered bonds), which offends my classical economic sensibilities and their fiduciary responsibilities. The only plausible non-credit driver of pricing is preferential prudential treatment for qualifying green investments. Like a lower risk weight. Too big a debate for today.

But if we were to introduce ESNs backed by green assets that are not eligible for regular covered bonds we have the potential to improve the cost of funding for the banks originating these assets. Only the potential. In most cases originators of these assets will continue to have cheaper marginal funding in the traditional covered bond market. I’m interested in the minority of cases where this is not the case. There this has the potential to improve the cost of funding therefore the pricing to the borrower and – the ultimate objective of all of this – increase the availability of funding to environmentally beneficial projects.

They will be ESNs, not covered bonds, so the contagion effect so feared by covered bond traditionalists is, if not totally eliminated, at least ameliorated. 

It’s a debate that we should be having.                    

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