Issuers want to get more of them into the market. Investors can't get enough of them. Policymakers want to facilitate their growth. We have entered the era of the sustainable covered bond.

These bonds raise funds to finance new and existing assets that meet certain sustainability criteria. They have been issued in three formats--green, social, and sustainability bonds--and generally aim to contribute to the achievement of the sustainable development goals set in 2015 by the U.N. 2030 Agenda for Sustainable Development and the Paris Agreement.

The public sector alone cannot fund the investments required to achieve these targets. The EU, for example, estimates that more than €260 billion will have to be invested annually through 2030 to meet its climate and energy savings goals. Three-quarters of these investments should be committed for improving energy efficiency in buildings, in the EU's view. This is because the buildings sector is responsible for about 40% of energy consumption and 36% of carbon emissions. And this is where sustainable covered bonds can play a key role in the transition to a more sustainable economy. The covered bond industry as a whole has €2.9 trillion in outstanding bonds and is a major funding tool for mortgage loans, especially in Europe.

In this article, we present a comprehensive guide to the fundamentals and key features of sustainable covered bonds. It benefits from the insight and valuable comments of numerous market participants and colleagues. A glossary at the end covers various terms and acronyms used by the industry.

What Is A Sustainable Covered Bond?

Covered bonds are debt instruments secured by a cover pool of mortgage loans or public-sector debt to which investors have a preferential claim if the issuer defaults (see "S&P Global Ratings' Covered Bonds Primer," published June 20, 2019.)

There are no legal definitions of green, social, or sustainability bonds. The market has therefore developed self-regulatory mechanisms on a voluntary basis through such initiatives as the International Capital Market Association (ICMA)'s Green Bond Principles (GBP), Social Bond Principles (SBP), and Sustainability Bond Guidelines (SBG). These and similar standards are sets of voluntary process guidelines that aim to clarify the approach toward issuing sustainable bonds.

Sustainable issuance programs that follow ICMA principles use frameworks that should follow four core components:

• Use of proceeds,
• Process for project evaluation and selection,
• Management of proceeds, and
• Reporting.

Use of proceeds summarizes how the issuer intends to use the funds raised by the bond issuance. The ICMA principles are not prescriptive. Rather, they identify broad key environmental and social objectives and possible eligible projects that should contribute to them.

Chart 1

Some banks have frameworks dedicated to either green or social covered bond issuances. Others use the same sustainable bond framework for covered bonds and other bonds.

Issuers often solicit external assessments before and after issuance. They may rely on second party opinions, verifications, assurance reports or certifications, or sustainable ratings. These independent evaluations seek to assess the alignment of the sustainable bond, associated frameworks and/or the use of proceeds against a recognized external environmental, social, or sustainability criteria.

The ICMA has also published a reference framework that helps issuers and investors map the investment targets of a sustainable program to the UN Sustainable Development Goals (SDGs). Green covered bond programs typically target the following goals:

• Affordable and clean energy,
• Sustainable cities and communities, and
• Climate action.

Social covered bond programs mainly target:

• Sustainable cities and communities,
• Quality education, and
• Reduced inequalities.

The Market For Sustainable Covered Bonds

The first sustainable covered bond was issued in 2014, with the first green and social covered bonds coming the following year. The market for sustainable covered bonds has expanded rapidly in the past few years and constitutes more than 16% of the overall euro-denominated covered bond issuance in the first 10 months of 2021, up from less than 5% in 2018.

The availability of cheap central bank funding for financial institutions caused overall covered bond supply to drop since the beginning of 2020. Investor-placed issuance in the first 10 months of 2021 was down 30% compared to the same period in 2019. However, sustainable covered bond issuance as of November 2021 has already exceeded 2019 and 2020 supply (see "Covered Bonds Must Adjust To A New Reality After COVID-19," published June 30, 2021).

Most sustainable covered bonds are backed by mortgages (87% of the amount outstanding). The remaining 13% are backed by public sector loans. This reflects the fact that most sustainable covered bonds are green bonds that typically finance energy-efficient buildings.

Chart 2

Chart 3

The sustainable covered bond market is also diversifying in terms of issuers and countries. In 2021, a record 16 financial institutions entered the sustainable covered bond markets for the first time.

Still, according to the European Covered Bond Council (ECBC), sustainable covered bonds constitute only 1% of the total amount outstanding and supply volumes remain low in absolute terms, despite strong growth.

Chart 4

The issuers' perspective

Three main reasons explain the supply dearth. First, issuers may struggle to find eligible cover pool assets. Finding sufficient eligible green and/or social loans to at least match the amount of sustainable covered bonds outstanding can be challenging. The underlying assets must meet the criteria of issuers' green or sustainable frameworks, as well as existing eligibility requirements for covered bond collateral pools. Banks may find it difficult to identify sufficient eligible assets in their balance-sheets, due to lack of loan-level data or access to public registries that may contain such data, including energy performance certificates.

In addition, setting up a green or social covered bond issuance program is more complicated and costly than an unsecured one. On the mortgage side for example, issuers must adapt their information technology systems, check energy certificate, and adapt loan contracts in order to receive the required information.

Finally, the pricing differential between green and vanilla issuance is greater in the senior unsecured space than for green and vanilla covered bonds. This may mean issuers favor the former (see "Sustainable Covered Bonds: Assessing The Impact Of COVID-19," published Dec. 1, 2020.)

However, as the regulatory framework becomes more supportive, banks may be incentivized to issue sustainable covered bonds, as both a funding strategy and a means to improve their environmental, social, or governance (ESG) credentials.

The EU has recently approved or amended several regulations that follow the full investment cycle, including the regulation on sustainability-related disclosures, the Taxonomy regulation for climate change, and the benchmark regulation. While these initiatives may increase the burden on issuers and investors in terms of transparency requirements, they also provide greater clarity for banks planning green or social issuance (see "The Regulatory Landscape" below.) Finally, we observe that investor demand for sustainable issuance continues apace.

The investors' perspective

To date, sustainable covered bonds have generally been oversubscribed in the primary market. Bankers report that a more diverse investor base is looking at these instruments. On top of traditional covered bond investors, ESG-dedicated funds are also placing orders. This additional demand has not consistently translated yet into a cheaper cost of funding for issuers--the so-called "greenium"--partly because the current accommodative monetary policy is keeping interest rates close to zero. However, market participants believe that this additional demand could become a supportive factor, for example in times of market correction.

Based on a recent ECBC investor survey, even traditional covered bond investors view sustainable issuance favorably. Most have introduced qualitative or quantitative ESG considerations into their investment policies, and green or social covered bonds tend to perform better in their ESG analyses.

Investors identify three main sources of concern. The first is a lack of liquidity. Sustainable covered bonds are generally easy to sell but very difficult to buy. Second is so-called "greenwashing", or the risk that sustainability claims made by issuers might be overstated or unreliable. Third is the lack of asset segregation, because upon issuer insolvency green or social assets will be mixed with other brown assets in the cover pool.

A normalization of monetary policy may assuage the first concern and Taxonomy regulation may help with the second (see the "The Regulatory Landscape" section). However, the structural issue of asset segregation will probably not be addressed until we see the first programs that are exclusively backed by sustainable assets.

Issuance outlook

We believe that sustainable covered bond issuance should grow further in the coming years, supported by strong investor appetite. Overall covered bond issuance should rebound once central bank monetary policy tightens (see "Covered Bonds Outlook Midyear 2021: Credit Stable Despite Waning Support," published July 23, 2021.) This should also lift sustainable issuance, because several banks delayed their planned green or social issuances due to reduced funding needs. The lack of a greenium will remain a negative factor in the near term. However, a normalization in monetary policy and an increase in interest rates may allow for a differentiation between yields on vanilla versus sustainable issuance, with the latter benefitting from a wider investor base. At the same time, upcoming bank regulation may reduce the costs of setting up a green or social covered bond issuance program versus an unsecured one. Financial institutions will need to comply with new transparency requirements regardless. Finally, several initiatives to identify eligible assets should facilitate the identification and ultimately increase the supply of eligible assets (see " Green Covered Bonds".)

The Regulatory Landscape

Sustainable finance plays a key role in delivering on the policy objectives under the EU's international commitments on climate and sustainability.

Chart 5

What is sustainable? The question behind the Taxonomy regulation

The Taxonomy regulation 2020/852, which came into force in July 2020, defines sustainable economic activities according to the EU. Its application will become progressively relevant to comply with various disclosure requirements, such as the sustainable finance disclosure regulation (SFDR) and the corporate sustainability reporting directive (CSRD). It will also be relevant for the development of official labels for financial products, such as the proposed EU green bond standard (EUGBS.)

The regulation identifies six environmental objectives. An economic activity should "substantially contribute" to one or more of these objectives to be classified as "environmentally sustainable" and thus Taxonomy compliant. Furthermore, such activity should:

• "Do no significant harm" (DNSH) to any of these objectives (i.e. should avoid adverse environmental impacts);
• Be carried in compliance with the minimum safeguards (i.e., should avoid adverse social impacts); and
• Comply with technical screening criteria.

Chart 6

The technical screening criteria (TSC) constitute the operational dimension of the Taxonomy, providing direction on what constitutes a "substantial" contribution and what is expected to "not significantly harm" any other environmental objective. The TSC are introduced via delegated acts. The European Commission (EC) published the first delegated act in June 2021, providing clarity on climate change mitigation and climate change adaptation objectives (see "Green Covered Bonds" for more details on these TCS.)

Although we understand that market participants generally welcome the Taxonomy as an important tool for defining what is sustainable, its implementation, particularly with respect to the DNSH and minimum safeguards criteria, is challenging. The DNSH criteria for climate change adaptation, for example, requires:

• An identification of the physical climate risks that may affect the performance of economic activity, such as floods or storms;
• A climate risk and vulnerability assessment to determine the materiality of these risks; and
• Adaptation solutions to reduce the risks.

Similarly, issuers may be able to report compliance with the minimum safeguards criteria at their own entity level, but will find it difficult to prove compliance from their commercial counterparts. Because of the challenges, many financial institutions will probably align their framework first to the criteria for substantial contribution, and only later to the other requirements of the regulation.

The Green Bond Standard

This proposed regulation intends to set a common framework of rules for the designation of European Green Bonds: those that pursue environmentally sustainable goals as defined by the Taxonomy regulation. It also sets up a system for the registration and supervision of external review providers.

The EUGBS will be voluntary and open to all issuers inside and outside the EU, including corporates, financial institutions, and sovereigns. The proposed framework shares similarities with the current market standards, such as the ICMA principles, and is designed to be compatible with them. There are two key differences: the requirement on the full alignment of the funded economic activities with the EU Taxonomy and the regulation around external review providers.

Chart 7

Issuers will be able to issue European green bonds even if they are not Taxonomy compliant at the time of issuance, but will be so within a period of five to 10 years, according to a Taxonomy alignment plan.

Furthermore, as the technical screening criteria will likely be reviewed and amended over time, issuers will need to apply bond proceeds as per the amended criteria within a five-year period to keep the EU green bond designation. This potential lack of consistency between criteria at issuance and throughout the life of the bond raises concerns. Some market participants believe that the five-year period to adapt to new TSC requirements may be insufficient to find alternative eligible assets, which may lead some banks to prefer other formats of green debt—such as senior non-preferred—or the issuance of relatively shorter dated green covered bonds.

Green Covered Bonds

Green covered bonds raise funds to finance or refinance green projects, such as energy-efficient buildings. They are mostly aligned with the ICMA's Green Bond Principles.

Green mortgages fund the purchase or refinancing of green properties or the renovation of buildings to make them more sustainable. The environmental credentials of buildings are commonly assessed using Energy Performance Certificates (EPCs). Such EPC include an energy performance rating and recommendations for cost-effective improvements. They serve to provide information to consumers on buildings they plan to purchase or rent.

The first issuances of green covered bonds were mainly backed by a selection of green assets already on issuers' balance sheets. Banks are now increasingly creating dedicated green loan products that they can use as collateral for green issuances. In some instances, the bank offers incentives to the borrowers by offering a discount on the interest rate or higher loan balances.

The Technical Screening Criteria

In June 2021, the EC adopted the climate delegated act, setting the TSC for the climate mitigation and climate adaptation objectives under the Taxonomy regulation. Among the sectors identified under this act, the TSC for construction and real estate activities are particularly relevant for covered bonds, due to the high share of programs backed by mortgage loans. These TSC relate to: i) construction of new buildings, ii) renovation of existing buildings, and iii) acquisition and ownership of buildings.

Table 1

The TSC for real estate activities include two key concepts:

The primary energy demand (PED) requirement:  Determines the amount of energy needed or consumed by a building.

The nearly zero-energy building (NZEB) requirement:  According to the Energy Performance of Buildings Directive (EPBD), an NZEB has a very high energy performance in which the nearly zero or very low amount of energy required is significantly covered by renewable sources.

To be Taxonomy compliant, the PED of newly constructed buildings should be at least 10% lower than the threshold set for NZEB requirements (as per national measures). Furthermore, the renovation of existing buildings needs to reduce the PED by at least 30%.

The TSC relating to ownership and acquisition specify that buildings acquired before 2021 must have an EPC class A or be within the top 15% best in class in terms of PED to be Taxonomy-aligned. However, there are certain challenges here. EPC databases do not exist in all EU member states. In addition, when these databases do exist, banks do not always have access to them, which makes it difficult to benchmark the assets in their existing mortgage portfolios. Furthermore, there are significant differences in EPC standards across member states: an EPC ranking of "A" in one country is not necessarily comparable to an "A" in another. EPCs are also only valid for a limited period (generally 10 years), after which the property needs to be reassessed. This may imply that member states that are already more sustainable will be able to comply with the Taxonomy more easily.

The environmental delegated act for the other four environmental objectives is likely to be published in 2022 and become applicable in 2023. Furthermore, the regulation will be expanded further to include other sustainable objectives, including social, but not before 2022 (see "Social and Sustainability Covered Bonds").

The EU Renovation Wave Initiative

According to estimates from the EC, to achieve the 55% emission reduction target by 2030, the EU would need to cut building's greenhouse gas emissions by 60%, their final energy consumption by 14%, and energy consumption for heating and cooling by 18%. However, across Europe, the weighted average energy renovation rate is around 1%, and deep energy renovations only account for 0.2%. This is much too slow to achieve the EC's targets.

In response, the EC launched in October 2020 its Renovation Wave initiative, which aims to at least double the annual energy renovation rate of residential and non-residential buildings by 2030, fostering deep energy renovations. The initiative identifies seven barriers holding back renovations throughout the value chain. It considers these to be key areas in which to intervene and achieve the increase in renovation needed. These include stronger obligations to have EPCs and minimum energy performance standards for existing buildings, promoting the decarbonization of heating and cooling, and making the construction industry more capable of delivering sustainable renovations.

Chart 8

A successful implementation of the European Renovation Wave initiative would greatly support green bond issuance by increasing the availability of eligible assets.

Social and Sustainability Covered Bonds

Social covered bonds raise funds to finance or refinance social projects, such as affordable housing or public lending. They are mostly aligned with the ICMA's Social Bond Principles.

Sustainability covered bonds raise funds to finance or refinance a mix of green and social projects, such as those involving energy-efficiency as well as affordable housing projects. They are aligned with the ICMA's Sustainability Bond Guidelines.

Social covered bonds constitute around 25% of the total sustainable covered bond issuance, and sustainability covered bonds around 4% of the total sustainable covered bond issuance. The assets in the cover pool can be either mortgages or public sector debt, although mortgages currently back most transactions.

Chart 9

Use of proceeds

Social covered bonds fund projects that directly aim to address or mitigate a specific social issue and/or seek to achieve positive social outcomes for a target population.

The SBP indicate six examples of categories of social projects:

• Affordable basic infrastructure (e.g., clean drinking water; sewers, sanitation, transport, energy);
• Access to essential services (e.g., health, education and vocational training, health care, financing, and financial services);
• Affordable housing;
• Employment generation, and programs designed to prevent and/or alleviate unemployment stemming from socioeconomic crises;
• Food security and sustainable food systems; and
• Socioeconomic advancement and empowerment.

Table 2

Toward a social taxonomy?

The EC has adopted a climate delegated act setting the TSC for two of the six environmental objectives under the Taxonomy regulation: climate mitigation and climate adaptation. However, the act has not yet covered any social objectives. The EU Platform of Sustainable Finance is working on this. Established as a permanent expert group by the EC, it is currently advising on further development of the EU Taxonomy and supporting the EC in the technical preparation of delegated acts. A separate subgroup on social Taxonomy is looking at extending its scope beyond environmentally sustainable economic activities to other sustainability objectives, such as social objectives (the so-called Social Taxonomy). The subgroup has been also asked to advise on minimum social safeguards.

In July 2021, the platform published a draft report on the Social Taxonomy. The draft report argues that a Social Taxonomy would help investors to identify opportunities to finance solutions around ensuring decent work, enabling inclusive and sustainable communities and affordable health care and housing. While the report is advisory and the EC has not taken a decision yet on whether to proceed, the Platform's advice will feed into the EC's report on a potential extension of the Taxonomy framework.

S&P Global Ratings' Analytical Approach

At S&P Global Ratings, we incorporate ESG credit factors into our credit ratings analysis through the application of sector-specific criteria when we think the ESG factors are, or may be, relevant and material to our credit ratings. ESG factors typically incorporate an entity's effect on and impact from the natural and social environment and the quality of its governance. However, not all ESG factors materially influence creditworthiness and, thus, credit ratings, which measure the capacity and willingness of the entity to meet its financial commitments as they come due (see "S&P Global Ratings Definitions"). Therefore, we define ESG credit factors as those ESG factors that can materially influence the creditworthiness of a rated entity or issue and for which we have sufficient visibility and certainty to include in our credit rating analysis (see "Environmental, Social, And Governance Principles In Credit Ratings," published Oct. 10, 2021.)

ESG credit factors can influence ratings, rating outlooks, and credit enhancement required for the assigned rating. This influence could be reflected, for example, through reduced ability of the underlying borrowers to repay the cover pool receivables, the value of any collateral, disruptions in servicing or transaction cash flows, financial exposures to transaction counterparties, or increased legal and regulatory risks.

The following are examples of key ESG credit factors that have affected creditworthiness or that, in our opinion, may influence future creditworthiness. Some events may relate to more than one of the ESG credit factors.

Chart 10

Our views of ESG risks across covered bond programs are established by analysts during industry portfolio discussions. They are typically qualitative at present, as there are currently limited ESG data points consistently available for collateral pools and other transaction characteristics that could be used to quantify the risk (see: "ESG Industry Report Card: Covered Bonds," published Nov. 9, 2020.)

In our published rating rationales, we aim to provide more insight and transparency of any ESG credit factors that are material to our credit ratings. For instance, if an ESG credit factor is a primary driver of a rating change, this will be disclosed in our rationale.

Environmental and social credit factors may affect the quality of the assets in the cover pool and the results of our collateral analysis. If, in our view, an environmental or a social credit factor presents a material risk to the repayment of the rated securities, it could impact the credit enhancement required to achieve a given rating, or potentially constrain the maximum potential rating. However, apart from ESG credit factors that affect the rating on the issuing bank, we would typically not identify any separate environmental or social credit factors for the covered bonds if we are not assigning any collateral-based uplift, as our analysis would be based on other factors such as the issuing bank's credit quality and the analysis of the resolution regime or jurisdictional support. To the extent ESG credit factors affect the rating on the issuing bank, this would be considered separately.

Governance factors, on the other hand, may affect the uplift that we assign to a program above the issuer credit rating (ICR). A governance credit factor would typically affect either the ratings, the rating outlook, or the number of unused notches. Unused notches are the number of notches the ICR can be lowered by, without resulting in a downgrade of the covered bonds, all else being equal.

The issuer's designation of the covered bonds as "green", "social" or "sustainable" is immaterial to our credit rating analysis. We do not review or monitor use of proceeds, the process for project evaluation and selection, the management of proceeds, or any ongoing reporting related to the eligible projects in the assignment or surveillance of our credit ratings. Failure of the issuer to comply with the stated use of proceeds will not constitute a breach nor trigger any consequences under the program documents. As a result, we do not believe the sustainable designation alters the program's credit risk profile.

Glossary & References

Climate Bonds Initiative (CBI).   An investor-focused not-for-profit organization that promotes large investments for delivering a global low carbon and climate resilient economy. The Initiative seeks to develop mechanisms to better align the interests of investors, industry, and government to catalyze investments at a speed and scale sufficient to avoid climate change.

For more information, see https://www.climatebonds.net/.

European Green Bond Standard (EUGBS)  In July 2021 the EC proposed a European Green Bonds Regulation which creates a regulatory defined green bond and a framework for regulating and supervising second opinion providers and external reviewers.

For more information, see https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/european-green-bond-standard_en.

Green Bond Principles (GBP).   The GBP, introduced by ICMA and updated in June 2021, are voluntary process guidelines for issuing green bonds. The GBPs outline best practices when issuing bonds serving environmental purposes through global guidelines and recommendations that promote transparency and disclosure, thereby underpinning the integrity of the market.

For more information, see https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/green-bond-principles-gbp.

Greenium.   The pricing difference between green and vanilla bonds.

Minimum Social Safeguards (MSS).   For an economic activity to be aligned to the Taxonomy, the counterparties carrying out the economic activity must have proper procedures in place to ensure the alignment with the OECD Guidelines for Multinational Enterprises and U.N. Guiding Principles on Business and Human Rights, including the eight fundamental International Labour Organisation conventions and the International Bill of Human Rights.

Nearly Zero-Energy Buildings (NZEBs).   An NZEB is a building that has a very high energy performance, as determined in accordance with the EPBD. The nearly zero or very low amount of energy required should be covered to a very significant extent by energy from renewable sources.

Social Bond Principles (SBP).   The SBP, introduced by ICMA and updated in June 2021, are voluntary process guidelines for issuing social bonds. The SBPs outline best practices when issuing bonds serving social purposes through global guidelines and recommendations that promote transparency and disclosure, thereby underpinning the integrity of the market.

For more information, see https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/social-bond-principles-sbp/.

Technical Expert Group on sustainable finance (TEG)  The group's role is to assist the EC, notably in the development of a unified classification system for sustainable economic activities, an EU green bond standard, methodologies for low-carbon indices, and metrics for climate-related disclosure.

For more information, see https://ec.europa.eu/info/publications/sustainable-finance-technical-expert-group_en.

Technical Screening Criteria (TSC).   They constitute the operational dimension of the Taxonomy, providing concrete criteria of what constitutes a "substantial" contribution and what is expected to "not significantly harm" any other environmental objective. According to the Taxonomy regulation, the EC has to review them regularly and amend them in line with scientific and technological development.

Related Research

• Covered Bonds Outlook Midyear 2021: Credit Stable Despite Waning Support, July 23, 2021
• Covered Bonds Must Adjust To A New Reality After COVID-19, June 30, 2021
• Sustainable Covered Bonds: Assessing The Impact Of COVID-19, Dec. 1, 2020
• ESG Industry Report Card: Covered Bonds, Nov. 9, 2020
• Credit FAQ: Are Covered Bonds Becoming More Sustainable?, Sept. 6, 2019
• S&P Global Ratings' Covered Bonds Primer, June 20, 2019