DBRS Morningstar’s Takeaways from ABS East 2021: More Questions Than Answers About ESG and ABS

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed at ABS East 2021, an industry conference for the asset-backed securities (ABS) sector. DBRS Morningstar’s Stephanie Mah, Vice President, moderated a panel about Environmental, Social, and Governance (ESG) factors on the final day of the conference. At this point, there are still more questions than answers about how to apply ESG principles to ABS. There is no set way to look at the underlying loans and translating that ESG risk into the deal level.

The murkiness of the data is the biggest hurdle, though the corporate bonds sector could provide some insights in terms of methodology. According to Rasool Alizadeh, Chief Financial Officer of AG Resource Management, ESG analysis in corporate bonds focuses on the corporation’s structure and management and asks what the purpose of the loan is for the company. He believes this approach will translate into ABS markets. But the governance part of ESG is tricky. “How do you translate that into the ABS market when the purpose of ABS is to be separate from the operating company?” asked Sarah Milam, Associate at Dechert LLP.

“At DBRS Morningstar we consider up to 17 ESG factors in our credit analysis,” said Mah. “On the corporate side, we see 15 out of 17 of those factors, but for structured finance it’s a bit more challenging. We consider eight of those 17 factors.” She further explained that the source of ESG risk in structured finance is typically from either the collateral underlying the transaction or the entities servicing the assets.

Both Milam and Alizadeh expect the guidance on what makes an ABS deal ESG compliant to come mostly from investors and less so from U.S. regulators. The opposite is happening in Europe, where regulators are setting expectations for ESG financing in terms of the anticipated results. Alizadeh believes the U.S. will eventually catch up to Europe, mostly because of investor demand rather than regulatory direction.

In terms of performance, Alizadeh believes that there is some correlation between green loans and the probability of default. For example, installing a solar panel is going to bring down the cost of electricity, which should translate into the borrower making regular solar panel payments. However, he noted that the history of this correlation is not extensive. Mah gave DBRS Morningstar’s perspective, saying that sustainability and credit aren’t necessary directly correlated. For example, from a social perspective, subprime loans expand the availability of credit to borrowers who wouldn’t necessarily qualify under prime terms. At the same time, from a credit perspective, there are usually higher defaults and losses on those types of receivables. “You can have something that is positive from a sustainability point of view, yet from a credit perspective, it’s a negative,” she said. Milam responded by noting that a positive development of the social lens in expanding to underbanked communities is the development of new ways of looking at the consumer through either artificial intelligence or models rather than the traditional FICO score or ZIP code. In her opinion, new and novel ways of looking at consumers can contribute to lessening credit risk.

The outlook is that ESG considerations are here to stay. However, Milam believes that the investment industry’s perspective will start to expand beyond the environmental part of the acronym, saying that there is an entire generation coming up that will be more likely to consider ESG factors in making their own decisions. Mah contends that sustainable investing is at an inflection point where attention is shifting away from how people invest and looking more at the outcomes of those investments. Previously, investors typically went the exclusionary route and avoided investing in industries like oil and gas or tobacco. Instead, the questions that should be answered are: What is the impact? Are greenhouse gas emissions lower? Is air quality improved? Are board compositions more diverse? Those considerations and more will be the focus in the future.

Written by Caitlin Veno

Notes:
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