On 22 June 2018, Luxembourg adopted a law introducing the option for Luxembourg covered bond banks to issue a new type of asset: renewable energy covered bonds or lettres de gage énergies renouvelables (the Renewable Energy Covered Bond) into the existing framework of covered bonds issued by Luxembourg covered bond banks (the Law of 2018).
Various covered bonds labelled as green have already been issued in the last years, such as the Green Pfandbrief issued by Berlin Hyp in 20151 , backed by mortgages over commercial properties which received a green label. While these instruments combined existing covered bond legislation with a certification that the underlying assets qualified as green, no legal framework existed before the Law of 2018. The Law of 2018 establishes for the first time a real legal framework by introducing the Renewable Energy Covered Bond into the Luxembourg legislation governing Luxembourg covered bond banks.
Luxembourg is also pioneering in other green finance areas. The world's first green bond listing was on the Luxembourg stock exchange in 2007 and the "Luxembourg Green Exchange", which launched in 2016, is still the only trading platform dedicated to green finance products and is the largest platform globally2 .
By introducing the Renewable Energy Covered Bond, Luxembourg intends to foster the development of the renewable energy industry and demonstrate its commitment to fight climate change3 .
Latest EU recommendations on covered bonds incorporated
The Luxembourgish legislator also used this opportunity to amend the Luxembourg covered bond framework to incorporate the recommendations from the European Banking Authority (EBA) in 2016. Following the amendments enacted by the Law of 2018, the Commission de Surveillance du Secteur Financier (CSSF) adopted three related circulars on 19 December 2018, which are discussed below.
The recommendations put forward by the EBA were also the basis for a legislative package proposed by the European Commission in March 2018 aimed at introducing European Union (EU) level rules for covered bonds. Currently, covered bonds are mainly regulated at a national level and the European Commission considers alignment in certain areas necessary to implement the Capital Markets Union action plan and develop the use of covered bonds as "a stable and cost-effective source of funding for credit institutions, especially where markets are less developed, in order to help finance the real economy"4 .
Although the European Commission's initiative has been endorsed by various political decisions and also by stakeholders, concerns have been raised that the rules are too intrusive. In spring 2018 the European Commission presented its proposals for a directive on the issue of covered bonds and covered bond bank's public supervision (amending Directive 2009/65/EC and Directive 2014/59/EU) and for a regulation (amending Regulation (EU) 575/2019) regarding credit exposures in the form of covered bonds, which were approved by the European Parliament on 19 April 2019, and are currently going through the trilogue process5 .
What is a renewable energy covered bond?
The Law of 2018 introduces a new class of covered bonds which Luxembourg covered bond banks (governed by the Luxembourg law dated 5 April 1993 as amended (the Banking Act)) can issue, in addition to the existing classes of covered bonds linked to real estate mortgages, public sector financings, lending secured by moveable assets and lending to certain credit institutions. This new type of covered bond is notable in that it is not linked to one specific asset but aims to cover the renewable energy project as a whole by requiring that the underlying loan is backed by all critical assets related to the financing of the relevant project.
A Renewable Energy Covered Bond may be issued by a Luxembourg covered bond bank to finance loans guaranteed by rights in rem or security interests over certain immoveable or moveable assets generating renewable energy and by substitution rights to main project contracts.
The Law of 2018 draws on the work of the European Union6 , defining renewable energy as "energy from renewable non-fossil sources, namely wind, solar, aerothermal, geothermal, hydrothermal and ocean energy, hydropower, biomass, landfill gas, sewage treatment plant gas and biogases", but broadens that definition by also referring to "energy produced from similar sources".
Technical definitions of "assets generating renewable energy" and of "main project contracts" are also included in the Law of 2018, thus providing for legal certainty and a clear understanding of the underlying assets over which the rights, security interests or substitution rights constituting the cover pool of Renewable Energy Covered Bonds may be taken.
The cover pool of Renewable Energy Covered Bonds
Substitution rights and the enforceability ofthe security interests
The cover pool of a Renewable Energy Covered Bond must comprise of rights in rem, security interests or substitution rights. The inclusion of the latter in the cover pool of a covered bond is another innovation of the Law of 2018. Substitution rights or step-in rights are granted by operation of applicable law or by contractual agreement and enable the bank to be substituted to the company generating renewable energy in a main project contract, when the company is in default under the granted loan.
By including substitution rights within the cover pool of Renewable Energy Covered Bonds, the robustness of the instrument itself is increased, since the bank or a third party designated by it can take over the project and ensure its continuance. This mechanism may ensure the creation of continuing cash flow, thus leading to payments under the defaulted loan and therefore avoiding failure of payments under the Renewable Energy Covered Bond.
Since the underlying assets of the cover pool of Renewable Energy Covered Bonds may be moveable or immoveable and located in several member states of the EU, EEA, OECD or certain other states, the mechanisms to ensure the validity and enforceability of the right in rem may differ. The Law of 2018 addressed this by requiring that the right in rem be either registered in a public register or their enforceability and validity be confirmed by an independent legal opinion.
Valuation of renewable energy projects
In order to take into account the specificity of the underlying assets of Renewable Energy Covered Bonds, the Law of 2018 limits the cover value of claims resulting from the loans guaranteed by rights or security interests over certain immoveable or moveable assets generating renewable energy to a certain amount of the estimated realization value of such asset, depending on the progress of the project and the use of renewable energy.
Guidelines for the prudent valuation of the renewable energy projects have been published by the CSSF in a circular. Such valuation should be made by an independent appraiser, at least once annually, following a specific policy established by the relevant covered bond bank, "who remains ultimately responsible for the proper valuation of the underlying projects"7 .
Promoting green financing through renewable energy covered bonds
The Law of 2018 intends to increase financings of renewable energy projects. Loans underlying covered bonds may be granted in various forms including (a) by way of acquisition of debt securities or similar instruments8 and (b) by way of acquisition of interests in companies generating renewable energy.
Renewable energy asset backed debt acquisition
A covered bond bank may acquire debt instruments issued either by:
- a securitization company or a compartment of a securitization company whose assets comprise at least 90 % of rights in rem or security interests over certain immoveable or moveable assets generating renewable energy and by step-in rights to main project contracts. The cover pool of the Renewable Energy Covered Bonds may not comprise more than 20% of such debt instruments; or
- an issuer other than a securitization company if the proceeds of the issue are used for at least 50% to refinance assets generating renewable energy and if the cover pool of the Renewable Energy Covered Bonds does not comprise more than 20% of such debt instruments.
In any case, the renewable energy cover pool of the issuer must not comprise more than 20% of the above instruments.
The second option is an innovation in comparison with existing covered bond types for which only debt issued by a securitization company or compartment thereof may constitute a loan.
For each of these possibilities, a rating agency9 must grant a step two rating to the relevant debt instruments. In contrast, for existing covered bond types, such rating must be a step 1 credit quality rating
Activities ancillary to renewable energy covered bond issuances
The Banking Act enables covered bond banks to engage in activities that are ancillary to the issuance of covered bonds. For instance, covered bond banks may take participations in companies and the Law of 2018 specifies criteria when the target company is generating renewable energy.
While in respect of companies other than those generating renewable energy, a covered bond bank may only acquire a third of the nominal value of all shares of the company (unless that company's object is in essence the same as the one of the covered bond bank), such limitation is not included when the target company generates renewable energy. Such limitation would indeed be contradictory to the bank's substitution rights, whose aim is to ensure the continuance of income even once the bank substituted itself.
The amount of participations taken in companies generating renewable energy may not exceed 20% of the covered bond banks net assets (fonds propres) in order to avoid risk concentration.
Amendments to general Luxembourg covered bond framework
In its 2016 report10, the EBA analyzed the covered bond frameworks of 22 EU member states and provided recommendations to harmonize the national regimes, in order to strengthen the resilience of covered bonds throughout the European Union.
While Luxembourg's legislation on covered bonds is in large part aligned with the EBA's recommendations, in certain areas shortcomings vis-à-vis other jurisdictions were highlighted and the Luxembourgish legislator took the opportunity to implement such recommendations into the Law of 2018. Among other recommendations, the Law of 2018 introduced a liquidity buffer, a new type of eligible substitution assets, extended on a transparency requirement and clarified the use of derivatives by covered bond banks.
2 Climate Bonds Initiative, May 2018, The green bond market in Europe. LuxSE, Press release 6 March 2019.
3 The law is in line with the goals formulated during the United Nations COP 21 which resulted in the Paris Agreement, notably that public funds alone will not be able to respond to climate change
4 COM (2018) 94, Explanatory Memorandum, p2
5 The trilogue meetings are informal negotiations between the European Parliament, the European Council and the European Commission aimed at reaching an agreement at any moment of the legislative procedure, which will then be approved by the formal procedures of each institution.
6 Directive 2009/28/EC of the European Parliament and of the Council of 23 April 2009 on the promotion of the use of energy from renewable sources
7 CSSF, Circular 18/705.
8 Restrictively enumerated in the Banking Ac.
9 registered with ESMA pursuant to Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on credit rating agencies
10 EBA, Report on Covered Bonds, Recommendations on harmonisation of covered bond frameworks in the EU, EBA-Op-2016-23, 20 December 2016.
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