Covered Bonds

How Covered Bond markets can be adapted for Renewable Energy Finance and how this could Catalyse Innovation in Low-Carbon Capital Markets

Unlocking bank lending in an era of capital constraint and limited public budgets

By Frank Damerow, Sean Kidney and Stuart Clenaghan[1]

Executive Summary is below | DOWNLOAD FULL PAPER NOW | Read the media release

On the 14 December 2012, Climate Bonds Initiative hosted a roundtable in London on Renewable Energy Covered Bond. A Steering Committee was formed to guide further development of the project.


There is now a broad consensus among governments, corporations, and the public alike that urgent action is required to cut greenhouse gas emissions. However, mobilising sufficient finance to transform the world’s economy onto a low-carbon footing is far from straight forward, especially given the financial crisis, which has forced banks to cut lending. The bond market could supplement loans, and one sector – covered bonds – should be explored as a means to support bank lending within the low-carbon economy, in particular to areas targeted by public policy such as renewable energy.

Covered bond markets have proven to be a reliable source of term-dated funds for banks to on-lend in specific sectors targeted by policy makers, such as housing, which have perceived economic multiplier effects. Legislation governing the issue of covered bonds has now been introduced in almost forty countries, therein recognising the contribution the market can make in aligning private-sector investment with public policy objectives.

Covered bonds are highly regulated, and enjoy superior credit ratings and lower funding costs compared with unsecured debt issued by banks. This is achieved through a dual recourse structure where bond investors have a claim over dedicated ‘cover pool’ of assets, as well as a general claim against the issuer itself. Covered bond legislation defines strict conditions that the issuer must comply with to ensure that the quality of the cover pool collateral is maintained.

In order to enable covered bonds to be adapted for low-carbon finance it will be necessary to create a consensus on what type of assets will be eligible, how these will be managed, and what definitions apply to low-carbon assets. The objective should be to establish a legislative framework, which both fulfils a low-carbon public policy purpose and enables reliable term funding to be accessed by banks.

This Discussion Paper outlines how covered bond markets could be adapted for renewable energy finance and how covered bonds could provide a stepping-stone towards broadening debt capital markets for low-carbon finance.

Executive Summary

  1. At a time when the need for global investment in renewable energy is rising, capital-constrained banks are lending less and charging higher interest margins, creating a bottleneck for senior debt funding. Bank lending is expected to be constrained further under Basel III. See p4.
  2. Banks have considerable project loan expertise and provide the majority of debt to project finance, including renewable energy. In order to maintain lending, banks need to find a way of refinancing existing loan portfolios. See p4.
  3. According to the International Energy Authority (IEA), an additional $1 trillion global annual investment is required to reduce emissions of greenhouse gases to a safe level – yet there are few fixed income products that the private sector can invest in outside of banks’ balance sheets. The decision by Germany to phase out nuclear power by 2022 will necessitate an estimated further €200 billion of investment in clean energy. See p4.
  4. Whilst public sector support for clean energy financing has been strong, especially through the provision of Feed-in Tariffs (FiTs), it is unlikely that most governments will extend their support above existing levels. Ways must be found to leverage existing public sector support, and through this facilitate increased lending by banks so that renewable energy projects remain economically viable. See p4.
  5. The world’s largest pool of capital – the $95 trillion bond market – has largely been untapped for renewable energy finance. Bond issuance could supplement bank lending, but it will take time for the market to grow as institutional investors generally take a conservative approach to new asset classes and need time to develop expertise. See p5.
  6. Covered bonds – called Pfandbriefe in Germany – could provide a stepping-stone in the development of a fully-fledged renewable energy bond market. See p6.
  7. The Pfandbrief market saw substantial growth in the 1990s, when the German government supported its expansion as a means to support the massive post-reunification investment in infrastructure in East Germany – a priority not dissimilar to the current need to invest in renewable energy. See p4.
  8. The development of the covered bond market outside Germany is supported by legislation in many countries.  Policy makers see covered bonds as a means to support bank lending for housing and public sector infrastructure, which both have perceived economic multiplier effects. See p8.
  9. In most countries existing legislation would need to be adapted to enable banks to issue covered bonds supported by renewable energy assets. See p9.
  10. The advantages that Renewable Energy Covered Bonds (RECBs) offer are two-fold. First, banks will be able to access cheaper and longer-dated funds to on-lend to designated renewable energy projects. And second, bond investors would be able to gain exposure to renewable energy assets with minimal adaptation of existing portfolio guidelines because of the high level of security offered by covered bonds. See p6.
  11. The enhanced credit quality of covered bonds is achieved through a dual recourse structure. Covered bonds are first and foremost obligations of the issuing bank. However, in the event of a default, bondholders have a preferential claim over the assets and associated cash flows in the cover pool, as well as an unsecured claim on the issuer. The issuer is obliged by law to over-collateralise the cover pool and replace any impaired or matured assets. Covered bonds are issued under a specific legal framework or on a contractual basis under general law. In either instance, covered bonds are designed to give maximum protection to investors. See p6.
  12. A particular feature of covered bonds is that in most jurisdictions the cover pool is transparent, so bond analysts would have the opportunity to gain experience of how renewable assets perform without taking a direct exposure to the underlying credits. See p5.
  13. What is required to unlock the potential of covered bond finance is specific legislative support to incorporate renewable energy assets within existing legislation, whilst ensuring high standards of security for investors. The world’s biggest covered bond market – Germany’s Pfandbrief sector – has already shown how the legal framework can be adapted to facilitate the finance of shipping and aircraft assets. See p9.
  14. Whilst legislation is being developed, an RECB market could be kick-started with the use of formal guarantees by agencies such as the European Investment Bank. Rather than providing guarantees direct to projects (which is current practice) agencies could back Feed-in Tariffs making such assets eligible for covered bonds finance, thereby improving the efficiency of public sector support for renewable energy and bringing new investors into the market. See p10.

[1] Frank Damerow is Strategic Portfolio Manager at a German bank; Sean Kidney is Chair of the Climate Bonds Initiative; Stuart Clenaghan, is a principal at Eco System Services Ltd.  Inspiration, advice and comment came from Jason Langley, Julia Hoggert, Dr. Carola Rathke, Dr. Matthias Heisse and Christoph Anhamm.