Responsible investment and climate action in investment-grade ABS: Where the limits lie
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Securitisation of financial assets plays a crucial role in global capital markets, allowing institutions to manage their balance sheets, often with the aim of creating capacity to finance further commercial activity, and supporting the efficient flow of capital through the economy. The process of transforming long term loans into tradable asset-backed securities (“ABS”) also creates attractive opportunities for investors, offering exposure to a wide range of underlying assets including mortgages, auto loans, corporate loans and other forms of consumer credit.
However, implementing responsible investment in the asset class remains challenging. Compared with other asset classes (e.g. equities or corporate bonds), ABS investors typically have more limited access to useful data to understand environmental, social and governance (“ESG”) exposures. The level of financial materiality of certain ESG issues in some ABS subsectors is questionable due to the structuring of ABS. There are few opportunities to exert influence through stewardship to improve ESG practices that contribute to real-world risk reduction (eg on climate change mitigation which is required for net zero alignment). And opportunities to invest in sustainability solutions are limited.
For these reasons, we take a deliberately cautious view to avoid over-promising on what can currently be done in this space. There is a risk of undermining credibility by overstating the extent to which responsible investment can be implemented or sustainability solutions can be targeted in a portfolio. A clear-eyed assessment of the challenges is essential if investors are to integrate ABS into portfolios in a way that meets asset owners’ ESG and/or sustainability objectives.
While there is some positive work taking place to enable responsible investment and there are signs of more sustainable issuances, we believe it is important to be clear about the scale and limits of what has been achieved.
Significant barriers remain and these can make ABS near incompatible with net-zero or other sustainability objectives that some asset owners have in place.
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Data limitations are the single most binding constraint on implementing responsible investment in ABS
One of the most significant obstacles to implementing responsible investment in ABS is the lack of standardised, reliable, and useful ESG data. Unlike direct equity or corporate bond investments, where sustainability-related reporting and ESG data disclosures are increasingly commonplace, ABS structures introduce complexity through multiple layers of ownership and credit intermediation. This makes it difficult for investors to assess ESG exposures with confidence, even where the underlying exposures could be considered financially material.
These challenges are not confined to specific subsectors of the ABS market. Even where incremental progress has been made, it typically applies to a narrow portion of the overall subsector’s investable universe. Where data is available, the use of proxies and estimations are common.
In other areas, meaningful progress is unlikely due to fundamental structural constraints rather than a lack of intent. Consumer ABS provides a clear example. Gaining visibility over how individuals spend via credit cards would require access to highly sensitive personal data and, even then, would likely be limited to merchant-level information. A transaction labelled “Amazon”, for instance, reveals little about ESG characteristics of the investment. Individual consumers are also effectively impossible to engage with at scale, leaving investors with no realistic mechanism to influence underlying risk exposures.
On a more positive note, ESG data availability for Collateralised Loan Obligations (the sub-investment grade corporate loans subsector of ABS used extensively in many funds, known as CLOs) has improved since the introduction of an industry-developed questionnaire in late 2023. However, the quality and depth of disclosures can vary significantly.
Sometimes data can be used to restrict which loans can go into a CLO pool through restrictions set out in the CLO documentation. For example, there can be ESG restrictions on the percentage of revenues from particular types of commercial activity undertaken by borrowers in a pool. These restrictions can offer investors false comfort, though, as they remain relatively weak, allowing companies that derive a large proportion of their revenues from restricted activities to remain investable. Even when there is some data available, it may not be the right data or be detailed enough to use. Emissions data for the underlying borrowers are generally estimated by third parties. Borrowers often have little incentive to improve disclosure, as greater transparency can risk raising their cost of capital in an area of the market that generally performs poorly on ESG issues. And the market comprises a few key loan originators (who sell loans to CLO managers who package them up for sale to ABS fund managers) who are unlikely to feel any pressure to provide detailed disclosures as their market dominance means they are “too big to avoid” in portfolios.
Stewardship opportunities to improve ESG practices are restricted and have limited effect
Poor data is one of the issues that hampers the potential to use stewardship to influence better ESG practices. And across ABS subsectors, the common issues of multiple layers of financial intermediaries and originators that are too-big-to-ignore are other key factors.
Returning to the key ABS subsector of CLOs, some of the large originators and CLO managers, particularly those in the US, are generally reluctant to engage with underlying companies and be engaged with, and some of them push back against providing ESG data or provide poor responses to the ESG questionnaires developed through industry initiatives. Given these originators’ and CLO managers’ scale and market dominance, investors have little leverage to influence better ESG disclosures and practices (both internally at the originator/CLO manager and at the companies being financed) without compromising portfolio characteristics, despite 2025 being a record year for new issue supply (increasing the number of opportunities coming from other originators).
In Residential Mortgage-Backed Securities (“RMBS”), another popular ABS subsector, under current market structures there is little an ABS investor can realistically do to improve ESG-related practices at the homeowner level, nor with mortgage providers.
For now, it seems that engagement efforts across the industry are concentrated on data disclosure rather than improving ESG practices.
Financial materiality of ESG issues is unclear
It is questionable whether some ESG issues identified as being financial material at underlying-loan level are still financially material when they are pooled and packaged in an investment-grade tranche of ABS. The legitimacy of some analysis that points to financial materiality is also open to challenge.
Does it really matter that ESG data is poor and that there are limited opportunities to conduct meaningful stewardship? Would investment returns be any different under a counterfactual scenario? Investment grade ABS are structured in a way that means losses are unlikely in the face of isolated negative ESG issues materialising. However, since more widespread ESG issues can cause price volatility it suggests there is some level of financial materiality, but that doesn’t generally result in impaired returns. Moreover, would there be any way of reducing that volatility if ESG data was better and stewardship was more effective?
RMBS, which are backed by pools of residential mortgages, provide a good case study to examine. Research from the Bank of England suggests that borrowers living in more energy efficient properties are more likely to keep up with mortgage payments. In practice, however, investors face a number of challenges:
Energy efficiency data is incomplete. While many mortgage originators in Europe provide data, others (particularly where legacy bank systems are involved) do not, forcing investors to rely on proxies or estimations. This potentially reduces the analytical value of the data.
Where data is available, it is often stale. For example, Energy Performance Certificate (“EPC”) ratings in the UK reflect the state of the property at mortgage origination and are not updated to reflect improvements, limiting the usefulness of the rating as a transaction ages. This issue is less pronounced in the buy-to-let market, where EPC are updated more frequently.
Lastly, observed relationships and possible explanations (e.g. more efficient homes have lower heating bills, which reduces strain on household finances) reflect correlation, not necessarily causation.
So, there doesn’t appear to be clear evidence that energy efficiency of residential properties affects an RMBS investor’s returns. However, if energy prices remain elevated because of the US / Israeli war with Iran it may provide a period that produces stronger evidence (either way).
Net zero alignment is challenging
Many asset owners have climate change related goals, including net zero targets. ABS is currently one of the less straightforward and less compatible asset classes for such asset owners. Structural features of securitisation (from persistent data limitations to the limited ability of investors to influence underlying assets) materially constrain the scope for demonstrable climate action.
While we generally favour strategies that deliberately invest in high emitters who are willing to transition over low-carbon strategies (for diversification reasons and because of the potential uplift in value when a high emitter transitions), that would require first being able to identify the high emitters with credible transition plans. That is not a realistic task without the necessary data being available. As such, it is unlikely such transition strategies will be available in this asset class.
The nature of ABS is that it frees up balance sheets to make further loans. It expands originators’ capacity to finance economic activity, including activity that is harmful to net zero goals. An exclusion of companies that derive more than 50% of revenues from thermal coal is weak but would not be unusual in a CLO. Some CLO managers won’t report on thermal coal exposure, and some don’t know what their thermal coal exposure is as originators can, for example, sell their “mining” company loans to CLO managers without disclosing what is being mined. This allows many high-emitting companies to remain eligible for inclusion in a CLO, with limited transparency, and with limited options for asset owners/ABS fund managers to influence them. When originators offload these kinds of high emitting loans to asset owners, it allows them to make further loans to such companies. Packaging such loans in CLOs helps to facilitate the financing of other high emitting activities, including unconventional extraction activities like oil sands extraction and arctic drilling.
Although diversification across many issuers reduces idiosyncratic credit risk, it does not mitigate systemic risks such as climate change. Moreover, the relatively short duration of CLO loans weakens incentives for borrowers to invest in long-term decarbonisation. As a result, there remains little scope for genuinely climate-driven or net-zero aligned CLO strategies, notwithstanding the inclusion of ESG language in many European transactions.
Additionally, in other ABS subsectors the impediments to creating such climate strategies include the lack of data (eg in consumer credit), the inability to alter the climate impact of an existing underlying product (eg in auto loans it is unlikely that the emissions produced per kilometre travelled in an internal combustion engine car will change), the impracticality of engaging with end-borrowers (eg there will be thousands of individuals in a single RMBS) and the resistance to engage or be engaged over such issues by players in the ABS chain (eg some originating banks).
Opportunities to invest in sustainability solutions are limited
Moving from risk management to opportunities, there has been some progress in certain ABS subsectors over the last few years to package exposures to sustainability solutions. This has led some to take an optimistic view of the asset class's potential to contribute to financing sustainability solutions.
There are now cases of "green mortgages" being securitised, allowing exposure to borrowers who receive preferential rates for energy-efficient properties. However, these transactions remain a small part of the market, accounting for around 5% of the European RMBS issuance (much less on a global basis) and concentrated in a limited number of countries (most notably the Netherlands). In most jurisdictions, mortgage originators have limited commercial incentive to systematically track or report the environmental characteristics of the properties they finance.
Moreover, initiatives to retrofit existing housing stock for improved energy efficiency requires homeowner engagement and willingness to invest, which remains inconsistent.
Despite these challenges, parts of the ABS market are evolving in response to growing investor demand for sustainability, albeit from a low base and with uneven progress.
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The first solar ABS deal was launched in Germany in 2024, with further issuance expected across solar, heat pump and housing retrofit finance. These deals point to genuine climate-aligned use of securitisation, but remain scarce, heavily oversubscribed and tightly priced. This limits their ability to support diversified portfolio construction at scale for the time being. Our colleagues at LCP Delta have written a separate blog to explore this area in more detail.
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The auto ABS market is seeing a shift as electric vehicles (“EVs”) comprise a greater share of the car market. EV loans and leases appear to have fewer delinquencies than those linked to internal combustion engines, potentially reflecting lower running costs or a more affluent borrower base. However, recovery values in the event of default tend to be lower for EVs. We believe that the stale data issue is less material for auto ABS compared with RMBS due to the shorter tenor of the financing. Over time, we expect that EV financing could play a more credible role in climate-aligned investment strategies as EV market penetration increases.
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Efforts are underway to improve ESG data availability and standardise disclosure templates for securitised assets. While these efforts should improve baseline data, the complexity of ABS structures means adoption is likely to be gradual and disclosure quality from originators is likely to remain inconsistent in the near term.
Given the limited availability of ABS solutions, and their concentration in certain geographies and ABS subsectors, a portfolio targeting a sustainability label would currently be a sub-optimal strategy.
Conclusion
ESG data is unlikely to ever be perfect in ABS. And while ESG exposures at borrower level can be financially material, the structure of ABS means that those same issues are far less likely to be financially material for an investment-grade tranche. With regards to stewardship, there are multiple links in the ABS chain where actions could be targeted but the ability to influence better ESG practices is severely hampered by market concentration of key players. Stewardship is also neutered since there are limited options to escalate following failed engagements – the massive demand for ABS outweighs supply meaning that a refusal to participate in a new issuance currently has no teeth. Both the poor data, and the limited possibilities to use stewardship constrain the ability to align an ABS portfolio with net zero. Portfolios will have exposure to CLOs that have limited-effect ESG screens and exposure to high-emitting borrowers (albeit allocations will be small). Sustainability solutions in ABS currently form a tiny proportion of well-diversified portfolios. The outlook is that none of these issues will change materially anytime soon.
That said, this should not be interpreted as a reason not to invest in ABS. On the contrary, ABS remains a highly effective and attractive asset class, offering diversification, compelling risk-adjusted returns, and exposure to large and economically important segments of the real economy. The challenge is not whether ABS is investable, but whether it is aligned with an asset owner’s ESG expectations and objectives for its portfolio.
In our view, responsible investment in ABS requires a degree of realism. Investors should be cautious about what can be achieved. A pragmatic approach, recognising incremental improvements, engaging where possible, and being transparent about the limits of what ABS can deliver, is likely to serve asset owners well.
ABS can play a valuable role in diversifying portfolios. The task for investors is not to force the asset class into an ESG mould it cannot yet support, but to integrate it thoughtfully into portfolios, with clear expectations and an honest assessment of its strengths and limitations.
