Greening the mortgage portfolio: the challenges and conduct risks faced by lenders

At-a-glance

• Mortgage lenders play a vital role in the transition to net zero. To reduce their financed greenhouse gas emissions and meet net zero targets, lenders need to make substantial improvements to the energy performance rating of their retail mortgage portfolios.
• This blog looks at challenges lenders face in transforming the composition of their mortgage books, and the conduct risks that may arise as they incorporate energy efficiency as a criterion into their lending processes and further develop their green mortgage products and services.
• The new Consumer Duty sets the standards of consumer protection the FCA wants to see across retail financial services. As lenders transform their mortgage portfolios, a proactive approach to the Duty can ensure that they have appropriate consumer protection ‘guardrails’ in place.

Tightening energy efficiency standards and retail mortgages

Homes make up 16% of greenhouse gas (GHG) emissions in the UK¹. To address this, the government is attempting to accelerate improvements in housing energy efficiency. In 2020, the Department for Business, Energy, and Industrial Strategy (BEIS) proposed:

• Requiring lenders to disclose:
  • portfolio-wide Energy Performance Certificate (EPC) data
  • the gross value of lending for energy performance improvement works
•  Introducing targets for lenders to achieve a portfolio-wide average EPC rating of C by 2030. The targets, voluntary at first, may become mandatory if lenders take insufficient action.

In addition, BEIS is consulting on raising the minimum energy performance rating of privately rented properties from EPC E to EPC C by 2025 for new tenancies and 2028 for existing tenancies. These proposals, though aimed at landlords, will have implications for lenders’ buy-to-let portfolios.

Financial services regulators are alert to the transition risk posed to lenders’ mortgage portfolios by tightening energy efficiency standards. In a recent speech, Anil Kashyap, a member the BoE’s Financial Policy Committee, stated: ‘the market value of properties will increasingly depend on their energy efficiency if carbon prices rise significantly’^2. Lenders are increasingly required to assess and disclose these transition risks (for example, under stress tests and through risk disclosures), and regulators have begun proposing that the energy efficiency of collateral is taken into consideration as part of credit assessments for mortgages.

Box 1 (at the end of this blog) sets out more detail on recent regulatory developments regarding the energy efficiency of mortgage portfolios.

Transforming the mortgage portfolio

As part of the UN-convened Net Zero Banking Alliance, 11 UK banks have committed to aligning their ‘lending and investment portfolios with net-zero emissions by 2050’. Notwithstanding the targets being proposed by BEIS, to meet their net zero commitments, lenders are increasingly setting their own targets to reduce financed emissions across their retail mortgage portfolios (including residential mortgages, bridging loans, second charge mortgages and buy-to-let).

Chart A demonstrates the scale of the challenge lenders face. In 2019, most residential properties in England and Wales with an EPC rating were rated D or below.

Chart A: Residential properties in England and Wales by EPC rating (2019).

To begin transforming their mortgage books, lenders are initially likely to focus on increased lending to energy efficient properties and voluntary uptake of energy improvements by homeowners. Several lenders have launched green mortgages that reward customers for buying an energy efficient (A or B rated) home or offer additional secured lending to allow customers (owner occupiers and buy-to-let landlords) to make energy efficient home improvements.

However, as targets begin to bite and regulators focus increasingly on how energy efficiency affects the value of collateral, lenders will need to start factoring energy efficiency into mortgage lending decisions and develop further their green lending products and services. This blog looks at some of the challenges that may impede their efforts and how they can manage the conduct risks that may arise.

Challenges for lenders

Poor data - to be able to assess the energy efficiency of property (and to disclose the energy performance of their mortgage portfolio overall), banks need access to EPCs. However, as Anil Kushyap highlighted ‘lenders rarely know anything about the energy efficiency of the properties they lend against given it has historically not been a data item they routinely collect’. Moreover, EPCs are currently only available for approximatively 50% of UK properties³ and they are only legally required when a house is built, sold, or rented.

In its consultation on improving energy performance through lenders, BEIS proposed that lenders collect EPC data as part of the (re)mortgage process. However, this is likely to add cost and delay to the mortgage application process and will be challenging to incorporate into automated/desktop valuations and mortgage affordability calculators.

Lack of consumer awareness and demand - public awareness about home energy performance and green mortgages is low. Several lenders are focused on ensuring that customers are better informed and can access information on green lending products and improving the energy performance of their homes. However, until consumers accept and support actions to improve home energy efficiency, lenders may face a continued lack of demand for green mortgages and resistance to measures consumers feel are being forced upon them. Given ongoing cost of living pressures, consumers also face complex choices – incurring costs in the short term to improve energy efficiency and reduce energy (and potentially borrowing) costs may mean foregoing expenditure on some essential goods today.

Supply chain issues - cutting emissions from existing mortgaged properties is dependent on a robust, skilled supply chain to install, and assess the effectiveness of, energy efficiency measures. However, the House of Commons Environmental Audit Committee recently found that there is a lack of registered and vetted suppliers⁴ and lenders have expressed concerns about the capacity of assessors to be able to provide EPC ratings for properties⁵. Until supply chain issues are resolved, lenders’ efforts to improve their energy efficiency of their mortgage portfolios may be constrained.

Notwithstanding these barriers (which, in any event, are beyond the power of a single lender to address), lenders must forge ahead with efforts to reduce emissions from their mortgage portfolio. As they do so, they will need to be alert to some of the conduct risks that may arise.

Incorporating energy performance into the lending process

Incorporating energy performance into lending decisions could create concerns around the fair treatment of consumers. These include:

Unaffordable borrowing - if lenders need to amend loan criteria and affordability assessments to account for additional funding required to improve poor performing property, this may result in the cost of borrowing becoming unaffordable for some customers.

To ensure a ‘just’ transition, lenders will need to work closely with policymakers to ensure that low income and vulnerable customers are not priced out of making improvements to their properties. This may involve signposting customers to additional sources of funding or support (i.e., grants) as part of the loan application process.

Mortgage prisoners - incorporating energy efficiency into lending decisions may also disincentivise lending to energy inefficient properties. Feedback on the introduction of the UK's Energy Efficiency Regulations 2015 (which prohibit landlords from letting property that does not achieve a minimum EPC rating of E) suggests that some lenders have refused to lend on F and G rated properties that have not registered an exemption.⁶

As lender appetite changes, owners of poor performing homes may find it harder re-mortgage at affordable or preferential rates, becoming ‘trapped’ with their existing provider. Lenders need to understand what proportion of their book is at risk of becoming ‘mortgage prisoners’ and be alert to the potential vulnerability of this population. This is likely to include leaseholders and those with shared ownership, who have less control over making changes to the fabric of their property.

Valuation of collateral - incorporating energy performance into the valuation of collateral, as regulators are increasingly proposing, will be challenging. Valuations are typically provided by independent third parties and lenders have little influence over the valuation methodology used. Valuations are also point-in-time assessments whilst energy efficiency affects the future value of property and may, therefore, be best considered as part of stress tests.

Rather than incorporate energy performance into the valuation of collateral, one option for lenders is to recalibrate creditworthiness/affordability assessments to assess the implications of energy efficiency on consumers’ energy bills more accurately. However, this could lead to inconsistent treatment of customers, particularly in the absence of more standardised EPC data. Moreover, it would require consumers (and lenders) to make complex decisions about how much to spend on improving property versus longer-term savings (for example, on energy bills).

Wider conduct concerns

Value and utility - green mortgages are often advertised as offering consumers ‘rewards’ (usually preferential interest rates or ‘cashback’ incentives) if they buy an energy efficient home or carry out green home improvements. However, the preferential rates are often only marginally different from lenders’ standard rates and green mortgages can often be beaten by non-green mortgage deals available in the wider market.

Focusing on headline rates may obscure other benefits of green mortgage products such as higher LTVs, ‘cashback’ or low product fees. Nevertheless, if green mortgages do not offer consumers benefits beyond those of a standard mortgage, regulators may, in time, become sceptical about firms’ motivations for launching them. In a recent speech, Sheldon Mills, warned that the FCA did not want the design and development of ESG products ‘being reduced to a hollow marketing opportunity’^7.

Regulatory concerns aside, lenders will need to develop more compelling green mortgage offers if they are going to convince enough consumers to purchase energy efficient homes or consider paying for energy efficient upgrades.

Mis-selling - If lenders are not on track to meet targets (voluntary or otherwise) as the deadline approaches, there is a risk they resort to increasingly assertive tactics to reduce the number of low EPC rated properties in their portfolio. For example, by repeatedly contacting homeowners with offers of additional lending to make improvements.

Lenders will need to be wary of creating incentives during the sales process which could encourage pressure selling, (for example, higher remuneration for advisors who sell green mortgages) or making exaggerated claims in customer communications (for example, on the benefits of energy efficient upgrades).

The FCA’s new Consumer Duty: regulatory guardrails for transforming mortgage portfolios

In its ESG strategy, the FCA expressed concern that ‘[…] there is a risk of harm if the financial sector responds to rising consumer demand and awareness of ESG issues without a supportive regulatory foundation and adequate guard-rails’^8.

The FCA wants to ensure that ‘consumers are able to access green products and services that fit with their needs and preferences’ and that providers ensure that green ‘products and services work as expected, and consumers are not misled’⁹.

The FCA’s new Consumer Duty (the Duty) sets the standards of consumer protection it wants to see in all retail financial markets. When it comes into force, the Duty will apply across all firms’ products and services but a proactive approach towards it can ensure lenders have the necessary guardrails in place as they transform the composition of their mortgage portfolio and develop new green mortgage products and services.

The Duty comprises:

• A new Consumer Principle: ‘A firm must act to deliver good outcomes for retail customers’
• Cross-cutting rules that firms must:
  • act in good faith towards retail customers
  • avoid foreseeable harm to retail customers
  • enable and support retail customers to pursue their financial objectives
• Four outcomes for the key elements of the firm-consumer relationship:
  • Products and services
  • Price and value
  • Consumer understanding
  • Consumer support

We set out in the Appendix some examples of how the Duty intersects with lenders’ transitions to more energy efficient mortgage portfolios.

Conclusion

Improving the energy performance of mortgage portfolios (and, by extension, homes) presents lenders with complex challenges, many of which can only be resolved through wider policy initiatives designed to address supply chain issues and improve consumer awareness and access to funding.

Despite these challenges, regulators will increasingly expect lenders to play their part in achieving net zero by transforming the composition of their mortgage book. In doing so, lenders must be alert to the risk of consumer detriment and the standards of consumer protection expected under the new Consumer Duty. Green mortgages present consumers with complex choices and trade-offs and lenders must ensure they are provided with the information they need to make informed choices. In time, lenders may look to use pricing to transform the composition of the book. They must ensure their green mortgage products offer fair value and have strong controls in place to avoid exacerbating vulnerability, financial exclusion, and energy poverty amongst consumers.

Box 1: Regulatory initiatives: the energy performance of mortgage portfolios 

Regulators are focused increasingly on the transition risks posed to lenders’ mortgage portfolios by tightening energy efficiency standards.

• In the UK, participants in the PRA’s recent Climate Biennial Exploratory Scenario (CBES) were required to assess the impact on their commercial and residential mortgage exposures of the transition to higher energy efficiency standards.
• Under the EBA’s pillar 3 disclosures on ESG risks, banks must disclose information on ‘exposures towards sectors that highly contribute to climate change’. This includes information on the energy efficiency of the real estate portfolio (commercial and residential).
•  In its advice to the European Commission on the revision of the Mortgage Credit Directive, the EBA has proposed that, when conducting credit assessments, institutions consider ESG factors affecting the value of collateral, for example the energy efficiency of buildings. This reflects similar obligations regarding the valuation of property under the EBA’s guidelines on loan origination and monitoring.

Finally, Article 208 of the CRR3 proposal states that changes to a property that increase energy efficiency are to be regarded as unequivocally increasing the value of the property for revaluation purposes.

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1. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1051408/2020-final-greenhouse-gas-emissions-statistical-release.pdf
2. https://edu.bankofengland.co.uk/speech/2022/july/anil-kashyap-speech-on-climate-reporting-and-risk-management
3. https://www.ukfinance.org.uk/system/files/UK%20Finance%20response%20to%20BEIS%20on%20EPC%20owner%20occupied%20homes.pdf
4. https://committees.parliament.uk/publications/3955/documents/39643/default/
5. https://www.ukfinance.org.uk/system/files/UK%20Finance%20response%20to%20BEIS%20on%20EPC%20owner%20occupied%20homes.pdf
6.  Improving home energy performance through lenders: consultation (publishing.service.gov.uk)
7. https://www.fca.org.uk/news/speeches/supporting-consumers-challenging-times
8. https://www.fca.org.uk/publications/corporate-documents/strategy-positive-change-our-esg-priorities
9. FCA Climate Change Adaptation Report