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ESG Focus: Transition Bonds – The Great Controversy

ESG Focus | Jul 23 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

Transition bonds – the controversial new asset class

The anaemic transition-bond market has suddenly become one of the hottest topics in the bond market today – and the stakes are high. 

– Transition bonds a US$1trn a year market
– The great debate that could threaten the transition
– The stakes are high
– Risks to investor

By Sarah Mills 

“Climate Transition Finance is arguable the most important topic for the sustainable finance market to deal with in the coming 12-36 months.” 
– Jacob Michaelsen, Nordea, November 2020

One of the hottest topics in the sustainable debt markets is that of a relatively new bond type designed to allow brown and not-so-green companies to finance their gradual shift to a cleaner way of doing business – the transition bond.

These bonds are designed to fund the imminent transition of nearly all of the world’s economies and corporations – a massive funding call.

In March, Standard & Poor’s Global forecast transition finance could account for US$1trn of the expected US$3trn annual funding required to meet climate goals. 

Others estimate the figure will be closer to US$1.6trn a year.

Yet uptake has been anaemic.

Bloomberg NEF notes that only six transition bonds had been issued this year to May, which compares with the Climate Bond Initiatives estimate of a total of 11 during 2020.

Dealogic notes that only US$7.3bn of transition bonds have been sold since 2017.

Most corporations and supra-nationals have favoured the loosely policed but more liquid green-bond market.

But big capital is expected to head “transitioners” off at the pass and corral them into transition finance – which is being treated as a new asset class.

Regulatory and government organisations are expected to lead the way. The London Stock Exchange launched a transition bond category in February on its sustainable bond market.

Japan’s Ministry of Economy, Trade and Industry is being pressured to sell 30 transition bonds by 2023.

The Asian Development Bank has announced it will no longer fund fossil-fuel exploration and will fund transition and environmentally supportive projects instead, including emission-control technologies.

The transition challenge

The problem for the powers that be is that many pure-play green funds, not to mention cautious investors, will not buy transition bonds – the prospect of stranded assets sending private capital running for the hills.

Fund managers, in particular, are baulking at the lack of clarity and risk.

Some countries like Germany avoided much of this argument, with the German government paying for much of the transition through taxpayer dollars; the quid pro-quo being labour deals.

But calculations suggest that outside wealthy Germany and a handful of others, governments have insufficient funds to support a transition of this scale and private investors are being called upon to foot the bill. 

The nature of transition bonds

There is no clear definition of transition bonds.

At present, transition bonds are use-of-proceeds or sustainability-linked bonds, directed specifically to transition but the difference between transition bonds and green bonds lacks clarity. 

The general idea is that green bonds fund innovation, then transition bonds provide funding to corporations to transition to the new technologies borne of the green bond market. 

Fossil-fuel dependent companies can still tap the green bond market for in-house green R&D, for example, but retrofits would fall under transition finance – particularly as the market progresses.

Transition bonds differ from green bonds in that green bonds are ideally dedicated to green impact – think innovation in green technology or water sustainability – although the reality is they are being used for retrofits.

In essence, the concept of additionality holds greater sway in the green market, and some argue that transitioning has a very low additionality quotient.

Green bonds tend to be earmarked for specific projects but transition bonds, while linkable to projects, ideally take into account the impact on the company-wide transition, and steps towards emissions reduction.

A matter of standards

As with all “green” financing, issuers are expected to comply with standards. 

The five transition principles are:

– Aligning with zero carbon by 2050 and nearly halving emissions by 2030;
– Be led by scientific experts and not be entity or country-specific experts;
– Be sure edible transition goals and pathways don’t count offsets;
– Include an assessment of current and expected technologies, which can be used to determine a decarbonisation pathway;
– Be backed by operating metrics rather than a commitment or pledge.

There is also a brown taxonomy and criteria being developed. 

The Climate Bonds Initiative is expected to kick-start the market with a transition bond framework covering four priority sectors: chemicals, metals and mining, plastics, and oil and gas. 

It will also determine which targets companies should meet (such as company-wide emissions) in order to qualify for transition issuance,

Meanwhile, the European Technical Expert Group suggests that such a taxonomy should (echoing the green bond principles of do no harm) incorporate technical screening criteria for significant levels of harm to environmental objectives.

The CBI is understood to be developing certification for the market, which might also help with the growing problem of transition-washing.

One of the main issues for investors was the lack of clarity in ICMA’s Climate Transition Handbook, published in December 2020, as to when a transition label can be applied. 

The handbook is a set of definition is under what qualifies as an investment under that framework, and this was perceived as a grating oversight.

The great debate

It is this risk-reward dilemma that has the capital heavyweights at odds, and threatens the future of the transition market.

The classification of transition bonds is arguably one of the most hotly contested topics in the ESG bond market.

At the moment, transition bonds are classified as both use-of-proceeds and sustainability-linked bonds (SLBs). 

In the past, the International Capital Market Association had no separate rules for transitioners and encouraged them to use the existing GSS bond market. 

Then, when the sustainability-linked bond market was established, they left it to the issuer to decide whether they opt for use of proceeds or sustainability-linked bonds.

But a heated debate is raging as to whether a transition-bond label is still needed now sustainability-linked bond principles have been published.

Environmental Finance also notes a growing push to expand the transition label from debt to equity issuances, and asset-backed structured solutions.

Of particular concern is that the format of transition bonds don’t guarantee company wide improvements: just that “underlying projects are not as dirty as they could be”. 

From a technical perspective, some believe that SLBs and loans represent a subset of transition finance (particularly given as transition finance is being treated as an asset class); not that transition finance should be a subset of sustainability-linked finance.

The stakes are high

Investors stand to benefit from step-up margin and penalties. Companies that miss targets will have to foot the bill. For now these penalties are low but are forecast to rise.

Also at stake is debt seniority. 

Regulators are signaling that use-of-proceeds issuance will be treated as senior debt but not SLBs.

Use-of-proceeds bonds, which are typically earmarked for projects, also have far less onerous penalties for failure to meet ESG targets; and they do not demand company-wide innovation (despite the transition principles) – for now at least.

Like the green bond market, a total miss will not result in loan default (nor will SLBs for now).

The SLB argument

The SLB camp also argues that transition bonds may mislead investors as to the green credentials of a transitioning company.

Transition-washing, a subset of green-washing, is rampant and is expected to escalate over the next few years as the stakes rise.

For example, Responsible Investor refers to a recent issuance from Indonesia’s state-owned electricity company PLN that was basically used to plug a working capital hole. The debt was also issued to PLN to improve its “credentialing”.

The Bank of China also tested patience with its false and misleading marketing of an US$781m transition bond, claiming it met the EU sustainable finance taxonomy (which it did not), and that it aligned with ICMA’s handbook (which it didn’t).

The SLB camp says transition bonds should be classified solely as sustainability-linked bonds, which are subject to step-up margins and penalties in the event targets are not met, to create a merit-based funding system.

They believe SLBs are better suited for transitioning because they are forward-looking in nature, whereas use-of-proceeds (with their project focus) are not.

SLBs demand improvement from a baseline, ensuring company-wide progress.

The more extreme SLB purists argue that even supporting efficiency upgrades in companies is a waste of money given the market is more than capable of driving the transition as companies seek ever more efficient sources of energy and water. 

They argue that transition bonds represent more of a fossil-fuel subsidy (often to laggard giants) than a destination worthy of green funds – money for nothing given pricing economies alone should drive the transition.

They claim providing funding subsidies to “recalcitrants” may delay rather than hasten the transition; and exacerbate losses in the long-term investment market from stranded assets. Laggards could well be defunct within a decade.

Many fund managers also support the SLB argument for technical reasons:

“We are better off, as a market, to give sustainability-linked bonds our full attention instead of diverting it into a label that is not fully understood and which may call into question the validity of the overall labelled bond market,” says Nordea’s global head of sustainable finance, Jacob Michaelson.

Many also note that in the absence of what constitutes a relevant transition, such that an updated taxonomy would provide, the risk of greenwashing goes up and that this suggests transition bonds carry more downside risk than is to be gained. 

If fund managers are to take a risk on transition, they expect to be rewarded, and SLB step-up payments and penalties for missed targets addresses this issue.

The use-of-proceeds/combo arguments

The use-of-proceeds (UOP) camp generally favours a double classification – one that allows brown companies to tap both use-of-proceeds and SLB markets.

The UOPs argue that the transition cannot be efficiently and politically achieved without such subsidies to some of the world’s largest economic powerhouses. 

They note that hard-to-abate sectors account for a large proportion of emissions and have the greatest impact. They also have greater transitioning challenges.

Then there is the democratic argument. The use-of-proceeds camp says transition is already baked into the green bond market and green bonds should be for everyone.

For example, if banks, with their broad exposure to the energy sector, can issue green bonds, why not oil companies?

They also argue that a transition market is being developed and that more options is likely to equate to a swifter transition.

Credit Suisse’s Marisa Drew, global head of strategy, finance and advisory, arguing for the defence in an Environmental Finance debate on the subject says the market should:

“…encourage the broadest, most inclusive lense when thinking about the provision of capital to fund transitions while still protecting the integrity of the markets to allow them to scale with confidence.” 

Odds are on sustainability-linked bonds

The odds are rising that transition bonds will be treated as a sustainability-linked bonds.

But not all issuers or investors want to see their coupons linked to sustainability KPIs and doing so doesn’t work for all asset classes.

Regulators may offer a solution to the innovation problem by implementing company-wide carbon-intensity commitments as a pre-requisite for use-of-proceeds issuance.

Certainly pressure on government organisations to issue transition bonds suggests a desire on behalf of the powers that be to test market appetite.

Risks to investors

When examining ESG risks, FNArena is usually talking to long-term investors – the sit-and-holds.

Risks do exist for short-term and medium-term traders, but volatility in energy prices is likely to remain a feature of global markets for some time, allowing trade-outs.

But these investors are keeping a keen eye to key ESG timelines.  

For example, the MSCI’s Net-Zero Tracker, listed companies have less than six years to align with the 1.5 degree Celsius warming target. 

Net-Zero aligned funds currently constitute nearly one half of the world’s assets under management and are growing rapidly – a few billion dollars in assets under management being added in the first weeks of July alone.

So when it comes to transition, what investors really care about is issuers strategies that lead to net zero.

Meanwhile, MSCI modelling suggests that there is potential for investors to make money from transitioning companies.

Institutional investors face an array of risks when investing in products with weak ESG performance, ranging from forced sales of bonds that don’t meet their standards to dissolution of the fund.

A lot will also depend on regulation. MSCI argues that new policies and investor-driven transition risk may be rising and suggests institutional investors may want to re-evaluate their bond portfolios – particularly the vanilla bond portfolios.

It suggests that a properly constructed transition bond from the right company could provide risk advantages over a standard bond. But as noted above, construction remains at the core of debate.

Equity market investors face the greater risk given green debt has seniority.

That could change depending on the complexity of instruments and lack of transparency as the market matures (think GFC).

Coming up

Our next article will be an introduction to the emerging sovereign GSS bond market.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

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