Polluting companies use transition bonds to move to a greener future

• Sustainability linked bonds see dramatic increase with 70% of total sold in 2021
• Transition bonds can contribute to a third of the $3 trillion needed to meet climate targets
• Effective transition requires clear international standards

Unlike green bonds, transition bonds are issued by companies in brown industries. These companies are high carbon emitters and largely rely on fossil fuel. They are unable to completely turn green due to their inherent reliance on carbon-intensive resources and therefore they are largely barred from selling green bonds.

Transition bonds are a new asset class targeted by these brown industries such as oil and gas companies to allow these not-so-green companies to finance their efforts to reduce carbon emissions. The proceeds from transition bonds are used for projects that support gradual reduction of carbon emissions. The deals that have been concluded so far include Castle Peak Power’s $300 million sale in February 2021. The company has committed to transfer proceeds towards construction of a gas turbine power station unit in Hong Kong. Bank of China’s Hong Kong branch issued a transition bond worth $780 million for projects that can support China’s Paris Agreement target of attaining carbon neutrality by 2060.

Sustainability linked bonds see dramatic increase with 70% of total sold in 2021

The COVID-19 pandemic has emphasised the need for private banks and investors to account for environmental, social, and governance (ESG) and has altered business values despite the market turmoil. According to Morningstar, this rising spotlight on sustainability linked investments has pushed the global assets under management (AUM) to more than $1 trillion in 2020. According to UNPRI, the Asia Pacific (APAC) region accounted for 2.4% of assets in sustainable funds.

Helge Muenkel, head of APAC sustainable finance at ING Bank, said, “The absolute amount of sustainable debt being issued in APAC is rising strongly, and so is the share of sustainable debt as a percentage of total debt in APAC. We also see a better diversification of structures, including more forward-looking, sustainability-linked financing structures”.

According to the non-profit organisation, Climate Bonds Initiative (CBI), 11 transition bonds were issued in 2020 and therefore the number in 2021 shows a slow growth. The International Capital Market Association (ICMA), an industry trade group, stated that although gaining traction for transition bonds has been slow, the financial industry’s appetite for sustainability linked bonds has been increasing. Leading up to the UN Climate Change Conference in November 2021, there has been a rising interest in sustainability linked bonds, with 70% of the $15 billion worth of sustainability linked bonds sold this year, include climate targets, according to ICMA.

Marisa Drew, the global head of sustainability strategy, finance and advisory at Credit Suisse, said, "While much of the focus on the capital markets has been on green and sustainability bonds, we see transition bonds as being a significant game changer in terms of broadening the universe of issuers who can begin to transition towards sustainability”.

Transition bonds can contribute to a third of the $3 trillion needed to meet climate targets

According to the research report commissioned by the committee on industry, research and energy of the European Parliament, energy-intensive industries (EIIs) account for nearly 22% to 30% of global carbon emissions. Decarbonising these EIIs will cost approximately $1.6 trillion per year. The UN Intergovernmental Panel on Climate Change had estimated that to reach the target to limit global warming to 1.5 degree Celsius under the Paris Agreement total private investments needed would be about $3 trillion annually. However, in 2019 the global total investments in energy projects accounted for only $635 billion, according to the International Energy Agency.

Amina Mohammed, the Deputy Secretary-General of UN, made a remark at G7 climate and environment ministerial meeting in May 2021 that public finance is $20 billion short of its target. Given this backdrop, S&P Global Ratings estimated that a new asset class such as the transition bond could offer some relief and provide up to $1 trillion of the estimated $3 trillion needed annually over the next 30 years for meeting the climate targets.

Muenkel said, “Transition finance acknowledges the fact that not all economic activities are ‘green’. In order to accomplish the overarching goal of limiting global temperature rises to around 1.5 degree Celsius as compared with pre-industrial levels, investors cannot only focus on financing green economic activities, but must also help brown activities become less brown. This will help investors to diversify their ESG investments”. He added, “Our Terra approach, which is a collaborative and sector-specific approach helps our clients transition to more sustainable business models. It stipulates that we will align our global lending book of about $827 billion with the goal of the Paris Agreement”.

Effective transition requires clear international standards

Sean Kidney, CEO at Climate Bonds Initiative, said, “Now we must tackle hard to abate sectors such as steel, oil and gas, plastics and cement. We need to transition them quickly, financing them with transition bonds”.

Regulatory and government bodies are leading the way. For example, the London Stock Exchange rolled out a transition category on its sustainable bond market in February 2021. The Japanese Ministry of Trade and Industry is also being pressured to launch and set a goal of selling 30 transition bonds by 2023. Another key announcement was made by the Asian Development Bank that it would no longer finance fossil fuel projects.

Although many seem to find this new asset class promising, transition bonds offer more room for greenwashing as compared with green or sustainable bonds as there is an absence of clear international standards of what constitutes “transition”. To address this rising concern, ICMA released the climate transition finance handbook, which provides strategies for transition for issuers. The guidelines for companies include four key elements - stating the climate transition strategy to investors, ensuring that the climate strategy is relevant to its business model, using science-based targets to design their climate transition strategy, and maintaining implementation transparency.

Transition bonds offer a starting point for carbon-intense companies to start their journey towards a green and sustainable future. However, more work needs to be done in terms of standardisation of the sustainable and transition bond market and mandatory disclosures on how the proceeds of the bonds are used and what is the impact of the project financed through these bonds.