A Path Out Of ESG Limbo

Transition bonds are providing a way for companies in hard-to-abate industries to deliver net-zero emissions.

Don’t let the perfect be the enemy of the good. The sustainable-finance community seems to be embracing this Voltairean notion—if judged by the recent attention to transition bonds, sometimes called brown bonds, a debt instrument designed for ecologically “sinning” companies that have pledged to do better.

They may be coming just in time. Green bonds, a favored debt instrument of the sustainability minded, typically finance “deep green” projects like wind farms in the North Atlantic. But they may not be sufficient in themselves to fund the clean energy projects and worldwide infrastructure investment needed annually to limit global warming, according to the International Energy Agency.

That’s because green bonds typically aren’t an option for the world’s largest hard-to-abate sectors: iron and steel, chemicals and petrochemicals, aviation, shipping, cement etc. These collectively account for about 30% of global greenhouse gasses, noted S&P Global Ratings in March of last year. S&P believes that transition finance, including issuance, may be able to contribute up to $1 trillion of the $3 trillion per year required annually to bring these lagging enterprises up to speed.

Enter transition bonds, a relatively new tool designed for companies that would not normally qualify for green bonds. An energy company could issue a transition bond, for example, to finance its move from coal to gas-fired power plants or to fund the early decommissioning of a coal-fired power station. The United Nations’ COP26 convention last November, in which signatories agreed to move their economies away from funding fossil fuel projects, should provide further impetus for this instrument.

To be sure, transition bonds won’t replace green bonds anytime soon. Green bond issuance for 2021 came in at a record-setting $517.4 billion, according to the Climate Bonds Initiative. By comparison, use-of-proceeds transition bonds, still a “nascent” subgroup, had 13 issues in 2021, worth $4.4 billion.

Still, transition finance appears to be gaining steam. “With the surge in net-zero pledges by governments in the Asia-Pacific region,” in particular, “we think there is going to be a greater collective push to decarbonize the hard-to-abate sectors,” says Aditi Mathur, a partner and head of the India practice at Singapore law firm Shook Lin & Bok. “Transition bonds have a unique role to play and are well poised for a potential growth in volumes.”

In Japan alone, transition bond issuance could reach 1 trillion yen ($8.6 billion) annually “in several years,” reported S&P Global in December. “East Asia could be a future growth market for transition bonds,” notes Minolee Shah, senior associate and professional support lawyer in the Debt Capital Markets practice of Herbert Smith Freehills. “There have already been some Asian issuers that have tested the market—most notably Bank of China last year.”

Transitions And Linkages

There remains some confusion between green bonds, transition bonds and sustainability-linked bonds (SLBs), which are also growing in popularity among “brown” industry firms. The main difference between the last two is that transition bonds are “use-of-proceeds” instruments. That is, funds must be used for an expressed ecological purpose like capturing and utilizing gas leakage from a closed landfill. SLB-raised funds, by comparison, can be used for any business purpose so long as certain performance targets are met.

As an example, Repsol, a Spanish-based energy and petrochemical company, offered all three debt instruments last year, giving investors a choice. As the company explains in a use-of-proceeds statement, green bond proceeds are to be used exclusively for green-eligible projects in categories such as renewable energy, biofuels and biogas, clean transportation and manufacture of hydrogen from electrolysis using renewable energy; while proceeds from its transition bonds are designated for projects such as increasing energy efficiency, carbon capture and utilization, and others.

As for the SLB option, proceeds are slated for “general corporate purposes”—but the company would be subject to “a coupon step-up or increased redemption fee” if it fails to meet three sustainability performance targets, the third of which is a 50% reduction of its “carbon intensity indicator” from 2016 to 2040.

Energy Firms Could Be Served

In which industry sectors might use-of-proceeds transition bonds make the biggest impact in 2022? “Transition bonds will be particularly strong in the energy sector in economies like China, India, Indonesia and the rest of Asean,” says Mathur. “Coal-fired energy generation in this region is set to grow faster than every other energy source.” The Asean region is also one of the most vulnerable to the impacts of climate change. “Transition financing will be needed to significantly phase down this carbon intensive source of energy,” she adds.

Meanwhile, Japan’s Financial Services Agency; Ministry of Economy, Trade and Industry; and Ministry of the Environment last year issued their own official guidance, the Basic Guidelines on Climate Transition Finance, based on the Climate Transition Finance Handbook published in 2020 by the International Capital Markets Association (ICMA), notes Shah.

Japanese investors are “actively seeking transition finance,” confirms Anjuli Pandit, head of sustainable bonds for Europe, the Middle East and Africa, and the Americas at HSBC, telling Global Finance that Japanese investors tend to have their own ideas about sustainable finance and aren’t lockstep followers of EU taxonomy for ESG finance, which tends to be biased toward green bonds.

“They are very sophisticated, mature ESG [environmental, social and governance] investors; and they are clear about how they would like to promote transition finance in different parts of the world,” explains Pandit. Japanese investors have been sending regular requests to the market for transition bonds to fund projects. They even have demand outside of Japan, she adds.

Transition bonds have been around for several years but have yet to catch fire. Why should 2022 be different? After all, they are still “a very new product which issuers and investors haven’t fully come to grips with yet,” says Shah. By contrast, SLBs are surging in popularity; and investors, particularly green funds, are more likely to turn to them.

“This is partly due to a credibility issue in the market, as there is more scope for greenwashing with transition bonds,” Shah adds. With use-of-proceeds instruments, corporates and other issuers don’t have their feet held to the fire by performance targets as they do with SLBs. Mayur Mukati, associate director of sustainable finance solutions at Sustainalytics, says that some of the earlier transition bonds were issued without adequate criteria and with climate transition strategies “that pushed the market to question the credibility of such labels.”

In the short term, transition bonds may have to pay a premium in order to attract institutional investors. The fact that issuers may not be deemed sufficiently green by some means “they may have to carry a ‘brownium,’” paying investors more than a corresponding green bond would pay, says Antonio Vives, principal associate at ESG consulting firm Cumpetere.

European issuers and investors may be reluctant to embrace use-of-proceeds transition bonds, given the EU’s stricter ESG taxonomy and regulations, adds Pandit. Institutional investors are getting mandates from their clients such as, “I’m giving you this much capital, and I want x% invested in green bonds,” she explains. “We are not hearing, ‘I want x% held in transition bonds.’”

Options Abound

Some complain that there are too many types of sustainable bonds on the market today, creating confusion and redundancy. But more options may be better for now.

“Any kind of instrument that encourages disclosure and data and enables investors to have more access to information to make decisions at this time in history needs to be encouraged,” says Pandit. “Whether we call many of these issuances ‘transition’ loans/bonds or not, they are unquestionably bringing hard-to-abate sectors to the market,” says Mukati. “The growth in such issuances is more important than the label these issuances hold.”

All told, “The just transition to a low carbon economy requires massive capital reallocation,” says Shrey Kohli, head of Debt Capital Markets at the London Stock Exchange Group. “Many sectors, from energy to steel production, transportation and mining are exploring ways in which to finance a capital-intensive shift towards more-sustainable business models over the next decade or more.”

And while transition bonds may not transform issuers overnight into pillars of the environmental community, they can at least help such companies climb out of ESG limbo and put them on a path to long-term sustainability.