More awareness needed for transition bonds issued by coal miners, oil producers
Growth in renewable energy unlikely to be main driver for successful transition
TO UNDERSTAND what transition bonds are, we must first look at what other existing sources of funding are available within sustainable finance to see how transition bonds fit in.
The four main bond categories for sustainable finance are: green bonds, social bonds, sustainability bonds and sustainability-linked bonds. Collectively, they are often referred to as GSSSL bonds.
GSSSL bond issuance last year totalled around US$1 trillion, making up roughly 15 per cent of all bond issuances.
Green bonds made up around 60 per cent of GSSSL bond issuances in 2023, according to the Environmental Finance Bond Database. They provide financing for new and existing green projects, such as solar farms or sustainable waste management facilities, and usually require a commitment from the issuer to reduce its carbon footprint.
Social bonds ranked second by issuance size, at around 18 per cent of all GSSSL issuances last year. Proceeds of social bonds must finance activities that at least achieve positive social outcomes or address a social issue.
These projects are aimed at populations such as those living below the poverty line; marginalised communities; migrants; the unemployed; women and/or sexual and gender minorities; people with disabilities; and displaced persons.
A NEWSLETTER FOR YOU
Friday, 12.30 pm
ESG Insights
An exclusive weekly report on the latest environmental, social and governance issues.
Examples include Latin America’s first gender-focused social bond in 2020, to fund loans to eligible women-led businesses in Colombia and first-time female homebuyers on low incomes.
Sustainability bonds are a close third in terms of GSSSL bond issuance size, at around 16 per cent in 2023. These are issues whose proceeds are used to finance a combination of green and social projects or activities.
Sustainability-linked bonds have the smallest GSSSL bond issuance size, at around 7 per cent in 2023. These are not restricted to green projects, but are instead associated with sustainability goals set by the issuer.
Bond coupons are linked to achieving those specified goals or outcomes, and the issuer is usually liable to pay additional interest if these targets are not met.
Some sustainability-linked bonds could also require the issuer to divert more funding to sustainability-related projects. This is meant to address a perceived complaint – that investors in sustainability-linked bonds stand to benefit financially from an issuer’s inability to meet its sustainability goals per the bond documentation.
What are transition bonds?
Transition bonds are a nascent financing tool whose proceeds are used to reduce an issuer’s environmental impact through decarbonising fossil fuel and hard-to-abate sectors that would not normally qualify for green bonds. Such sectors might include steel, cement and petrochemicals.
Companies issuing transition bonds are also required to have a transition strategy and transition bond framework.
Last year, transition bond issuances came to about US$3 billion. For some perspective, sustainability-linked bonds, the smallest GSSSL group, chalked up about US$66 billion in issuances in 2023.
Like green bonds, transition bonds aim to finance a specific sustainable project. Whereas the green bond issuer typically is viewed as already operating sustainably, however, transition bond issuers are usually in the process of transitioning to lower-carbon operations.
In the past, the Asian Development Bank (ADB) refused to fund coal mining, and oil and natural gas production and exploration. This policy was later revised to ensure reliable and affordable access to energy throughout developing countries in Asia and the Pacific, in addition to promoting the low-carbon transition in the region.
The introduction of transition bonds may give ADB an avenue to support the dual aims of its energy policy, and provide financial support to coal plants transitioning to cleaner solutions.
Hurdles and drivers
We believe there are two major hurdles in the adoption of transition bonds – the poor reputation transition bonds have attained, and a lack of established standards.
Transition bonds have a reputation for being a potential outlet for greenwashing, or transition washing, to use a more recently coined term, in which a company’s environmental performance or intentions are exaggerated or misrepresented.
Such perceptions exist as most issuers of transition bonds are companies with significant existing levels of carbon emissions, and most of them are not known for being environmentally conscious to begin with.
The lack of consistent international standards required to issue a transition bond could also be interpreted as greenwashing, as the steps taken may be too small or inconsequential or, at worst, undefined.
This latter shortcoming may be changing, though. The International Capital Market Association (ICMA) in 2020 released a Climate Transition Finance Handbook, and in February 2024 published a report titled Transition Finance in the Debt Capital Market, to define transition finance and “further unlock the potential of the sustainable bond market to finance transition”.
The association represents financial institutions active in international capital markets worldwide, and is a key standard setter for labelled bonds.
ICMA further noted the International Sustainability Standards Board’s new sustainability corporate reporting standards and the European Sustainability Reporting Standards as opportunities for transition finance to play a more mainstream role in the GSSSL bond market, and proposed the voluntary adoption of transition plans in preparation for more established market standards.
It is worth noting, however, that ICMA has not issued principles for transition-labelled bonds. Its Climate Transition Finance Handbook argues that transition is best conceived as a theme that can be financed by green and sustainability bonds, as well as sustainability-linked bonds, while recognising the development of a “climate transition” label adapted notably to certain jurisdictions and regions. The handbook also adds that transition plans can be financed by unlabelled bonds.
We have identified three main drivers for transition bonds:
1. The incentives issuers and buyers have for using transition bonds
The issuer’s main incentives would be a lower issuing cost and an improvement in reputation. The pricing premium – or greenium – has been diminished lately, however, due to stabilising demand from buyers amid record issuances of GSSSL bonds.
In 2018, the average greenium was around 5 per cent. In 2023, it was near zero. Unless there is greater support from governments to lower issuing costs, for example in the form of tax incentives or a change in perception on transition bonds, it is unlikely that transition bonds will gain traction among both buyers and sellers.
2. A push for domestic issuances over international issuances
Japan was the first in the world to issue sovereign climate transition bonds, and the country has been a huge advocate for transition bonds – about two-thirds of all transition bonds have come from Japanese issuers. It is likely that Japan is pushing for transition bonds due to its heavily industrialised economy.
Another major issuer of transition bonds could be China. The steel industry in China accounts for about 5 per cent of its gross domestic product, and represents around 15 per cent of the country’s total carbon emissions. The Climate Bonds Initiative estimates China’s steel industry will require investments of around 20 trillion yuan (S$3.8 trillion) to achieve carbon neutrality.
It is likely that the future of transition bonds is going to be heavily influenced by the success of the issuances in these economies.
3. Continued demand for fossil fuels
While great amounts of effort are being put into eliminating the need for fossil fuels, there is no widespread alternative to jet fuel or ship diesel – which means steady or even rising fossil fuel use as the economies of developing countries grow.
There is still a range of industrial processes, such as cement-making and the production of plastic, that will possibly collectively fail to meaningfully cut carbon-intensive fuels by 2050 as well.
While industries such as land transport and energy have seen great levels of innovation and commitment to reducing carbon emissions, others such as aviation, shipping and manufacturing are facing much greater difficulty transitioning as there really is no clear cost-effective alternative to fossil fuels.
Industrial processes, notably, make up a huge fraction of emissions and yet are extremely difficult to reduce. Global fossil fuel use is expected to flatten or decline by mid-century before starting to grow again, due to rising energy demand in various parts of the world.
There is wide recognition that achievement of net zero by 2050 will be an uphill battle, albeit a vital one. The faster growth in renewable energy is encouraging, but it is unlikely to be the main driver for a successful energy transition.
It may be time to look past the reputations of companies in hard-to-abate sectors and give them a chance to change. Transition bonds could provide the avenue for that with proper incentives guided by established standards for such bonds, leading to an improved reputation and greater market acceptance.
The writer is credit research analyst at OCBC
Copyright SPH Media. All rights reserved.
