Transition Bonds

What are Transition Bonds?

Transition bonds and transition financing are evolving concepts that would enable issuance of debt that would not likely satisfy green financing requirements. The proceeds would be used to fund a firm’s transition towards a reduced environmental impact and/or to reduce their carbon emissions. The proceeds could be used exclusively to finance new and/or existing eligible transition projects, and the issuer would be required to commit to shifting to more sustainable business practices.

While transition financing does not require the project or the issuer to be classified as “green,” the issuer would be required to use the proceeds for climate transition-related activities. Some possibilities for eligible use of proceeds include:

• Carbon capture and storage
• Switching coal plants to natural gas which produces less greenhouse gas emissions
• Waste-to-energy
• Switching diesel powered ships to natural gas
• Use of recycled raw materials and/or higher levels of recycling

One of the earliest examples of a transition bond reflects the rationale for these financing instruments. The transition bond was issued in 2019 by a Brazilian beef producer, Marfrig who had previously tried unsuccessfully to issue a green bond in attempts to clean up its supply chain by using funds to buy only from suppliers that had committed to not destroying the rainforest. This lack of success was the result of conflicting issues. In particular, Marfig operated in a “brown” industry, which was unlikely to meet “green” standards. However, they were attempting to improve, and were displaying “best in class” (sector) behaviour. Eventually, the solution to this dilemma was to repackage the issue as a “sustainable transition bond.” The resulting 10-year $500-million US issue ended up being three times over-subscribed with a 6.625 per cent coupon (below its recent $1-billion US 7-year issue coupon rate of 7.25 per cent).

Why are transition bonds important?

The potential importance of transition financing is clear from the March 18, 2020 statement from Mark Carney speaking before the UK’s House of Lords EU Financial Affairs Sub-Committee:

“If we are concerned about this whole economy transition and we are concerned about mainstreaming sustainable finance then you need that whole transition bucket in the middle rather than just ‘green’ and ‘brown’ finance.”

Potential global demand for transition financing is reinforced by comments from Michael Ferguson, who works on sustainable finance at S&P, who noted in a 2019 interview:

• green bond issues are on average five times oversubscribed
• the pace of green bond issuance is “simply not enough to meet demand”
• this leaves a significant void that banks hope to fill with transition bonds
• there is “excess demand for environmentally sensitive investments”

Ferguson went on to state: “The universe of potential investments that would fall under transition bonds as opposed to green bonds is a lot larger, so it seems to me there would be a much bigger audience and potentially a pricing advantage.” However, the issue remains controversial, with opponents citing concerns over “greenwashing.”

What are the guidelines and criteria?

To date, few formal requirements exist for transition bonds. However, in December 2020, ICMA launched new guidelines on climate transition finance to complement the Green & Social Bond Principles.¹ Specifically, the ICMA Climate Transition Finance Handbook is based on the notion that “The concept of climate transition focuses principally on the credibility of an issuer’s climate change-related commitments and practices.” In other words, specific use of proceeds is only part of the story. To qualify as legitimate transition financing, the issuing firm must demonstrate it is part of a broader and credible firm-level transition strategy.

ICMA further notes that transition pathways must be tailored to the sector and operating geographies of an issuer, and notes that issuers are generally at different starting points and on different pathways. As such, the document does not seek to provide definitions or taxonomies of transition projects but rather, it is intended to provide clarity on “the issuer-level disclosures which are recommended to credibly position the issuance.” Such disclosures should reference relevant elements in connection with any specified use of proceeds, and these disclosures “could be included in the company’s annual report, framework document, or investor presentation, as long as they are publicly accessible to investors.”

ICMA recommends four key disclosure elements (and some potential components thereof):

1. Issuer’s climate transition strategy and governance
2. Business model environmental materiality
3. Climate transition strategy to be “science-based” including targets and pathways
4. Implementation transparency

What are the challenges?

There is lingering skepticism about green bonds, particularly as no universally accepted standards have been adopted. Garnering public trust in transition bonds as a solution for climate change, rather than as vehicle for firms to make themselves appear more environmentally friendly (often referred to as “greenwashing”), is difficult. To avoid greenwashing and distrust, there needs to be well-defined and widely accepted criteria for eligible transition bond projects and reporting requirements.

What’s happening in Canada?

Transition financing can be critically important for Canada, given our resource-based economy, and the fact that many transitional activities may not technically qualify as “green investments,” despite the fact they would contribute to important improvements. Transition bonds offer Canadian firms an opportunity to access funding markets at reduced rates for projects designed to reduce their negative environmental impact. This will allow Canadian firms an opportunity to transition from high-carbon to low-carbon while reducing the negative economic impacts associated with an immediate exclusion from low-cost funding markets. In fact, one of the recommendations from the Expert Panel on Sustainable Finance is to work with financial sector leaders to accelerate Canada’s supply of liquid green and transition-linked fixed income products.

What’s the future of transition bonds?

Still in its early stages, regulations are not yet in place for the commitments required by companies to be eligible for transition bonds. However, firms will likely be required to commit to specific targets and broader sustainability goals. If the number of firms seeking financing for environmental projects continues to increase and institutional investment grows, transition bonds may experience growth like that of sustainability-linked loans.

• ¹Source: Climate Transition Finance Handbook, 2020.