Sustainable finance: why transition bonds and loans are not popular even as demand for green and sustainable products is growing

Difficulty in defining and standardising the hurdles that projects need to overcome to qualify for transition finance is to blame, deal arrangers and asset managers say
Demand for sustainable investment is growing rapidly and there is ample room for transition finance to grow, Bank of America executive says

Green finance

Eric Ng

Published: 2:00pm, 2 Feb 2022

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Transition finance – or labelled bonds and loans that help companies transition their carbon-intensive operations to climate-neutral outfits aligned with global green ambitions – has failed to become mainstream despite rapid growth in recent years.

Difficulty in defining and standardising the hurdles that decarbonisation projects need to overcome to qualify for transition finance has been blamed, deal arrangers and asset managers said.

“The fact that transition bond and loan labels have not been used heavily is probably because there is understandably some caution by issuers and borrowers, given there isn’t an agreed set of standards for using such labels,” said Jonathan Drew, head of ESG Solutions at HSBC’s global banking and markets division. “Some may feel the label doesn’t give sufficient clarity, which is key in transition planning, and therefore feel it opens them to risk of criticism.”

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Transition bonds issuance globally nearly tripled in each of the past two years, from US$585 million to US$1.67 billion in 2020 and US$4.56 billion last year. Still, the combined value of last year’s nine deals pales in comparison to the US$485 billion of green bonds, US$180 billion of sustainability bonds and US$91 billion of sustainability-linked bonds issued, Refinitiv data shows.

Moreover, mainland China’s US$1.08 billion and Hong Kong’s US$296 million in transition bonds made up virtually all of the deals in Asia-Pacific last year.

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The proceeds of green and sustainability bonds are earmarked for specific projects with environmental and social benefits, such as wind farms and waste recycling facilities.

The use of proceeds from sustainability-linked bonds, however, is not restricted, but their coupon rates vary based on the attainment of sustainability targets set by the issuers.

The relatively thin transition finance deals are partly down to trade body International Capital Market Association (ICMA) not recognising a transition bond the same way it does alternatives like green or sustainable-linked bonds, said Nicholas Pfaff, its head of sustainable finance.

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For the latter, the ICMA has laid out clear guidelines for issuance and reporting, such as the categories of projects that qualify for green bonds issuance and the principles for selecting performance metrics for sustainability-linked bonds.

In the case of transition finance, aligning corporate actions with the Paris Agreement’s ambition of containing global warming well below two degrees Celsius by 2100 from pre-industrial levels is not a straightforward matter, especially for sectors such as aviation and cement, where carbon abatement technology is still under development.

“Climate transition needs to be underpinned by a corporate strategy,” Pfaff said. “So we decided that there shouldn’t be a new label for transition bonds. Instead, we issued a set of high-level recommendations for transition finance that would work for both use of proceeds and sustainability linked instruments.”

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An example of a transition bond is one that finances the construction of a gas-fired power plant. A Hong Kong unit of listed power utility CLP Holdings, which last September pledged to achieve net-zero carbon emissions by 2050, has issued three such bonds totalling US$1.15 billion since 2017.

While natural gas’s carbon footprint is half that of coal, it is a “transition” fuel that is not aligned with the Paris Agreement without a stringent cap on the plant’s operation years.

“The biggest concern with financing transition projects is that you don’t want to lock in high carbon-emitting activities which might meet your threshold now, but will preclude you from meeting your lower emissions goals 10, 20, 30 years from now,” said Gabriel Wilson-Otto, director, sustainability investing at Fidelity International, which has US$738 billion in assets under management.

“You have to be incredibly careful about the extent to which the commitment and the integrity of the issuer are solid. The complexities and different understanding around transition finance mean it can be challenging to rapidly scale up,” he added.

Still, demand for sustainable investment is growing rapidly and there is ample room for transition finance to grow, especially in Asia, provided there is sufficient transparency about projects’ sustainability credentials, said Joseph Pepping, head of the Asia-Pacific debt capital markets syndicate at Bank of America.

“Transparency and partnering with investors and rating and verification agencies will be key for borrowers and issuers of transition finance products to win support from a wider ecosystem of investors,” he said.

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