Transition bonds: a new tool to fund the shift towards climate sustainability?

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– Transition bonds are increasingly used to finance sustainable solutions

– Following 11 last year, six transition bonds have been issued so far in 2021

– It is estimated that they could total $1trn annually in the future

– There are concerns that the instruments could lead to “transition-washing”

As companies look to shift towards more environmentally sustainable modes of operation, transition bonds are increasingly being seen as a key financial tool for those in fossil fuel or heavy-polluting sectors.

Transition bonds are a relatively new class of debt instrument used to fund a company’s transition towards reduced environmental impact or lower carbon emissions. They are often issued in fields that would not normally qualify for green bonds, such as large carbon-emitting industries like oil and gas, iron and steel, chemicals, aviation and shipping.

Amid a heightened awareness of the need to reduce carbon emissions, many expected transition bonds to play a key role in global financial markets in 2021.

However, data compiled by BloombergNEF found that, as of mid-May just six had been issued this year. A total of 11 were issued during 2020 as a whole, according to analysis from non-profit organisation Climate Bonds Initiative (CBI), so 2021’s figure to date does not represent a huge increase.

The deals for 2021 include the $300m sale from Castle Peak Power in February, the proceeds of which will be put towards the construction of a gas turbine unit at a power station in Hong Kong, and the Hong Kong branch of Bank of China’s issuance of a $780m transition bond in January for projects aligned with China’s goal of achieving carbon neutrality by 2060.

Elsewhere, in January the European Bank of Reconstruction and Development issued a A$280m ($216.6m) transition bond to finance its portfolio of green transition projects, while in February Italian energy infrastructure company SNAM launched a €750m dual-tranche transition bond to help meet its goal of carbon neutrality by 2040.

Appetite for transitioning

While the uptake of transition bonds may have been a little slower than expected, there are some signs that they will play a more prominent role moving forwards.

In February the London Stock Exchange announced the establishment of a transition bond segment on its sustainable bond market, while there have been calls for Japan’s Ministry of Economy, Trade and Industry to introduce a goal of selling 30 transition bonds by 2023.

In another significant decision, earlier this month the Asian Development Bank (ADB) announced that it would no longer fund coal mining or oil and natural gas production and exploration.

While this was a blow to companies dealing in fossil fuel production, the announcement was an encouraging sign for the future of transition bonds in emerging markets, as the bank noted that it would continue to provide financial support for plants transitioning to cleaner solutions.

“ADB will support developing member countries to mitigate the health and environmental impact of existing coal-fired power plants and district heating systems through financing of emission control technologies,” the bank said in a statement.

Looking ahead, transition bonds are principally expected to benefit from broader global trends towards sustainable or green finance.

Analysis from the CBI released in April found that, despite the severe economic impact of Covid-19, a record $700bn in green, social and sustainable finance was issued last year, almost double the $358bn witnessed in 2019.

Indeed, in March Standard & Poor's Global predicted that transition finance could account for $1trn of the estimated $3trn in annual funding needed to meet long-term climate goals.

Concerns over “transition-washing”

Although many are optimistic about the value of transition bonds, others are concerned about how much of an impact they will actually have in bringing about positive sustainable and environmental outcomes.

A common criticism revolves around just how ambitious many of these transition bonds are, with the absence of clear international standards raising concerns about the potential for “transition-washing” by companies.

To help address this concern, in December last year the Switzerland-based industry trade group International Capital Market Association published the "Climate Transition Finance Handbook" to provide a framework for transition strategies.

The guide, which aims to create general rules for transition-themed green bonds and sustainability-linked bonds, stated that bonds with the “transition” label should clearly stipulate how the funding will be used to support the Paris climate accord.

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