13 November 2020
Is a transition bond label still needed now that the Sustainability-Linked Bond Principles have been published?
Yes, argues Marisa Drew of Credit Suisse
First, let me explain why we launched in September the Financing Credible Transitions white paper with the Climate Bonds Initiative (CBI). The documents present a framework designed to support the rapid growth of a transition bond market and define what a transition label should encompass. The genesis for this work came about following an increasing level of dialogue with multiple types of stakeholders with a keen interest in fostering a capital markets response to financing the transition of high carbon-emitting sectors toward Paris alignment.
I was hearing directly from institutional debt investors who were keen to put more money to work in sustainable strategies generally but also specifically in supporting transition opportunities. In addition to wanting to see more brown-to-green corporate issuance, they wanted to see a broader definition and more diversity in the 'uses of proceeds' in the green bond market and participation from more issuers along the credit curve. Today the green bond market is overweighted towards high-investment-grade sovereign, FIG and real estate issues, and there is not as much participation from corporates and lower rated credits.
In respect of transition investment opportunities, investors were also were also beginning to grumble about the fact that there are many self-labelled 'transition' or other types of labels cropping up but with no consistency to the labels and no agreed methodology or market-adopted framework to govern the transition market and help protect it from greenwashing.
Meanwhile, from the issuer community, I was hearing a great deal of frustration from high carbon-emitters that really do want to make the investment to transition, but do not qualify under existing green bond market principles to access that market. These companies recognise that they need a huge amount of investment to migrate their business models and would like to access a dedicated pool of transition-aligned capital.
The third constituent I was interacting with was the regulatory community asking for the capital markets to play an active role in financing the acceleration of corporate transitions.
In response, we surfaced these issues to the CBI, who agreed that there was a gap in the market. We first explored the possibility to expand the existing Green Bond Principles (GBPs) in an attempt to bridge this gap and meet these stakeholder requests. There was, however a general reluctance to adjust the GBPs because they are well understood by the market and operate effectively and efficiently at scale, which they did not want to risk disrupting.
Instead, we birthed the notion of creating a 'sister market' to sit alongside the green bond market, with a specific framework and robust set of principles for those dedicated to a sustainable transition. And after a year's work we came out with a paper to articulate this vision. For issuers looking to use the transition label, it prescribes five principles (See box).
Given the investment needs of trillions of dollars to ultimately get us globally to a net zero emissions status, we wanted this framework to have a broad reach and to apply not only at a use of proceeds level but also at an enterprise level – we are trying to encourage whole-business model transitions in addition to investments in greener activities or projects. And we want to make sure that the transition label and concept is not limited to debt; we think this should be applicable to equity issuances, asset-backed structured solutions, and so on.
The five transition principles
The Financing Credible Transitions paper lays out five principles for an ambitious transition:
- Align with zero carbon by 2050 and nearly halving emissions by 2030;
- Be led by scientific experts and not be entity- or country-specific;
- Be sure that credible transition goals and pathways don't count offsets;
- Include an assessment of current and expected technologies which can be used to determine a decarbonization pathway;
- Be backed by operating metrics rather than a commitment or pledge.
On the issue of whether a transition label, framework and standard in the bond market is still needed following the publication of the Sustainability-linked Bond Principles, we actually think sustainability-linked bonds and loans represent a subset of transition finance that can neatly fall under our proposed transition framework and ethos.
They are not mutually exclusive – we think they're actually complementary. That said, not all issuers or investors want to see their coupons linked to sustainability KPIs and linking the cost of capital to KPIs does not work for all asset classes. We want to encourage the broadest, most inclusive lens when thinking about the provision of capital to fund transitions while still protecting the integrity of the markets to allow them to scale with confidence.
Marisa Drew, is chief sustainability officer and global head of sustainability strategy, finance and advisory at Credit Suisse.
Note: For the purposes of this article, the term Transition Bond refers to 'use of proceeds' bonds only
Let me be clear to begin with – 'Climate Transition Finance' is arguably the most important topic for the sustainable finance market to deal with in the coming 12-36 months. And rightfully so.
We have already spent considerable time on accepting Green into the mainstream, and have even gone to great lengths in codifying this in a Taxonomy as part of the EU's Sustainable Finance Action Plan. This inevitably leaves the topic of 'Brown' or 'Transition' (recognising that these terms are not synonymous) as the next, but not final, frontier.
Indeed, this was recognised by the EU-appointed Technical Expert Group on Sustainable Finance in their final report on the Taxonomy, where they highlighted that a fully realised Taxonomy should incorporate also "technical screening criteria for significant levels of harm to environmental objectives. (...) So-called 'brown' Taxonomy criteria."
The case against 'Transition Bonds'
With that said, let me also be clear and state that I do not believe the market currently needs a new Transition Bond label. The key reasons for this are:
- 'Transition' is already baked into the Green bond market. This is eloquently formulated in the 'Shades of Green'1 methodology, where, in essence, anything that is not 'Dark Green' represents transitioning.
- Green bonds are/should be for everyone. To this point, it is somewhat hollow to say that an oil company can't issue a green bond if you would buy a green bond from any of the major banks, most of whom have significant oil-related exposure on their balance sheet. In any case, isn't a green bond from, say, an oil company seeking to invest into renewable energy not the purest form of transition there is?2
- In the absence of clear and well-agreed upon definitions for what constitutes a relevant transition (such that an updated Taxonomy would provide3 ) the risk of 'Greenwashing' goes up. To this extent, it seems to me that, from a broad market perspective, 'Transition Bonds' carry more potential downside risk than we can hope to gain from them.
Sustainability-linked structures are better suited to address transitioning anyway
More specifically to the point of this article, I maintain that Sustainability-Linked Bonds (SLBs) are better suited to deal with transitioning than Transition Bonds, for the simple point that sustainability-linked structures are forward-looking in nature, and use-of-proceeds are not (necessarily). That is, SLBs require improvements on a KPI – or the transitioning from something to something better.
That is in contrast to Transition Bonds, where we cannot guarantee overall improvement of the issuer, but simply that the underlying projects are "not as dirty as they could be".
Obviously the market for SLBs is still in its infancy and one could certainly highlight that we need better definitions of what "material" and "ambitious" means – especially in the context of transitioning. That said, I maintain that, for the time being, we are better off, as a market, to give SLBs our full attention instead of diverting it to a label that is not fully understood and which may call into question the validity of the overall labelled bond market. That hardly seems a sensible move to me.
Jacob Michaelsen is head of sustainable finance advisory at Nordea.
1- As popularised by ‘CICERO Shades of Green’, the second party opinion provider
2- I recognise that many would argue that this would require a credible transitioning story away from fossil-based energy production. A valid point, but one that deserves more nuance than can be afforded here.
3- There is already a number of credible and relevant initiatives providing guidance on this, such as the Transition Pathway Initiative