Green bond market starts to tackle the tough questions
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Green bond market starts to tackle the tough questions

Transition bonds are likely to play a prominent role in labelled debt markets in 2021, after the market produced long-awaited guidance in December. As Jon Hay reports, the new market is bound to provoke disagreement — but it will be a creative conflict.

Green bonds have become intensely popular and influential, even spawning broods of regulations in China and Europe — now being copied elsewhere in the world — whose effects go far beyond that product. But they have barely touched many industries with high carbon emissions, which need to go green most urgently.

That is about to change. “We are speaking to all the major oil and gas companies in our client base, as well as other transitioning sectors such as heavy industrials and the aviation sector,” said Arthur Krebbers, head of sustainable finance for corporates at NatWest Markets in London. “The discussion has ramped up significantly in the last two or three years, from them not wanting this as an agenda item to now requiring detailed advice on what instruments are available.”

Of all green, social and sustainability (GSS) bonds ever issued, according to Dealogic, 50% have come from public and private financial institutions, 16% from government and 34% from companies. Of that third, 80% are from just three sectors: power and utilities; property; and transport, mainly rail.

But if climate change is to be moderated, all sectors will have to go green or disappear — from oil to cars, heavy machinery to steel, cement to aviation.

Hence the urge, which bubbled to the surface of the market in 2019, for transition bonds — a variant of green bonds to address companies “which are ‘brown’ today but have the ambition to transition to green in future”, in the words of a white paper by Axa Investment Managers in June 2019.

In gestation

So far, transition bonds are more of an idea than a market. About 10 deals have been issued since 2017, by borrowers including gas transporters Snam and Cadent and the European Bank for Reconstruction and Development. Meanwhile, cumulative issuance of GSS bonds has swelled to more than €1tr.

Yet this has changed little in the real economy. Although green bond investors like to call them impact investments, nearly all green bonds finance activities the issuers were doing anyway.

“The first 10 years of this green finance revolution from 2010 to 2020 were about doing a stock-take, a footprinting exercise — ‘what do we have today?’” said Yo Takatsuki, head of ESG research and active ownership at Axa and one of the white paper’s authors. “It has now become much more about ‘where are we headed?’ To meet net zero, we have to take out half of human emissions by 2030. That’s going to take a huge push.”

He was speaking at the launch in December of the Climate Transition Finance Handbook, the first formal guidance the Green and Social Bond Principles organisation has produced for transition bonds. It could be a key that unlocks a more vibrant market.

The slim transition Handbook is the fruit of a year’s work. It would offer “a bridge… for hard-to-abate sectors to access GSS financing,” said Denise Odaro, head of investor relations at the International Finance Corp and chair of the GSBP’s executive committee.

Review 2020

It may not take long. At the end of October, Patrick Pouyanné, CEO of Total, the French oil company, said the firm planned to issue a “very large” transition bond.

When that happens, many will be sceptical. Total declared in May that it planned to get to net zero emissions by 2050, including those from customers burning its products — in Europe. Worldwide, however, it will only reduce carbon intensity — the emissions for each unit of energy — by 15% by 2030 and 60% by 2050.

Should environmental, social and governance (ESG) investors support such a company?

Deciding whether something is green is no easy task. The financial sector’s thirst to be told the answers has led the European Union to create its Taxonomy of Sustainable Economic Activities — an encyclopaedic rulebook dictating what financial players can officially call sustainable. 

Its first two chapters, covering climate change mitigation and adaptation, are likely to be completed in January after a hasty final consultation ending in December.

Already, the Taxonomy is causing problems. Bank issuers of green bonds — many of them backed by mortgages on energy-efficient homes and commercial buildings — are up in arms because the Taxonomy will categorise as sustainable only properties with an Energy Performance Certificate grade of A.

This covers about 1% of European buildings. Up to now, green bond issuers have tended to follow the Climate Bonds Initiative, an NGO, which suggests the top 15% of buildings in any location should count as green.

More worryingly, the Taxonomy is set to class biofuels as sustainable — though, when burnt, they produce roughly as much CO2 as fossil fuels, sometimes more. 

The gas industry is fighting to raise the Taxonomy’s cap for energy generation of 100g of CO2 per kilowatt hour — something that would appal many environmentalists.

What is transition?

The green bond market has largely avoided controversy, by sticking to assets and projects that most issuers and investors are happy — rightly or wrongly — to agree are green. 

This made it easy for market participants to write guidelines — the Green Bond Principles — which are purely formal and do not address the content of bonds.

The same will not be true for transition bonds. The whole idea is that they are for non-green issuers and assets. The central question in trying to create the market is therefore working out how fast and deep the transition of a given activity or set of assets needs to be, for it to be eligible for labelled transition financing.

As Sean Kidney, CEO of the Climate Bonds Initiative, puts it: “You can’t have a transition to nowhere. It has to be a transition to somewhere, and that has to be the Paris Agreement.”

Faced with this challenge, the GSBP has gone further than it has dared go before in steering market participants to what level of greenness they should aim for. Its Handbook clearly guides issuers that they should have long-term targets aligned with the goals of the Paris Agreement, meaning limiting global warming ideally to 1.5C.

“The climate transition strategy [of an issuer] should be based on science-based targets and pathways,” said Farnam Bidgoli, head of sustainable bonds at HSBC and one of the Handbook working group’s co-chairs, at the launch. “Investors expect that the transition trajectory should be quantifiable, measurable, benchmarked against science-based trajectories where these exist, and should be publicly disclosed and verified by other bodies.”

This is a world away from the bland suggestions in the early versions of the Green Bond Principles of the kinds of activities issuers might want to finance. But it does not constitute a set of standards in itself.

The Handbook also carries several other important decisions that will shape the market. 

It does not establish transition finance as a new kind of bond, but as a kind of conversation issuers can have with investors when issuing a labelled debt instrument. This conversation should be about the transition the whole organisation is making, not just about a subset of its assets.

The debt instrument might be either green bond-style notes with a defined use of proceeds or sustainability-linked bonds, in which the use of proceeds is free but the coupon penalises the issuer if it fails to hit a sustainability target.

Review 2020

The similarity between SLBs and transition bonds has gradually become apparent, especially since Enel, the Italian power and gas firm, has been joined in issuing SLBs by other issuers, from Brazilian paper company Suzano to fashion house Chanel.

SLBs are inherently about transition, since their step-up coupons are linked to the issuer improving its sustainability performance.

In October, Etihad Airways issued the first deal explicitly called a transition SLB — a $600m sukuk. It was also in form a green bond, since the proceeds were earmarked to support Etihad’s transition. The Abu Dhabi state-owned firm has ambitious decarbonisation plans, including a 50% reduction in net emissions by 2035.

The two products will not merge. Some SLBs do not concern the climate transition at all, such as pharmaceuticals group Novartis’s deal in September, linked to Novartis treating more patients.

But together, transition bonds and SLBs are changing how the labelled debt market works.

Green bonds are based on the idea that if the issuer allocates bond proceeds to a defined green use, the investors have invested in a green way. 

This makes them a weak instrument for ESG investing. Green bonds only tell investors about a small part of the issuer’s activities, while leaving them exposed to the risk of all of them. Nor do green bonds guarantee a change in an issuer’s total environmental impact.

With transition bonds and SLBs, labelled debt investors will at last be doing what true ESG investors should always have done — studying the whole organisation they invest in.

How far, how fast?

If the green bond market clamoured for standards, transition finance will need them still more.

In fact, the Taxonomy defines transition activities. But although the EU created the Taxonomy to satisfy green bond market participants, they do not seem confident they will be able to rely on it for this.

The Handbook points to the Taxonomy alongside other sources of verification, such as the Science-Based Targets Initiative and Transition Pathway Initiative.

In September, the Climate Bonds Initiative and Credit Suisse produced a 40 page paper, Financing Credible Transitions, intended to set out, in more detail than the GSBP Handbook, how transition finance could protect itself from greenwashing. It distinguishes between activities that will have a future after 2050 — such as steelmaking — and those that will not, such as coal. 

The guide insists that companies should use the best available technology, and that carbon offsets do not count. Already some bankers are saying this is too ambitious.

In the green bond market, hardly any deals have been controversial. In transition finance, every deal will be. But the market will be doing more useful work — engaging issuers’ and investors’ minds on the real question: what technologies and investments will actually help society cope with climate change? GC

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