The death of transition bonds

Lack of transition bond principles and lure of sustainability-linked bonds leads to stunted market growth.

The transition bond is dead – that was the verdict from Bram Bos, lead green bond portfolio manager at NN Investment Partners when he made his predictions for the sustainable debt market in 2022.

“I think they were dying in September and they’re dead now,” he said at the December press conference, adding that he had stopped tracking issuance levels because they are so low.

In a year in which sustainable debt smashed every conceivable record, transition bonds stood out for failing to rise to the occasion. A handful of issuers entered the market, but their contribution struggled to reach $4 billion, in a year that saw total sustainable debt issuance surpass $1 trillion.

Axa Investment Managers first proposed the label in 2019, warning that the green bond market could find itself “undermined by a desire for further issuance which the sector cannot currently provide” – in other words, spiralling demand could tempt companies to come to the market with deals to finance greener projects instead of truly green ones, posing a reputational risk for the booming asset class. Axa proposed a separate label for these issuers in a bid to encourage money to flow into companies in transition without risking accusations of greenwashing.

Muddied meaning

The lack of clarity on what can be considered for financing under the ‘transition’ label has been a major stumbling block for the development of these bonds. The International Capital Markets Association (ICMA) published a “climate transition finance handbook” at the end of 2020, but it failed to provide the same level of detail as the body’s Green Bond Principles and similar guidance for social, sustainability and sustainability-linked bonds.

As a result, agencies providing second-party opinions have assessed projects using different standards. ESG consultancy Vigeo Eiris reviewed Brazilian beef producer Marfrig’s transition financing framework against the Green and Social Bond Principles, while risk management firm DNV developed its own company-specific assessment criteria for frameworks from Italian utility Snam and British gas supplier Cadent last year.

Bos said this lack of uniformity has played a role in stunting market growth, claiming ICMA’s transition finance working group “ended nowhere, because they just couldn’t agree what it was”. He added that when a bond without a clear definition is issued, investors face uncertainty. “With some kind of standard being there, it’s clear what [the bond] is and investors can decide whether they want such a bond, but we didn’t even get to the second step.”

According to ICMA’s deputy CEO and head of sustainable finance, Nicholas Pfaff, the organisation had just published its Sustainability-linked Bond Principles when it began discussing the rules for transition finance, and the working group was unsure whether yet another set of principles was necessary.

“It’s not that the market isn’t doing anything about transition, it’s just they’re not doing it under the label”
Nicholas Pfaff, ICMA

“The conclusion of the group was you can use either sustainability-linked bonds or use-of-proceeds bonds to serve the transition, so it was better to give guidance that could apply to both,” he explains. “If you wanted to retain the transition label, you could call it a ‘green transition bond’ or a ‘transition sustainability-linked bond’ or shorten it to ‘transition bond’, but you’d have to tell investors what the underlying structure was. At the time, you were seeing a few use-of-proceeds bonds that were starting to be marketed as transition bonds, and the idea was to reset the debate and say ‘let’s look at this more holistically’”.

Many sustainability-linked bonds (SLB) are already measured against climate targets, including those validated by the Science Based Targets initiative, Pfaff says, and green bonds also fund transition projects – especially under the climate mitigation category. “So it’s not that the market isn’t doing anything about transition, it’s just they’re not doing it under the label.”

Colour blind

Aside from a lack of dedicated principles, the criticism attracted by some early deals may also have dissuaded issuers from entering the market. While Marfrig’s $500 million ‘sustainable transition’ bond in 2019 was three times oversubscribed and secured the company its lowest ever coupon at the time, it proved controversial. One former Mirova portfolio manager said that “brown to light-brown is not enough”. Green bond veteran and Climate Bonds Initiative founder Sean Kidney argued that Bank of China’s 2021 deal, the first to align with ICMA’s new guidelines, “should not be labelled as [a] transition bond” because its inclusion of gas was inconsistent with a 1.5C pathway.

Similarly, Snam, whose inaugural sustainable bond was labelled as a “climate action” bond, faced criticism from investors. Sanaa Mehra, EMEA head of sustainable debt capital markets at Citigroup, says: “Although investors recognised the importance of transition investments, they were not clear what the Climate Action Bond label signalled, as this pre-dated the establishment of the transition bond label and the ICMA Climate Transition Finance Handbook (CTFH).”

Later issuances that have adopted the transition bond label have been appreciated by investors, she said, as have Snam’s SLBs. Although the establishment of guidelines such as ICMA’s CTFH has provided market participants with clearer guidelines when using the transition bond label, possible greenwashing accusations “[do] make issuers a bit nervous”, Mehra adds.

A spokesperson for Snam tells Responsible Investor that the company “perceived some degree of scepticism” from mainstream investors that did not have in-house experts who could assess corporate transition strategies. However, the spokesperson continues, a growing number of investment houses are establishing ESG teams, and investors are becoming more pragmatic by rewarding companies trying to be more sustainable. Snam will align spending for future transition bonds with the EU’s green taxonomy, and has started issuing sustainability-linked bonds.

Bos noted that use-of-proceeds transition bonds have been struggling to compete with SLBs when it comes to issuer preference, noting that some transition bond issuers had “moved over to the SLB format in the last six to nine months, so clearly the emergence of SLBs has pushed transition bonds even more to the background”.

This preference is in part because SLBs allow a company to communicate their commitment to decarbonisation without having to identify particular projects. Mehra says issuers may be “a little uncomfortable calling this activity green or transition” when issuing transition bonds, because they don’t know how the investor community will receive the decision, while the sustainability-linked format allows them to “show the whole transition strategy”. SLBs are often easier for issuers with well-established climate strategies and KPIs to issue than transition bonds because the structures are already in place, she adds.

Done and dusted

Despite the growing focus on transition finance in the global financial markets, Bos doesn’t believe that transition bonds will make a comeback. “It’s really not going to happen. We can have a lengthy discussion about it, but the fact that there has been nothing in the last few months is very telling, and I really think that given the noise around transition bonds, [issuers] prefer to issue a green bond or an SLB going forward.”

Nevertheless, the pipeline for transition bonds has not run entirely dry. Snam is keeping open the option of taxonomy-aligned transition bonds and Japan’s Tokyo Gas plans to raise up to ¥20 billion ($160 million; €154 million) later this year from a transition bond to fund five projects – among them the construction of a liquified natural gas project supplying gas to a chemical plant and a gas-fired power station in northern Shikoku.

However, Bos thinks that investors are increasingly recognising that it’s too late to finance some fossil transition projects. “The urgency around climate change has only been growing in the last few years […] why should you fund something which will be a gas project or maybe even an oil project which [will have a life] of 15 to 20 years? We don’t have that time”.