Transition bonds: A new frontier
Transition bonds are the newest form of instruments in the sustainable fixed interest arena. The transition towards net-zero is a herculean task. It requires a staggering USD3.5 trillion of funding per year to achieve the desired goal of a more sustainable global economy that will deliver on low carbon targets by 2050. While green, sustainable and sustainability-linked bonds are significant contributors to this journey, they will not be sufficient to finance the transition alone.
What are transition bonds?
These instruments focus on helping firms to raise capital to help finance their transition from a high carbon emitting business model to one that is low carbon over a clearly defined period and according to science-based targets. Very few of these instruments actually exist at this precise point in time, therefore our discussion on this subject will be conceptual rather than factual.
How do transition bonds differentiate with other ESG bond instruments?
We believe that the transition label is the key differentiator here, as it allows for a wider set of participants. For issuers such as SSE plc or Enel, whose sustainability credentials are in little doubt, the transition label matters little. However, for those non-green newcomers aspiring to a greener future, and for whom acceptance among the investor audience may not be automatic, these instruments could be a game changer. That said, this also means investor scrutiny needs to be intensified – for instance, the risk of inadvertently supporting an oil & gas company, albeit one with quickly materialising green ambitions, is understandably high.
By necessity, there is a long list of potential transition candidates. A flurry of regulations and initiatives aimed at catalysing our shift to a low carbon, world such as the Paris Agreement on climate change has seen more ‘brown’ companies set out plans to play a more active role in the transition.
The transition towards net-zero is a herculean task. It requires a staggering USD3.5 trillion of funding per year to achieve the desired goal of a more sustainable global economy that will deliver on low carbon targets by 2050
The UK now has a target of net zero carbon emissions by 2050. To that end, British Petroleum (BP) is pledging to become a net zero company by 2050, or sooner, through a ten-fold increase on low carbon investments to the tune of USD5 billion per annum and reducing its oil and gas production by over 40%. Royal Dutch Shell also intends to reduce its carbon footprint and is working to offer customers a range of lower-carbon energy sources, such as renewable electricity and hydrogen. Shell also aims to cut the carbon intensity of its products by 30% by 2035 and by 65% by 2050 versus a 2016 baseline.
Whether or not these two companies adopt the transition label to fund these projects, their role is still to try and move these companies to a low-carbon future. In its role as financier, the investment community at large must ultimately keep a close watch on their progress and hold them accountable via continued engagement. We envisage that exerting pressure on the sector in this manner will actively help achieve global climate goals within the desired timelines.
Why does the definition matter?
We are of the view that the current definition of transition bonds misses a social element and that such transitions should also occur via means that are socially just or they run the risk of faltering. Some high-profile renewable energy projects have stalled and are facing legal challenges, for instance, due to the developers’ neglect of indigenous land rights, human rights and community consultations.
Incorporating such social aspects ensures that the climate transition contributes to the broader Sustainable Development Goals framework and is the focus of the “Just Transition” work done by the London School of Economics and the Grantham Research Institute on Climate Change and the Environment, among others.
We are of the view that the current definition of transition bonds misses a social element and that such transitions should also occur via means that are socially just or they run the risk of faltering
While changing the definition of these instruments will add a further layer of complexity, it may prevent transition finance instruments from ignoring key social issues on human rights, land rights, living wages and job security, to name a few.
Furthermore, the concept of becoming a low carbon business model also has a raft of potential pitfalls that investors need to be aware of. We are seeing an increasing number of companies using “offsets” to claim that their net carbon emissions are declining. In our view, transition must be focused on reducing the absolute lifecycle emissions of products and or services provided by companies. We would add that proceeds from transition bonds should, therefore, not be used to purchase carbon offsets such as forests.
Other important considerations
In our view, for a transition strategy to be credible, it ought to be based on robust, scientific transition pathways that are in line with the rapid reductions needed to limit global warming to well below 2°C above pre-industrial levels. A credible transition framework should adhere to recommendations set out by the Task Force on Climate-related Financial Disclosures (TCFD) and should include a Transition Pathway Initiation (TPI) Management Quality Level 4 (see chart below) and a Paris Pledge Carbon Performance scenario to ensure appropriate levels of ambition on the part of the issuing company. As noted earlier, it must also be socially just and have buy-in from local communities and workers.
TPI’s Management Quality framework is based on 16-17 indicators, each of which tests whether a company has implemented a particular carbon management practice. These 16-17 indicators are used to map companies on to 5 levels/steps. The data are provided by FTSE Russell.