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A pale green bond for the energy transition

The concept of transition bonds began as an idea to sell bonds that were difficult to market as green bonds, mainly natural gas bonds, but has evolved into an opportunity to accelerate decarbonisation efforts

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This article comes from the spring 2020 edition of the FORESIGHT Climate & Energy magazine, which was largely written before, or at the beginning of, the Covid-19 pandemic.

As green bond issuance soars, investor attention has turned to financing “brown” projects to help carbon-intensive companies improve environmental credentials and pursue more sustainable business models. A rigorous vetting process and dialogue between investors and issuers of a new class of “transition bond” can help avoid greenwashing and investments that lock-in fossil fuels

PALE GREEN
Transition bonds can be issued by oil and gas companies, as well as cement, steel, mining and other “brown” carbon-intensive industries looking to fund projects to cut their carbon footprints with an eye to becoming green GREEN BOND BOOM
A record $255 billion in green bonds and loans were issued in 2019. Transition bonds, which can complement green bonds and demonstrate the step-by-step process of the clean energy transformation, are an idea whose time may have come KEY QUOTE
Transition bonds need to be combined with rigorous targets, measurements and scrutiny to avoid the risk of greenwashing and companies seeking to buy time we don’t have Spanish oil and gas major Repsol helped break the ice for carbon-intensive bond issuers in 2017, tapping the green bond market with a €500 million issue to finance efficiency upgrades at its refineries. While proceeds from the bond were earmarked for projects targeted to cut 1.2 million tonnes of CO2 emissions, it was excluded from major green bond indexes. Investors were sceptical Repsol’s bond was sufficiently “green” since these projects also extended the life of fossil fuel assets. Demand for such pale-green bonds, however, has created interest in so-called transition bonds. They can be issued by oil and gas companies, as well as cement, steel, mining and other “brown” carbon-intensive industries looking to fund projects to cut their carbon footprints with an eye to becoming green. Transition bonds are all the rage, or at least the idea of them. The AXA Investment Managers arm of French insurer AXA has called for the creation of a new transition bond asset class separate from green bonds and the International Capital Market Association (ICMA) in 2019 set up a working group on transition finance. “There has been very rapid growth in discussions of the concept of a transition bond among issuers and underwriters,” says Stephen Liberatore, head of the environmental, social and governance (ESG) team at US asset manager Nuveen. Only a small number of what are considered to be transition bonds have come to the market. Among these was a €500 million bond sold by Italian gas group Snam to investors in February 2019 to finance biogas and biomethane investments and efficiency upgrades for existing infrastructure. Liberatore says Nuveen did not invest in either the Snam or the Repsol bonds. The projects they were funding “were undoubtedly better for the environment because they made both businesses more energy efficient”, he says. “But we aren’t looking to extend the life of fossil fuels.” For transition stories, the asset manager wants to be sure investments result in fundamental changes in business processes. That is in addition to routine green bond requirements like transparency, disclosure and the ability to measure their impact in helping a company decarbonise, Liberatore says. CREATING CONFUSION Bram Bos, lead portfolio manager for green bond strategy at Netherlands-based NN Investment Partners, says the rise of labels like transition bonds and sustainability-linked bonds creates confusion. “One of our concerns is that dirty issuers could take advantage of this confusion to join the sustainable fixed-income sector for marketing purposes or to benefit from low yields with no real intention of changing their business models,” he says. The debate over transition bonds comes at a boom time for the green bond sector. A record $255 billion in green bonds and loans were issued in 2019, says the UK-based Climate Bonds Initiative. “There is a vast demand for green bonds,” states Sean Kidney, head of the NGO. Whether that demand can partially be satisfied by transition bonds is proving controversial. And while financial markets, including the debt capital market and green bond segment, have been impacted by the Covid-19 outbreak, green bonds could emerge even stronger from the healthcare emergency. The International Energy Agency (IEA) is not alone in arguing that the transition to green energy should feature in government economic stimulus plans to recover from the pandemic. Isabelle Laurent, deputy treasurer and head of funding at the European Bank of Reconstruction and Development (EBRD), believes creating a new asset class for transition bonds would be confusing and “unhelpful”. ICMA’s green bond principles and the EU’s sustainable finance taxonomy already provide ample room for issuing green bonds to finance transition projects, she believes. “The EU taxonomy defines not only what is considered green today, but what needs to be transitioning to become sustainable,” adds Laurent. Indeed, the EBRD in October 2019 issued its inaugural, €500 million five-year green transition bond in accordance with green bond principles to help finance decarbonisation investments in fossil-fuel dependent sectors of the economy like cement, steel, chemicals and transport. By flagging it as a “green transition” bond, the EBRD was seeking to improve the transparency of the market and enhance its dialogue with investors, says Laurent. Decarbonising carbon-intensive sectors of the economy is key to the energy transition and also makes financial sense. The EBRD estimates CO2 savings for projects tied to its green transition bonds of approximately 2.75 times more (for each euro invested) than those associated with its environmental sustainability bonds. Its sustainability bonds provide funding for projects in areas like renewable energy and energy efficiency traditionally associated with green bonds. A FOCUS ON TRANSITION The concept of transition bonds began as a “simplistic idea” to sell bonds that were difficult to market as green bonds, mainly natural gas bonds, but has evolved into an opportunity to accelerate decarbonisation efforts, says Kidney. “From our perspective, it is really good there is a focus on transition and an understanding we are transitioning and that this is a process.” The challenge is to develop a clear understanding in each sector of the economy of what decarbonisation involves and how quickly it must be achieved. In the steel industry some companies have targeted becoming net zero carbon in 2050. “We need to get steel down to zero carbon much faster, by 2035, and this requires a different breakdown in capital expenditures, with fewer investments in gas and more in green hydrogen,” says Kidney. Talk about transition bonds is part of “a sorting out” of the market, states Tom Sanzillo, director of finance at the Institute for Energy Economics and Financial Analysis (IEEFA). “You have a new entrant and acknowledgement of a tranche of projects that are now seen as profitable. What you need now are standards, metrics and accountability to make sure that they are not only profitable, but also meet carbon standards.” Gunnela Hahn, head of sustainable investment at the Church of Sweden, sees potential in the idea of transition bonds for issuers with credible transition strategies. Transition bonds “need to be combined with rigorous targets, measurements and scrutiny to avoid the risk of greenwashing and companies seeking to buy time, which we don’t have”, she says. Instruments like external advisory boards and outcome-based mechanisms in which issuers have to pay higher interest rates when targets are not met could help reassure investors, adds Hahn. A HOLISTIC APPROACH Laurent believes it would be useful to give greater guidance on what investors are looking for to corporate issuers seeking to tap bond markets for transition projects. Alongside “meaningful” projects that are not business as usual and do not lock in fossil fuels, investors are also looking for broader organisational changes that show a company is serious about meeting the targets of the Paris Agreement. Dialogue between investors and issuers is seen as key in working out what projects should be financed for the energy transition. Whatever the bonds are called, potential sellers should be able to find plenty of investors ready to evaluate their business case. “There will be some investors who will only invest in wind or solar farms or assets they see as indubitably green, but the more expert investors will have in-house expertise and a broader idea of what needs to be done,” says Laurent. “I think the EU taxonomy will help those who have had a narrower view to think more holistically about what we need to do by 2050.” With issuance dominated by banks and utilities, Bos says a greater number of green bonds from industrial companies would be welcome. “I would be very keen on oil and gas, metals and mining companies issuing green bonds — with the emphasis on green — because it would be an indication they are moving in the right direction and would allow for a greater diversification of portfolios. Of course, we would screen these companies very carefully and there must be a very clear strategy in place to move away from fossil fuels.”

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Heather O’Brian