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August 14, 2023

Unlocking the puzzle of transition bonds

Although popular in Japan, a lack of easy definition means transition bonds remain shunned by investors. But signs of clarity are emerging

By Adrian Murdoch


transition bonds, climate
As one door closes… Transition bonds have struggled to gain traction, but this could change soon. (Photo by Marko Aliaksandr via Shutterstock)
  • A July report from Sustainable Fitch emphasises that ambiguity in defining transition activities has hampered progress.
  • Only $3.5bn transition bonds were issued last year, all of them in Japan.
  • Transition finance’s primary demand resides in energy, transport, buildings, industry and land use sectors.

While the EU has been a leader in developing sustainable and green finance standards, Capital Monitor has long maintained that transition bonds are the misunderstood child of sustainability financing.

This was highlighted by Sustainable Fitch in a July report which points out that much of the problem remains definitions.

A lot of work has gone into clarifying what can be considered green or sustainable. The EU Taxonomy, for example, sets strict emissions intensity levels for certain manufacturing activities before they can be considered green.

By its very definition, transition finance supports a process that is ongoing. No wonder then that policymakers, investors and companies have struggled to develop a clear and common understanding of transition activities, the report says.

This has impacted issuance. Last year saw only $3.5bn transition bonds sold, versus $487.1bn green bonds and $166.4bn sustainability bonds, according to London-based non-profit organisation Climate Bonds Initiative.

“Companies, borrowers and banks are shy in transition finance as the risk of greenwashing accusations is very real. Oil companies improving Scope 1 emissions is not transition, that we mostly agree upon but going further than that is difficult,” noted Eila Kreivi, chief sustainable finance advisor at the European Investment Bank in Brussels, on LinkedIn.

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It is worth flagging up that very few companies disclose credible transition plans at all.

“Transition finance relies inherently on forward-looking climate commitments by companies,” wrote Alexander Lehmann, a fellow of Brussels-based economic think tank Bruegel, in a blog post in April.

Only on the basis of well-defined transition plans will investors be in a position to understand the residual climate risks to which companies are exposed, while bond and loan markets will increasingly feature contracts that link financial terms to the achievement of climate outcomes, he continues.

At least, Kreivi adds: “We are now finally starting to see some movement in this space.”

Lack of definition

A universally agreed definition of what constitutes a transition project or investment is “one of the hurdles that needs to be overcome in order to close the transition finance gap,” says Kathrin Wartmann, associate director of climate research at Sustainable Fitch in London and lead author of the report.

Sustainable Fitch argues that “clearer guidance is coming”, which, together with concrete sectoral transition plans and corporate transition plans, is needed for investors to move the necessary capital towards transition activities while avoiding greenwashing.

The first Climate Transition Finance Handbook, published by the trade association International Capital Market Association (ICMA) in December 2020, provided information on how green, social, sustainable, and sustainability-linked instruments can be used towards transition activities. In the handbook’s update in June, ICMA strengthened these guidelines, in particular emphasising the potential of sustainability-linked bonds to finance transition plans for hard-to-abate sectors.

ICMA, however, last year made clear it has no intention of creating a formal label for transition bonds, in the same way it has done for green bonds, for example. Transition “isn’t a product; it’s a process, a trajectory, a theme,” said Nicholas Pfaff, ICMA’s deputy chief executive, at the time.

Bruegel’s Lehmann points out the work that is being done in the regulatory sphere. In the EU, the Corporate Sustainability Reporting Directive will require roughly 50,000 companies to publish their climate transition plans, beginning in the 2024 accounting period. In parallel, the International Sustainability Standards Board (ISSB) is developing new disclosure rules, with a climate standard to take effect from next year. In addition, there are now various guidelines and regulations on transition finance and related corporate disclosures in Japan and other key Asian markets.

For example, Singapore is in the process of developing the Singapore-Asia Taxonomy, which is under final consultation. This taxonomy operates using a “traffic light” classification system, which seeks to appropriately categorize activities as green, amber or red according to their level of alignment with environmental objectives.

And in April, Canada’s Sustainable Finance Action Council (SFAC) proposed a framework that includes both green and transition credentials.

Transition bonds: big in Japan

The report points out that the greatest need for transition finance is concentrated in a handful of sectors: energy, transport, buildings, industry and agriculture, forestry and other land use.

Asia remains the focus of transition bond issuance. In a note in September last year, the Asian Development Bank called transition finance an “important part” of the equation to address climate change.

Japan has become a leader in developing transition finance frameworks and guidance as it has one of the most heavily dependent economies on fossil fuels, with coal and natural gas accounting for 68% of electricity generation. Indeed, every transition bond last year was Japanese and denominated in yen.

The country’s Ministry of Economy, Trade and Industry (METI) has developed a roadmap to provide a concrete direction for transition toward achieving carbon neutrality in 2050 for heavy-emitting industries. It is also helping individual sectors. In March, it published its technology roadmap for transition finance in the automotive sector.

The People’s Bank of China is also weighing up the introduction of transition finance standards for four industries – steel making, coal power, buildings and building materials, and agriculture – although no details have been released yet.

“Investors have been cautious to actually move funds into the transition finance space,” the report says. That is perhaps understandable under the circumstances. However, the key objective is to ensure that an activity can eventually proceed onto an appropriate net-zero pathway.

Transition finance remains work-in-progress, the question remains how long it can last. As Kreivi writes: “We need definitions in this space. Regulatory or soft guidance, no matter, but some clear guidelines”.

[Read more: Why Japan embraces transition bonds]

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