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Transition bonds: In the shadows of sustainable finance

Andrew Wong and Ian Teo
Andrew Wong and Ian Teo • 8 min read
Transition bonds: In the shadows of sustainable finance
Transition bonds provide funding for industries which would have been rejected based on traditional green bond requirements / Photo: Sam Larussa via Unsplash
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Transition bonds are a nascent financing tool, in which proceeds are used to reduce an issuer’s environmental impact through decarbonising fossil fuel and hard-to-abate sectors that would not qualify for green bonds such as steel, cement and petrochemicals. Companies issuing transition bonds are also required to have a transition strategy and transition bond framework.

However, transition bonds has been slow to gain traction. To put things into perspective, among the four main bond categories for sustainable finance (green, social, sustainability and sustainability-linked, otherwise known as GSSSL bonds), the smallest category of bonds, sustainability-linked bonds, had about US$66 billion in issuances in 2023, making up only 7% of GSSSL bond issuances. On the other hand, transition bonds only had around US$3 billion in issuances. This speaks to how relatively small and unknown transition bonds are compared to existing GSSSL bonds, albeit they were only introduced around 2021.

How are transition bonds different?
Transition bonds are like a combination of the more widely accepted green and sustainability-linked bonds but with both similarities and differences. Their similarity to green bonds lies in that the finance they both provide can be for or are directed at a specific sustainable project.

However, the existing standards required to issue a transition bond are not as high as that of a green bond where the green bond issuer is typically viewed as already operating sustainably.

To this end, transition bonds are more akin to sustainability-linked bonds, in which the bond issuer is not required to already be operating sustainably but is usually in the process of transitioning to lower-carbon operations.

However, while the intention of transition bonds and sustainability-linked bonds are the same, a difference is that sustainability-linked bonds contain very specific issuer-appropriate targets or sustainability performance targets to facilitate the transition. On the other hand, transition bonds are not required to contain such targets and can instead refer generally to the use of proceeds categories such as energy conservation and improved energy efficiency that are tied to a transition bond framework.

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Filling the gaps left by GSSSL bonds
In the past, the Asian Development Bank (ADB) refused to outright fund coal mining and oil and natural gas production and exploration in its draft 2021 Energy Policy. This was for obvious environmental reasons but also for related social reasons with pressure from the NGO Forum on ADB, an Asian-led network of civil society organisations based in Asia and the Pacific region, to stop funding coal projects given their detrimental impact on local communities.

This decision, however, was reversed in a subsequent revision of the ADB’s Energy Policy given its intention to also ensure reliable and affordable access to energy throughout developing countries in Asia and the Pacific, in addition to promoting the low-carbon transition in the region.

Driving this change of stance is the relative dominance of coal-fired power generation within Asia and the region’s contribution to over 50% of global greenhouse gas emissions. At the time of the revision, the NGO Forum on ADB also noted that ADB should develop clear steps on how it will support developing member countries in their efforts to transition away from fossil fuels and super-pollutants.

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The introduction of transition bonds therefore may give ADB an avenue to support the dual aims of its energy policy and provide financial support to coal plants transitioning to cleaner solutions. In a sense, transition bonds provide companies in frequently shunned industries an opportunity to receive funding when they would have been rejected on traditional guidelines based on traditional green bond requirements due to their excessive greenhouse gas emissions.

Why are transition bonds having difficulty gaining traction?
We believe the main factor in the adoption of transition bonds is the lack of established standards for transition bonds. This has led to transparency concerns for transition bonds that stem from the absence of clear and consistent international standards regulating them.

The International Capital Market Association (ICMA), a trade association that represents financial institutions active in international capital markets worldwide and a key standard setter for labelled bonds, has not issued principles for transition-labelled bonds and its 2020 Climate Transition Financing Handbook argued that transition is “best conceived as a theme that can be financed by green and sustainability bonds as well as sustainability-linked bonds while recognising the development of a ‘climate transition’ label adapted notably to certain jurisdictions and regions”. The handbook also adds that transition plans can be financed by unlabelled bonds.

This shortcoming though may be changing. In February, ICMA also published a report titled “Transition Finance in the Debt Capital Market”, seeking to define transition finance and “unlock further the potential of the sustainable bond market to finance transition”. While noting the slow growth and adoption of transition finance and transition bonds due to greenwashing concerns and the prevailing use of green and sustainability bonds for climate finance, ICMA also recognised that climate transition finance was “at the top of the agenda among both policymakers and market participants” and also highlighted the recent release of various guidelines on transition finance by the OECD, European Commission and the Asean Capital Markets Forum.

Global outlook for transition bonds
The trajectory of transition bonds remains uncertain although we could sense where they might be headed by assessing the key drivers behind them. We have identified two main drivers:

1. Push for domestic issuances over international issuances
Despite the headwinds faced by transition bonds in getting accepted internationally, there might be a bright spot for transition bonds in the domestic market where clear transition guidelines are in place and where domestic financial institutions play the dominant role in the domestic market.

Japan has been a huge advocate for transition bonds. About two-thirds of all transition bonds have come from Japanese issuers, supported by the world’s first sovereign Climate Transition Bond Framework published in November 2023 which includes areas such as nuclear energy, carbon capture, and alternative fuels and feedstocks for the manufacturing industry. The transition roadmaps for sectors including iron and steel, chemicals and cement published by Japan’s Ministry of Economy, Trade and Industry also highlighted its commitment to assist the transition for hard-to-abate sectors that have a high dependence on fossil fuels and no simple solutions for reducing emissions.

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The country is planning to issue JPY20 trillion ($172.8 billion) of Economy Transition Bonds in the next 10 years according to ICMA, including the JPY800 billion 10-year Japan Climate Transition Bonds issued on Feb 14. It is likely that Japan is pushing for transition bonds due to its heavily industrialised economy and sees a need to reduce its emissions to meet global standards and net-zero commitments. This localised emphasis and absence of globally accepted taxonomies and guidelines, have likely driven the dominance of domestic or local currency issues of transition bonds as opposed to US dollar issuances in the past three years.

Another major issuer of transition bonds could be China. In January 2021, Bank of China issued the country’s first transition bond with US$780 million raised in two tranches, stating their commitment to sustainable finance and the greening of the steel industry across the country. The steel industry in China accounts for around 5% of its GDP and represents around 15% of the country’s total carbon emissions as stated in BNP Paribas’s research titled “Transition bonds: evolving across financial institutions and governments in Asia”.

The Climate Bonds Initiative estimates that China’s steel industry will require investments of around RMB20 trillion ($4.17 trillion), to achieve carbon neutrality. Such issuances are supported by the development of guidelines on technical pathways for decarbonisation of carbon-intensive industries by China’s National Development and Reform Commission (NDRC) and other relevant ministries.

It is likely that the future of transition bonds is going to be heavily influenced by the success of the issuances in these economies.

2. Continued demand for fossil fuels, even in 2050, makes transitioning all the more important
While industries like motor vehicles and electricity production have seen great levels of innovation and commitment to reducing carbon emissions in the form of electric vehicles and wind/solar energy respectively, other industries like aviation, shipping and manufacturing are facing much greater difficulty transitioning as there really is no clear cost-effective alternatives to fossil fuels.

Industrial processes, notably, make up a huge fraction of emissions and yet are extremely difficult to reduce. Global fossil fuel use is expected to flatten or decline by mid-century before starting to grow again due to rising energy demand in various parts of the world. This increase will be led by natural gas demand which is projected to increase 126% by 2100, according to The Guardian.

There is wide recognition that achievement of net zero in 2050 will be an uphill battle, albeit a vital one. The faster growth in renewable energy is encouraging but it is unlikely to be the main driver for a successful energy transition. It may be time to look past the reputation of companies in hard to abate sectors and give them a chance to change. Transition bonds could provide the avenue for that with proper incentives guided by established standards for transition bonds leading to an improved reputation and more market acceptance.

Andrew Wong is a credit research analyst with OCBC’s global markets research team. Ian Teo is an intern with the credit research team

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