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Transition Finance and Transition Bonds

Transition finance refers to any form of financial support that helps high-carbon companies start to implement long-term changes to become greener. Transition finance bridges the gap between traditional and sustainable financing as businesses begin the journey to net zero. Sustainable finance has a tremendous impact on the development of clean technologies such as wind and solar power. 

Transition bonds are a new class of bonds, the proceeds of which are used to fund a firm’s transition towards a reduced environmental impact or to reduce their carbon emissions. The proceeds can be used exclusively to finance new and/or existing eligible transition projects. Transition bonds raise funds from investors, with the proceeds earmarked to help businesses cut their overall climate impact. This could include investing in low-carbon technology or redesigning energy-intensive processes. For credible transition bond issuance, issuers should disclose a net-zero target and a strategy for long-term decarbonization.

Incorporating environmental targets with bonds and loans could be a useful tool, creating a further incentive for companies to cut emissions. For example, a business issuing a three-year bond could commit to cutting its overall carbon emissions by 10% over those three years, and agree to pay investors a premium if it falls short of that target. 

Key benefits for issuers of transition bonds:

  1. Investor diversification for sectors that have been traditionally excluded from the green market but have a key role to play in addressing climate change
  2. Enhancing visibility of the bond, company and sustainability activities
  3. Reinforcing the sustainability strategy through commitments to investors and key stakeholders
  4. Increasing investor dialogue and engagement that facilitate a better understanding of the business

How do institutional investors evaluate and select transition bonds?

The term “transition” can have different meanings depending on the context that is considered. To reduce carbon emissions in a specific sector, it requires a decarbonization of the actual economic activity performed in this sector. Therefore, in this context, transition is as the shift of economic activities toward production technologies and methods that reduce the greenhouse gas (GHG) emissions in a manner consistent with international climate goals. While the notion of transition is applicable to a range of environmental impacts and goals, the terms is currently used primarily to refer to a shift to a low-carbon economy, focusing on climate change mitigation and GHG emissions as the primary indicator.  

General climate change mitigation goals such as the Paris Agreement are defined at the level of the economy as a whole. These climate goals translate into national and sector specific GHG reduction targets, with transition pathway differing across different industries, from steel production to cement production to shipping, among other areas; each facing a distinct set of challenges and barriers. 

In assessing transition bonds, we look at the level of the economic activity and apply the lens of transition towards net-zero carbon by 2050, as put forward by The Intergovernmental Panel on Climate Change (IPCC) to meet the climate targets outlined Paris Agreement. For the assessment of trajectories, we utilize work done by the International Energy Agency (IEA) on sustainable development scenario (SDS) trajectories. We primarily look at two dimensions for its assessment: (a) the Transition Bond Framework, and (b) the transition strategy of the issuer, to which we refer as issuance- and issuer-level considerations.

Four components of the transition bond framework

  • Project evaluation and selection
  • Use of proceeds
  • Management of proceeds
  • Reporting  

Issuance-level considerations include (a) the use of proceeds for activities that align with carbon reduction pathways; (b) project evaluation and selection; (c) management of proceeds; and (d) allocation and impact reporting. In issuer-level considerations, we assess the issuers’ transition strategy for the respective economic activity subject to the bond issuance. Specifically, we assess relevant commitments, targets and reporting on their alignment with transition pathways.

Our approach is anchored in the global goal to achieve net-zero emissions by 2050 and we recognize that the imperative to reduce emissions exists equally in all locations. We also recognize that emissions-reduction pathways may in some cases vary somewhat as a result of regional differences in technology development, infrastructure and regulatory standards. Where feasible and relevant, we may consider regional context in carrying out activity-level assessments.

In carbon-intensive or hard-to-abate sectors, our criteria for transition eligibility are technology-specific, where feasible. We consider choice of technology to be relevant in many contexts because some technologies can result in a lock-in of carbon-intense production processes and are thus not aligned with transition pathways.

The EU Taxonomy classifies some of the eligible economic activities within it as transition activities, for which performance thresholds will become more stringent over time. For the activities covered in our transition taxonomy, our eligibility criteria are consistent with corresponding criteria in the EU Taxonomy. There are some activities such as activities related to green buildings – that the EU Taxonomy classifies as ‘transition’ while the green bond market has generally regarded them as green. We continue to treat such activities as green if they meet credible sustainability performance standards.

Issuance-level considerations:

  • Use of proceeds: alignment of financed business activities and projects with our transition eligibility criteria 
  • Project evaluation and selection
  • Management of proceeds 
  • Allocation and impact reporting

Issuer-level considerations:

  • Issuer’s climate transition strategy and governance
  • Business model environmental materiality
  • Climate transition strategy to be ‘science-based’ including targets and pathways
  • Implementation transparency

Our approach to assessing transition bonds includes issuer-level considerations, which include an assessment of the alignment of the issuer’s transition strategy and commitments with internationally established decarbonization pathways. Our transition taxonomy will closely align with science-based evidence and research supported by authoritative bodies such as IPCC and IEA along with other independent initiatives for investment community that support transition to a low-carbon economy such as the Transition Pathway Initiative, which aligns itself with Science Based Targets (Sectoral Decarbonization Approach). 

For additional guidance, we will also consider well-known and independent scientific research findings from regional/national authorities, where feasible or required, such as studies produced by the EU Commission (Joint Research Centre). 

Transition pathways must be tailored to the sector and operating geographies of an issuer, and issuers are generally at different starting points and on different pathways. We are seeing the start of a large-scale shift to renewable energy; however, to achieve the ambitions of the Paris Agreement, we believe the financial sector must help businesses in high-carbon sectors find a way to make the transition towards net zero emissions. Businesses in high-carbon sectors may need to undertake complex transformations to reduce their carbon emissions. Traditional forms of sustainable finance are not always a good fit for these transitional phases. For example, an airline company may use a green bond to finance research into biojet fuel; unfortunately, investors may not be willing to accept the financing of a new, less carbon-intensive fleet of aeroplanes.

To date, few formal requirements exist for transition bonds. To qualify as legitimate transition financing, the issuing firm must demonstrate it is part of a broader and credible firm-level transition strategy. We recommend four key disclosure elements: 

  1. Issuer’s climate transition strategy and governance
  2. Business model environmental materiality
  3. Climate transition strategy to be “science-based” including targets and pathways
  4. Implementation transparency

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