Moving beyond green bonds
Transition finance can be the engine needed to fuel a net-zero future, write Rachel Hemingway, head of transitions, Gabriela Constantin, industrial transitions programme manager and Oluwatoyin Oyekenu, Agri Foods programme manager, Climate Bonds Initiative.
To limit the impacts of climate change, rising greenhouse gas levels urgently need to be reversed and communities and economies must be supported to adapt. This requires a combined effort from all sectors to align with a 1.5-degree future – meaning high-emitting companies may need to reimagine their business activities and phase out operations that cannot transition. This offers a huge investment opportunity for capital market actors.
The green and sustainable debt market has grown rapidly over the past decade, funding renewable energy and sustainable infrastructure. However, large emitters in the hard-to-abate sectors have yet to in the green finance market. These actors must not be excluded from the sustainable debt market as their transition to net zero – while requiring large amounts of finance – is critical to achieving the goals of the 2015 Paris agreement.
Transition planning and avoiding greenwashing
To facilitate financial flows to all sectors and support this whole-economy transition, the Climate Bonds Initiative, an investor-focused not-for-profit organisation, has expanded its focus beyond green bonds into the transition finance market, providing guidance for developing and financing forward-looking climate change strategies (captured within a transition plan) that are aligned with a 1.5-degree future.
Transition finance instruments need to be reinforced by and contribute to science-based 1.5-degree sector transition pathways defined within a published transition plan. This ensures that the finance raised is targeted to credible investments that will deliver the necessary environmental benefits, avoiding the risks of greenwashing. Transition plans also provide comfort to investors who are looking to finance ambitious climate action and hold net-zero-aligned portfolios.
However, beyond investor comfort, transition plans are useful tools for issuers. They communicate how the issuer intends to adapt its business model to enable the transition to a low-carbon economy. To date, the Climate Bonds Initiative has published transition pathways for buildings, agriculture, steel, chemicals, hydrogen, cement and shipping, focusing on sectors where impact is greatest. Criteria in progress include mining, commodity supply chain and electricity utilities. Published guidance is also available for developing and assessing credible transition plans.
Types of transition finance
In addition to loans and equity, there are two distinct groups of labelled bonds that can be used for transition financing: use of proceeds and key performance indicator-linked bonds. UoP bonds, such as green, transition, sustainability, or social bonds, fund projects with dedicated environmental and/or social benefits. Adhering to standards and UoP categories is key to understanding their impact. KPI-linked bonds, such as sustainability-linked bonds, are used for general-purpose financing of an issuer that sets material, ambitious, realistic and explicit sustainability targets at the entity level. They involve penalties or rewards linked to failing or succeeding in meeting pre-defined, time-bound sustainability performance targets. Both instruments are valuable for financing the transition and the Climate Bonds Initiative is able to offer certification for both, as well as for transition plans that are not linked to a specific instrument.
Disclosure and transparency
Certification and third-party verification of transition plans and finance are key to demonstrating credibility for investors and stakeholders. Regulatory changes are emerging that support this in terms of disclosure requirements for both corporate and financial actors.
For financial institutions, the European Union’s Sustainable Finance Disclosure Regulation requires market participants to disclose their sustainability risks and impacts in an effort to foster transparency. For corporate actors, the Corporate Sustainability Reporting Directive proposal requires disclosure of non-financial metrics to support the EU sustainable finance universe, including the SFDR and the taxonomy regulation. Many other jurisdictions, including the US, UK and Japan, are introducing mandatory disclosure regimes.
Sustainable finance taxonomies can also promote this transition, spearheaded by the Climate Bonds Initiative taxonomy and the EU taxonomy. These classification systems define environmentally sustainable economic activities by providing a shared language among investors, companies and policy-makers, promoting a unified approach to sustainable investment.
While transition finance is still an emerging field, there is a pre-existing body of guidance for what constitutes credible and ambitious action for issuers and investors. More needs to be done and there is a vital role for investors and policy-makers in guiding transparency and credibility of transition plans and finance through requiring third-party verification and certification.