There is still much to debate in the development of an asset class that will support the transition to a low-carbon economy.

Mathias Leijon

Mathias Leijon

Since the first green bond was issued in 2007, the market has exploded in value, with $205.1bn-worth of issuance in 2019, according to Dealogic. That was the first year the $200bn mark had been reached, and a 38% increase on 2018. While green bonds are still only a tiny fraction of the total bond market, insatiable investor demand is likely to keep pushing issuance up.

This is good news for those who subscribe to the increasingly uncontroversial view that there is an urgent need for economies globally to operate far more sustainably. But it is also clear that solely funding projects and organisations that can neatly be classified as ‘green’ will move things only so far: the real dirty work still lies ahead.

Beyond bonds

To meet the aims of the 2016 UN Paris Agreement on climate change, a global commitment to keeping the increase in global average temperature to below 2 degrees Celsius above pre-industrial levels, so-called ‘brown’ companies, which currently produce high levels of carbon dioxide, will need to transition to far lower carbon-emitting, and ideally carbon-neutral, ways of operating. This will be a mammoth undertaking, necessitating drastic changes across the entire economy.

“In order to meet the Paris goals, it has become clear in the past 12 months that following a pure green framework will be nowhere near enough,” says Amit Puri, global head of environmental and social risk management at Standard Chartered. “Unless companies are supported to transition to new ways of working, we’re not going to meet these targets.” 

At the moment it is difficult for high-carbon emitters to issue bonds under a green heading. “It has been at the front of many companies’ minds that they want to do the right thing. They have wanted to access the capital markets but have felt restricted. The green market is not currently geared up for this challenge,” says Mr Puri.

Green bond issuance is, according to many in the financial world, barely scratching the surface of what is needed. “While there has been pretty impressive growth, we’ve seen huge parts of the bond market not participating in this type of issuance,” says Farnam Bidgoli, head of sustainable bonds for Europe, Middle East and Africa (EMEA) at HSBC. “To date a lot of the issuance has been concentrated in a few specific sectors: utilities, transport, real estate. We’re very keen to see others in there too.”

Reputational risk

While supporting brown companies in transitioning to more sustainable ways of working might sound reasonable in theory, in practice this type of financing has the potential to be divisive. So far, significant concern across investors, issuers and banks alike of being seen to be supporting ‘greenwashing’ (enabling issuance with spurious environmental credentials) has held back substantial developments in this area.

“There is increasing consensus within the sector on defining what is ‘green’,” says Nicholas Pfaff, a managing director at the International Capital Market Association (ICMA) and secretary of the organisation’s Green Bond Principles, a set of guidelines around issuing green bonds. “When you get to transition, this is a new area, and at the moment there are many more questions about what that means.”

Some issuers have been testing the market. As far back as 2017, Spanish fuel company Repsol issued a green bond to finance investments in improved energy efficiency at chemical and refinery facilities. In July 2019, Brazilian beef producer Marfrig issued what it labelled a ‘sustainable transition bond’ to support sustainable beef production within the Amazon biome region. And in September 2019, Italian energy company Enel issued its first ‘general purpose Sustainable Development Goals (SDG)-linked bond’, which committed it to meeting targets on renewable energy production on pain of paying a higher coupon to investors.

These are just a few examples, and while they all successfully attracted investment, each also raised questions. Repsol faced criticism for its ‘green’ label, because although it was increasing energy efficiency, the improvements indirectly related to fossil fuel technology. Marfrig’s bond might reduce deforestation in the beef industry on the one hand, but some regard cattle rearing as inherently environmentally unfriendly, due to the methane gas that cows produce. Still others regarded Enel’s bond as a retrograde step for a company that had previously been an active green bond issuer, given that its new category of bond has lighter requirements around how it spends the money.

How to move forward

It is clear this kind of issuance has the potential to be a reputational minefield. Bankers say there are many more businesses waiting in the wings which genuinely want to reduce their carbon emissions, but are wary of criticism. 

There is a lively debate under way within the industry about how to come up with a solution that will allow brown companies to access the finance they need while guarding against greenwashing criticism.

In June 2019, Axa Investment Managers described the green bond asset class as being at a crossroads “with the potential for the bonds to be undermined by a desire for further issuance which the sector cannot currently provide” and put out draft guidelines for a new class of ‘transition bonds’. The guidelines are not a finished product, but Standard Chartered’s Mr Puri believes they kick-started dialogue. There is now considerable consultative work under way.

In November 2019, ICMA set up a climate transition finance working group with representation from 17 leading banks, supranational issuers and institutional investors to consider some of these issues. It established another working group in January to look at what it calls sustainability/key performance indicator (KPI)-linked bonds, of the sort issued in 2019 by Enel. It expects to provide an initial report at the Green Bond Principles annual general meeting in May.

Separately, in September 2019, Credit Suisse announced it would be partnering with the Climate Bonds Initiative, a not-for-profit organisation that promotes investment into the low-carbon economy, including via its climate bonds taxonomy. The partnership will undertake research and engage with the broader market to come up with an approach for developing what it calls a ‘sustainable transition bond market’. 

“This is not a just Credit Suisse thing. We really want this to be a market-adopted framework with broad industry engagement,” says Marisa Drew, the bank’s CEO of impact advisory and finance. “We’re currently in a situation where there is idiosyncratic issuance activity developing around transition securities, where bonds are being issued under a variety of different headings. Underwriters and issuers are self-labelling their own versions of SDG bonds or other types of transition bonds, which gets complicated for investors. I think there is something to be done here to establish harmony and consistency in this emerging sector.”

Is transition finance green?

There are differing views on whether transition bonds should be an entirely distinct category of bond or whether they should be accommodated within existing green bond frameworks.

Isabelle Laurent, deputy treasurer at the European Bank for Reconstruction and Development, which has issued what it calls 'green transition bonds', believes there is no reason why bonds that support climate transition cannot be issued under a green bond heading. “We shouldn’t have separate categories for transition finance. It should be within the green framework,” she says. “These bonds are funding projects that support companies to operate more sustainably. We may not get there immediately with one project, but they should help to move things in the right direction. I believe that thinking about it in that way is much more helpful for investors than a potentially nebulous concept of ‘transition’ finance.”

For some, it is important to preserve the integrity of the existing green bond market and not to risk diluting it by introducing potentially more controversial transactions. “Some investors don’t want to see scope creep and don’t want to start changing the definition of what ‘green’ is,” says Trevor Allen, sustainability research analyst at BNP Paribas.

Jonathan Drew, a managing director working on sustainable finance within HSBC’s real assets and structured finance division for Asia-Pacific, adds: “There is a debate going on about the labelling of transition bonds. Some think it is more appropriate to extend the existing green label and to think about shades of green, whereas others think a separate label may be needed. There are pros and cons to both approaches.”

Upholding standards

Whatever decisions are made about how to label these bonds, there is widespread agreement on the need for there to be high standards and strong safeguards in place. “Rigorous due diligence is absolutely essential,” says Antonio Keglevich, global head of sustainable finance advisory at UniCredit. “The industry must act on facts and avoid all greenwashing.”

For some, this includes attaching KPIs to transition bonds as standard practice, to ensure there is a clear framework in place for measuring success. And if those KPIs are linked to the coupon, it provides a clear incentive for issuers to meet their targets too. 

“My view is that KPIs for transition bonds are essential. There needs to be every assurance in place for how the funds being raised are used and KPIs provide clear proof points,” says Mr Allen. “A transition product without a KPI linked to it is just a promise. It is important for there to be specific targets attached and also a clearly defined pathway for how those goals can be achieved.”

He also believes that consideration should be given to what are appropriate goals at an individual industry level. “When creating a framework, we need to be mindful of the differences between sectors in how far technology has developed to provide low-carbon alternatives. There need to be sector-specific goals that are applied over appropriate timeframes,” says Mr Allen.

Making issuance straightforward

Given the emergency that climate science increasingly suggests the world is facing, this focus on labels and requirements for this type of issuance might seem excessively academic. But in the early days of the green bond market there were similar issues with building confidence and understanding. “Sustainable business should be easy business," says Leonie Schreve, ING’s global head of sustainable finance. “Clearly defined standards will make it easier for everyone.”

An independent framework, with clearly agreed standards, should make the process more straightforward and less susceptible to criticism. “No bank really wants to be the arbiter of what does and does not qualify as a ‘transition’ bond and what uses of proceeds are appropriate,” says Credit Suisse’s Ms Drew. “In the absence of agreed standards and a rigorous framework for defining transition bonds, these have the potential to be difficult discussions with issuers and market participants. Having an independent framework, which is principles-based, will take away questions of motives and the inherent potential for a conflict of interest.”

But in the short term, in the absence of agreed standards, and as this nascent market develops, banks will have a vital role to play in ensuring the integrity of the sector. Even once standards are established, they will need to be applied conscientiously to maintain trust. 

There is a growing recognition within the industry that this is a responsibility they must take on. “I don’t think banks have any choice other than to hold the line,” says Daniel Klier, global head of sustainable finance at HSBC. “Ten years on from the crisis we’re slowly gaining the right to speak again as an industry, and I think if we don’t get this right there will be huge upset about greenwashing.”

Making change last

While there is an increasingly strong commitment to this issue within the banking sector, society as a whole remains sceptical about providing finances to heavy polluters, not least because companies increasingly need to appear to be taking this issue seriously in order to maintain their social licence to operate.

“There are some really outstanding actors out there who genuinely recognise the urgent need to move towards a low-carbon economy, and those investors and issuers do play a leading role,” says Kevin Ranney, director of sustainable finance solutions at Sustainalytics. “But as public and investor concern about this grows, it is in all companies’ interests to provide signals to the market that they are on board with the transition, although the level of ambition may vary. When companies make a commitment, such as getting to net zero by a certain date, they need to be scrutinised carefully.”

Mathias Leijon, head of corporate, institutions and investment banking at Nordea, believes the industry has a responsibility to engage with the public on these issues. “Practitioners should be out there talking about these issues and not shying away from debate, even when it becomes vocal and tough,” he says. “We need to be able to explain what the facts are and we need to be transparent. We also need to be open to learning and accepting we will not get everything right. But, ultimately, we all want to change the same things. On that there isn’t a conflict.”

A recent report by the Banking Environment Initiative, entitled ‘Accelerating the transition to a low carbon economy’, stresses the importance of organisations undergoing a change in mindset for transition efforts to really ramp up. 

For Natalie Mordi-Hillaert, head of EMEA environmental and social governance capital markets at Bank of America, far more should be made of the virtuous circle effect that opening up issuance to a wider range of companies would create. “Not enough value is placed on the fact that engaging in this type of issuance creates positive changes within organisations,” she says.

“The urgency around climate and the public relations elements linked to transactions of this nature guarantee some level of C-suite involvement and quite often lead to further integration of sustainability in business strategy and planning going forward. Shutting out a subset of the market due to high levels of greenhouse gas emissions is denying these companies the opportunity to go through the change we want to see and, ultimately, get us closer to a zero-carbon economy.”

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