The first – transition bonds – is a use-of-proceeds instrument akin to traditional green bonds. The second – sustainability-linked bonds – is a target-linked instrument similar to sustainability-linked loans (SLLs). The emergence of these products has resulted in much discussion and debate among bond-market participants. By and large, they view market experimentation with new products as a positive step in the ongoing evolution of sustainable finance in the bond world.

It is clear, however, that to achieve the credibility and rigour now apparent in the more established products – green, social and sustainability (GSS) bonds – work needs to be done to set market-based guidelines and principles for the new instruments.

While the innovations have come via transactions, it makes sense that a broad-based market initiative like the GBP – including the related Social Bond Principles and Sustainability Bond Guidelines – which already provide a de facto global standard for the GSS market, takes the lead in analysing the new products and gaining consensus on appropriate structures.

The first big innovation in the sustainable-bond markets in 2019 was the further development of transition bonds. The idea is to support companies shifting to less carbon-intensive business models.

There have been various initiatives on transition bonds over recent years, most occurring in 2019. These include issuance from the corporate sector, a global investor setting guidelines for the products and the first issuance of these instruments in the supranational, sovereign and agency sector.

Corporates took the lead. The first recorded transition bond was issued in July 2017 by Hong Kong power producer Castle Peak Power Company, a subsidiary of CLP Holdings. The US$500 million 10-year energy bond was issued to pay for a natural gas plant the company says is critical to Hong Kong’s efforts to cut carbon emissions.

CLP Holdings’ Climate Action Finance Framework states that the company’s climate-action bonds – which include energy-transition or emission-reduction bonds – align with the GBP.

In February 2019, Italian natural gas infrastructure company Snam issued a €500 million (US$553 million) August 2025 climate-action transition bond. Proceeds will fund the company’s investments in biomethane and energy efficiency, along with those aimed at reducing its methane emissions by 25 per cent by 2025. A second-party opinion on the Snam bond, provided by DNV GL, states that it is aligned with the GBP.

Six months later, Brazilian cattle producer Marfrig Global Foods (Marfrig), issued a US$500 million 10-year sustainable transition bond. Proceeds will be used to buy beef from cattle farmers in the Amazon Biome that avoids land in areas the Brazilian Institute of the Environment has embargoed, such as deforested areas or where land use would threaten indigenous rights. Vigeo Eiris’s second-party opinion on the Marfrig bond states that it is aligned with the four core components of the GBP and SBP voluntary guidelines issued in June 2018.

Until 2019, there were no set definitions or parameters for transition bonds. AXA Investment Managers (AXA IM) took up the challenge and published draft guidelines in June. Its goal was to facilitate broader deployment of sustainability principles in the bond market.

Explaining the rationale for transition bonds, Yo Takatsuki, head of environmental, social and governance (ESG) research at AXA IM in London, said: “We are calling for the establishment of a new type of bond, distinct from green bonds. While green bonds are intended for issuers to use the proceeds to finance environmentally friendly projects, we see a significant gap where investors could deliver real impact for companies not yet at this stage. There is an opportunity to provide finance to companies that are brown today but have the ambition to transition to green.”

Crédit Agricole issued the first transition bond under AXA IM’s guidelines at the end of November 2019 – a 10-year €100 million private placement, of which AXA IM was the sole purchaser. The bank will earmark an amount equivalent to the proceeds of the bond for loans made to projects in carbon-intensive sectors that will contribute to the transition to a low-carbon economy. Takatsuki confirms the bond is aligned with the core components of the GBP.

In a further evolutionary step, in October 2019, European Bank for Reconstruction and Development (EBRD) issued its first green-transition bond. The proceeds of the €500 million five-year bond are earmarked for supporting EBRD’s green transition project portfolio. This comprises investments in energy and resource efficiency, including the circular economy and sustainable infrastructure such as low-carbon transport and green logistics.

In its green-transition-bond template, EBRD states: “The carbon intensity and environmental vulnerability of EBRD’s region [make] it especially exposed to climate-related risks…To address this challenge, EBRD recognises that there is an urgent need for projects to go beyond supporting assets that are considered already to be low carbon…to finance investments in those sectors of the economy that today are highly dependent on the use of fossil fuels, thereby enabling them to transition to low-carbon and resource-efficient operations.”

EBRD’s green-transition bonds also align with the four core components of the GBP. In an opinion piece published in Environmental Finance in November 2019, Isabelle Laurent, EBRD deputy treasurer and head of funding, and Carel Cronenberg, associate director, head of monitoring, reporting and verification, energy efficiency and climate change, state: “Green transition projects should not be considered ‘light green’ projects, and do not, in our view, need any derogation from all core components of the GBP.”

They add: “Indeed, our ex-ante assessment of the CO₂e savings of our portfolio of projects underpinning our green transition bonds is approximately 2.75 times greater than those associated with our environmental sustainability bonds for each euro or dollar invested.”

The second – and more controversial – innovation in 2019 was a type of bond that mimics the SLL product, which has shown impressive volume growth in its relatively short history.

In September 2019, Italian energy company Enel issued the first sustainability-linked bond. The US$1.5 billion five-year transaction offers a 2.65 per cent coupon that will increase by 25 basis points if Enel does not achieve, by 31 December 2021, renewable generation capacity that is at least 55 per cent of its consolidated installed total.

The same company issued a second sustainability-linked bond in October. The €2.5 billion three-tranche deal has a similar structure to the earlier US dollar transaction. The €1 billion June 2024 tranche and the €1 billion October 2034 tranche both have a 25-basis-point coupon step-up on the same terms as the US dollar deal. Meanwhile, the €500 million October 2034 tranche offers an interest rate that will increase by 25 basis points if the company fails to reduce greenhouse-gas emissions to no more than 125 grams of CO2 per kilowatt-hour by 2030.

These transactions echo the €200 million ESG-linked Schuldschein issued by German engineering group Dürr in June 2019. The coupon on this product can increase or decrease according to the company’s sustainability rating. A Schuldschein is a German private debt instrument that shares aspects of loans and bonds – it has been described as a loan in the form of a bond.

Enel’s sustainability-linked bonds do not align with the four core components of the GBP. There is no requirement for specific use of proceeds, the focus instead being on the issuer’s strategy to transition to a low-carbon economy. There is also no requirement for a green-bond framework or for second-party opinion reports, nor for any reporting on the assets during the life of the bond.

These target-linked instruments have created a flurry of debate. Environmental Finance has reported that at least one big green-bond investor called the deals “greenwashing” because the company is doing no more than offering an option on not delivering its renewables goals. Other investors and underwriters have lauded the development. Benefits cited include helping bondholders advance UN Sustainable Development Goals (SDG)-related targets, enabling greater volume of sustainability issuance by moving beyond eligible use of proceeds and allowing a stronger focus on strategic alignment with global goals at the corporate level due to the emphasis on ESG integration.

In a sector evolving at such a furious pace, a key issue is how new products can offer the same degree of rigour, transparency and credibility that has been established for more traditional GSS bonds via the GBP, SBP and SBG.

The GBP executive committee and ICMA have been discussing the role of the principles in this context. Lars Eibeholm, treasurer at Nordic Investment Bank in Helsinki and chair of the GBP executive committee, tells KangaNews: “It has become clear that we need to discuss what we are facilitating. Is it only GSS bonds or do we have a bigger agenda?”

This has led to what Eibeholm calls “vision and mission” discussions within the executive committee. He confirms that a wider mandate is on the cards. “We have decided that the GBP can look into a wider scope of bond instruments that can facilitate a move to a more sustainable and low-carbon economy where bond-market financing can be used.”

As such, the committee has been deep-diving into the details of transition and sustainability-linked bonds.

By January 2020, of the new asset classes the GBP had made most progress on transition bonds. Following the establishment of a taskforce, a Climate Transition Finance working group was established in November 2019. Coordinated by AXA IM, HSBC and J.P. Morgan Chase, the working group’s terms of reference state that it will consider the concept of transition financing in the context of the green-bond market.

The terms of reference state that the working group will not retrospectively reassess and validate the credibility of self-labelled transition bonds already issued. Instead, it “is purely focused on understanding why corporate issuers from carbon-intensive industries have been largely absent from the green-bond market thus far and considering providing guidance for potential future issuance”.

There are two key areas of focus for the working group, according to the terms of reference. First is industry diversification. The aim is to assess why issuers from across bond market segments have been largely absent from the green-bond market despite their importance to climate transition.

Second is the importance of issuers’ climate strategy and financing. This will entail reviewing the application to issuers absent from the green bond market of GBP Pillar 2 – process for project evaluation and selection.

No doubt there will be much to report on during the year ahead as the working group gets into action. However, Eibeholm confirms that a transition bond issued under the AXA guidelines and EBRD’s climate transition bonds are covered by the GBP, as both follow the four core components of the principles.

Eibeholm agrees that companies in transition need to be encouraged to raise funding. “We all realise that aiming for a 1.5-degree target demands a huge effort,” he says. “The way our economy operates needs to completely transition, while still aiming for GDP growth. We need to encourage not just the companies that already fulfil the requirements for a sustainable economy but all the others, too.”

It will be important, however, to set the right criteria for transition bonds. This is where the GBP executive committee believes it can play a key role. “We need to say to companies

it’s okay if you come from the brown sector as long as you are moving in the right direction, you have a clear strategy for transition and you are playing with open cards when you issue transition bonds,” Eibeholm explains. He adds that if issuers do this, the GBP – backed by its issuer, underwriter and investor members – will be accommodating and accepting of transition-bond issuance.

According to Eibeholm, one of the advantages of the involvement of the GBP, SBP and SGB in the bond market is that this mitigates the risk some issuers face of their bonds not meeting key players’ green standards. He comments: “Many issuers are wary of issuing a bond that follows the GBP but is then not viewed as such by the market, a stock exchange or industry body. We need to mitigate this risk and have clear guidance for a wider scope of issuance as long as the bonds meet certain standards and promote integrity. This comfort is needed to propel the market forward.”

When it comes to labelling different types of products, Eibeholm says bonds – whether they be green, blue, social, sustainability, SDG, transition or any other labelled bonds – are all strategies that follow the four core components of the GBP. He explains: “Underpinning the labels are strategies. The labels point to the impact or objectives an issuer wants to achieve.”

Once an issuer has set its strategy, Eibeholm says, it can choose between two kinds of instruments. These are use-of-proceeds bonds – like green or transition bonds – and general corporate-purpose bonds with KPIs linked to the issuer’s sustainability performance.

Sustainability-linked bonds do not follow the core components of the GBP, Eibeholm says. Nevertheless, linking back to the vision and mission discussions at the GBP, the executive committee thinks it is valid to consider sustainability-linked bonds.

As Eibeholm comments: “This is where the ‘vision and mission’ discussion is important. We could have said sustainability-linked bonds are not for the principles to consider because we focus only on use-of-proceeds bonds. But the group decided we needed to have a larger and much broader outreach because our purpose is to facilitate the transition to a low-carbon economy, not just the instruments using green, social, sustainability and other labels.”

As a result, the GBP executive committee has set up a taskforce to look into sustainability-linked transactions. In early January 2020, Eibeholm told KangaNews the taskforce would be evolving into a working group for sustainability-linked bond products. “We hope to make an announcement by mid-January. As soon as this is done, we will publish the terms of reference for the working group.”