When Marfrig, one of the world’s largest beef producers, issued a transition bond in 2019, it raised some eyebrows. “It was not an obvious sector to tap the sustainability market,” says Ana Carolina Oliveira, head of sustainable finance for ING in the Americas. With BNP Paribas and Santander, the Dutch financial services firm helped coordinate the issuance of the 10-year, $500m bond aimed at ensuring the traceability of Marfrig’s cattle supply chains to mitigate the risk of deforestation. Three-times oversubscribed, the bond flew off the shelves.

Transition bonds are a relatively new asset class for carbon-intensive industries. They allow companies to raise capital to kick-start the process of greening their operations in line with the shift to a low-carbon economy. As they’re sometimes regarded as an asset class in their own right, the International Capital Markets Association (ICMA) has made it clear it believes transition bonds should be seen as a label that can be applied to sustainability-linked or green bonds.

Port Talbot steelworks in Wales, UK, February 2021. (Photo by Dan Istitene/Getty Images)

“Was it the right way to go?” Oliveira asks, referring to Marfrig’s bond. She cites a continuing lack of clarity over exactly what constitutes a transition bond, and says the Climate Transition Handbook, published in December 2020 by ICMA setting out guidance on issuing a transition bond, is mute on when a transition label should be used. Investors remain confused in the absence of a taxonomy, says Krista Tukiainen, who leads a research team at the not-for-profit Climate Bonds Initiative (CBI).

“The transition handbook and a taxonomy have two complementary functions,” says Tukiainen. “The former is a [set of] guidelines for the process of issuing a transition bond, and the latter is a set of definitions as to what qualifies as an investment under that framework. The latter is still missing for the transition bond market, and the responsibility to build those standards does not fall to ICMA.”

The CBI is working to establish a taxonomy across four priority sectors – chemicals, metals and mining, plastics, and oil and gas – that will include definitions of transition assets and projects. It will also clarify targets companies should meet, such as company-wide emissions reductions, to be allowed to issue transition bonds.

A preference for sustainability-linked bonds

There are only 17 transition bonds in the market, worth around $15bn in total, compared with the much more established $1.1trn green bond market, according to the CBI database.

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One potential form of transition bond, the sustainability-linked bond, involves the issuer committing to make sustainability improvements, such as reducing emissions, within a predefined timeline. The issuer is free to use proceeds from such bonds as it pleases, as long as it meets its sustainability improvement targets. Capital raised through green bonds, however, must be used exclusively for pre-identified projects with clear environmental benefits – a so-called “use of proceeds” approach.

Many companies can obtain the finance they need to fund sustainable activities through these existing products, without the transition label. “The expectation is that many transition companies will use sustainability-linked bonds to finance the process, but it doesn’t necessarily need to be labelled as a transition instrument,” says Oliveira. “Many issuers from carbon-intensive sectors like the flexibility that the sustainability-linked bond provides.”

The CBI has also received feedback from issuers arguing it is easier to use green or sustainability-linked bonds without the transition label, Tukiainen says. “A transitioning gas firm could issue a use-of-proceeds bond to purchase renewable energy assets without needing a transition label,” she states. “Use-of-proceeds bonds are widely understood, and there is market consensus on their definition, alongside an established mechanism for reporting.”

Tukiainen anticipates the transition label will be be relevant only to investments that make a substantial contribution to reaching net zero by 2050 but do not have a long-term role to play, such as the operation of a plastics recycling facility until a specific sunset date. Sectors that do have a long-term role in a net-zero economy, but where the pathway to net zero is unclear, may also benefit.

Shrey Kohli, head of debt capital markets and funds at London Stock Exchange Group (LSEG), believes green bonds and sustainability-linked bonds alone are insufficient for carbon-intensive sectors.

“Transition bonds are for firms operating in an industry where investors want better disclosure or more science-based measures on how they’re delivering net zero,” he says. “It isn’t enough to only disclose your use of proceeds or key performance indicators.”

LSEG announced the launch of a transition bond segment on its sustainable bond market in March. Despite the lack of a universal taxonomy, “the entry criteria are robust”, Kohli says. “With a transition bond, we require firms to commit to net zero. They must be aligned to the targets in the Paris Agreement, have science-based pathways linked to their net-zero commitments and must report under the framework set by the Task Force on Climate-Related Financial Disclosures. These criteria are not specifically required by a green or sustainability-linked bond. It’s an added requirement on our side because that’s what investors want to see.”

‘A Babylon of labels’

While recent discussions have focused on whether transition bonds have the right label, Kohli believes this distracts from the real debate. “What investors care about is that companies articulate strategies that lead to net zero. Arguing over labels or semantics is pointless. The real question is, where are we going to be in 2025 or 2035? Companies in carbon-intensive industries have to change their business models because if they don’t, then that is a problem.”

Wolfgang Kuhn, former head of pan-European fixed income at Aberdeen Standard, agrees. He says the focus should be more closely on what these mechanisms are achieving – or not.

“None of these instruments hurt, but we need to stop playing with labels and designations, and think about how we can really finance the transition of our economy,” he says. “That can only happen if we stop financing fossil fuel companies. If BP can genuinely transition, then buy one of their transition bonds. There is too much virtue signalling in these designations. There ought to be a gold star for a cement firm that is really trying to turn things around, but I don’t think the ambition is there, and that is where my problem is. The transition bond allows too much gradualism, and it’s too vague.”

Addressing the issue of gradualism, Tukiainen believes the speed of uptake hinges on how quickly a definition of “transition” is generated: “If the transition bond market fizzles, it will be due to the lack of consensus on what a transition-labelled bond is. I don’t mind if that happens, as long as we continue to advance the conversation about what the transition mechanisms are and how firms can make verifiable progress over time.” A new EU taxonomy for green investment could be used for transition bonds, she adds: “The EU have clearly said they want it to be a tool for transitioning entire companies and economies.”

If transition bonds fail to capture the heart of investors, it is “because they aren’t interested in financing the transition”, Kuhn says. When that happens, “more people will go back to the drawing board to discuss how we really think about finance. It’s becoming a Babylon of labels, and at some point people will start to wonder why they spend their days analysing several green bond standards instead of looking at what the actual company is doing.”