The shift to greener and more sustainable business models comes with a price tag. Companies therefore need to raise the finance to invest in more carbon-efficient technologies and to pay the cost of decommissioning older energy-intensive and polluting assets.
The instruments of choice for many companies seeking to fund these investments are sustainability and transition bonds.
Generally speaking sustainability bonds finance spending on green investments, according to Courtney Lowrance, managing director, Sustainable Banking and Corporate Transitions at Citi.
“How we see the market evolving is that there are generally two types of sustainability bond,” she says. “The first one is likely to use the proceeds for green, social and sustainable investments. The second one is sustainability-linked, and the proceeds are for general corporate purposes but they are structured so that they are linked to sustainability key performance indicators (KPIs). There is a step up in the coupon if the company doesn’t meet those KPIs.”
In other words the interest the company pays on the debt bond rises if it does not meet the stipulated sustainability targets.
"Sustainability bonds are a use-of-proceeds instrument whereby the bond proceeds are used to finance or refinance projects that address environmental and social objectives," adds Alan Duffy, CEO and head of banking with HSBC Ireland.
“They operate in a similar fashion to green bonds but are focused on projects with a mix of both social and environmental benefits. Issuances to date have been largely focussed on areas such as social housing, clean public transport and renewable energy projects for SMEs.”
And they are growing in popularity.
"Sustainability bonds are proving particularly attractive for supranational issuers such as the World Bank, with the heightened focus on coronavirus response efforts driving 2020 volumes higher, more than doubling to about $160 billion," says Duffy.
“One of the most notable trends over the last 12 to 18 months has been the sharp rise in the popularity of sustainability-linked bonds. As these instruments are available for general corporate purposes, they have much broader potential application, with issuers quite evenly spread across a wider range of sectors from consumer staples to healthcare and technology.”
Projects
Transition finance is a horse of a different colour, however.
“Transition bonds are an emerging financing structure developed to address carbon-intensive sectors and issuers such as energy, transport and industrials,” says Duffy. “Bond proceeds are generally targeted at projects which cut CO2 emissions but don’t use green technology.
“Transition bonds are a use-of-proceeds instrument whereby the loan proceeds are used for specific eligible projects. Eligible projects could include, for example, an investment in the gas network to facilitate the future transportation of hydrogen and other low-carbon gases.”
Transition bonds are particularly useful for energy companies seeking to raise finance at competitive rates, according to Grit Young, M&A partner with EY Ireland.
“If they put bonds on the market that they are going use for energy transition that will get them into the green investment space. It also allows investors put money into oil and gas companies without getting into brown investments.
“Some energy companies have dual listings. They are trying to reduce the cost of capital. But it will take a bit of time to create a standard framework for green finance of this nature, it’s still fairly new.”
And the pace of change makes it difficult for investors. “The goalposts are constantly changing,” Young adds. “Investors have to continually re-evaluate if they are putting their money into the right technology. They want to put their money into green assets that give the best financial returns and the best climate return.”
The early-stage nature of the transition finance market is also noted by Lowrance, who points out that there have only been 16 issuances carrying the label over the past few years. “That’s not a lot and they have met with mixed results,” she says. “Transition finance is a very nascent market.”
There are no standards for it yet, and the International Capital Market Association (ICMA) has not felt the need to create any. "There is a feeling that we have enough labels and they all focus on some sort of transition," she adds.
Standards
This can create problems for the issuers of such bonds. While there is considerable investor appetite for green, sustainable or social bonds, if a transition bond does not meet the standards for one of those investments it might be excluded from portfolios.
Lowrance does believe the market for the bonds will grow, however.
"Transition bonds are needed and there will be growth. The most visible ones we have seen so far have been in oil and gas. Energy infrastructure operator Snam was the first issuer. However, they have generally been investing in gas infrastructure which is seen as a transition fuel but to mixed results. Investor feedback says it felt too much like business as usual."
That said, she is bullish on transition bonds.
“We are seeing real acceleration in decarbonisation and that requires companies to invest significant amounts of capital. We are already seeing oil and gas, steel, airlines and other hard to abate sectors looking at transition finance instruments.”
The use of sustainable finance instruments in general is widely expected to increase sharply over the coming years, according to Duffy.
“HSBC recently concluded its annual Sustainable Financing & Investing survey for Europe, and the results showed almost 97 per cent of European companies plan to start to transition to ESG-friendly business models within five years,” he says.
“It is clear from our interaction with corporates and investors alike that sustainability has become a top priority, and we’ve definitely noticed a heightened urgency around this topic.
“Sustainable finance has a major role to play in enabling the transition to net zero, and it’s great to see European companies leading their global peers and actively embracing these innovative financing instruments as they tap into global capital markets.”