Over the past few years, it has become clear that issuer and investor appetite for financing climate response and other environmental objectives is strong and accelerating. The growth of the green bond market reflects this trend, with total annual issuance of over $290 billion in 2020, an over 5x increase from 2015, according to the Climate Bond initiative (CBI). Despite this burgeoning growth, concerns have emerged that the issuance of green debt alone will not be enough to deliver the objectives of the Paris Climate Agreement and 2050 climate-neutrality goals. In fact, the Intergovernmental Panel on Climate Change estimates that $3 trillion of annual investments are needed to limit warming to 2°C by 2050 and that annual investment in low-carbon energy technologies and energy efficiency needs to be increased by roughly a factor of five by 2050 compared to 2015 levels.

These goals will require more than just increased investment in green projects. They also require significant capital investment in new processes and technologies that enable the shift away from fossil fuels toward clean energy, such as solar, wind, and hydroelectric power, decarbonization of high-carbon industries, electrification, and carbon removal, according to the World Resources Institute. Transition finance provides a potential solution by enabling the largest carbon-emitting industries and companies to raise capital and use the proceeds for activities that help them reduce their carbon footprint.

We believe the amount of transition finance needed to meet the goals of the Paris Agreement is commensurate with the amount of greenhouse gas (GHG) emissions produced by the world's largest hard-to-abate sectors. Given these sectors (e.g. iron and steel, chemicals and petrochemicals, aviation, shipping, cement) constitute about 30% of global GHG emissions (see chart 1), we believe transition finance, including issuance, could contribute up to $1 trillion annually (or 30% of the estimated $3 trillion per year required to meet net-zero emissions by 2050) over the next 30 years.

Chart 1

While the transition issuance market is still quite small, we believe it will grow quickly, particularly as standards for transition instruments become more comprehensive and robust. In January 2021, for example, the Hong Kong branch of the Bank of China raised $780 million from the first transition bond to be aligned with the recommendations of the International Capital Markets Assn.'s (ICMA) recently published Transition Finance Handbook. The bond, which was largely used to fund natural-gas-based power generation in China, received mixed reviews from the market, with some participants claiming that it lacked the "ambition asked of transition bonds" and was not properly aligned with the goals of the Paris Agreement as it lacked a science-based target. Nonetheless, the bond was over 4x oversubscribed and has outperformed the broader credit market over the past month, highlighting that investor appetite for such instruments is strong. We expect other issuers will soon follow suit and believe transition finance will be key to scaling up capital allocation across a wider variety of companies and countries, enabling them to move one step closer to meeting their net-zero commitments.

We understand that the growth of transition finance will not come without its challenges. There is currently no standard set of principles or market-adopted framework to govern the use of the transition label. In our view this elevates the risk of "transition-washing," where issuers overstate their contributions to a net-zero economy. We believe effective and standardized disclosure is required to ensure that market growth for transition finance is robust. In our view, effective disclosure would entail improving transparency and credibility in setting, reviewing, and reporting on science-based targets. We believe that marrying effective disclosure with consistent reporting practices could help transition finance become a mainstream practice in the debt capital markets.

The Growth Of Transition Finance

Transition finance has been broadly defined as any form of financial support that enables the largest carbon-emitting industries and companies--including those in the materials, oil and gas, chemicals, and transportation sectors--to contribute to a net-zero emissions economy. These issuers often cannot allocate large quantities of capital exclusively to green projects (as defined by the Green Bond Principles or EU Taxonomy) without sacrificing profitability and long-term growth. According to HSBC, in this respect, transition finance bridges the gap between traditional and sustainable financing by extending some of the same benefits that have typically only been available in the green bond market to a wider group of sectors and issuers.

To date, the transition market has been built on use of proceeds instruments.   The transition use-of-proceeds model allows carbon-intensive companies or governments to finance specific projects that help reduce global emissions and support climate mitigation. For example, the U.K.'s largest gas distributor, Cadent Gas, issued a €500 million transition bond in March 2020 partially to finance the retrofit of its gas transmission and distribution networks (to facilitate carrying lower-carbon alternatives such as hydrogen and reduce methane leakage from pipelines). Similarly, French corporate and investment bank Credit Agricole issued a €100 million transition bond in November 2019 (the first of its kind from a commercial bank) to fund a selection of loans made to projects in carbon-intensive sectors that contribute to the transition to a low-carbon economy, such as liquid-natural-gas-powered ships, investments in energy-efficient industries, as well as gas power assets in countries where power generation currently relies on coal.

Table 1

The transition market could expand beyond the use-of-proceeds model to include sustainability-linked instruments if standardization and comparability challenges with this new asset class are addressed.   Despite greater interest from investors in transition use-of-proceeds bonds over the past few years, many argue that these instruments may not be the ideal candidates to aid the sustainable finance transition. Issuers, particularly in hard-to-abate industries, may find it difficult to identify a suitable number of transition projects to allocate capital to or might lack the capacity to implement effective tracking or reporting practices. Many investors instead view general corporate purpose, or sustainability-linked instruments, which directly link the cost of funding to the achievement of specific sustainability performance targets (SPTs) at the entity level, as a stronger driver of change than use-of-proceeds instruments because the environmental and social objectives apply to the whole company instead of a specific transaction. We are already starting to see new, emissions-intensive industries enter the market. For example, in November 2020, LafargeHolcim became the first company to issue a sustainability-linked bond in the building materials industry. The €850 million issuance is linked to the company's target to decrease emissions across its operations by 2030. In addition, French multinational oil and gas company, Total, recently announced that from now on it will only raise funds in the bond market using sustainability-linked bonds linked to key performance indicators, including its own emissions and indirect emissions related to customers' use of its energy products.

According to a report by the Carbon Disclosure Project, just 100 companies have been the source of more than 70% of the world's GHG emissions since 1988. The report also shows that these global-scale emissions are concentrated over a small number of producers, with just 25 linked to 51% of global industrial GHG emissions (see table 2). These producers will face increasing pressure from stakeholders and national regulators over the next few years to set ambitious emissions reduction goals, backed by verifiable science-based targets, to ensure they are aligned with the Paris Agreement's goal. In our view, transition instruments at the entity (rather than activity or project) level incentivize these companies to set and meet a broad set of sustainability targets tied to their overall business strategy, particularly given the increasing regulatory and financial pressure if they do not adapt their business models quickly enough.

Table 2

However, in our opinion, key challenges for sustainability-linked transition finance still exist. For example, there are no restrictions on how the capital raised can be spent; issuer performance against set targets is also often self-reported, self-policed, and unaudited, which increases the risk of potential greenwashing. In addition, SPTs are unique to each individual issuer, limiting comparability. The need for transparency and effective sustainability-related disclosure in such transactions is clear. In our opinion, The Sustainability Linked Loan Principles published by the Loan Market Assn. in March 2019 and the Sustainability-Linked Bond Guidelines published by ICMA in June 2020 are key to promoting market discipline because they provide a standard set of best practices, which include the importance of setting appropriate SPTs, reporting on progress in meeting them, independent external reviews, and relating the product to the borrower/issuer's overall business strategy. Ultimately, we believe the sustainability-linked transition instrument market could grow rapidly as a complement to use-of-proceeds issuance if these key challenges are adequately addressed, enabling a wider range of issuers and sectors to obtain sustainability-related funding and increasing issuer capacity to improve sustainability performance across a significant share of their operations and value chain.

Increasing Market Standardization And Transparency

The limited issuance of transition financing to date partially reflects a lack of consensus globally on definition and scope, including which entities or activities qualify under the transition framework.   So far, no agreed methodology or framework governing the transition market exists, which has raised concerns of inconsistency in the market and the potential for transition-washing (whereby a company disseminates misleading or unsubstantiated claims regarding a project's environmental benefits or sustainability performance). If these risks stand unmitigated, investors could become discouraged by a market where companies self-label transition instruments and a variety of company-specific targets make benchmarking difficult. For example, Castle Peak Power Co.'s 2017 use-of-proceeds transition bond, used entirely to finance natural gas projects in China, was highly controversial. Some claimed that natural gas is considered a "bridging fuel" between coal and renewable energy, and thus its use can be justified while other renewable infrastructure is built. Others, on the other hand, argued that the bond didn't meet transition criteria because it allowed for the extension of fossil fuels. This case highlights the importance of a uniform "transition" definition.

That said, attempts are being made to define the type of sectors and projects that would fall into scope for transition finance. In June 2019, AXA Investment Managers issued the first set of guidelines on transition bonds (commonly known as the Transition Bond Guidelines). The guidelines propose following the same structure as the existing Green Bond Principles, Social Bond Principles, and Sustainability Bond Guidelines and are framed on the four components of: use of proceeds, process for project evaluation and selection, management of proceeds and reporting. However, in addition to the issuance-level components, AXA also aims to establish clear expectations for the issuer's broader environmental strategy and practices that it claims should be "intentional, material to the business, and measurable."

In a similar vein, CBI recently released a white paper titled "Financing Credible Transitions" that aims to promote transition as a concept by presenting a starting point for the market to see a credible brown-to-green transition as ambitious, inclusive, and aligned with the Paris Agreement (thereby avoiding greenwashing), and put forward a framework for using the transition label in practice.

Most recently, in December 2020, ICMA published the Climate Transition Finance Handbook. Unlike the other transition finance guidelines that came before it, the handbook does not define a formal set of principles for transition bonds nor the business activities that could be considered "transition." Rather it sets out guidelines for issuers to demonstrate their climate transition strategy and acts as additional guidance for issuers seeking to utilize either use-of-proceeds bonds or sustainability-linked bonds to achieve this strategy. The guidelines have four main elements:

• Issuer's climate transition strategy and governance;
• Materiality of environmental issues to issuers' business models;
• Use of science-based climate transition strategy, including targets and pathways; and
• Implementation transparency.

We believe this handbook will enhance transparency and disclosure within the transition finance market, helping to reduce claims of green- and transition-washing. In addition, ongoing standardization and independent external reviews could increase issuer confidence in transition finance, paving the way for carbon-intensive issuers to tap the sustainable finance market.

The Path Forward

In our opinion, with the right tools transition finance could be on the cusp of impressive growth in 2021 and beyond. We expect to see the transition label taking on a much wider scope and being used across a variety of sectors and activities. This could range from entities making efficiency improvements (such as airlines investing in more energy-efficient aircraft) to potential overhauls of entire business models (such as power producers transitioning from coal to wind or solar energy). Ultimately, we believe the transition label will expand beyond the sustainable bond market into a wider range of financial products that help scale up capital allocation for companies and countries able to demonstrate rigorous and achievable climate transition strategies. The challenge remains how this can be done quickly and efficiently while avoiding key downside risks, including green- or transition-washing.

The author would like to acknowledge the contributions of Jose Navarro of Warwick University Business School and Snehal Suryawanshi of CRISIL to this research.

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