As the green bond market has developed, it has become clear that many companies that operate in industries with high greenhouse gas emissions (so-called “brown companies”) have been excluded due to concerns around claims of “greenwashing” and that their participation risks undermining the credibility of the green bond market as a whole. However, in the drive toward achieving the Paris Agreement goals, the participation of brown companies will be vitally important; the impact of brown companies’ going green or becoming greener should not be underestimated in the global efforts toward decarbonization.
Brown companies require substantial capital investment in order to improve their environmental impact as part of the global drive toward creating carbon-neutral economies, giving the international capital markets a critical role in this journey.
Transition bonds are a relatively new asset class, specifically targeted at “brown” issuers, which allow them to raise capital with the specific aim of becoming greener, or at least “less brown.”
According to the recently published International Capital Markets Association (ICMA) Climate Transition Finance Handbook (December 2020) (the Handbook), transitions bonds can be issued both in the form of “use of proceeds instruments,” aligned to the Green Bond Principles or Sustainability Bond Guidelines, or sustainability-linked bonds (SLBs), aligned to the Sustainability-Linked Bond Principles, all also administered by the ICMA. The concept of transition is not (and should not be) strictly linked to the form of the products themselves but rather to the issuer’s overall strategy in becoming greener. Reflecting this distinction, the Handbook aims to help facilitate transition financing rather than set out specific guidance or principles.
What is in the Handbook?
Noting that the green bond market is struggling to accommodate brown companies, the working group convened as part of the Green Bond Principles and Social Bonds Principles administered by the ICMA has sought to bridge that gap by providing in the Handbook guidelines for issuers of climate transition finance and, in particular, calling for issuers’ climate strategies to clearly reference science-based targets and transition pathways.
The Handbook comprises disclosure recommendations with the purpose of facilitating successful transactions to help ensure that issuers have the necessary access to capital to fund decarbonization efforts and the implementation of climate transition strategies on the basis of science-based alignment with the Paris Agreement. It provides clear guidance and common expectations to capital markets participants on the practices, actions, and disclosure to be made available when raising funds in the international debt capital markets for climate transition-related purposes.
The recommendations in the Handbook are based on four key elements:
1. Issuer’s climate transition strategy and governance. “The financing purpose should be for enabling an issuer’s climate change strategy. A ‘transition’ label applied to a debt financing instrument should serve to communicate the implementation of an issuer’s corporate strategy to transform the business model in a way which effectively addresses climate-related risks and contributes to alignment with the goals of the Paris Agreement.”
2. Business model environmental materiality. “The planned climate transition trajectory should be relevant to the environmentally-material parts of the issuer’s business model, taking into account potential future scenarios which may impact on current determinations concerning materiality.”
3. Climate transition strategy to be “science-based” including targets and pathways. “The issuer’s climate strategy should reference science-based targets and transition pathways. The planned transition trajectory should be quantitatively measurable (based on a measurement methodology which is consistent over time), aligned with, benchmarked or otherwise referenced to recognised, science-based trajectories where such trajectories exist, publicly disclosed (ideally in mainstream financing filings), include interim milestones, and supported by independent assurance or verification.”
4. Implementation transparency. “Market communication in connection with the offer of a financing instrument which has the aim of funding the issuer’s climate transition strategy should also provide transparency to the extent practicable, of the underlying investment program including capital and operational expenditure.”
Disclosure focusing on these elements should be referenced in connection with any transition bond issuance, irrespective of structural format (i.e., whether issued as a green bond or in SLB format). Relevant disclosures could be included in the issuer’s annual report, framework document, or investor presentations so long as they are publicly accessible to investors.
For each of the above four elements, the Handbook details the rationale behind the element and makes recommendations with regard to the substance of the required disclosure and whether independent review, assurance, and verification are available and in what form.
Note that the Handbook is intended to be complementary to, rather than to replace, the various existing ICMA principles and recommendations. Where a brown company seeks to issue self-labeled climate finance transition instruments, it should, irrespective of the instrument’s format, incorporate in its disclosure the elements outlined in the Handbook as a means of benchmarking its overall transition strategy against an approved and recognized methodology. Furthermore, the Handbook will enable third-party, independent reviewers to opine on the alignment of the issuer’s disclosure relative to the guidance provided in the Handbook.
There are arguments that with the increasing popularity of SLBs, self-labeled transition bonds will become redundant. Transition bonds should not, however, be thought of as a separate, distinct category but rather as an instrument that can take different forms issued by a brown company as part of its overall strategy to transition to a greener profile and in relation to which the disclosure aligns with the recommendations set out in the Handbook. If the ultimate goal is to achieve the Paris Agreement objectives, and sustainable finance is seen as a tool to achieve these objectives, climate transition finance will play a fundamental role in that process. The publication of clear guidance promoting transparency and the credibility of transition bonds is a welcome step in that process.
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