Transition finance in bond markets will require credible corporate governance arrangements

Bond issuers in capital markets are increasingly focused on transition finance. Unlike green finance, which is directed at activities that are already consistent with a 1.5 degree warming scenario, transition finance funds emission abatement and low-carbon technologies where no purely green technology is readily available. This form of finance inherently relies on climate commitments by the company. For capital markets to work, bond issuers will need to get better at explaining their climate transition plans and underpin such plans with sound management and governance arrangements.

On the side of investors, the low-carbon transition has also defined some very different investor mandates and objectives. A new interpretation of fiduciary duty that is consistent with climate policies has already been reflected in legislation in a number of jurisdictions. Requirements for better sustainability disclosures will also expose asset managers and investment advisers to greater market discipline. Individually and in the various investor coalitions, such as the Glasgow Financial Alliance for Net Zero, asset owners set themselves targets for the mobilization of green assets and also for the decarbonization of their portfolios.

Many have argued that transition finance requires a new type of taxonomy, in addition to the green taxonomy that identifies unambiguously green activities aligned with a 1.5 degree climate scenario. Such a classification would set out the various ‘shades of green’ of technologies deployed on the path to a net zero world. Shipping, for instance, is a typically ‘hard-to-abate’ sector. Gas-powered vessels may reduce emissions at first, while not offering the ultimate net zero technology. The EU’s technical expert group proposed such a separate taxonomy but legislation seems unlikely in the remaining term of the current EU Commission.

That is no grave loss, as a static taxonomy is neither sufficient nor necessary for transition finance to take off.  A more logical step will be to elevate climate transition plans issued by enterprises and to make sure such plans are sufficiently robust and ambitious based on private sector verification. Transition plans indeed seem to be central in recent templates developed by international bodies, such as the OECD or the G20 Sustainable Finance Working Group.

Net-zero pledges and other climate plans lack sufficient detail or fail to set credible targets.

As yet, corporate climate targets on the whole seem unambitious or lack credibility. Net-zero pledges and other climate plans lack sufficient detail or fail to set credible targets. In February, the Climate Disclosure Project showed that only a small fraction of the 18,000 companies monitored globally met their key indicators of climate transition plans. Only in a handful of EU countries did more than 10 percent of reporting companies define plans that met most of the required indicators. Overall, the number of climate plans, and their support in corporate governance remains disappointing.

Current trends in the EU bond market underline why better transition plans are direly needed. Green bonds issuance experienced strong growth in 2021, though then dropped slightly last year. The instrument still appeals to investors with a mandate for ESG alignment. Yet as is well known, green bonds do not necessarily deliver climate outcomes. The use of bond proceeds is the subject of a non-contractual green bond framework which is subject to private sector verification. Failure to use proceeds in the way initially set out by the issuer in its green bond framework will not constitute an event of default or give the bondholder the option to accelerate repayment or demand other remedies.

A more recent phenomenon are sustainability-linked bonds which have grown rapidly in the past years, with about EUR 89 billion issued in EU corporate bond markets in 2022. Such instruments are essentially agnostic on the way bond proceeds are used, though will hold the issuer to account for a time-bound sustainability target. Should that target be missed the issuer would pay a higher coupon rate or incur other penalties. Despite recent rapid growth, this market is still quite immature. A new ESMA study showed there has been a near uniform bond contract structure and typically undemanding coupon step-up penalties of only 25 basis points, largely unrelated to the issuer’s credit risk. Many of the performance targets set in corporate bond issues seem to have been unambitious or failed to capture relevant emissions. As it operates currently, the corporate bond market does not reward climate commitments sufficiently.

In the EU, this picture will change quickly as the Corporate Sustainability Reporting Directive (CSRD) requires roughly 50,000 enterprises to publish climate transition plans from 2024. EFRAG, the EU accounting body, has just articulated some detail in its new draft standard. This should bolster market transparency of where the Union’s corporate sector truly stands in relation to the 1.5 degree climate target.

Companies, in particular those with a capital market presence, will need to explain better how they will deliver on often distant climate targets and define robust incentives and management structures.

But important additional detail still needs to be fleshed out. One question is how the finite remaining budget for global greenhouse gas emissions is allocated to decarbonisation paths in each industrial sector in the EU. Here, a number of private sector initiatives already offer guidance based on scientific decarbonization pathways. A second key aspect of transition plans is how internal management systems back up corporate climate targets. Companies, in particular those with a capital market presence, will need to explain better how they will deliver on often distant climate targets and define robust incentives and management structures. The EFRAG standard merely requires companies to explain how the transition plan is embedded in the overall business strategy, which risks producing superficial language. Investors will require much more detail, for instance on how executive remuneration relates to climate change performance, or whether the company uses an internal carbon price.

Sustainability-linked and transition bonds are becoming mainstream. Bond investors increasingly seek reassurance on climate outcomes, rather than on climate-related expenditures. If outcome-based instruments are to work, information and disclosure needs to become much better. The new EU green bond standard, agreed provisionally in late February, belatedly also includes disclosure provisions for sustainability-linked bonds, implying that verification providers which are accredited under the new standard will also assess transition plans.

Last year, over 21 per cent of EU and UK bond issuance was labelled as being sustainable in some form. Institutional and retail investors, including the beneficiaries in long term pension plans, deserve a better sense how Europe’s corporate sector delivers a monumental structural transformation as the low-carbon transition unfolds.

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By Alexander Lehmann, a non-resident fellow at Bruegel, the Brussels think tank, and teaches at the Frankfurt School of Finance.

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