Should Transition Bonds have a place in the path towards carbon neutrality?

The European Union’s target of achieving net-zero emissions by 2050 is a costly one. An annual investment of €260 billion is estimated as needed to advance EU transition to a low-carbon economy. To allocate funds in the best way, both public financial institutions and private investors need a clear framework to properly identify sustainable investment opportunities. The European system, the EU Taxonomy, only considers already sustainable activities, thus rewarding companies currently doing a good job. Nonetheless, several industrial activities, whether due to the nature of their business or to lack of finance, are in a worse position, despite their potential emission reduction. The introduction of a Transition Taxonomy may help address this gap, while, at the same time, avoid abrupt changes that might carry high societal costs.

In December 2015, the world watched 196 of its leaders commit to fight climate change and promote a rapid transition towards a low-carbon future. At the core of the Paris Agreement is the goal of limiting global temperature increase below 2°C while pursuing efforts to prevent it reaching 1.5°C. The Paris Agreement became a landmark moment, allowing for the world to grasp the real emergency of transitioning to a low-carbon society. In the following years, several of its signatories pledged to go even further in their nationally determined contributions (NDCs), announcing plans to reach carbon neutrality in the upcoming decades.

Setting the example was the EU, which took upon its Member States the leadership of the world’s low-carbon transition. Last December, the European Commission presented The European Green Deal, detailing the roadmap for the EU’s future growth strategy aimed at decoupling economic growth from resource use and carbon emissions.

Finding the €260 billion investment, estimated by the Commission as the amount required to achieve the Union’s climate neutrality goal, might be easier than you think. In recent years, investors’ appetite for sustainable or green investment opportunities has increased significantly, with the annual global issuance of Green Bonds having tripled between 2016 and 2019, reaching €225 billion. However, investors need a clear framework to properly identify sustainable investments and understand which companies are already doing a good job, as well as those which are in a worse position, whether due to the nature of their business or due to lack of finance, but have the potential to improve.

But what are these sustainable or Green Bonds? Bonds can be seen as a loan taken by companies, government or banks in order to finance (or refinance) a given investment project. What is specific to Green Bonds is that the borrowed funds are meant to be allocated to investments in environmental and climate change projects which are deemed green, according to the Green Bonds Principles. The World Bank and the European Investment Bank were pioneers in issuing these types of bonds, with their Green Bonds and Climate Awareness Bonds, respectively.

To help guide investments towards sustainable projects, the European Commission developed the EU Taxonomy, an EU-wide classification system for environmentally sustainable economic activities. The goal of this system is to help sustainable finance participants (financial markets, companies, EU institutions and Member States) to assess the green financing potential of companies and projects, and evaluate a company’s environmental performance. In this way, investors can identify environmentally friendly activities, as well as promote the growth of low-carbon sectors.

As with any pioneering work, the EU Taxonomy is not beyond criticism. The Technical Expert Group (TEG) for sustainable finance set by the European Commission noted, in their Technical Report on Taxonomy published in March, that additional tools are required to help assess the potential for efficiency improvements in emission-intensive economic activities, which have so far been excluded from the EU Taxonomy.

A Transition Taxonomy, identifying companies for which improvements towards significantly better environmental performances can be pursued, is essential to reduce harmful environmental impacts of emission-intensive industries. In fact, industry was responsible for 17% of the Union’s greenhouse gas emissions in 2017, trailing only emissions from the energy sector. Given so, emission reduction from this sector must be a priority if the goal of carbon neutrality for the EU is to be achieved.

We must be realistic in accepting that some of these industries can never be green or compatible with an absolute-zero emissions future due to the nature of their processes, e.g., cement and steel manufacturing. But financing towards more efficient use of resources (from energy to materials), the incorporation of new technologies and methodologies, as well as the training of the workforce towards new green skills has the potential to reduce industrial emissions at the same time as maintaining jobs and equipping workers with new skills essential in the low-carbon economy we aim to build.

With industry representing one-in-four jobs globally, a complete shutdown of emission-intensive plants and sectors would have a disastrous social impact. As the gilet jaune episodes in France so clearly showed, the implementation of blind, one-way measures that, although inadvertently, result in an amplification of social inequalities and injustices, are likely to be met with significant resistance by civil society, undermining the positive environmental outcomes they were aiming at. A holistic approach to both social and environmental problems is mandatory from European leaders, and Transition Bonds can play an important role in coupling positive social and environmental outcomes.

Unfortunately, being aimed at emission-intensive industries, sceptical voices point out that Transition Bonds can be used by polluting companies as a cover up. The issuance of this type of bond offers companies without any real commitment to shifting away from current business practices a chance to boost their image - what is known as greenwashing. Another source of criticism lays in the fact that a gradual transition to more efficient, greener industrial practices might be insufficient given the timeframe the world has to reach net-zero emissions.

The solution may be to regulate the issuance of Transition Bonds for financing (or refinancing) new and existing transition projects through Transition Bonds Principles, whose structure should follow that of Green, Social and Sustainability Bonds Principles. Such structure includes defining the scope of possible uses for the proceeds, with issuers being required to state how the financing will be allocated to projects within a range of predefined transition-activities in specific categories, such as energy, transportation, industry and buildings. Furthermore, Transition Bond Principles must also delineate the process for project evaluation and selection. In this step of the process, it is essential that the companies wishing to issue Transition Bonds fully disclose the potentially negative environmental and social impacts and externalities of the project under evaluation. To ensure transparency in the allocation of the proceeds, the project progress should be tracked both through a formal internal process defined by the issuer, as well as through external audits. Transition Bond Principles should define specific reporting requirements and key measures of impact, prescribing penalties if companies fail to meet the targets they establish.

Although functioning in a similar way as other corporate debt instruments, by being bound to clear targets, transition bonds have the potential to incorporate broader social and economic benefits, while addressing the low-carbon transition in industry. Providing incentives for investment that reduce harmful environmental impacts from emission-intensive economic activities - Transition Taxonomy - will be an important lever for achieving the Union’s goals.

As a result of the COVID-19 pandemic, the world is facing the biggest economic shock since the 1930s. As funding packages are being discussed to address its effects, European leaders must avoid committing the same errors made in the response to the 2008 financial crisis, picking economic growth over environmental and social goals. The European Union has now the opportunity to promote a cleaner, more resilient and cost-effective industrial sector, aligned with the long-term objective of sustainable growth. Incorporating Transition Bonds into the EU Taxonomy is key to address both social and environmental problems in the long-term transition towards a low-carbon, sustainable economy.