China has both the intent and the future green finance needs to take advantage of new transition finance markets, but collaboration between regulators, issuers and investors is necessary to allow these flows to grow, according to a new report.
China became one of the pioneers of transition finance in 2021, when Bank of China issued a $500mn three-year bond and a Rmb1.8bn two-year bond following the International Capital Market Association’s transition handbook. Earlier in February, the People’s Bank of China declared a commitment to formulating standard on transition finance, and the National Development and Reform Commission drew up guidelines for the transformation of the energy sector.
But issuances of transition-linked finance to date pale in comparison to the trillions estimated to be needed for China to meet its new commitments to reach carbon peaking by 2030, and to achieve carbon neutrality by 2060.
A new report by the Climate Bonds Initiative finds that the strictures of China’s existing green bond frameworks mean that many of its high-polluting heavy industries cannot tap into finance that is linked to transitional activities, such as those that would improve polluting technology or interim activities that will be phased out but are currently necessary.
In the steel industry, RMB2tn ($314bn) is estimated to be necessary to enable carbon-reduction technologies and processes – such as new electric furnaces, better use of waste heat, and swapping carbon for green hydrogen as the agent used to remove oxygen from iron ore.
While the China Metallurgical Industry Planning and Research Institute is drafting an action plan to achieve carbon peaking by 2025, the CBI finds that steel companies are largely reliant on short-term debt financing, mainly from banks, that fails to incentivise long-termism. Financial institutions need to allow companies in the sector more time and flexibility to transition; companies could capitalise on the introduction of more energy-efficient technology and climate governance to improve their credit ratings; and government and regulators should develop policies to incentivise these changes, the report says.
More broadly, however, the CBI identified a lack of credible standards and instruments for transition activities that are not covered by green bonds – meaning investors could struggle to keep companies focused on decarbonising.
Credible transition plans involve Paris-aligned goals incorporated in key performance indicators; robust plans for achieving these KPIs; governance put in place; financing made available for the transition; and the independent verification of reporting on the indicators, according to the CBI. It concludes that, while guidance is being drawn up by several bodies, “to date, there is no internationally agreed conceptual definition of what constitutes credible transition finance and the criteria for classifying its operations”.
CBI chief executive Sean Kidney says: “Now is the time for the world to tackle the rapid transition of the hard-to-decarbonise sectors, such as steel, cement, petrochemicals and aviation. Practical solutions are available; countries need regulatory action and capital that backs up pathways for change.
“Climate Bonds Initiative is drafting rigorous scientific criteria to guide the setting of thresholds and trajectories for these sectors. This represents the continued evolution in the labelling of financial instruments to encourage large-scale investment towards net zero,” he adds.
Do transition bonds answer the problem?
Despite the consensus that better frameworks for assessing companies’ alignment with transition to net zero are welcome, some investors are still debating the specific instruments that should be used to achieve this.
Thirty transition bonds have been issued globally so far, according to the CBI, while the increasingly popular sustainability-linked bond can also commit companies to achieving climate-relates KPIs. But some worry that by relaxing or diverging from the use-of-proceeds conditions set out in the green bond market, this kind of instrument could provide cover for companies to continue the status quo.
Previous attempts by corporates to issue transition bonds have often been met with suspicion, and Kidney has previously criticised the lack of scientific rigour in the Bank of China’s 2021 tranches.
Simeon Willis, chief investment officer at UK consultancy XPS Pensions, says that it is illogical for the company’s asset owner clients and peers to ignore China if they care about sustainability.
“Investment is one of the key ways that we as individuals and society can influence international progress, so making a decision that you’re not going to invest in China… I think you’re missing a great opportunity for us as stewards of capital to influence a market that we otherwise are external to.”
But with the stakes high over potential threat of greenwashing, XPS pressures asset managers appointed by its clients to do thorough due diligence even on green bonds included in portfolios, rather than relying on the green label as a guarantee.
“When we see that approach from the manager, we want to make sure that, as well as the green label, they’re considering the sustainability credentials of the company as a whole,” says Alex Quant, investment consultant and head of ESG research at XPS.
A transition bond framework, he says, “would just require a similar level of interrogation from the investment manager to ensure that the company they’re investing in is appropriately adpating and contributing through their shift in activities”.
While the role of green bonds is clear, the advantages of a specific transition bond over climate being addressed in standard fixed income instruments is less so: “Really we want all bonds to be transition bonds, so giving it a label actually isn’t particularly beneficial, because really you can’t find a single company out there that hasn’t got work to do,” Willis adds.
China’s progress could slow in 2022
The Chinese government’s overhaul of heavy industries looks set to be a steady one, in contrast to radical measures unleashed against coal power generators and the residential development sector in 2021, according to Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis.
Recent policy measures such as an updated green bond catalogue removing controversial inlcusions such as ‘green’ coal, the PBOC’s green lending tool (albeit with a limited amount of loans eligible to be used as collateral), and the introduction of a national emissions trading scheme (ETS), lay the ground for some green capital to begin flowing to projects in the country, but with global uncertainty rising, furrther dramatic regulatory change may have to wait.
“It seems there’s a fine-tuning, or even playing down in the tone of decarbonisation this year,” she says. Garcia-Herrero and colleague and Natixis economist Junyu Tan suggest that the country’s new ETS, the largest globally from inception but which lacks liquidity and seees most companies enjoying a surplus of allowances, is emblematic of the current “glass half full, half empty” status of Chinese sustainability efforts.
With the government reluctant for the moment to progress this market in a way that increases costs for brown energy providers and their industrial clients, enabling transition finance may be seen as a useful halfway house for Beijing, signalling intent without the disruption of a radical green overhaul
“If you can’t do it all, or can’t take the path that you’d imagined, you have to come up with a mid-way solution,” says Garcia-Herrero, adding: “It shows that this is the intention but it’s maybe not the right timing.”