Going green with a pragmatic approach

The market is set to grow further with the government’s commitment to issue green bonds to fund public infrastructure projects while issuers and investors alike are becoming increasingly keen with increased awareness.

But not everything that is “green” is gold. Here are a few things to consider before investing into green bonds.

Green bonds can legally be used to fund non-green projects

While growth of the GSSSL market is rapid, proceeds from GSSSL bonds can generally be used to fund non-GSSSL purposes. There is no clause or covenant that significantly compels the issuer to deploy the bond proceeds to its stated use, with explicit statements from certain issuers that deviation from its intended use of proceeds is not an event of default.

Although the intended use of proceeds is not strictly enforceable, and short of a rogue issuer, we think this is similar to a gentlemen’s agreement where issuers may keep to their promises as best as they can.

Pay attention to real changes

We think investors concerned about GSSSL clauses should monitor developments of the issuer itself. It is possible that more companies are issuing GSSSL bonds as a substitute to conventional bonds, which means that rather than proceeds providing additive material environmental benefits, some of these proceeds would go towards projects which the issuers would have undertaken regardless.

That said, it is noteworthy that GSSSL supply should also come from issuers who are looking to build-out their sustainability credentials and sustainability-centred business models in a bid to transition from brown to green.

While there is still room for improvement, we are encouraged by the growth of the GSSSL market as it raises awareness over the important discussions surrounding climate change.

Green finance has gone mainstream but brown not talked about much

The move towards mainstream adoption of green finance (of which green bonds are a subset) globally in the past decade has been helped by improvement in underlying project returns, spurred by policy interventions de-emphasising fossil fuels for power generation and transportation.

However, it is becoming more evident that a big elephant in the room is what to do about the pre-existing high emitting “brown industries”, in particular sub sectors where research and development work is still required and technologies where they exist have not been scaled up commercially.

Why does brown matter?

Investors focused on going green may be tempted to exclude brown industries to solely finance green purposes.

For one, it is much simpler to only select and track green bonds and secondly only a small subset of companies operate in industries that are purely green. However, money rushing only into green means potentially creating a “green bubble” which may lead to unexciting investment returns.

Exclusion of brown industries may also not be the best strategy to tackle climate change, as funding may be shifted to capital providers that are outside the spotlight such as private capital with no decarbonisation considerations.

As an illustration, the mere act of a publicly-listed company selling a high-emitting steel plant to a private entity does not reduce emissions on a net basis. Currently, the steel-making process is still highly reliant on coal to provide the high temperatures required to turn iron ore into steel.

Economic growth and job creation aside, brown industries may be crucial to supply chains and our standards of living, such as production of materials for use in buildings and infrastructure.

As such, instead of cutting out brown industries entirely, the objective to going green could be better served by helping brown industries find methods to cut down emissions, such as to “greenify” the processes to make them, lengthen the product lifecycle or increase the rate of recycling.

Therefore, in our view, Singapore’s push towards being a sustainable finance hub will need to consider the challenges of how to finance the transition for brown industries to become more sustainable. There is after all a limit to how many purely green projects there are that can be financed.

Transition finance is a concept, not a separate asset class

There have been attempts led by bond investors at creating a new asset class labelled as “Transition Bonds” since 2019.

However, this new asset class has not taken off, unlike green bonds. In December last year, the International Capital Market Association (ICMA), a key trade association for participants in capital markets, came up with a Climate Transition Finance Handbook to address the issue of transition finance, providing guidance and recommended disclosures for issuers wishing to label financing instruments with a climate “transition” label.

Rather than being a unique type of bond (such as the case of a green bond or sustainability bond or social bond or blue bond), the label “transition” can be used on different types of bond formats as long as funding is used by an issuer to credibly transition.

Sustainability-linked bonds as a way to effect Transition Finance

At OCBC Credit Research, we had first discussed the role and scope of Transition Finance in June. We continue to hold the view that Transition Finance is an important part of the financing equation on the quest towards decarbonisation and that sustainability-linked loans and SLBs are key instruments in meeting such transition needs.

SLBs link certain key performance indicators (KPIs) at an issuer level and if structured appropriately, this should catalyse change across an issuer’s entire business operations rather than solely through specific project investments.

Sembcorp Industries’s new SLB comes with a KPI linked to reducing greenhouse gas emissions intensity by December 2025 and — if unmet — coupon rate on the bond will increase by 0.25% per annum. Given that each brown industry is different, and that each issuer is on a different trajectory in its decarbonisation path, KPIs would need to be structured differently for them to be effective in meeting decarbonisation goals.

This would mean that the climate change strategy of each brown issuer and their capital and operational spending patterns would need to be assessed on a case-by-case basis. While comparison with peers may be difficult, price discovery is not insurmountable, in our view.

Singapore is able to take a pragmatic path

In many ways, Singapore does not suffer from preconceived notions given the nascent stage of the market development of GSSSL bonds and is therefore able to shape the market in a more pragmatic way that considers the requirements of the region.

In our view, rather than being overly fixated over bond labelling, it is important to keep the discussions focused on how to finance industries more broadly as we transition into a low carbon world.

Some government funding, venture capital and early-stage financing has been made available for research and development purposes, while in the past few months, certain asset managers have set up new transition funds dedicated towards supporting companies across a broad range of industries which are credibly transitioning.

In many cases, the decarbonisation technology and innovation still lack economic feasibility and more still needs to be done before decarbonisation projects are able to reach bankability and therefore mass adoption.

To accelerate the process, policy push which encourages uptake of new technologies, building of new low carbon facilities and phasing out dirty facilities would be required — all of which point towards the need of a more robust carbon pricing regime over time.

Andrew Wong, Ezien Hoo and Wong Hong Wei are credit research analysts with OCBC Bank’s Global Treasury Research and Strategy team

Photo: Sembcorp Industries