September 6, 2019 / 10:41 AM / 12 days ago

Rise of controversial transition bonds leads to call for industry standards

(Updates to include details on timing of BNP Paribas’ work on transition bond standards)

* Bonds

* Deal from Brazilian beef producer shows demand for transition bonds, but also difficulties

By Gareth Gore and Miluska Berrospi

LONDON/NEW YORK, Sept 6 (IFR) - When Marfrig floated the idea of doing its first-ever green bond earlier this year, the company’s bankers knew the deal would be a difficult sell. As one of the biggest beef producers in the world - it slaughters more than 33,000 cows a day, including many that have been reared in parts of the Amazon cleared of rainforest - the Brazilian issuer was unlikely to meet even the minimum standards of many green investors.

A short non-deal roadshow in London confirmed those suspicions. Despite commitments from Marfrig to use funds only to buy cattle from suppliers that had signed up to not destroying more rainforest, investors baulked at the trade. “The first time we looked at this, the proposal was to do a green bond, which we had to refuse,” said one banker involved. “We thought it was not possible.”

But the bankers had an idea. Why not re-label the transaction? Instead of calling it a green bond, which would mean having to comply with industry-wide standards and risk drawing the ire of the ESG community, bankers suggested rebranding the trade as a “sustainable transition bond”, a made-up term that they thought would reflect Marfrig’s efforts to clean up its supply chain.

“The reality was we had an issuer who was best in class – best in class in its sector, at least,” said the banker. “Everybody knows that beef is not green. But, at the same time, here we have an issuer who is making a lot of effort in an area that is fighting deforestation. It is not addressing all the issues around beef, but should that be a reason not to encourage the effort being made?”

Driving the gamble was the fact that, despite green investors having ruled themselves out, bankers knew there was rampant demand from regular fund managers keen to buy anything they could point to as showing how they too are doing their bit to save the planet.

The bet paid off. When Marfrig printed the US$500m 10-year sustainable transition bond last month - via BNP Paribas, ING and Santander – the deal was more than three times oversubscribed. Such strong demand enabled the company to lock in a coupon of 6.625%, its lowest ever, and well inside the 7.25% yield on the shorter-dated US$1bn seven-year notes it had sold just a few weeks earlier.

CASH COW While the deal was the first so-called sustainable transition bond, there have been two similar deals previously: Hong Kong power producer Castle Peak Power sold an energy transition bond last year, while Italian utility Snam did a climate action bond in February.

Generically known as transition bonds, the asset class is expected to grow substantially. The combination of demand for assets with any kind of sustainability label, issuers keen to show their green credentials, and banks chasing deals create ideal conditions.

“Pretty much every investor shop I have talked to has put in place or tried to put in place some kind of sustainability framework,” said Michael Ferguson, who works on sustainable finance for S&P. “Even if they don’t have a mandate to invest exclusively or have some kind of proportion weighted to green bonds, they face pressure to at least show how it is they are considering sustainability metrics.”

According to Ferguson, having the right label can substantially boost demand for a deal, with green bonds are on average five times oversubscribed, compared to three times for vanilla deals. The pace of green bond issuance, which is on track to hit US$250bn this year from next to nothing a decade ago, is simply not enough to meet demand, leaving a yawning gap that banks hope to fill with transition bonds.

“There really is excess demand for environmentally sensitive investments,” said Ferguson, who said one thing driving the development is that the potential issuer base is extensive. “The universe of potential investments that would fall under transition bonds as opposed to green bonds is a lot larger, so it seems to me there would be a much bigger audience and potentially a pricing advantage.”

But that pool of issuers is only broader because the bar for doing transition bonds is much lower than for green bonds. Every one of the three deals brought to market so far have caused controversy – the CPP and Snam deals because they will fund the continued burning of fossil fuels, and the Marfrig deal because beef production is considered to be the biggest single contributor to deforestation globally.

WHERE’S THE BEEF? Banks argue transition bonds can be a bridge to better practices, helping companies and sovereigns raise funds to fund projects that may make them, if not green, at least less brown. Examples might be a shipping company overhauling its fleet to run on natural gas, which though polluting is less so than oil, or refitting power stations to burn gas instead of coal.

“There does seem to be a view that you shouldn’t try and use a green bond to finance any kind of technology that might lock in the use of fossil fuels,” said Farnam Bidgoli, head of sustainable bonds in EMEA at HSBC, which did the CPP deal. “That being said, there is no scenario that takes us to 2050 targets that doesn’t include some use of fossil fuels, and so the question is how you square that circle.”

Amine Bel Hadj Soulami, global head of sustainable investments at BNP Paribas, agreed. “We think that the overriding aim of our role here – and also for a lot of investors – is to look at how things can be improved, even in sectors that are not green by nature,” he said. “That is not easy, but it is something we want to encourage.”

The trouble is, while there is demand from investors and issuers, and while the philosophy behind transition bonds as an asset class makes sense, there are no rules governing what can be labelled as such. As a result, some argue the asset class is open to abuse by banks keen to earn fees from deals and issuers and investors keen to be able to boast about their own, sometimes empty, credentials.

QUESTIONABLE MONITORING The Marfrig deal is a case in point. Some were shocked by the transaction, arguing that company shouldn’t be buying cattle from producers that have destroyed rainforest in the first place. Many also doubted Marfrig’s claims that it could monitor each and every one of the 10,000 suppliers it buys cows from with the use of unspecified “geo-analysis”.

“I’m pretty suspicious about all this because the language I saw with the release of the announcement was to enable them to buy deforestation-free cattle which they had already committed to doing,” said Daniel Brindis, a senior forests campaigner at Greenpeace. “It wasn’t clear to me that this really represents a ‘transformative’ change for the company.”

BNP Paribas said that it was aware the bond might prove divisive. “We fully anticipated the controversy, and we analysed that in depth, and we made the determination that ... this was the kind of thing we wanted to support because it really goes with our principles of accompanying companies that are making efforts towards sustainability,” said Bel Hadj Soulami.

“Sometimes we have to have the courage to do things like that if we want to be a leader,” he added.

The Marfrig deal was even controversial inside BNP Paribas itself, with other bank officials admitting to being concerned that their institution was associated with such a deal, and suggestions that some at the firm had been against the bank being involved.

The deal came with a second opinion on its ESG merits - from Vigeo Eiris - but that view was highly caveated. Similarly, the bond prospectus contained additional provisos. “There is currently no market consensus on what precise attributes are required for a particular project to be defined as ‘sustainable,’ and no assurance can be provided that the use of the net proceeds ... will satisfy,” the prospectus said.

Santander declined to comment on the Marfrig deal. ING issued a statement saying: “We believe this helps create greater impact than supporting only what is already green. The Marfrig bond was marketed as a transition bond to appeal to a broader spectrum of investors.”

Marfrig declined to make anyone available to discuss the deal, but said in a statement: “Regarding transition bonds, we believe that it is a very important tool to incentivate companies to become more involved in the sustainability theme, and shows a goodwill and work towards ESG.”

CLEANING UP Calls are now growing for banks to work together with investors and issuers to come up with a set of standards for transition bonds as an asset class. Investment manager AXA IM has developed guidelines to support would-be issuers of transition bonds, covering considerations such as reporting, management of proceeds, and issuers’ sustainability strategies, to create a rigorous market for such deals.

While the green finance market has seen a huge amount of work over the past few years to determine what should be financed, disagreements still happen. The transition bond market faces the additional complication of defining what a transition is, towards what, and by how much.

“From my perspective, I just may prefer to invest in a company that is already doing something that is more environmentally friendly, or having a better impact than someone who is transitioning in that way,” said Yvette Klevan, a portfolio manager with Lazard Asset management.

The International Capital Markets Association, which drove much of the work around green bonds, is currently considering what to do about the transition space. Banks, too, are waking up to the fact that they need to have an internal policy in place for reputational reasons. BNP Paribas has begun work on its own policy. The bank said that the work had begun before the Marfrig deal and was not a response to the controversy around the deal.

The hope is that, if done correctly, this asset class can be beneficial for everyone.

“Investors have built up funds, they need to invest them and want to have a large investment universe,” said one prominent banker in the ESG space. “Issuers want to promote what they are doing, even if they are coming from carbon-intensive industries. And of course banks are chasing trades. So the whole industry is pushing to develop this market.” (This article will appear in the September 7 issue of International Financing Review; Reporting by Gareth Gore and Miluska Berrospi)

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