The situation

Governments across the world are now committing to reach net-zero emissions by mid-century. Indeed, climate-related risks pose significant financial risks to the economy. This puts tremendous pressure on all stakeholders, including Canadian pension plans which are at risk of holding stranded assets. Furthermore, these large asset owners are increasingly scrutinized by beneficiaries to decarbonise investments within their portfolios. To address this situation, pension plans are progressively choosing low carbon investment strategies, whether those are implemented in-house or through external managers. Either way, investors are now facing a real challenge since their own plan to achieve net-zero emissions by 2050 relies mainly on pledges undertaken by corporate issuers and governments. 

Target setting

In the past few years, a lot of corporations have been making pledges to reach net-zero carbon emissions by 2050. However, as mentioned in the 2023 report ‘Are Companies Developing Credible Climate Transition Plans’ from the CDP (formerly Carbon Disclosure Project), few companies have implemented and publicly disclosed a credible transition plan to achieve their target. Furthermore, many of those commitments fail to address scope 3 emissions, which in some cases, represent the lion’s share of total emissions. The heavy reliance on the use of carbon offsets and carbon capture, utilization, and storage (CCUS) also raises concern as the primarily focus of corporations should be on reducing their carbon emissions.

According to best practices, issuers’ targets should be based on science and cover all their scope 1 (fuel combustion) and scope 2 (electricity consumption) emissions as well as scope 3 (upstream and downstream activities) emissions if these represent more than 40% of total emissions. To this day, the Science Based Target initiative (SBTi) has the most robust guidelines for setting corporate greenhouse gas reduction targets. It uses decarbonisation pathways based on science and more importantly, considers the realities and issues associated to most industries. A growing number of companies are using the SBTi to approve their corporate targets.

Tomorrow’s economy

Under science-based 1.5^oC scenarios, the use of fossil fuels is expected to decrease dramatically by 2050. Furthermore, the latest IPCC (Intergovernmental Panel on Climate Change) report has stated that no new fossil fuel infrastructure should see the light of day, and decarbonisation of existing ones is also needed if we want to limit global warming to 1.5 ^oC. Accordingly, some companies inevitably need to change their business model to keep operating. The most obvious industry that comes to mind is oil and gas, which represents an important share of the Canadian economy. This also implies that all companies using fossil fuels as an input in their processes, need to innovate and adopt alternatives. As investors, it’s increasingly important to understand how this dynamic will play out.

How to get there?

Trillions of dollars will be needed to decarbonize economies across the globe. Investments to expand new and existing technologies will be particularly crucial in the near term. These technologies can range from carbon capture, utilization and storage (CCUS) to the integration of more renewable energy into the electrical grid, as well as improving energy efficiency across high emitting industries (cement, steel, aluminium, etc.).

In the past few years, significant attention has been drawn to the green bond market, which has experienced tremendous growth and is now considered mature. This financial instrument requires that proceeds be allocated towards eligible green investments or projects, which can be validated by existing green taxonomies such as the Climate Bonds Taxonomy. More recently, working groups across the country have been developing a similar framework to help define eligible transition activities within the Canadian context. In our opinion, this step is crucial to the development of transition bonds, which like green bonds, relies on the concept of use of proceeds. To date, there has been a few issuances of transition bonds across the globe, but none in the Canadian investment-grade market.

An important milestone occurred in early 2023. The Sustainable Action Council has published the ‘Taxonomy Roadmap Report – Mobilizing Finance for Sustainable Growth by Defining Green and Transition Investments’. The suggested framework refrains from taking a stance on the exact definition of a transition activity, which should be published in the near future. It rather provides guidance to companies looking to issue transition bonds. The first part of the proposed framework includes corporate general requirements such as setting a net-zero target and a 2030 interim target, implementing a credible transition plan, and disclosing climate-related risks at the corporate level. In our view, these requirements are essential if we are to avoid greenwashing within this nascent market. The second part of the framework outlines potential criteria to differentiate transition projects from green ones. This milestone is critical considering there has been greenwashing incidents within the green bond market.

In the Canadian context, our view is that transition bonds are the missing link to get to net-zero by 2050. All things considered, the greater decarbonisation opportunities lie in the energy sector. Since a green bond can’t be used by oil and gas companies to finance decarbonization of fossil fuel related assets, they will have to resort to transition bonds. On the other hand, companies can tap into the green bond market to fund green projects that are part of tomorrow’s economy. Canadians still rely heavily on fossil fuel activities for a large share of their needs and will continue to do so in the near future. It would be virtually impossible to transition away from these energy sources overnight. 

Bottom line

In a nutshell, we now have more clarity on how the transition to net-zero could be implemented. Having a dedicated framework will help companies communicate their transition strategy, while a transition taxonomy will help identify if specific activities or projects fall under such label. Furthermore, this added credibility could appease issuers that fear risks arising from the emerging transition bond market. From an investor perspective, this will provide the necessary information to assess the integrity of issuers and their transition projects, which in turn, could encourage them to fund the gradual transition away from fossil fuels instead of directly divesting from high emitters. As Canadians, we need to help all Canadian stakeholders transition to a low carbon economy. If high emitting companies are serious about greening their activities, count us in. 

The AlphaFixe Team