China’s fledgling transitional finance sector wins early backers, faces challenges ahead

China has introduced transitional bonds to help heavy emitters fund their decarbonization projects, including some related to coal, but finance experts suggested it could be long before the market takes off.

The National Association of Financial Market Institutional Investors (NAFMII) in late May rolled out the new financial instrument in a pilot scheme to promote China's low-carbon transition.

Huaneng Power International, Datang International Power Generation, Aluminum Corporation of China, Shandong Iron & Steel, and Wanhua Chemical Group tested the water last month and managed to raise a total of CNY 2.29 billion ($340 million).

The transitional bonds, which will be used to fund activities like coal-to-gas switching, have repayment periods between two and three years.

"Those issuers could have secured low financing costs even if they chose traditional finance, but they were willing to issue transitional bonds to meet their [emissions] targets," said Han Ning, market innovation director at the NAFMII, the self-regulatory body for China's interbank market.

"By doing that, they show their willingness to disclose more of their activities and put themselves under the scrutiny by domestic and international investors," Han told the China SIF Summer Summit on 12 July.

China, the world's largest GHG emitter, has become a top green finance market after President Xi Jinping declared national targets of peak CO2 emissions by 2030 and carbon neutrality by 2060.

The country's total green loan balances exceed CNY 18 trillion and bond balances reached CNY 1.3 trillion as of March, according to the People's Bank of China (PBOC), the Chinese central bank.

Nonprofit Climate Bond Initiative (CBI) estimated more than $20 billion worth of green bonds were sold in China over January-March, making it the world's largest issuing country of the financial instrument.

But heavy emitters stand less chance of tapping into the large pool of finance. The PBOC's latest catalogue of activities eligible for green bond issuance—also known as the Chinese green taxonomy—excludes fossil fuel projects and has strengthened decarbonization criteria.

To fill the gap, the NAFMII's pilot scheme for transitional bonds targets the power, refining and petrochemicals, chemicals, building materials, steel, nonferrous metals, paper, and aviation sectors, most of which are either energy intensive or hard to decarbonize due to their production and operational means.

Bond issuers can use their sales proceeds to fund projects that are listed in the taxonomy but fail to meet its technical criteria, clean production and efficient use of coal, clean use of natural gas as energy, low-carbon capacity replacement, green equipment and technology, among other projects.

"From a pure quantitative emissions perspective, lower-carbon coal- and especially gas-fired power projects can help China achieve decarbonization targets, particularly if they are replacing lower-efficiency coal-fired plants," S&P Global Commodity Insights Climate and Cleantech Director Conway Irwin said.

However, China could face a "credibility challenge" by allowing coal projects to receive transitional finance, Irwin told Net-Zero Business Daily. "It is unlikely that international financial institutions that are moving towards their own emissions targets—and many of which have committed to end coal financing—will want to be attached to any of these projects."

Others at the summit suggested China's transitional finance rules will need to take into consideration the country's economic conditions. China is the world's largest coal producer and power generator, and coal—despite being the most carbon-intensive fossil fuel—remains its most stable energy source and important to the local economy.

"The transition of traditional industries, like coal, needs to be gradual and orderly … They provide many employment opportunities," said Zhang Mingzhe, head of green finance at Postal Savings Bank of China.

Challenges for corporates

The requirement for transitional finance is expected to be large. China's steel industry alone needs $3.14 trillion of investment to reach carbon neutrality, according to CBI's analysis.

Luo Pengcheng, head of corporate and asset research at WW Research Institute, part of Shougang Fund Group, said companies embarking on a low-carbon transition will be eventual winners.

"The number of companies will decrease following the energy transition. The remaining players will enjoy a concentrated industry," Luo said.

But some in the financial sector said prospective Chinese transitional bond issuers need to have strong carbon data integrity, disclosure standards, and establish credible decarbonization pathways for financiers to open the liquidity tap.

The issuers need to disclose how their low-carbon projects align with China's sectorial emissions targets for 2025 and national goals for 2030 and 2060, according to the NAFMII's guidance. Third-party verification is recommended but not required.

With China's financial services industry generally lacking carbon accounting skills, companies sometimes "don't understand or don't want to comply with" transitional finance requirements, Zhang said.

Earlier this year, Chinese authorities reported a series of cases of negligence and fraud in emissions reporting, in which third-party verifiers were unable to provide final checks because they either intentionally helped falsify the data or did not perform their duties properly due to insufficient competence.

"There is a lack of data integrity ... lack of foundation to gather basic data," Zhang said.

Zhu Ling, country lead for China's capital markets at CDP, a nonprofit specialized in carbon data disclosure, said the "information deficiency" could threaten the energy transition. "We have a gap to fill in this aspect," Zhu said at the summit.

Moreover, Chinese issuers—especially those in the hard-to-abate sectors—should provide credible transition plans by benchmarking their performances against GHG emissions, said Jeffrey Sukjoon Lee, Asia-Pacific manager for sustainable finance at Moody's ESG Solutions.

"It is important to choose a KPI [key performance indicator] relevant to your core business," Lee said at the same event. "In most cases, carbon emission-related KPIs … would be the most relevant."

Government support needed

Chinese issuers, based on the NAFMII's guidance, must publish a full-year report by 30 April and an interim report by 31 August every year on the progress of their transitional projects. The NAFMII will audit the issuers and punish those who didn't spend the money on low-carbon projects with its self-disciplinary rules.

However, the Chinese government has yet to develop official transitional financing standards, such as a taxonomy or a government-sponsored auditing system. Neither has it provided bespoke financial support for transitional activities.

Financiers would be more willing to enter the fledgling sector if there is more "direct, stable" support from policymakers, Zhang suggested.

"Merchant banks need to have long-term planning, and they lack direction and policy support for that," he said.

Han said she hopes investors can have "more tolerance" for transitional bonds as its pilot scheme just began to operate recently.

"We should have a bit more time to refine the financial instrument, to bring it in line with the energy transition," Han added.

Posted 13 July 2022 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.