Supporting decarbonisation: Why transition and sustainability-linked bonds can and should co-exist

The sustainable debt landscape continues to evolve with a diverse and growing range of instruments all trying to address slightly different financing challenges and attract investors with different objectives.

Typically, there are two main ways in which an issuer may seek to offer sustainable debt. It can be issued either as a use-of-proceeds bond¹, where capital is directed toward a specific project with a specific sustainability goal depending on the category, or via debt tied toward general sustainability improvement without specific ring-fencing of capital.

Within the use-of-proceeds category, the most common types are green, social, and sustainability-themed bonds with newer subcategories emerging such as blue bonds (focused on water ecosystems) and orange bonds (promoting gender equality).

Most recently, there has been the reemergence of transition bonds, which aim to expand the types of projects financed beyond traditional green classifications and to help finance the necessary economic shift from ‘brown’ or higher-carbon activities toward ‘greener’ alternatives.

Meanwhile, under the general organisational improvement lens, the most common type of issuance has been the sustainability-linked bond and the less common sustainability-linked loan bond.

With consensus being that trillions of dollars are needed for the world to fully reach net zero emissions by 2050, transition bonds and SLBs are both tools that can be used to expand the sustainable finance market that has traditionally driven capital mostly toward only green activities. While important, this leaves out critical sectors and parts of the so-called real economy.

There is an argument that since both transition bonds and SLBs can be used to finance activities beyond those typically classified as green, it’s confusing and unnecessary to have both instruments in the market as it creates extra fragmentation, potentially leading to both investor confusion and portfolio management complications.

However, we believe the two classifications have significant differences and should be used by both issuers and investors who have varying goals.

Transition bonds: Purposeful funding of brown-to-green activities

As a use-of-proceeds instrument, transition bonds finance specific projects and therefore have more ‘purity’ in purpose which can appeal to investors who are seeking tangible and targeted actions.

Transition bonds are supposed to have post-allocation reports and quantitative key performance indicators on the environmental impact of the project, making it much easier for investors to assign proportional impact to their portfolios and demonstrate decarbonisation to their end clients.

The International Capital Market Association’s recent guidance has helped clarify the criteria for climate transition bonds². By requiring entity-level transition plans that follow science-based pathways and are aimed at preventing future carbon lock-in, investors can feel more secure that issuers are not just isolating transitioning assets and issuers can feel more confident the market will recognise their efforts, thereby potentially alleviating greenwashing concerns on both sides.

This may make transition bonds more appealing for issuers in high emission sectors and/or where decarbonisation commitments can be challenging (such as shipping, manufacturing, or industrial areas like steel and cement) as they can now credibly point to these projects and KPIs.

While not finalised, proposed regulatory developments, including the Sustainable Finance Disclosure Regulations 2.0’s³ introduction of a “transition product category”, may also help facilitate growth of the transition bond market.

To date, many investors have struggled with where to allocate financing that isn’t enough to be considered green but is still more environmentally friendly than conventional debt.

The introduction of this category may allow for a clearer landing spot, which could unlock a positive feedback loop where having dedicated pools of capital drives new issuance in the category - leading to further market expansion.

SLBs: A flexible instrument suitable for different issuers and sectors

As SLBs focus on overall organisational sustainability improvements, they can offer greater flexibility in decarbonisation efforts. Issuers can tailor near-and-mid-term interim carbon reduction targets to be both in line with their expected improvements, as well as based on what is technically and/or economically viable.

SLBs may also be appealing to issuers who do not have significant capital expenditure projects related to decarbonisation (as would be needed for a use-of-proceeds bond) but rather can improve their carbon footprint through operational efficiencies such as improvements in procurement practices, or research and development in lower-carbon technologies.

In addition to offering solutions to investors for sectors with lower capex needs or with less obvious levers for decarbonisation, SLBs offer the opportunity for investors to be compensated should KPIs not be achieved.

The ‘step-up’ mechanism in SLBs is not meant to act as a penalty but rather allows investors to be compensated for the perceived increased risk from the issuer who fails to achieve the KPIs and may struggle in a world moving towards decarbonisation.

In addition, SLBs can be used for sustainability efforts beyond decarbonisation. We’ve already seen material sustainability performance targets on a variety of topics including human capital (Brazilian company B3’s Gender Equity and Diversity SLB⁴, biodiversity (Chile’s 2026 SLB focused on protecting terrestrial and inland water areas⁵ ), and water (Saur Group’s SLB with KPIs targeting water withdrawals⁶). This allows investors to participate not only in financing improvements on emissions but also help meet other sustainability related financing goals.

Investors’ choice

Transition bonds could potentially be more suited for those seeking asset-level transparency with dedicated capital going toward specific projects with reportable KPIs they can bring back to their stakeholders.

They can be used for financing hard-to-abate sectors which traditionally have not enjoyed as much attention but are some of the most critical and impactful parts of the global decarbonisation journey⁷.

Transition bonds can also avoid some of the operational complexity of SLBs such as setting credible targets; the need for improvements in data tracking and having continuous verification. This can potentially make investors more comfortable with the ambition and attainability of the issuer’s sustainability profile. 

The potential downside of transition bonds is they are relatively new and so it’s unclear if there will be continued demand for the product, which could impact liquidity and therefore make portfolio diversification more challenging. In addition, as the market is still evolving, guidance and examples around impact reporting remains limited, with little clarity on the core metrics issuers should use to demonstrate the outcomes of their transition activities. If the issuer fails to achieve their longer-term climate goals, there is little recourse for the investor.

In contrast, SLBs could possibly be more suited to those interested in broad issuer-wide transitions and who are less concerned about the near-term decarbonisation fluctuations. They offer compensation if the issuer fails to meet their objectives, and with a broad variety of issuers in both sectors and geography, allow for potentially easier portfolio diversification.

The risk for investors is that SLBs, while improved, are still facing complaints around their structures. These include weaker sustainability performance targets which allow issuers to easily achieve targets without meaningfully changing their operating models, as well as ineffective penalty structures that don’t compensate investors enough for the additional sustainability-related risks. Additionally, investors may struggle to claim impact without having financed a specific initiative.

Potentially complementary and effective tools for both issuers and investors

As demand for sustainable investment opportunities grows, both SLBs and transition bonds provide a diversified toolkit that help accommodate different issuer needs, investor preferences, and market conditions.

Both instruments have strengths and address distinct market needs, and rather than viewing them as mutually exclusive or competing options, their coexistence offers optionality in the sustainable debt landscape and should continue to encourage broader participation and innovation.