What is transition finance?

A new type of green finance has emerged and, rather than simply blacklisting “bad” companies, it is offering even the heaviest polluters a pathway to a greener future
Transition financing

If overnight the world’s money men divested out of everything that wasn’t truly green, the global economy would be on its knees. From oil and gas to steel, cement or aviation, carbon-intensive industries keep the wheels of commerce moving. These hard to abate sectors need investment right now if they’re to shift to a net-zero world. This is where transition finance comes in.

To date sustainable finance has focused on activities that are already green, yet there are many pathways to the Paris climate agreement. Some investors are now taking a carbon-footpath approach instead, using their capital to persuade heavy polluters to change their ways rather than eliminate them from investment portfolios, through a decarbonisation or carbon-footprint strategy.

“We’ve built a successful green finance market so far in the 2020s, with momentum towards that vital first trillion dollars in annual green investment. But the urgency remains. We need to replicate that market in transition finance, at speed, sector by sector, industry by industry,” says Sean Kidney, chief executive of the Climate Bonds Initiative (CB).

You need a big carrot, not a big stick… you need to reward companies for doing the right thing

This is a crucial time for transition finance. There is an unprecedented need to tackle climate change and, in the process, high-emitting sectors, which are unable to access green funds. Many businesses have ambitions to change, but they need money and encouragement to do so. Since there’s a lack of regulatory incentives to decarbonise, such as a meaningful price on carbon, the drive will come from markets. 

“You need a big carrot, not a big stick. That’s the view of those holding trillions in funds who are looking to park them in businesses tackling green issues. There is an increasing realisation that you need to reward companies for doing the right thing,” says Marisa Drew, chief sustainability officer, advisory and finance, at Credit Suisse.

 Time for a transition framework

Robust standards, definitions and benchmarks are also required for transition finance to work. This is why the CB and Credit Suisse with others are trying to develop a framework defining credible strategies for companies.

At the same time, the Transition Pathway Initiative, led by asset owners that assess companies’ preparedness for the transition to a low-carbon future, is empowering investors with tools and data to help investment decisions in this area. Players in this field are increasingly figuring out what “good” looks like.

“Transition aims need to be backed up by a plan and concrete metrics and not just pledges with no substance,” says Drew.

It is early days, but it’s an exciting class of investment, providing clear financial benefits for change. It also opens up the market to a much wider group of investors around the globe who aren’t just focused on green bonds and financial products.

“This is the fuel that will power many industries’ transition costs. The size of the required capital investments is in the many trillions of dollars without which we cannot move to net zero and have thriving economies,” says Jan Laubjerg, global head of power, utilities and renewables at HSBC. “We recently announced steps to support our customers with between $750 billion and $1 trillion of finance and investment by 2030 to help with their transition.”

Transition finance is not without its challenges. Greenwashing -  making false green claims - primarily comes to mind. Just like other forms of sustainable investing, science-based targets are vital, underlined by third-party oversight and disclosure. Standardisation is also crucial.

“To avoid the risk of greenwashing, a steel company, for instance should not be issued with a transition bond without allocating at least some of the proceeds to the decarbonisation of its most carbon-intensive activities. Some bonds issued to date under the transition label have not been strong and have faced criticism,” says Kevin Ranney, director of sustainable finance solutions at Sustainalytics.

“The issue is that the goal of decarbonising is far more ambitious than improving ESG [environmental, social and governance] performance, and it requires greater levels of investment, stronger strategies and a longer-term view. This is more than most companies have contemplated to date.”

Time to drill down on high-emitting sectors

Shipping, livestock and energy are just some industries where carbon intensity is high, other sectors include chemicals, mining, plastics and aluminium production. It’s better to get seasoned businesses to evolve, use their know-how and market connections to transition, than slash funding with a scorched-earth investment policy.

“The problem is many high-carbon-producing industries are highly leveraged; just look at airlines and energy companies,” says Barnaby Barker, investment analyst at SCM Direct. “Although we’re currently in a low interest rate environment, some companies are already highly indebted, without the added, yet unknown, negative effects of COVID-19. So they may not have the debt capacity to finance the costs involved in transitioning major parts of their business.”

It doesn’t help that some companies aren’t engaged with this transition process yet. There is not always a clear financial benefit to transitioning, at least not in the time horizon that companies or boardrooms plan for, and the short-term quarterly pressures of earnings announcements don’t help.

“No major fossil fuel energy company has yet aligned its emissions reduction plans with limiting climate change to 2C, although some companies such as Eni, Shell and Total are starting to get close,” says Adam Matthews, co-chair of the Transition Pathway Initiative.

“The gap between US and European oil and gas companies is stark, with no US company even disclosing intentions to align. In contrast you are seeing alignment to greater ambition among electric utilities in both America and Europe.”

Like green investing, transition finance needs to gain its own momentum and create its own virtuous circles. Each player in the market, including governments, issuers, underwriters, investors and auditors, will need to come forward with their piece of the puzzle so a robust ecosystem is created over time. “Once companies use it to transition, this type of finance will be a signal to others that they can attract funding, if they are willing to change,” says Masja Zandbergen, head of sustainability integration at Robeco. “We strongly believe companies that drive transition finance are likely to thrive in the long run and therefore be good investments.” This will be a good thing.