Transition Finance Gap Remains Amid Uncertainties

Published: August 07, 2023

The purpose of transition finance is to fund the improvement of carbon-intensive activities in pursuit of a more sustainable world. This contrasts with green finance, which is used by companies or projects already considered as being green.

Transition finance is one of several tools developed in recent years to align global financial flows with a low-carbon, climate-resilient future. However, while a considerable amount of work has gone into defining what can be considered green or sustainable, policymakers, investors, and companies have struggled to develop a clear and common understanding of what encompasses transition activities.

A significant number of economically vital sectors remain highly energy intensive or have hard-to-abate emissions, including electricity generation, heating, steel and cement production, transport, and agriculture. Substantial financial investments are needed to transition these sectors towards low-carbon activities. As much as $125tr. is required to transform the global economy and achieve net-zero emissions by 2050, according to the United Nations-backed Race to Zero campaign. The challenge is working out how to allocate capital towards these activities in the absence of a universally accepted transition standard.

The parameters to define the improvements that are possible and necessary for such carbon-intensive activities differ between sectors and social, political, and economic contexts. Because of this, it remains difficult to agree on a universal definition of transition activities. This poses challenges to international investors, since some activities might be considered transition in one context but not in another.

The upshot is that transition finance can be a vague and confusing topic for investors despite the considerable demand for financing needed to move the global economy towards a low-carbon future.

Navigating pitfalls

A key concern is to avoid financing projects or activities that can lead to carbon lock-in. This refers to a situation where economic, technical, social or political barriers to decarbonisation create an environment that favours the continued development of fossil fuels. For example, the building of new liquid natural gas (LNG) infrastructure with a lifetime of several decades in regions where renewable energy is economically viable. This could lead to political pressure to continue running the infrastructure despite it not being environmentally or economically viable in a few years. This could also limit long-term low-carbon goals.

Various transition finance instruments are available to align financial flows with the goal of the 2015 Paris Agreement, with labelled bonds and loans among the most commonly used. Use-of-proceed bonds with a transition label are still rare, reflecting the challenges for issuers and investors to define a project or activity as being in the transition category.

Sustainability-linked bonds (SLBs) with transition key performance indicators are more common, but are often considered to be less transparent and to carry a higher risk of greenwashing. This is where companies use false or misleading information to present their activities as more environmentally sound than they really are.

The first Climate Transition Finance Handbook, published by the International Capital Market Association (ICMA) in December 2020, provides information on how green, social, sustainable, and sustainability-linked instruments can be used towards transition activities. In the handbook’s June 2023 update, ICMA strengthens these guidelines, in particular, emphasising the potential of SLBs to finance transition plans for hard-to-abate sectors.

Despite not introducing guidelines for transition bonds, the revised handbook acknowledges the efforts made by several jurisdictions to provide guidance for transition instruments and aims to lay out common elements that should be adopted by any credible transition approach.

Transition approaches vary

While the EU has long been a leader in developing sustainable and green finance standards, Asia, with its high economic dependency on carbon-intensive sectors, is ahead of the curve on transition finance.

Regulators across Asia have been keen to clearly define transitional activities to aid carbon-intensive and hard-to-abate sectors in raising funds for their shift to more sustainable practices. Europe has focused on green rather than transition activities due to fears of greenwashing allegations, to which transition projects are more exposed. In North America, anti-ESG politics has inhibited the market from adopting new transition-labelled instruments.

Countries such as Singapore and Japan have been proactively developing their own transition frameworks and guidelines. In Southeast Asia, concerted action is being taken at both the regional as well as national levels to more clearly define what transition entails. Regulators are working to establish interoperable transition elements within sustainable finance taxonomies in order to facilitate more viable transition financing for hard-to-abate sectors. China is also working on establishing a transition taxonomy in alignment with the G20 Climate and Sustainability Working Group’s sustainable finance roadmap.

Whether or not taxonomies include criteria for transition activities varies widely across jurisdictions. This creates a further challenge for investors and issuers functioning across multiple countries.

There has been a proliferation of sustainable finance taxonomies and other frameworks defining transition finance principles, such as the aforementioned including the ICMA’s handbook.

This suggests clearer guidance is in the pipeline, which together with concrete sectoral transition plans and corporate transition plans, is needed for investors to move the necessary capital towards transition activities and meet the targets.