What is transition finance?

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.

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