Transition Finance: Challenges and Solutions

Despite all the challenges, asset owners realise that without greater investment in transition-finance assets, we cannot meet the Paris Agreement climate-change goals on a global scale

Transition finance

High-emission businesses that wish to transit to a greener operational model often face a lack of funding. Source: unsplash

Achieving a sustainable future needs a lot of effort and even more money. While investors willingly support the projects promoting renewable energy, high-emission businesses that wish to transit to a greener operational model often face a lack of funding. Transition finance has to overcome many obstacles to play its role in averting climate change. However, once those challenges are solved, it will have a tremendous real-life impact on the global ecosystem.

What’s transition finance?

An increasing number of governments, public companies and financial institutions have committed to reaching net zero emissions by 2050. The aim is to avoid negative climate change by limiting the average global temperature increase to 1.5 °C.

However, many asset managers allocate their investments predominantly to small-scale startups working on sustainable solutions. At the same time, to effectively achieve the ambitions of the Paris Agreement, the financial sector must also help businesses in high-carbon sectors transit to net zero production. 

Such heavy-carbon industries include the energy system and transport, including shipping and aviation, chemicals, steel, and cement. They all require major investments to achieve significant emission reductions. To help them reach those long-term goals, transition finance is coming to the rescue.  

Transition finance as an investment approach focuses on enabling a climate-change strategy in challenging industries. The segments mentioned above see emissions grow the fastest and need financial support the most. It is especially true for companies in emerging markets where overall funding is subdued. Hence, transition finance helps high emitters receive the capital and influence they need to transform their operations. 

“Transition finance is the legitimate and effective alternative that enables the move from brown to green while meeting standard risk-and-return objectives. Financing even heavy emitters, as long as they are on a verifiable path to net zero and promising attractive risk-adjusted returns, will reap benefits for investors as well as the planet. Transition finance is not in conflict with the fiduciary duty of asset owners. It is an attractive return opportunity which at the macro level mitigates the biggest systemic risk of our time.”
Hendrik du Toit, founder and CEO, Ninety One

The challenges transition finance faces

Although heavy emitters need the most money to change their harmful practices, asset managers are not willing to invest much. 

The problem is that high-carbon companies might need innovations that are not profitable initially. Neither do they bring low emissions results in the short term. Investors, thus, are suspected of «greenwashing», as they technically support the high-emitting sector. 

In fact, the lack of legal clarity often leads to a lack of disclosure. Therefore, 55% of the senior professionals at asset-owner institutions surveyed by Ninety One find it tricky to measure or quantify an organisation’s progress in climate strategy or products. Therefore, the most cited barrier to transition finance agreed by 60% of respondents is a lack of companies with credible and viable transition plans. Besides, there is a lack of demonstration projects that illustrate successful decarbonisation in most of the high-emitting sectors. 

If companies seeking investments do not disclose a net-zero target and a strategy for long-term decarbonisation, chances are they may claim false transition activities. For instance, some companies in the fossil fuel industry divest high-polluting business units or contract polluting processes to third parties. Legally, they are lowering the emissions level. Practically, however, such practices bring no positive environmental impact.

On the investors’ side, the situation is similar. ESG-branded assets are often showing small carbon footprints, addressing only the «cleanest» industries. At the same time, they are not improving decarbonisation levels in any way, as those business sectors have always been low-carbon. Meanwhile, other industries cannot become more eco-friendly due to the lack of funding.

Furthermore, many asset owners are mainly concerned about the profitability of their investments. With transition finance, healthy returns may come in the long term, which vents a lot of capital from the market. There is a widespread belief that climate-related investing generates lower returns. About 40% of asset owners, surveyed by Ninety-One, support that opinion. 

Finally, the financial instruments that provide incentives for better performance of emission reductions are scarce. According to HSBC whitepaper, transition bonds have the potential to change the situation. They can raise funds from investors and channel proceeds to help businesses cut their overall climate impact. Additionally, bonds and loans could set environmental targets and pay investors a premium if the company falls short of that target. 

transition finance

Source: depositphotos.com

Market opportunities vs environmental impact

ESG-branded assets are forecast to rise to $41 trillion this year and surpass $50 trillion by 2025. Moreover, they are expected to comprise one-third of the total global AUM by that time. The paradox is that, in 2021, more CO2 was released than in any other year to date, as the enhanced coal use catalysed the surge. According to the latest Emissions Gap Report, the global low-carbon transformation requires an investment of at least $4-6 trillion per year.

Although asset owners are sceptical about the profitability of green investments, transition finance actually has more chances to pay out. Thus, due to the soaring energy costs, some high-emitting companies have made large profits in 2022. Many climate-focused funds that shy away from transition finance have missed out on associated returns.

When we say many, we mean the vast majority of asset managers. While 60% of asset owners say fighting climate change is one of their fund’s strategic objectives, only 19% use transition finance to any extent. Besides, 87% invest only half of their fund’s assets into climate-related strategies. For 56%, the amount is even less (under 25%).

In addition, most private capital firms miss out on the opportunities emerging markets offer. Thus, 53% of fund managers are concerned about the risk-return profiles available in emerging market transition finance assets. It happens because many of the related companies lack measurable, science-based decarbonisation plans. 

How can we popularise transition finance?

Despite all the challenges, the Ninety-One report found that 56% of asset owners realise that without greater investment in transition-finance assets, we cannot meet the Paris Agreement climate-change goals on a global scale.

Solving the pervasive market issues may be challenging but still possible. To begin with, clear standards and benchmarks for transition finance assets could accelerate the development of the market. 

For example, transition targets and plan disclosures can be aligned with frameworks such as the TCFD recommendations, IEA guidelines and other internationally recognised guidelines. 

Reduction targets should be science-based and consider various regional and sectoral factors. Although, in this case, it is possible that the pathway may not be linear, short- and mid-term targets set on the pathway toward the long-term targets would show the prospective investors whether the fundraising company is going in the right direction.

The investment plan provided by the transiting company may include not only capital expenditure but also operational expenditure for investors to better understand the financial needs. The prospective investment seeker should estimate costs related to research and development, M&A, employee training and reskilling programs, as well as dismantling and removal of carbon-heavy facilities within the investment plan. 

Besides, international standard setters should find a credible approach to identifying and labelling transition activities. For instance, they may develop a list in which specific transition activities are presented with descriptions of technical pathways and emission reduction targets. Efforts like that are already made in the EU and China. There also needs to be a transparent reporting mechanism for investors to understand how the company meets its transition goals. 

Transition finance

Solving the pervasive market issues may be challenging but still possible. Source: unsplash

In addition, the development of enticing financial incentives may boost the transition financing initiatives. For example, a business can issue a three-year bond and commit to cutting its overall carbon emissions by 10% over those three years. If it fails, the business guarantees to pay investors a premium. If it manages to deliver on the promise, both investors and the environment benefit. Moreover, if the company delivers stronger results than expected, the agreement may be that investors charge a lower interest rate or provide additional financing. Instruments like this would be an additional stimulus to both VC funds and high-emitters themselves.

Finally, transition finance should be part of a global agenda and included in the innovative financing options to address climate change. For instance, blockchain technology may be employed to add much-needed transparency to the market. 

Private funds may not cover all the needs of high-emitters. Therefore, fiscal subsidies, tax incentives, and green finance-related incentives from central banks and governmental institutions should be considered to enhance the viability of transition projects.

End note

Transition finance is crucial to decarbonising emission-intensive sectors. Investors, however, lack clear standards and benchmarks for transition finance assets. In addition, innovative financial instruments that may boost transition finance adoption are currently scarce. Nevertheless, with the issue increasingly becoming a hot topic at international forums, the sector is promising attractive risk-adjusted returns and significant environmental impact. 

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