Transition finance isn’t easy, but investors, industry bodies and governments are preparing the ground.
Net zero investors do not start with a blank piece of paper. So, while it’s important to identify companies with inherently sustainable operations, products and technologies – such as renewable energy – asset owners also recognise the importance of funding the transition efforts of hard-to-abate industries.
“A purist definition of investing only in green assets doesn’t go anywhere near far enough to decarbonise the planet – brown, or transition assets, have to be tackled,” says Brian Hensley, Partner at specialist climate policy consultancy Kaya Advisory.
Broadly speaking, the term ‘transition finance’ typically refers to an investment strategy that focuses on delivering real-world impact by investing in some of the most challenging industries to decarbonise, like steel manufacturing or aviation, alongside upscaling green technologies and infrastructure.
A recent survey of 300 senior professionals at asset owner institutions and advisors by South Africa-based global asset manager Ninety One revealed that only 19% of respondents are using transition finance “to any extent”, with 35% planning to make transition finance-related investments in the next 12 months. Fifty-two percent said they believe that transition finance is a major commercial opportunity for asset owners, with 60% expecting transition finance to grow rapidly over the next three years.
“A number of asset owners have set their decarbonisation targets and are now realising they have to also support the transition and need to incorporate this into their sustainable investment strategies,” Nazmeera Moola, Ninety One’s Chief Sustainability Officer, tells ESG Investor.
Twenty percent of respondents to the Ninety One survey claimed their firm is actively researching opportunities in transition finance, and 8% are building their internal capabilities in this area.
The low numbers are largely down to the fact that the practical realities of transition finance is “mind-blowingly complex”, according to Hensley.
Asset owners and managers are having to wrestle with inconsistent and limited corporate disclosures on transition strategies, as well as the fact that there isn’t an established definition of what constitutes a credible transition asset.
A growing number of transition frameworks and guidance are now being published by governments and investment industry groups, but many investors have taken it upon themselves to identify how they can best invest in the world’s transition to net zero.
Down to the very last detail
“Without clear guidance, investors are left with ad hoc approaches and following broad net zero frameworks,” says Kaya Advisory’s Hensley.
The Group of 20’s (G20) Sustainable Finance Working Group (SFWG) has developed a transition finance framework that can be voluntarily adopted by jurisdictions and investors. It covers five pillars: the identification of transition activities and investments, reporting on these activities and investments, developing transition-related finance instruments, designing policy measures, and assessing and mitigating negative social and economic impacts.
The G20 paper is “a needed foray into thinking about the process by which the complex issues of transparency and governance of transition assets can be addressed”, says Hensley.
It recommends the development and implementation of transition-focused taxonomies to help define credible transition activities for investors.
An existing example is the European Commission-appointed Platform on Sustainable Finance’s (PSF) draft extension of the EU environmental taxonomy.
While the current taxonomy covers economic activities positively contributing to its six environmental objectives, the proposed ‘traffic light’ framework would extend coverage to brown and transitioning activities from high-emitting and hard-to-abate sectors.
The red category would include activities that need to urgently transition (and therefore require investment) to more sustainable practices, as well as activities that cannot avoid significant environmental harm, such as thermal coal mining. Activities in the amber category fall between causing significant harm and making significant positive contributions and can qualify for taxonomy-aligned investment – provided there is a clear transition plan in place.
Charles Boakye, Equity Analyst of ESG and Sustainable Finance at investment bank Jefferies, says that “more taxonomies isn’t the answer to what is a complicated question around transition”.
Despite seeing some merits, the European Sustainable Investment Forum (Eurosif) said extending the taxonomy would likely require long negotiations, carry high political costs and invariably lead to a more complex framework that would only add to entities’ existing reporting burden.
“Furthermore, an over-complicated and intricate system would be more susceptible to misinterpretation and thus heighten the risk of greenwashing,” Eurosif said.
The Commission is currently reviewing the draft, published in March, and has said that no decision has been taken at this stage on whether to propose or not an extension to the existing taxonomy framework.
Gas and nuclear energy have already been included in the environmental taxonomy as transitional industries, “but not in a way that defined what a transition asset is,” says Hensley.
Lawmakers have set some parameters for investors by defining what related economic activities will be sustainable within gas and nuclear energy – for example, R&D investment in advanced technologies promoting safety and minimal waste in nuclear energy.
Investors are having to make their own minds up on what constitutes a credible transition asset.
For example, a common area of debate is around companies’ reliance on future low-carbon technologies to achieve net zero, such as carbon capture and storage (CCS).
A number of oil and gas majors have invested capital into CCS, and it features heavily in the climate transition plans of firms such as Shell. However, in instances where CCS works at scale (which is a whole separate issue), it will allow for the continued burning of fossil fuels, even if it is capturing and storing the CO2 underground, thus technically reducing companies’ emissions. For some, this use of CCS is a key contribution to transition as carbon-intensive industries gradually wean themselves off fossil fuels, but far from all.
While it is important to define and invest in both green and transition assets, Mark Campanale, Founder and Executive Chair of think tank Carbon Tracker, warns that some existing assets will need to be left behind.
“After all, there’s no ‘transition strategy’ for the internal combustion engine in cars, or for turbines in gas / coal-fired power stations. They will become obsolete quite rapidly,” he says.
Investors have poor visibility of corporates transition plans.
“Improved, comparable and reliable corporate sustainability-related disclosures are essential to enable investor assessments on transition,” says Aleksandra Palinska, Eurosif’s Executive Director.
“For many years, it has been flagged that there is often an insufficient amount of data on investee companies, in particular with regards to climate targets and transition pathways,” Palinska adds, pointing to a survey Eurosif is currently running to get an overview of how investors are sourcing climate-related data.
“Methodologies are an important aspect and – especially for climate scenarios – an evolving field. Different companies might be using different methodologies and that makes it very hard for investors to compare them.”
Decarbonisation strategies are not keeping pace with the net zero commitments of polluting companies, according to the latest Net Zero Company Benchmark update published by the Climate Action 100+ engagement initiative (CA100), which involves 700 institutional investors with a collective US$68 trillion in assets.
While 75% of focus companies have now committed to net zero by 2050 or sooner, many have yet to disclose what actions will be taken to achieve these targets, CA100+ said. Only 10% have adequate short-term decarbonisation targets.
Further, the recently launched Transition Pathway Initiative Global Climate Transition Centre (TPI Centre) noted that 51% of the world’s largest publicly-listed energy companies are failing to disclose a decarbonisation strategy that outlines medium- and long-term plans to reducing emissions. In addition, 89% aren’t disclosing how they are working to decarbonise their capital expenditures, the report added.
The TPI Centre aims to expand its assessments of companies’ management and governance of their carbon emissions, as well as their transition pathways, to cover up to 10,000 companies across a broader range of asset classes, including fixed income.
“Companies that are on a trajectory to transitioning should be able to demonstrate not only targets aligned with the Science Based Targets initiative, but also an alignment from a financial perspective,” says Sarita Gosrani, Director of ESG and Responsible Investment at investment consultancy bfinance.
“Best practice lies in the analysis of a company’s financial statements and overall strategy to understand the authenticity of transition plans, as well as pricing these into a company’s valuation. Further, this analysis should be done by the financial analysts who are familiar with the sectors and peers rather than by ESG teams in a silo,” she adds.
The development of new reporting standards is expected to improve the availability, reliability and comparability of information on investee companies’ transition progress.
The European Sustainability Reporting Standards (ESRSs) will apply to companies falling under the scope of the anticipated Corporate Sustainability Reporting Directive (CSRD). Reporting requirements cover 13 themes across four categories, including materiality assessments and risk management. In parallel, the International Sustainability Standards Board (ISSB) aims to provide both a climate and general sustainability reporting baseline that can be adopted by jurisdictions globally.
However, ISSB’s narrower focus on enterprise value – as opposed to Europe’s focus on double materiality – may prevent investors from getting the whole picture of an investee company’s climate transition efforts, says Eurosif’s Palinska, who notes that “identifying credible climate targets and transition plans will require consideration of impacts”.
Last week, the ISSB confirmed that companies disclosing in line with its standards will be required to report their emissions across Scopes 1-3, which bfinance’s Gosrani warns “may change the overall emissions story of investment portfolios, particularly for investors investing for a ‘green portfolio’ today”.
Ultimately, transition plans are “highly specialised to the specific characteristics of each company and tend to require an ad hoc analysis from investors”, says Federica Casarsa, Policy Officer at Eurosif.
“Some coherence can be identified within sectors, but in general companies adopt the assumptions, targets, and pathway that best fits their characteristics. What is important is that the sustainability reporting standards harmonise the information to a certain extent, in some cases prescribing for specific methodologies to be used (e.g., Scope 3 emissions where this is key to ensure comparability).”
Spoilt for choice
There are emerging solutions that aim to set guide rails for transition finance.
In the summer, Eurosif published a whitepaper aimed at better identifying and measuring sustainable investments beyond established green assets, including impact and transition investments.
The work considers how to further “calibrate and complement” the Sustainable Finance Disclosure Regulation (SFDR) so it better accounts for impact and transition investments, Palinska says.
The proposed new classification scheme defines five sustainable finance categories: exclusion-focused, basic ESG, advanced ESG, impact-aligned, and impact generating. The latter covers transition assets. The criteria defining these categories included general characteristics, pre-investment strategies, post-investment strategies, performance measurement, and documentation.
This week, the UK’s Financial Conduct Authority (FCA) published a consultation outlining new fund labels to combat greenwashing. The regulator included ‘sustainable improver’, which will apply to transition-focused funds investing in assets that will become more sustainable over time.
Governments are also taking steps to ensure clarity on transition plans.
Expected to report shortly, the UK Transition Plan Taskforce (TPT) was launched by HM Treasury with a two-year mandate to develop a ‘gold standard’ for climate transition plans. In Japan, the government has established the Taskforce for Formulating Roadmaps for Promoting Transition Finance in the area of Economy and Industry, which will develop and publish sector-specific roadmaps for credible climate transition plans.
Without a universal methodology for assessing transition plans, investors are developing in-house approaches.
“The challenge when dealing with asset owners is to give them the confidence that our transition finance approach is robust enough,” says Ninety One’s Moola.
Ninety One’s transition plan assessment framework is built on three core pillars. The first is the ambition of the target, which assesses whether a company’s plan is Paris-aligned and adjusted according to the company’s sector and geography. The second concerns the quality of the plan – for example, considering whether the company has outlined how it plans to finance efforts to achieve its targets and its dependence on untested technologies. The final pillar is focused on the implementation of the plan – essentially, are companies walking the walk?
“It has to be very bespoke to each situation and each company,” Moola says.
Norges Bank Investment Management (NBIM), which manages Norway’s US$1.2 trillion sovereign wealth fund, recently published its 2022-25 climate action plan, noting that it will engage with all 9,000 portfolio companies on their climate-related performance. Companies will be asked to provide science-based short- and medium-term net zero targets alongside credible transition plans and regular reporting on their decarbonisation progress.
“Investors need to address climate change from two angles,” says Moola.
“They need to invest in the solutions, whether that’s new infrastructure, renewables or electric vehicles. But they also need to invest in carbon-emitting companies to encourage rapid decarbonisation. Both require huge amounts of capital if the world is going to limit global warming to 1.5°C. Doing one without the other won’t address the climate crisis effectively enough.”