As Regulators Take Stock On Transition Plans, Financial Institutions Should Begin Their Own Planning

The development of transition plans – complete with estimates of the financial resources needed to be mobilized – is becoming a key focus for companies responding to climate change. However, the definition of just what a ‘transition plan’ is and what makes it credible remains somewhat ambiguous. In a recent stock-take of transition plan use cases for micro-prudential regulators, the Network for Greening the Financial System (NGFS) differentiated between ‘strategy’ and ‘risk management’ oriented transition plans.

But going one step back from even this difference, the NGFS highlighted the difference between a ‘transition plan’ and the process of ‘transition planning’. Currently, there is a wide variety of regulatory expectations on climate risk, and even where transition plans are not required, it will be prudent for financial institutions (especially banks and insurers) to start the process of ‘transition planning’.

Transition plans are intended to map out the implications of the global economy reorienting itself quickly enough to reach Paris Agreement, global Net Zero, national climate change or corporate targets. The selection of reference points will be a key input into the credibility of one transition plan versus another, particularly with regards to its consistency with the scientific evidence on the progression of climate change.

Their exact format, as well as what they must include, is not standardized, however, and remains significantly variable between entities. Non-financial entities must effectively compare their business-as-usual trajectories with the reference pathway to the target they select and then account for the additional investment required to be aligned with the target.

For non-financial companies, a transition plan may be relatively simple, at least in theory. If a power company had a single fossil fuel power plant with a few dozen years of life left, it could create a transition plan to lower its emissions over time and compare that with what would be necessary based on its market share to be consistent with the government’s Nationally Determined Contribution (NDC) under the Paris Agreement.

The power company used as an example could look at forecasts for electricity demand, and its own ability to remove emissions, and identify what mix of investments it would need to make in renewable projects (rather than expansion of the fossil fuel generating capacity) and emissions reduction to remain consistent with the national target. At some point, it is likely to run out of emissions reduction investments to make or will face rising costs from emissions that make it economically non-viable, and the remaining fossil fuel power plant will have to be retired in favour of renewable sources, which it will have to finance in one way or another.

The process of evaluating these decisions falls under the description of ‘transition planning’ and can be achieved even without a formal ‘transition plan’. The planning may start with evaluating goals drawn from a country’s NDC, but in the process of developing the transition plan, it may come to light that the NDC isn’t likely to be enough – if a similar level of ambition was adopted globally – to meet global goals.

The power company may thus have to look at other pathways to find one that are more ‘credible’ in terms of being both achievable and realistic for the company and in line with science-based pathways to limit the global temperature rise. This highlights the value of the process of ‘planning’ itself, but also some of the considerations that arise on the non-financial side of the economy.

The non-financial (power) company is most likely working on transition planning from the strategy perspective. It knows that climate change presents a risk to its business in the future, and that investors and lenders will ask questions about its strategy in response. Within financial institutions, it is possible to do additional planning, but the ability to do so will be curtailed by the counterparty’s progress on transition planning and will be hamstrung if there are not transition plans widely available from its customers.

Those transition plans would likely outline the opportunities the financial institution or investor has to shift its financing from mis-aligned companies and instead finance the (hopefully credible) transition plans of its customers. In the absence of clear understanding of its customers’ transition financing needs, more of the financial institutions’ transition planning focuses on understanding the risks they face.

The transition risks that financial institutions must plan for are rarely related to issues under their direct control, such as emissions in their own facilities. Much more commonly, they relate to the risks that a rise in the cost of emissions will cause (directly or indirectly). As these risks are identified, there will be concentrations at individual institutions, and interlinkages between institutions and across different sectors where transition risk could spill over.

The risk management types of transition planning and transition plans are the ones that financial sector regulators are most concerned about. However, as the NGFS report highlights, it is unlikely there will be multiple transition plans created for all of these different audiences. Instead, it’s more probable that transition planning activities that deal with one or more of these issues will be picked up in transition plans that address stakeholder concerns, investors and financial regulators.

Currently only about a quarter (27%) of regulators surveyed by the NGFS are engaging with financial institutions on their transition plans, with another eighth (13%) having some peripheral engagement. The bulk of the remainder (58%) are not currently. However, for most regulators (69%), they are not clear yet on how transition plans impact their mandates or have that definition as a work-in-progress. Consequently, for financial institutions, there is some evidence to look at about how regulators are likely to address transition planning and what information they might require or use in evaluating transition risk within their mandates. The breadth of what they consider will vary considerably between developed and emerging markets.

As NGFS summarizes: “Micro-prudential authorities in emerging markets and developing economies (EMDEs) [may focus on helping] less sophisticated financial institutions in those jurisdictions to develop their transition plans, ensuring consistency with transition pathways, and how that would translate into the strategy, risk management, governance, and market opportunities for these institutions”. In the meantime, it will be valuable for financial institutions to begin their own transition planning, even if it begins qualitatively or is based on rougher sources of data that can help to overcome a lack of data or transition plans by their customers.