Funding Credible And Bankable Transition Finance After COP28

Following the conclusion of COP 28 last year, OIC financial institutions should now focus on how the final declaration points towards key risks and opportunities arising from climate transition risks, as well as the role they can play within the energy transition. One of the most important elements of financial institutions’ strategies across OIC countries will be the role of transition finance. This has been a hotly debated issue, all but overlooked by binary green/not-green taxonomies.

For emerging markets & developing economies it is a critical piece of amassing enough funding to be able to transform economies in a way that will over time promote economic growth while reducing emissions along science-based pathways. Some of the pitfalls for transition finance are discussed in a recent interview with the Chief Sustainability Officer at UOB.

Some of the challenges with transition finance relate, on the one hand, to the credibility of the transition plan prepared by a bank’s customer. Credibility is focused on ensuring that the emissions reduction from the financing is rapid enough to align with scientific pathways. It is also important that it doesn’t create carbon lock-in by financing or extending the life of activities that are not compatible with a Net Zero pathway that front-loads much of the emissions reduction.

Credibility is a focus for regulators and investors, including the Monetary Authority of Singapore, which has set out transition planning guidelines for financial institutions. There are other efforts to create international guidance on transition planning for different sectors by the Transition Plan Taskforce in the UK (RFI recently commented on the sectoral guidance for banks, which is expected to have international relevance).

Another challenge of transition finance beyond credibility is bankability, which requires finance to be directed not only to projects that meet emissions goals but also to demonstrate commercial viability. Eric Lim, CSO of UOB, explained the reliance that bankability has on national sectoral pathways: “Suppose [a customer’s] investment plan generates new low-carbon economy assets, but the sectoral or national ecosystem isn’t ready to maximize the commercial value of those assets. In that case, they might be shooting themselves in the foot from a commercial standpoint.”

The continued challenge of credibility and bankability have been sources of delay in the past for wide applicability of transition finance and it could continue into the future, slowing progress at a time when the cost of inaction is high and rising. This should encourage financial institutions to expand their view towards projects that have more immediate viability, or where risks are presently underestimated.

On the opportunity side, energy efficiency was included in the final COP 28 declaration, where parties agreed to double the global average rate of energy-efficiency improvements to 4% each year until 2030. For OIC financial institutions, this presents an opportunity to boost their contributions to emissions reduction, although it remains difficult to measure in a way that can mobilize green finance.

The reason the declaration is particularly important in EMDEs is because it can widen the scope of the balance sheet being used for climate mitigation. In EMDEs, in contrast to developed markets, electricity growth has been continuing to grow with the economy. As long as renewable energy capacity is growing at a slower pace than electricity demand growth (which will be increased over time by electrification), new renewable capacity is only decarbonizing new electricity demand and so isn’t reducing total energy sector emissions. Energy-efficiency investments can reduce emissions themselves, but also help renewable energy projects make a greater contribution on progress towards national Net Zero targets.

On the risk side, the agreement to transition away from fossil fuels is adding the weight of all of the parties to the UNFCCC to the Net Zero by 2050 roadmap from the International Energy Agency, which includes no new oil and gas fields approved for development. The transition element through midcentury is inherently unpredictable, but will undoubtedly involve acceleration of fossil fuel asset retirements.

Analysis from Carbon Tracker lays out an important transition risk relating to asset retirement obligations (AROs), which they estimate at up to $4.8 trillion globally. They outline the way that these liabilities could rise in value and materiality as the transition progresses and the expected remaining life of oil and gas assets shortens.

As the transition away from fossil fuels progresses, defaults by companies on their AROs and litigation to cover the costs of these defaults may lead to higher bonding requirements. This would have the impact of weakening the creditworthiness of operators and producing a self-reinforcing increase in transition risk exposure at both counterparty and industry level at a time when revenue may be declining.

There are many aspects of the transition that remain big areas of uncertainty for financial institutions in OIC markets. However, as action follows the COP 28 declaration for action on renewable energy, energy efficiency and the transition away from fossil fuels, financial institutions will need to adapt their approach in pursuit of new opportunities and mitigation of risks as they become more evident.