How transition finance could eclipse sustainability-linked financing

One of the consequential outcomes of COP 28 was the agreement to transition away from fossil fuels in order to reach the global climate goals of limiting warming to 1.5˚ C, which requires reaching Net Zero by 2050. After COP 28 ended there has been a widespread effort to determine the best way to achieve that transition, for which finance plays a key role.

The area of ‘transition finance’ has been raised as a solution for several years but there is a frequently expressed concern that a lack of definition constrains its effectiveness. One of the clearest defined frameworks for international transition finance, the Just Energy Transition Partnerships, has announced large financing commitments but struggled to deploy the financing committed. As a possible solution, two major banks have said they are working on ways to create financing instruments to monetize the emissions reductions from coal phase-out plans.

In the meantime, transition finance is not so common and has been supplanted in terms of volume of financing by sustainability-linked loans (SLLs) and sustainability-linked bonds (SLBs), some of which focus on emissions-reduction KPIs. The benefit of sustainability-linked financings (SLFs) is that they are available for use by issuers or obligors that don’t have projects that qualify under use-of-proceeds frameworks like those for green, blue or sustainability finance.

However, with the flexibility that SLFs offer comes a trade-off in that KPIs are not always for the most material issues; they can be avoided or offset by refinancing if targets are likely to be missed or overwhelmed by the size of the new issue premium that many SLBs saw. These problems have been known for years, but only recently have they become sources of disruption for the market, which saw a decline of new SLLs of 56% driven by stronger regulations and the disappearance of the ‘greenium’, compounded by higher interest rates.

The drop of SLFs came at the same time that interest globally in transition has picked up, which has led to an increased focus on transition finance. Some jurisdictions are developing their own transition finance frameworks, including Malaysia and Hong Kong. Underpinning all the work of transition finance are transition plans that explain how a company with sources of revenue generated by activities incompatible with the climate transition can become aligned with global climate commitments to Net Zero by 2050.

The UK’s Transition Plan Taskforce (TPT) has stepped in to try and set out guidance on credible transition plans for the UK with an eye to helping create consistency internationally. Transition plans need several elements to be viewed as ‘credible’, including pathways towards alignment with climate goals that are ambitious enough to support global Net Zero by 2050 and realistic investment plans to achieve the target reductions.

One important factor in assessing the credibility of transition plans is that pathways towards Net Zero by 2050 must be able to deliver emissions reduction at a rapid enough pace to limit warming to 1.5° C and with enough focus on emissions reduction rather than offsets. The reductions must begin as soon as possible and be as front-loaded as possible, which is often easier said than done. Sectors that are not eligible for green finance fall into two broad categories. There are those that can transition to be compatible with the global climate commitments and those that are fundamentally incompatible with climate mitigation objectives that need to be phased out.

The reason why transition finance might be more efficacious than SLF is that it will follow a transition plan that lays out the objectives, metrics, intermediate targets and financing needs for an entity to transition. This plan can be evaluated for its alignment with Net Zero targets, and the financing linked to it by use of proceeds requirements will be directed in a way that makes the provision of finance more directly connected to transition activities.

SLFs often provide financing not linked to specific uses of proceeds, which makes them harder to connect the financing provided with the ultimate KPIs targeted. A similar situation recently studied quantitatively gives an indication for why this might happen. A study released last month looked at companies that had approved science-based targets from SBTi.

This study compared the emissions reductions of companies depending on whether they had their targets subjected to external assurance or not. The headline finding from the paper was that companies that had the data behind targets assured saw greater emissions reduction than those that hadn’t while also having higher emissions than those that didn’t.

Combining those findings may not necessarily support the presence of greenwashing, but instead suggest that the process of measuring and targeting emissions reduction may be complex and subject to error. Therefore, while more approximate data can help companies to understand the materiality of their emissions or guide financial institutions in setting their strategies, when they engage with customers and provide financing to support transition, that robust data is important to getting the results they seek.

The focus on transition finance has clearly accelerated from where it was just a couple years ago, when it appeared to have been supplanted by sustainability-linked finance. The shift is important, especially for emerging and developing economies, which account for a large proportion of OIC countries. These countries will be investing in the transition of unsustainable activities at the same time as they scale up financing for sustainable activities and manage the Just Transition in line with their SDG priorities and they need to attract as many sources of financing for every part of the process.