Bridging the gap between brown and green
The world is at a critical juncture in its pursuit of net-zero emissions, particularly concerning hard-to-abate sectors such as cement, steel, and petrochemicals. Collectively, these industries account for a significant portion, approximately 40% of global scope 1 and 2 greenhouse gas (GHG) emissions. According to recent data, the contributions of specific sectors such as oil and gas (10%), steel (7%), cement (6%), trucking (5%), aviation (3%), primary chemicals (3%), shipping (2%), and aluminium (2%) are notable. This substantial share underscores the urgency of addressing emissions from these sectors, which are not only essential for economic stability and job creation but also face challenges in accessing the affordable financing of their decarbonisation efforts.
Distinguishing green and transition finance
Transition finance has emerged as a critical mechanism to support companies, particularly in emission-intensive sectors, on their journey toward achieving net-zero emissions. Green finance focuses on funding projects directly contributing to climate mitigation, adaptation, and biodiversity conservation. It is done through instruments like green bonds, often excluding high-carbon industries such as shipping, oil and gas, aviation, steel, cement, and chemicals.
Transition finance addresses this gap by enabling these hard-to-abate sectors to decarbonise through sustainable practices rather than divesting from them entirely. This approach not only facilitates the reduction of emissions in pivotal industries but also ensures a just and equitable transition by considering socio-economic and governance aspects. As global energy demand continues to rise and reliance on fossil fuels remains significant, transition finance plays a vital role in bridging the gap between traditional and sustainable financing, fostering innovation and infrastructure development necessary for a gradual shift toward greener alternatives while aligning with the goals of the Paris Agreement.
However, there is a need for significant investment to support this transition. Achieving a net-zero economy requires an estimated US $3.5 trillion annually by 2050 on a global scale. Despite these pressing needs, the global transition finance market remains relatively small compared to green finance, currently valued at US $12.5 billion versus US $2.2 trillion in 2022, depicting a stark gap that must be bridged.
Challenges in transition finance:
Several factors hindering the growth and adoption of transition financing as a phenomenon are discussed below:
- Lack of standardisation and knowledge gaps: Absence of standardised definitions, appropriate metrics, and transition finance instruments endorsed by international organisations are creating knowledge gaps acting as a major hindrance to the adoption of transition finance. Countries and regions are at different stages of transition finance readiness, with varying approaches to taxonomies. There is no universal standard for the eligible activities for transition finance. For example, in China, while the national taxonomy is yet to be finalised, the local governments of Huzhou and Chongqing came up with their own local taxonomies, where Chongqing’s local taxonomy classified clean production and efficient use of coal as transitional, whereas Huzhou refrained from doing the same
- No mandatory disclosure: A credible disclosure is often viewed as an ideal system to function, since it helps delineate the ambitious goal into actionable steps. Unfortunately, the transition finance landscape has no mechanism in place for mandatory disclosure of transition plans. This problem is furthered due to the lack of a standard for what qualifies to be a credible transition plan. Consequently, this triggers the issue of investor confidence as transition finance inherently is challenged with the high risk-return fluctuations and uncertainty
- Lack of cohesion among stakeholders: Transition finance flows are supported majorly by service providers like climate rating agencies, skill providers, and consultants, systemic enablers like policymakers, regulators, standard setters, private finance like banks, asset managers, corporates, and public finance through government funding and international grants. They are often challenged with their inability to get along, informed by their varying levels of interest and power in influencing the transition finance system, making the adoption of transition finance harder
- Transition washing: It refers to the risk where initiatives misrepresent their environmental impact without making substantial decarbonisation efforts. The lack of clearly defined credible criteria and tailored thresholds for what qualifies as a legitimate transition activity remains a significant hurdle. This absence of clear scientific standards can lead to accusations of greenwashing, undermining the investor confidence. For instance, British Petroleum (BP) known for heavy reliance on fossil fuels announced net-zero target, but continued its substantial investment in fossil fuel projects, claiming their investments in renewable energy projects to offset their emissions, thus facing the allegations of transition washing
- Green premiums and unviable project economies: Transitioning hard-to-abate sectors often involves technological innovations and operational changes. These sectors frequently face high costs and performance risks, making transition projects less competitive compared to the well-established processes. For instance breakthrough technologies like hydrogen and sustainable aviation fuels (SAF) and Carbon capture, utilisation and storage (CCUS) face green premiums costing 2-5 times higher than the fossil fuel alternatives. In addition to this, risk-return mismatch and larger gaps compared to green alternatives make it difficult to justify the risk-return profiles of transition finance investments
Strategies for accelerating transition finance:
Transitioning to green economies requires a comprehensive and targeted finance strategy. The initial focus is on establishing clear definitions, standards and taxonomy, fostering stakeholder engagement, ensuring transparent communication, and addressing informational gaps through credible disclosure of transition plans. These overarching solutions create a foundation for more targeted interventions curated for various players in the transition finance ecosystem. These include:
- Innovative financial products: This involves creating instruments tailored to transition projects such as transition bonds and sustainability-linked bonds. For instance, ENGIE Chile, supported by IFC, used innovative financing reinforcing social policies during its energy transition. A similar innovative effort of developing a blended finance instrument to mobilise private climate-related investment is financing steel decarbonisation in India endorsed by the Global Innovation Lab for Climate Finance
- Creating a supportive ecosystem: Governments and regulatory bodies must assume the responsibility of creating a regulatory environment for the financial institutions to thrive. This can be done by offering policy incentives such as tax breaks, subsidies, and guarantees to projects aiming to de-risk transition investments. Germany’s feed-in electricity tariffs (FiT) is one such policy mechanism designed to accelerate investment in renewable energy technologies by providing the operators with remuneration above the retail and wholesale rates of electricity. Besides the incentives, standardisation of frameworks by harmonising taxonomies for consistent categorisation, and promoting interoperability of the disclosure standards like International Sustainability Standards Board (ISSB) and European Financial Reporting Advisory Group (EFRAG) makes the ecosystem easy to navigate
- Internal expertise & data: Financial institutions need to develop specialised teams and robust data systems to assess the transition plans. For instance, one of Japan’s leading banks, Sumitomo Mitsui Banking Corporation (SMBC) acknowledges the need to enhance knowledge and skills to understand customers’ transition strategies
All in all, transition finance requires a common platform that brings together all the players in the ecosystem. Such collaboration is essential to enhance financing mechanisms and ensure a just transition adhering to the ESG aspects, giving a comprehensive direction to the goal of sustainability. Additionally, it is pivotal to recognise that green and transition finance instruments are not competitors but complementary enablers working towards the shared goal of sustainability. In fact, transition finance often acts as a prerequisite to better enable the success of green finance by closing the gap in the continuum from traditional financial instruments to green finance instruments serving a key purpose.
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