Transition finance, which provides financing to high carbon-emitting industries, should be part of a broad range of innovative financing options to address climate change.
Addressing climate change and taking action on its impacts and effects remain an urgent concern worldwide. There has been strong consensus that the financial sector should go beyond supporting purely green activities to effectively transform the existing carbon emitters. Realization of transition finance is crucial in the efforts to combat climate change.
Transition finance is a concept where financial services are provided to high carbon-emitting industries – such as coal-fired power generation, steel, cement, chemical, paper making, aviation and construction – to fund the transition to decarbonization.
The transition finance concept emerged from the understanding that effective decarbonization of the entire global economy will require much more than green finance. Green finance and sustainable finance – as they are currently defined – have focused largely on supporting activities that involve minimum pollution and carbon emissions. However, a much larger amount of financing is required in carbon-intensive sectors that need to decarbonize, and to eventually achieve net zero emissions.
The key challenge to transition finance is the lack of private sector financing for decarbonization activities due to various barriers, including: the lack of a clear definition of transition activities, which may lead to investor fears that their participation may be seen as “green washing,” or claiming to invest in an eco-friendly business that isn’t; lack of disclosure; which may encourage false transition activities; the lack of financial instruments that provide incentives better performance of emission reductions; and the lack of demonstration projects that show successful decarbonization is achievable in most of the high-emitting sectors.
To address these issues, and to effectively mobilize private investment in transition activities, a transition finance framework needs to be established. To make transition finance feasible, this policy framework should consider the following elements: identification of transition activities; disclosure and reporting; financing tools; incentives, and mitigating social impact.
First, there needs to be a credible approach to identifying and labeling transition activities. Any activity supporting a credible transition towards net-zero greenhouse gas emissions should be considered as transitional. One way to identify transition activities is to develop a “transition finance taxonomy” in which specific transition activities are presented with descriptions of technical pathways and emission reduction targets. This is being done in the European Union and some pilot regions in the People’s Republic of China, focusing on industries such as steel, cement, petrochemical, and agriculture industry.
The transition finance concept emerged from the understanding that effective decarbonization of the entire global economy will require much more than green finance.
The identification approaches should be flexible and dynamic, and serve to reduce the cost of market participants and mitigate risks.
Second, good reporting practices are also necessary to help prevent transition activities that convey a false impression or support an unsubstantiated claim on sustainability, where firms may claim to invest in emission reduction activities but are in fact involved in projects that lock-in high carbon emissions– a behavior often termed as greenwashing.
Third, a toolbox of financial instruments should be developed to support transition activities. This can include debt instruments such as transition and sustainability-linked loans and bonds. For example, if the fundraiser of a project can deliver stronger-than-expected emission reduction performance, investors will charge a lower interest rate. The toolbox can also include equity-related instruments, such as the transition funds launched in Europe. Additionally, existing instruments such as private equity, venture capital funds, buyout funds, and mezzanine financing facilities can also be adapted to facilitate transition activities. De-risking facilities should also be developed to help lower the perceived risks of transition.
Fourth, fiscal subsidies, tax incentives, and green finance-related incentives such as central bank financing facilities should be considered to support transition finance and enhance the bankability of transition projects.
Fifth, socioeconomic costs, such as unemployment, energy shortages, and inflation, need to be accounted for and disclosed during the design of transition activities. To mitigate these costs, assessing employment implications thoroughly and including mitigation measures in transition plans, such as employee training and reskilling programs, are crucial to realize “just transition.” Efforts are also encouraged to integrate such social elements (e.g., employment performance) in the key performance indicator design of sustainability-linked products.
Asia and the Pacific should take the following steps to promote transition finance:
First, regulators and financial institutions in the region should clarify the eligibility criteria for transition activities, which could be in the form of transition taxonomy, to lower the cost for banks and investors. This will guide companies to adopt the best technical pathways for transition.
Second, demonstration projects should be developed to highlight the feasibility of transition finance, which is new to most in the financial sector. Concrete examples are needed to counter the perception of high costs and risks. These could include transition project in coal-fired power generation, steel, cement, and petrochemicals.
Last, Asia and the Pacific should consider launching its own transition funds. Transition funds can be launched by either governments or international organizations, such as multilateral development banks and other international financial institutions, or through international collaboration among different countries to reduce the funding costs and risks for these transactions, and help attract private sector investment.
A broad range of activities, with innovative financing options, are needed to address climate change. Transition finance is an important part of that equation.
This blog post is based on information shared at East Asia Forum 2022.