The journey to net zero is proving a hard one. The fine words and ambitious targets of COP conferences are not easy to turn into reality and the changes in government policy, especially in the UK, are making that journey even tougher for many businesses and their investors. Finance is central to meeting this challenge but the major institutional investors have at times looked uncomfortable as they try to match fine statements about helping the world tackle climate change with coherent and consistent investment strategies.
At the heart of this struggle is the concept of transition finance. The words might appear to carry an obvious meaning – using investment funds to support the transition from a fossil fuel dependent, carbon intensive world to a net zero carbon world. If only it was that easy. Defining transition finance has proved far from simple as there are a host of terms and alternative definitions swirling around the whole area of what is loosely referred to as green finance: sustainable finance, climate finance, green finance, impact investments, socially responsible investing all compete for attention, leading to a lack of clarity and making institutional investors an easy target for climate change campaigners, especially those aggressively targeting the big fossil fuel industries centred on coal, oil and gas.
For some institutions the response has been to focus a proportion of new investment into obviously green projects, such as renewable energy. That still leaves them with the challenge of what to do with their massive investments in fossil fuels: that is where transition finance comes in. It is focused on supporting those businesses in their transition journeys.
There is, however, a deep cynicism about how carbon-intensive businesses are using money earmarked to support their transition to a greener world. How do investors know that they are not merely replacing money that would have been earmarked for transition projects and are instead diverting it back into fossil fuel projects using the luxury of the new investment for the transition?
Having a transition plan is a great start, but it’s only half the battle
Peter Bosshard, Global Co-ordinator of the Insure Our Future campaign, sums up the doubts about the enthusiasm of the fossil fuel sector to wholeheartedly embrace the transition to a net zero world: “Looking at the fossil fuel industry over the past few decades I don’t think it is impossible for coal, gas and oil industries to transition but we don’t see the will to do it.” He points to the intense lobbying of US federal and state regulators by the fossil fuel giants as an indication of where their priorities lie: “I think we have to accept that they are not engaged in the transition to green energy.”
There are reasons to be more optimistic, says Russ Bowdrey, Executive Director, Climate Research at MSCI Inc, and he says institutional investors have a crucial part to play in turning pledges into reality: “Having a transition plan is a great start, but it’s only half the battle. For change to manifest itself, the plan needs to be followed through and turned into reality. This is where incentives will be key. Executives and decision makers need to be incentivised to make the transition work,” he said.
Bowdrey continued: “At the same time the picture is more nuanced. Institutional investors and underwriters have a role to play in increasing pressure on corporates to ‘do the right thing’ through aligned incentives. What is becoming clearer is that there is a straightforward risk appetite angle to these too which providers of capital and insurance need to approach with eyes wide open.”
The challenge of bringing clarity to this confused debate is vexing practitioners and academics alike. The Centre for Climate Finance and Investment at the Imperial College Business School has tried to pick a way through, defining green finance as “sources of funding to new capital and operating expenditures that generate measurable progress towards the achievement of a well-recognised environmental goal.” Its analysis of the various terms and definitions led the Business School to offer a succinct definition of transition finance: “Transition finance is capital provided to economic agents to achieve a minimum rate of carbon emissions reduction.” This still leaves open the related questions of what might be an acceptable minimum rate of carbon emissions reduction and how you measure the impact of investment in it.
Things are heating up
The first question is the source of intense debate as the impacts of global warming are felt in dramatically changing weather patterns around the world. The ambitious targets that flowed from an agreement to limit global warming to a 1.5 degrees Celsius increase over pre-industrial norms that 196 countries signed up to at COP21 (Conference of the Parties) in Paris in 2015 are coming under increasing pressure. The debate over what that means in terms of achieving net zero carbon emissions and, crucially by when, rages on and will be played out again at future COP meetings. The most widely accepted target date for achieving net zero emissions to meet the 1.5 degrees Celsius commitment is 2050 and that is largely what financial institutions are focused on. Climate change campaigners are pressing for a more ambitious timetable. While that is a wider debate that will set the parameters for the finance sector, the issue of measurability and providing a practical framework for transition finance has moved centre stage.
The Glasgow Financial Alliance for Net Zero (GFANZ) launched, as its name suggests, in Glasgow for COP26 in 2021, has recently initiated a consultation aimed at giving additional substance to a four-point strategy for transition finance it announced last year. Within an overall objective of developing and scaling of climate solutions, this encouraged investors to support the climate transition by allocating capital to solutions, companies and assets aligned with the 1.5 degrees Celsius pathway, or companies and assets with a serious commitment to transition. It also said they could invest in the timely phasing out of highly polluting assets such as coal mines and coal-dependent energy producers.
Now, GFANZ wants to refine those definitions and support financial institutions to forecast the impact of these strategies on reducing emissions with some practical tools. Mark Carney, former Governor of the Bank of England and now GFANZ Co-Chair and UN Special Envoy on Climate Action and Finance, set out the ambition behind GFANZ’s latest proposals: “To achieve the largest and most rapid reduction in emissions possible, transition finance must be mobilised – urgently and at scale.
Trillions of dollars are required to bring emissions down and private finance will need to play a central role. We need to be able to track impact by measuring the expected decarbonisation contribution of financing. This consultation links decarbonisation contribution methodologies to the GFANZ financing strategies as a proposed approach to measuring the impact of transition finance over time.”
GFANZ is gathering market feedback, with the expectation that it will be able to influence the debate at COP28 and beyond. It is working on a principles-based approach to segment portfolios by the four key elements of its earlier strategy, backed with greater transparency.
To provide further clarity around transition finance, it is also addressing the issue of measurability of the impact of transition finance through a concept called Expected Emissions Reductions (EER), which it says will allow financial institutions to quantify the ‘emissions return’ of their transition finance activities more effectively.
This has not immediately impressed those looking for the finance sector and its regulators to bring greater confidence to measuring the impact of their investments: “There is a fundamental problem with EER approach in that it is based on an unknowable counter-factual baseline, crucially what is business as usual over the coming decades”, says Paddy McCully, Senior Analyst of Energy Transition at California-based Reclaim Finance.
“Of course lots of educated guesses can be made about this but a counter factual is, and always will be, impossible to know. And because of this there will always be a tendency for BAU projections to assume high emissions, so that the financial institutions can show that their interventions will produce a large gap between business as usual and what actually happens, and so generate lots of EERs,” McCully continued.
There is also fresh, if stuttering, pressure coming from the European Commission, which has issued its own proposals on transition finance, including its own definition: the “financing of climate and environmental improvements to transition to a sustainable economy, at a pace that is compatible with the climate and environmental objectives of the EU.” The Commission’s recommendation clarifies how EU firms can voluntarily use the existing regulatory framework as a means for facilitating transition finance but stopped short of recommending any new rules. These will have to wait until after the European Parliament elections in June 2024 and the arrival of a new Commission next November.
Taking the temperature
In the meantime, institutions will be looking to position portfolios in the expectation of some of these new rules becoming reality in the next few years. Many have turned to the bond markets, where an estimated $2trn has been raised since the European Investment Bank issued the first Climate Awareness Bond in 2007, according to Deloitte. Although green bonds are an important funding source for renewable energy projects, they currently represent less than three percent of global bond market issuances. Within that, bonds focused on transition finance are an almost negligible proportion (see Fig 1). This is where the sort of initiatives being driven by GFANZ come in. It acknowledges there is a huge challenge in unlocking the scale of finance required to achieve significant decarbonisation of the real economy – both through funding clean energy and helping existing businesses genuinely committed to the transition.
Creating consistent definitions that are applicable across markets and sectors will help to scale transition finance to ensure real economy decarbonisation, help financial institutions independently identify their risk exposure and the investment opportunity ahead. They can also serve as safeguards to verify that the reduction of emissions in their portfolios corresponds to actual emissions reductions in the real world, rather than being achieved solely through divestment from high-emitting assets. More money, with greater clarity and measurable impact that can win the trust of investors, governments and climate change pressure groups, is what the world will be watching for as institutional investors are pushed more and more into the net zero spotlight with the scrutiny that brings.