Global stock take on transition finance helps set the direction for a future standard

• An OECD white paper investigates some approaches to transition finance to draw some conclusions about where common ground exists
• The taxonomy approach to ‘labeled’ bonds may be insufficient for transition finance, and creating alternative frameworks will be very important for Islamic markets
• The interplay between climate science and more localized economic considerations make transition finance more dynamic than ‘green’ or ‘climate’ finance where taxonomies have driven significant clarity for responsible finance

Standards have been developed in many subjects relating to green, climate-aligned and sustainable responsible finance, but there is one area that has eluded efforts to standardize definitions: transition finance. However, a new stocktake of transition finance approaches from the OECD helps provide some overarching direction.

Transition finance is a critical part of the responsible finance market effort to reach Net Zero by 2050. Its importance is particularly high in Islamic markets, where significant parts of the economy may be operating in high-emitting sectors that either don’t have commercially available low-carbon solutions or are at high risk of becoming stranded assets. These include coal-fired power stations that could be bought up, retired early and replaced with renewable energy under a plan by large investors and the Asian Development Bank that could be released at COP26.

The working paper from the OECD offers a look at the transition finance frameworks that have been developing. It comes away with a two-part summary that may explain why transition finance hasn’t developed as quickly as other types of ‘labeled’ bonds. In short, transition finance is focused on “triggering entity-wide change to reduce exposure to transition risk” and is defined by its attributes rather than an easy label.

The authors summarize the eligibility criteria of transition finance as “(i) substitutability (absence of a zero or near zero alternative); (ii) a commitment by the borrower/issuer to a low-emissions transition trajectory; and (iii) avoiding lock-in, i.e. investments that prevent the implementation of green alternatives available in the future.”

Despite the current lack of a label, there are many of the elements that could go into a label present in this description. Mirroring other labels, there is a role for a taxonomy that defines at least a list of eligible investment types defined by the absence of zero or near-zero alternatives. The experience of taxonomy development has shown that a bright-line approach leads to significant jostling about what is immediately above and below the line.

For transition finance, it is much less important exactly where the line is drawn between transition and unsustainable activities because the definition includes much more than just scientific data and includes economic assessments that will change over time. For example, defining an absence of economically sustainable zero or low-carbon alternatives will depend on the country and assumptions.

The outcomes of a bright line taxonomy is conceptually easier than measuring a focus on the issuer’s intent, avoiding lock-in of technologies that are incompatible with most roadmaps for decarbonization, and ancillary social impacts. However, it will result in balancing the push and pull of competing interests instead of, in the words of the white paper, “triggering entity-wide change to reduce exposure to transition risk”.

The RFI Foundation has been researching elements of transition risk for the financial sector in Islamic markets, and we have provided some estimates of where these risks are the greatest in Malaysia and Indonesia (the two reports released so far). What is clear from our research is that elements of transition risk are closely linked with the underlying economy. They also reach the surface in different ways for different parts of the financial system.

What that means for formalization of transition risk frameworks is that what is relevant for one investor or financial institution may not work well for another. For example, fixed income investors may find much greater direct exposure from transition risks to projects they finance. Banks may have some of this type of direct exposure as well, while equity investors will face a range of direct and indirect risks emerging from the potential for the power sector, for example, to become more costly, which would affect manufacturing, services and other sectors.

Financial institutions and investors will end up managing their own transition risks relating to what they finance. At the same time as they reduce exposure to transition risk-exposed sectors, those sectors will be the ones seeking additional financing to mitigate their own transition risk exposure. Regulators, especially in the banking and insurance sectors, are becoming more concerned about systemic risks relating to climate risk which forces financial institutions to manage sometimes competing priorities.

This interplay between moving away from some risks while directing more financing for transition risk to similar or the same sectors is a confounding puzzle if there is not more knowledge and agreement on roadmaps that lay out the trade-offs involved with different strategies for transition. Having a global stocktake is a good first step towards better definition around transition finance, but there is significant work remaining to improve evaluation and assessment of transition finance opportunities by investors and financial institutions.

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