Transition finance mapping highlights key gaps
Transition finance is a particularly challenging concept to move from idea to reality. In contrast to sustainability, which has been defined in taxonomies, there are far more pieces in the puzzle when creating transition finance. It is made up of more discrete thresholds when evaluating and assessing credible transition thresholds. The Climate Bonds Initiative has compared a range of transition guidance methodologies and created a mapping of the issues covered or omitted from each guidance, some related to transition finance and others focused on corporate transition planning.
As an example, evaluating the Paris alignment of emissions targets is a critical part of most transition guidance, especially the inclusion of short- and medium-term targets and alignment of emissions metrics against credible science-based pathways. However, there is substantial variation around the inclusion of interim emissions targets, the inclusion of scope 3 emissions, identification of primary metrics among those available, and timeframes for aligning with science-based pathways.
The consequence of the misalignment between different guidance on transition finance is important because it creates a barrier for companies and financial institutions to contribute to an important, difficult aspect of the decarbonization process. There are much more clearly defined definitions about what activities are most sustainable (‘dark green’ in classification terminology) in that they provide a climate solution that is needed to achieve the Paris Agreement targets. There are also clear, although not always unambiguous, definitions around economic activities that are incompatible with the global transition.
The gap between these two ends of the spectrum is not entirely included in the ‘transition’ category. Companies that are not working on transition or those that are not doing so in a systematic and credible way may not be incompatible with the climate transition, but they would not be included in the transition category. Clear guidance on transition plans and transition finance provides a way to separate out companies involved in the transition from those that are not ‘dark green’ but describe in general terms their interest in sustainability while not being able to meet transition criteria.
For a financial institution, especially one operating in emerging & developing economies where ‘dark green’ assets are relatively scarce, there is a tension in its sustainability efforts related to climate change. On the one hand, investors may be looking at the share of activities a bank finances that align with a regional or national taxonomy, or its progress in bringing down reported financed emissions.
Transition finance may not contribute to either of these objectives because most corporate transition occurs far from the thresholds for ‘green’ activities. In many cases, expanding finance to a corporate customer beginning a transition process may counterintuitively increase financed emissions if it includes high-emitting assets in a bank’s portfolio rather than a not ‘dark green’ but more modest emitter without transition plans.
When financial institutions are confronted with the choice to pursue ‘paper decarbonization’ of their financing portfolio by dropping high-emitting customers, or transition finance that brings financing of more high-emitting companies onto their balance sheet, they have to walk a tightrope. They will face pressure from business, government or labor groups to support a Just Transition by continuing to provide finance to high-emitting businesses.
They will face investors who have quantitative targets for emissions that may have binary ‘invest/divest’ screens based on reported financed emissions per $1 million of balance sheet assets. They will also face regulators concerned about the quality of banks’ evaluation of climate and environmental risks who may view slip-ups, in the words of Frank Elderson at the ECB, as calling into question “the fitness and propriety of those in charge of establishing and steering banks’ practices”.
There is no easy way out of this situation, whether that is to only finance green activities or to ignore climate-related risks. The only realistic way is to finance assets that start by smoothing the path for offering ‘green’ finance for those that qualify. With other financing provided, every bank should be able to evaluate how much the direct and indirect emissions risks of different activities have salience for likelihood of on-time repayment, and transparently set priorities between mitigating climate risk to the bank from an individual counterparty and contributing to an economy-wide decarbonization that meets stakeholder expectations for a Just Transition.
There are trade-offs between these outcomes. More finance for green projects may mean more constrained lending to higher-emitting companies. More transparency about financing provided to companies with transition plans may mean more stringent disclosures required of customers. A focus on credible, transparent transition plans may make it harder for companies with fewer resources to develop a transition plan to access finance.
Each individual bank doesn’t have to carry the weight of these issues all on its own, because there are substantial efforts to improve definitions of what ‘credibility’ in a transition plan looks like. Regulators are also increasing the minimum expected in terms of climate-related risk evaluation. And investors will also likely improve their ability to ‘look beyond’ customer Scope 1 and Scope 2 financed emissions metrics as a sole source of truth on a bank’s climate-related risk.
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