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How to accelerate transition finance for net zero

To effect transition finance at pace and scale, FI’s will need to operate iteratively in a complex ecosystem.

In brief
  • FIs supporting the transition of high-emitting sectors are hindered by varied and inconsistent definitions of transition finance.
  • FIs need to embed the right mechanisms and processes into their operating model and maintain a culture of improvement.
  • Success will require ongoing, iterative effort over many years.

The results of the Paris Agreement’s Global Stocktake, which evaluates the world's progress on reducing greenhouse gas emissions and that are set to be revealed at COP28, are expected to confirm that the planet is struggling to limit global warming to 1.5˚C.

While an estimated US$1.1t was invested in the global energy transition in 2022,1 the world needs more than triple that amount — between US$3.5t and US$4t every year until 2050 — to get on track for net zero.

Given this pressing need to secure additional investment, it’s clear that financial institutions (FIs) have a vital role to play in accelerating the global flow of transition finance — the process of making capital available to help high-emitting businesses and industries become more environmentally friendly.

Trillions of dollars will need to flow not just into green sectors, but also to transitional technologies and activities — which are often loosely defined given the wide range of industries, evolving innovations, changing regulations and inconsistencies in terminology and definitions.

FIs will therefore need to go far beyond just setting environmental goals or making declarations for change. To avoid “paper decarbonization,” they will need to ensure they are delivering tangible, real-world improvements aligned to clear, measurable and verifiable objectives.

The world is struggling to limit global warming to 1.5˚C.
Amount of additional investment is needed every year until 2050 to get on track for net zero.
1

Chapter 1

Current transition finance frameworks

A summary of existing frameworks and challenges to scale finance for net zero.

FIs face significant challenges as they look to actively support the transition of high-emitting sectors, corporates and countries.

This is exacerbated by varied, inconsistent approaches to defining and characterizing transition finance and eligible products, activities and sectors. For example, the European Union’s Taxonomy Regulation, which provides a classification system for sustainable economic activities, is yet to clearly define the taxonomy for transition activities. Similarly, the Climate Bonds Initiative (CBI), which provides specific criteria for green bonds, is less precise when it comes to transition bonds.

FIs can draw on a range of guidance to navigate a landscape of shifting policies and evolving technologies, but these tools vary in their scope and intended applications. Transition finance frameworks can be loosely categorized using the three tiers set out in the EU’s International Platform on Sustainable Finance (IPSF) report.2

Transition finance frameworks

Activity level

Entity level

Portfolio level

Transition plan guidelines: define climate transition plans for organisations, i.e. steps for how they can actually decarbonize. These range from transition plans for which all entities and countries are in scope (e.g., TCFD), to specific Financial sector plans (such as GFANZ).

Taxonomies: assess and classify economic activities as ‘transition’ activity. Different classification categories reflect the varying degrees of climate impacts.

E.g., EU, South Africa, ASEAN, Indonesia, UK Taxonomy, Canadian Taxonomy, Australian Taxonomy

Frameworks for issuers: provide guidance for capital market participants on what is required or recommended when raising capital for transition activities.

Portfolio level: tools for FSOs to measure their portfolio alignment against a sectoral pathway or scenario.

E.g., GFANZ, PACTA

Reporting: disclosure requirements on entities to declare their climate transition plans, and their climate impacts.

Sectoral pathways: trajectories and criteria for sectors to decarbonize. They are based on sectoral climate science and can be used by entities to assess their alignment and progress. 
 

2

Chapter 2

Challenges associated with mobilizing transition finance

The internal and external obstacles facing FIs to scale up transition finance.

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FIs are working to develop approaches to transition finance that will allow them to support both new and existing clients’ transition journeys. However, FIs face their own internal obstacles, including:

  • Operationalize the transition: pricing the transition into decision-making and incentive frameworks requires FIs to use multiple levers (including capital allocation, funds transfer pricing, emissions budgets and adjusted risk appetites) in order to develop a climate-adjusted view of economic profitability. However, this is a complex process given exposure to multiple sectors with differing transition pathways. Changes to internal incentive structures will be needed, requiring buy-in from the top and business unit heads.
  • Engage with clients: FIs need to dial up engagement with their clients to assess their transition plans and provide tailored support where appropriate. Not only will this require significant investment and effort; firms may also need to make some difficult decisions over clients that are unable or unwilling to transition, despite support.
  • Assess credibility: reviewing the alignment of their portfolios with 1.5°C pathways will be a key element of FIs’ net-zero journey. This is a challenging exercise, particularly when assessing the alignment of companies, or of assets that require managed phase-out. It’s made harder by the fact that many corporates haven’t yet disclosed their transition plans with sufficient transparency and detail.
  • Consider suitable metrics: current metrics that focus on decreasing financed emissions to achieve portfolio decarbonization may not incentivize FIs to finance the transition of high-emitting entities or activities. However, it’s encouraging that portfolio alignment is considered as the leading indicator in the Science-Based Targets initiative’s (SBTi) latest guidance on the Financial Institutions Net-Zero (FINZ) Standard3 currently under development.

FIs also face many external challenges to engaging in the transition of capital and investment. This in turn, in many instances, has the effect of pushing up the cost of transition financing and depressing returns on investment. Key external challenges include:

  • Political inertia: policymakers around the world are not generating the momentum required to unlock transition finance at the levels needed to make a 1.5˚C pathway attainable. This is illustrated by patchy national emissions targets, insufficient investment in accelerating technology development in certain sectors and the lack of mechanisms to generate a global carbon price.
  • Framework limitations: inconsistent rules and standards contribute to the mispricing of climate risks and make it harder to intermediate supply and demand for transition finance. In addition, few current frameworks provide clear links between transition plans and taxonomies, mechanisms to prevent carbon lock-in, alignment with other sustainability goals, or proportionate treatment for small and medium-sized enterprises (SMEs) and companies operating in developing markets.4
  • Investable pipeline: immature technologies and policies — and their impact on investment horizons and returns — impact FIs’ risk appetite and the availability of investable opportunities. For example, the long-term financing needs and uncertain returns associated with many early-stage low-carbon technologies may limit funding for areas with the most acute need of capital.
  • Regional distortions: mobilizing finance in developing regions is often made hard by excessive costs of capital — even for green technologies like wind or solar that are more readily funded in mature markets. Political risks contribute, along with a lack of local financing capabilities — reducing investor appetite and creating a danger of continued fossil fuel dependency.

3

Chapter 3

Accelerating flows of transition finance

Building capabilities for transition finance: internal and external improvements to action.

If FIs are to successfully navigate the complexities of transition finance and maximize the associated opportunities, they need to embed the right mechanisms and processes into their operating model and activities.

That will require ongoing, iterative effort over many years, including instilling a culture of continuous improvement. Firms are at varying levels of maturity, so best practice will vary — especially across regions. For now, once net-zero-aligned targets are set, focus should be on these actions:

  • Target real-economy transition: setting targets and metrics that prioritize real-world decarbonization, and monitoring progress against these to minimize the risk of divestment and increase portfolio decarbonization.
  • Set the right incentives: using internal levers such as capital allocation and adjusted risk appetite to create the right set of incentives for client-facing staff and decision-makers, helping to deliver on net-zero transition.
  • Develop greater specialization: recruiting specialized talent and training existing staff will help firms develop their transition finance capabilities, as well as improve their understanding of emerging technologies and the evolving policy landscape.
  • Improve data for decision-making: overcoming the continuing obstacles of data quality and availability will depend on making the right investments. A data strategy with a clear roadmap for improving data quality at sector, client and activity levels is key. Investment in internal processes will also be needed if firms are to be able to track progress and inform their investment and lending decisions.
  • Innovate new products: creating in-house transition finance frameworks based on best-in-class industry guidance and placing robust controls around the scaling up of products such as transition funds and bonds will enable FIs to finance the transition while minimizing greenwashing risks.

The right government policies can be a huge accelerator of transition technologies. The US’ Inflation Reduction Act (IRA) is a prime example, deploying up to US$379b in federal funding for green technology and clean energy projects. Meanwhile, the UK government plans to commit £20b in funding to the early development of carbon capture, usage and storage (CCUS) technology over the next 20 years, as well as developing new business models and carbon pricing mechanisms alongside the private sector.

Governments and regulators, in consultation with the private sector, can also accelerate transition finance by clarifying sector pathways and improving the coverage and consistency of taxonomies. In our view, key framework improvements to prioritize over the next two to three years are:

  • Evolution of industry and voluntary standards and frameworks: for FIs this would include the SBTi’s FINZ standard and Glasgow Financial Alliance for Net Zero (GFANZ) guidance providing a clearer view of portfolio alignment and associated transition criteria and metrics.
  • Comparable categories and coverage: more consistent categorization of economic activities between different taxonomies would be valuable, especially for global FIs that operate across multiple regions. For instance, the Canadian Sustainable Finance Action Council (SFAC) 9  and the Australian Sustainable Finance Institute have published their own roadmaps for categorizing transition activities.
  • Greater interoperability of disclosure: enhanced interoperability across key disclosure standards such as the International Sustainability Standards Board (ISSB) and European Financial Reporting Advisory Group (EFRAG) would make it easier for FIs to manage the volume of compliance – for example, by reducing the need for multiple interpretations, and by making it easier to align metrics and KPIs in a way that incentivizes growth.
  • Transition planning guidance: there needs to be a concerted effort across jurisdictions to move toward the mandatory disclosure of high-quality transition plans. A hugely positive step is the UK’s Transition Plan Taskforce (TPT), which provides a gold standard framework for a strategic, rounded approach to transition planning and takes into account related considerations such as nature and just transition. 
  • Enhanced collaboration: collaboration between FIs, trade bodies, policymakers and regulators will be critical to building momentum behind transition finance, especially when it comes to establishing shared standards, agreed parameters and greater cross-border interoperability.
  • A global taxonomy: in an ideal world, there would be a standard global transition-specific taxonomy. A myriad of factors, including the diversity of different countries’ economies, make this especially challenging. In the next few years, it would be more realistic to focus on transition disclosures, industry and voluntary standards and frameworks, and mechanisms for interoperability.

Success is dependent on a range of factors, including strong political leadership and policies, consistent definitions and regulations across jurisdictions, supportive industry frameworks and FIs’ own capabilities and investments. FIs therefore need to optimize factors within their own control. These include mobilizing transition finance through the right structures and incentives, engaging closely with clients, and collaborating with peers, regulators and other stakeholders to improve industry frameworks, policies and practice.


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Summary 

There is a pressing need for the world to upscale investments in transition finance for reducing carbon emissions and curbing global warming. FIs can play a vital role in expediting the global transition finance flow, but they should ensure that they are making concrete, real-world advancements rather than mere paper decarbonization efforts.

About this article

A photographic portrait of Gill Lofts
Gill Lofts
EY Global Financial Services Sustainable Finance Leader
Passionate about creating a legacy in the financial services industry. Proud mother of two daughters.

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