Many governments, asset owners, and other bodies claim to share a common goal in achieving net zero. But current strategies to propel transition finance often diverge and result in misalignments, says Rhodri Preece of CFA Institute.
Decarbonising high-emitting industries such as shipping, cement, and steel production is one key element in the march towards the climate targets set out in the Paris Agreement. But this comes with a cost; according to the World Economic Forum, the transition will require total infrastructure investment of $13.5 trillion between now and 2050.
A 2023 Masdar survey of 500 senior executives working in high-emitting industries indicated that only 40% have drawn up plans to achieve net zero by 2050, and of those who have yet to set net zero targets, half (53%) said the main obstacle is the lack of reliable financing.
Transition finance – financial support that helps decarbonise these high-emitting activities or enables the decarbonisation of other economic activities – can play a key role in enabling the transition for investors who intentionally seek to incorporate net zero targets into their investment strategies.
While national and regional policy frameworks tend to steer investment toward industries that posit themselves as ‘low carbon’, funding transition solutions for high-emitting sectors is one of the key routes to unlock progress towards net zero.
However, the role transition finance can play in decarbonising carbon-intensive sectors is yet to be fully recognised. Many governments, corporations, asset owners, and asset managers claim to share a common goal in achieving net zero. But the current strategies to propel transition finance often exhibit divergence, resulting in misalignments, inconsistencies, and incoherence. Scaling transition finance, therefore, requires navigating a complex landscape of economic, regulatory, environmental, and technological factors.
So, what exactly are the barriers?
At a fundamental level, there is a lack of consensus on how to define ‘transition finance’, and there is no common understanding of eligible activities and entities. International divergence between transition taxonomies also create significant barriers. While these taxonomies are designed to act as a common language between investors, policymakers, and other stakeholders, there is currently insufficient interoperability between different taxonomies. National and regional authorities have taken a range of approaches to develop their taxonomies, yet these approaches pay insufficient attention to transitional activities and instead emphasise the green economy.
The EU, for instance, has created a much-discussed taxonomy for ‘sustainable activities’, but Japan uses roadmaps instead to shape transition strategies for high-emitting sectors. Many other regions have not yet adopted a transition taxonomy or roadmap, which inhibits investments in emissions-reduction technologies. It doesn’t help that no international organisation has so far endorsed any transition finance instruments.
Building on these inadequate foundations are a confluence of other factors hindering transition finance from taking off.
To start with, knowledge gaps among the investor community hampers mainstream adoption and creates challenges in effectively communicating and implementing transition strategies.
Then, the lack of credible net zero transition plans from corporates and fit-for-purpose disclosures dissuade prospective investors. Without clear transition plans, supported by economic feasibility assessments, it becomes more difficult for investors to assess, monitor, and track a company’s decarbonisation progress, making it challenging to hold companies accountable.
There are tangible steps that each stakeholder group can take to accelerate progress
While we know that government support and public-private partnerships will be essential to accelerate the growth of transition finance, there is a widespread perception that investing in the novel technologies involved in decarbonising high-emitting sectors carries a higher financial risk. This contributes to an unfavourable risk/return profile and often discourages essential government support for transition projects.
How to grow transition finance?
Collaboration among institutional investors, asset managers, corporations, and regulators is essential to address these challenges and advance transition finance. And there are tangible steps that each stakeholder group can take to accelerate progress.
Institutional investors that wish to incorporate net zero considerations into their investment strategies should take steps to disclose both their portfolio emissions and decarbonisation progress by reporting changes in emissions over an appropriate time horizon. Together with a disclosure of specific portfolio decarbonisation targets, this will help promote transparency and awareness of decarbonisation goals and facilitate dialogue and comprehension among all stakeholders.
Meanwhile, corporations who have set net zero targets should provide feasible and credible transition plans to assure investors that they are committed to their transition targets. Further, companies should report inflation- and forex-adjusted carbon intensity per unit of revenue, so investment managers can better measure the impact of their investments and report on progress toward net zero goals. To incentivise accountability, companies can also consider linking decarbonisation to executive pay.
Arguably the most important factor is the role that governments and regulators can play in partnering with private sector stakeholders to develop transition taxonomies, harmonise transition plan disclosures, and require economic feasibility disclosures. There is also scope for greater provision of public and blended finance facilities to better mobilise private sector investment and use labelling to help individual investors navigate the investment product landscape.
A systemic shift
Reaching net zero will require a systemic shift in how the global financial system operates. The framing of sustainability so far has typically been green and clean and as a result, many investment strategies that incorporate net-zero considerations exclude or underweight high-emitting sectors for the creation of low-emission portfolios.
To incorporate transition finance into this narrative, a paradigm shift is necessary: asset managers need to pose different questions, gather more data, and develop new evaluation and stewardship methodologies. If funding is to be directed towards the projects, companies, and sectors that require the greatest support in cutting emissions, asset managers should begin an earnest evaluation of opportunities in high-emitting sectors.
Equally important is the need for corporations, regulators, and other actors in the transition finance system to cultivate new skills, establish fresh priorities, and, above all, embrace a new mindset. These collective changes will go a long way in driving the transformative impact of transition finance on a broader scale.
*Rhodri Preece, CFA, is senior head of research at CFA Institute.
