Transition Finance: Need an enabling policy and regulatory interventions

To reach net-zero, we need to decarbonise deeply across the economy and the industries contributing to Greenhouse Gas (GHG) emissions. Although green finance can be used in industries which can reduce GHG emissions significantly, it can't be used in industries where significant decarbonization will need a longer time, for example, in the steel, cement, and airline industries. Transition finance is acknowledged as an instrument to use in industries, often called hard-to-decarbonise industries. 

However, there are concerns over the usage of transition plans. Since this financial instrument covers industries, including high-carbon-intensive sectors. Hence, there are concerns about greenwashing and capital contributing to carbon emissions, even if it supports making industries less carbon-intensive. A crucial challenge in transition finance is that transition relies on future planning. The absence of a globally accepted approach to a credible transition plan supporting net zero makes financial institutions and other stakeholders apprehensive about the concept of transition finance. The lack of a taxonomy and labelling standard also hinders corporations’ ability to communicate transition strategies effectively to financial institutions. 

Several transition projects (e.g., green hydrogen, sustainable aviation fuel) are not commercially viable. The return expectation from these projects is not commensurate with the risks. As carbon pricing is absent or low in several countries, there are inadequate incentives to invest in transitional activities where financial returns are not attractive or extremely low or negative. 

Transition finance at a system level requires massive steps from various stakeholders in the economic system, including non-financial corporations, investors, policymakers, and regulators. While investors and lender will play their part as capital providers, concurrent support from policymakers and regulators will also be critical. 

Designing a transition pathway

A net-zero transition pathway can clarify and identify transition/net-zero enabling technologies where transition finance is most needed. An appropriate transition pathway would give a roadmap to a net-zero economy, which offers an emission reduction target from the economy and identifies transition and enabling technologies with their time and scale of usage at the country level. It also includes phasing down or shutting high carbon-intensive projects. 

The second step would be to set a target for emission reduction from each sector. The target is based on the scope and scale of usage of transition technologies over time. The target must be scientific and aligned with international initiatives like SBTi or the Transition Pathway Initiative (TPI).

Transition finance taxonomy and labeling 

Policymakers and regulators must define transition finance taxonomy and label it that can help bring clarity to the real economy and financial sector. While transition finance taxonomy can readily define transitional/enabling activities without miscommunication, labeling transition finance can give the financial product (e.g., green bond) a proper identity, essential to transitioning the economy to a net-zero goal. Policymakers can state the assets/projects that are eligible and not eligible and their green intensity that will support financial institutions to differentiate transitional assets easily and asses the carbon intensity of their portfolio.  

Labeling transition finance products will enhance transparency and bridge the information gap between the borrower/investee and lender/investors. Watertight definition and labeling of transition finance can also mitigate greenwashing risk. 

Disclosure

Various disclosure standards, including IFRS S2 and standards drawn from TCFD, advocate corporations to disclose Climate-related information, including strategies to decarbonize the business, decarbonization targets, and the impact of various climate scenarios on financial performance. In response to Climate-related transition risks, the transition plan is one of the scenarios corporations can disclose in their Climate-related disclosure. Regulators can make it mandatory for their regulated entities to disclose the impact of transition planning on their financial performance.  As the economics of transition technologies is considered to assess its impact, investors and lenders can better understand the effect of transition planning and accordingly make lending/investment decisions robust without relying on empty promises of corporations. Disclosures and reports will also spread awareness of transition finance and enhance reporting quality that aids in better lending/investment decisions. 

Financial incentives

Several transition technologies/activities are not commercially viable now, and these technologies are associated with performance risk. These risks discourage mainstream investors from investing in these technologies. However, these technologies may find adaptability over time, like any other technology, if they demonstrate technological and commercial viability. Till that time, these technologies need risk and patience capital. Here, public financers can provide risk, patient, and, if required, grants that can support further development and scale-up of adoption of these technologies.  

Transition finance at a system level requires massive steps from various stakeholders in the economic system, including non-financial corporations, investors, policymakers, and regulators. While investors and lender will play their part as capital providers, concurrent support from other stakeholders will also be critical. A combination of long-term planning, governance, reporting, disclosure, policies, regulation, engagement, and monitoring acts can smooth and succeed the transition trajectory. 

Policymakers and regulators can design policies and regulations, governance, reporting, disclosure, financial support, and engagement acts that can smooth and succeed in the transition trajectory.

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