Making change: The role of transition finance

By Austen Crean

20th Nov, 2023

Much has been made about the shift of capital flows into ‘sustainable’ investments, with regulations and reporting structures such as the EU Taxonomy and the Sustainable Finance Reporting Disclosure (SFDR) more clearly defining what constitutes a sustainable investment or activity that accelerates the transition to net-zero. But this is only one side of the coin. In order to attain a long-term reduction in emissions in line with 1.5°C targets, we must also scale up investment in higher emitting sectors and companies to help them shift to a lower-carbon model.

What is transition finance?

Transition finance refers to directing capital towards carbon-intensive companies or sectors which are gradually decarbonizing but for which further capital and expertise is required to accelerate the transition. The UNEP FI have broadly defined two categories of transition finance:

1. Committed to Aligning: Financing or enabling entities committed to transitioning in line with 1.5°C-aligned pathways.
2. Managed Phaseout: Financing or enabling the accelerated managed phase-out (e.g., via early retirement) of high emitting physical assets.

Policy and regulatory landscape

A number of recent regulations have emerged intending to encourage and enable ‘sustainable’ investment through a common language. However, transition finance is often excluded from these frameworks, even as they contribute toward the achievement of sustainable outcomes. For example:

• The Sustainable Finance Disclosure Regulation (SFDR) is a set of EU rules which aim to make the sustainability profile of funds more comparable and better understood by end-investors. SFDR provides specific definitions and classifications of ‘sustainable investments’. A high-emitting entity in the process of transitioning would not be classified as ‘sustainable’ within this framework because the classification system assesses the characteristics of investments as they are today, not as they may change in the future.
• The EU Taxonomy is a classification system establishing a list of environmentally sustainable activities and applies to companies in scope of the Corporate Sustainability Reporting Directive (CSRD) and investors in scope of SFDR reporting regulations. The taxonomy sets out six environmental objectives which may be supported by different economic activities in different sectors. Similar to SFDR, high-emitting entities in the process of transitioning would be unlikely to have many activities that are considered ‘aligned’ by the EU Taxonomy.
• A distinct approach in the UK, the Sustainable Disclosures Regulation (SDR) aims to create a framework for disclosures on sustainability for corporates and investors in the UK. A key component of the SDR is the disclosure of transition plans, including high-level targets for activities designed to mitigate climate risk, interim milestones, and actionable steps in pursuit of those targets. Final Disclosure Framework and Implementation Guidance for transition plans was published in October, which will help companies in key high-emitting sectors produce credible net-zero transition plans. Furthermore, SDR includes a voluntary classification and labelling of financial products, including an option for ‘sustainable improvers’, or investments to improve the environmental and/or social sustainability of assets over time.

While SFDR and the EU Taxonomy do not yet recognize transition finance within their frameworks, there is an opportunity for funds operating in the UK to credibly display the mitigation and transition activities of their portfolio companies through the use of SDR. Furthermore, the European Commission has expressed a desire to support transition finance and the consultation on improvements to SFDR in the autumn will feature transition finance, so we may well see regulation on transition finance in the near future.

Investors have repeatedly cited the lack of recognition of transition finance – widely accepted as necessary to transforming the financial and real economies away from carbon-intensive activities – as a shortfall in both the EU Taxonomy and SFDR. At the same time, they argue, the demands of the regulations and the small number of investable companies already in alignment mean a diversified and sustainable fund is not workable. Some funds have even gone so far as to assert the highest sustainability classification under SFDR (so-called Article 9 funds), while still investing in transitioning companies, leaving them vulnerable to critique. Such a mismatch between legal frameworks and claims made by funds presents a serious risk, meaning it is perhaps better for now that investors should use other levers to communicate credible, science-based sustainability credentials. These may include the SDR-aligned disclosure framework and use of CapEx to measure sustainable activities under the EU taxonomy, which can better capture forward-looking activities.

What is the business case for investing in transition finance?

There are many reasons why it makes financial sense to invest in transition finance. Here are a few we have observed:

Driving the just transition

Given that over 70% of global emissions come from industry, electricity and heat production and agriculture alone, the opportunities for driving rapid decarbonisation by investing in companies in these sectors with credible transition plans is great. Furthermore, as governments around the world continue to drive the cost of emissions up through carbon taxes and similar policies, companies who are transitioning faster will be in a position of competitive advantage.

Opportunities linked with the green transition

A rapidly changing physical, regulatory, and societal environment means that new business opportunities are constantly arising and often companies in high-emitting sectors can be well positioned to take advantage of these opportunities. For example, commodity trading and mining company Glencore recently repurposed its metallurgical facility into a battery-grade lithium, nickel, and cobalt recycling plant to take advantage of growing demand from the electric vehicle (EV) market.

Where to go from here

For investors interested in transition finance, there are a number of resources that provide excellent guidance. Three that we find particularly useful are:

• The OECD Guidance on Transition Finance provides a guide for practitioners, ensuring that transition finance is grounded in credible transition plans and avoids sacrificing environmental integrity for inclusiveness.
• The UNEP FI Net-Zero Banking Alliance Transition Finance Guide provides investors with a summary of levers available to them, an overview of approaches and frameworks currently leveraged by market participants and future opportunities for investing in the green transition.
• The International Capital Markets Association produces principles, guidance and practical information on various sustainable finance tools such as green bonds and sustainability linked bonds, helping investors and issuers navigate the green transition.

The desire to offer attractive sustainable investment products remains very high within the investment community, but the methodologies for doing so reliably are in flux. While transition finance is surely a key piece of the puzzle, navigating the current environment can be complex. Sancroft has specialised knowledge and expertise to help investors engage in transition finance and communicate the sustainability credentials of funds, while mitigating regulatory risk. Email austen.crean@sancroft.com or alex.miller@sancroft.com to find out more.