In brief
The term ‘transition finance’ has now firmly established itself in the lexicon of financial market participants, however, there does continue to be some differing perspectives around the scope of the term’s definition. Some consider it to encompass climate transition across all sectors of the economy, whilst others take the narrower view that it concerns financing aimed at assisting higher emitting organizations, such as those involved in energy production, transportation, mining, and cement, the transition towards decarbonization.
Alongside the financial markets, that have been shaping the products and services needed to implement transition finance (whatever its definition), governments and regulatory bodies have also been striving to engage with and support transition through conducting market reviews, developing standards and implementing disclosure requirements.
This brief alert examines some of the risks and challenges facing organizations that are striving to develop transition plans and financial institutions that are in a position to provide the financing needed to realize these plans. It also considers what governments and regulators are doing and what more they could be doing to support the development of the transition finance market.
In detail
It is estimated that trillions of US dollars are needed in transition-related investment in order to meet net-zero targets. Aside from agreeing what constitutes transition finance, the biggest overarching challenge to reaching these levels of investment is probably risk aversion. The Loan Market Association (LMA) highlighted in its recent response to the Transition Finance Market Review’s (TFMR) Call for Evidence that there was increasing reluctance to use sustainable finance labels, such as green or sustainable finance that can be used to support transition activities, particularly when investing in high emitting sectors, due to the potential reputational damage from greenwashing claims that such investment might attract. Indeed, these issues do need to be carefully navigated but all sectors of the economy, and most especially high-emitting sectors that continue to be a necessary part of the economy, require well-structured investment to assist them to decarbonize and contribute to a low-carbon economy. Ultimately, supporting transition has to be the preferable option to abandonment. Stranded assets would have negative impacts for the environment, the connected economy and result in financial losses for exposed finance providers. In January of this year, the European Central Bank (ECB) published a piece on its ‘Supervision Blog’ titled “Failing to plan is planning to fail” – why transition planning is essential for banks, in which it highlighted that “misalignment with the EU climate transition pathway can lead to material financial, legal and reputational risks for banks” making it “crucial for banks to identify, measure and manage transition risks.”
Overcoming these challenges requires some key infrastructure to be put in place, including the collection and disclosure of consistent and comparable data and the establishment of enabling policies and regulatory frameworks to create investment incentive, certainty and confidence in the market that alleviates those reputational risk fears.
The UK government in its Green Finance Strategy 2023 announced that it wanted to be “the best place in the world to raise capital, invest and obtain financial services to facilitate a transition to a net zero future” and on 14 March 2024 it launched its Call for Evidence: The Transition Finance Market Review, which many market participants have responded to, including, as noted above, the LMA. We expect the UK Government to issue its findings later this summer. In the outline of the approach to the review it is stressed that the review will not be seeking to propose a “fixed definition or approach” and that the focus will be on “principles that drive credibility and integrity”. The idea seems to be that this will allow transition finance to evolve and adapt to market needs and provide a framework for the development and application of innovative solutions in line with advancements in technology and policies. The review also encouraged respondents to think widely about financing all activities of an organization’s credible net zero transition through the deployment of all types of financial investments, products, and services. This means thinking about the needs of the organization as a whole to create a ‘transition finance’ package that might include, specific use of proceeds finance (i.e., ‘green finance’ or ‘social finance’) together with general purpose finance (more akin to sustainability linked finance), as well as other business support products, such as insurance and related advisory services.
In its response, the LMA supported an approach of “high-level and principles-based guidance” to help enhance “transparency and consistency” and noted that it would particularly welcome recognition, in such guidance, of the fact that different industries each have significantly different starting points for their transition. They also supported recognition of the need to ensure interoperability between the frameworks being developed in different jurisdictions. This point recognizes the potential difficulties that cross-border businesses may otherwise face with compliance and consistency of approach. It is understood that the LMA are also working with the market on an additional tool to support transition finance in the form of a framework for a transition use of proceeds loan label.
It is envisaged that greater consistency and transparency in transition finance products can also be developed on a foundation of consistent comparative data collected as a result of improved reporting standards based on those published in June 2023 by the International Sustainability Standards Board (ISSB). It is anticipated that these standards will act as a global baseline that many jurisdictions are likely to follow; and is an illustration of the potential for international co-operation in this area. Existing sustainability disclosure requirements in the EU and UK do already provide a repository of data to feed into the development of transition finance products, with further harmonization with ISSB standards expected. Borrower-level disclosures and those further down the supply chain, for example those required by the EU Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive (CSDDD), should help lenders to work together with borrowers to establish appropriate KPIs and monitor compliance with them more effectively, whilst also improving their ability to ensure that they are meeting increasing management and disclosure requirements. Corporate disclosure rules are increasingly requiring the disclosure of transition-related metrics: for example, the CSRD requires disclosure of climate-related targets, including whether the target is absolute or relative, scope of the target and applicable methodologies and assumptions, and the ISSB will mandate disclosure of quantitative and qualitative climate-related targets set to monitor progress towards achieving strategic goals, along with any targets the disclosing entity is required to meet by law or regulation. Further, the taxonomies underlying disclosure requirements – such as the EU Taxonomy – can also be used as transition tools themselves, to define transition targets, compare current with planned performance, and identify transition finance needs.
As already noted, banks are also facing increasing management and disclosure requirements relating to prudential climate and transition risk: for example, sustainability risk management requirements form part of the forthcoming reforms to the Capital Requirements Directive (CRD) framework, and at the international level, the Basel Committee on Banking Supervision is exploring whether to establish a disclosure framework for climate-related financial risk, including transition risk. Though these requirements are likely to add to the regulatory burden, prudent risk management and harmonized reporting frameworks should also help to reduce the potential perceived risks arising from engagement in the transition finance market.
Carefully considered, robust transition plans will also play a key role in the harmonization of the transition finance market: the Network for Greening the Financial System has urged closer engagement and coordination between financial and non-financial institutions to build credibility in the transition finance market and enhance investment opportunities. In the UK, the Transition Plan Taskforce, which aims to develop the gold standard for private sector climate transition plans, has indicated that the TPT Disclosure Framework, published in October 2023, is also designed to align with and build on the ISSB reporting standards. Furthermore, in its recently published implementation update on Sustainability Disclosure Requirements (SDR), the UK Government announced that the Financial Conduct Authority (FCA) will be consulting on “strengthening its expectations” for transition plan disclosures. Industry commentary indicated that this announcement had been welcomed by investors but that some were pushing for transition plans to be mandatory for UK companies and for the timetable for implementation overall to be swift and pushed up the agenda. In the EU, transition plans are voluntary, but the European Commission considers them one of the key tools that businesses can use to set targets and anticipate financing needs. The CSRD does not require organizations to implement a transition plan if they do not already have one but it does require disclosure if they already have one at the time of their disclosures. Companies in-scope of the CSDDD will be required to adopt and put into effect transition plans, with those reporting a transition plan under the CSRD deemed to have complied. For banks, the forthcoming CRD reforms look set to mandate prudential transition plans.
It is also worth noting that regulatory approaches to sustainability-related product labeling are likely to have an increasing impact on transition finance. In the UK, the FCA has specifically factored in transition funds to the SDR (through the “Sustainability Improvers” label), and asset managers launching such funds will be particularly focused on investee companies’ transition planning. In the EU, the European Supervisory Authorities have recently proposed a new retail-driven label for EU transitional funds. As regulators refine their approach to transitional investment strategies, investor expectations may change or become more rigorous over time.
As already highlighted, addressing the risk of greenwashing is a key concern as financial institutions expand their transition finance offerings and adapt the business models to meet sustainability challenges. Both the FCA and the European Banking Authority have raised concerns about greenwashing in the sustainability-linked loans market, where a lack of prescriptive regulation and potentially weak targets and KPIs disconnected from transition plans raise the threat of greenwashing accusations. For example, firms may wish to be cautious about linking group-level transition policies to individual products and services to avoid the risk of misleading end-clients and investors. Greenwashing accusations also raise the risk of reputational damage, for example through vague, aspirational language in business plans, investment and lending misaligned to net zero targets, or weak targets using unscientific methodologies. Regulators are beginning to respond to these risks through prescriptive action: the FCA’s anti-greenwashing rule, applying to all authorized firms (including banks) requires firms to ensure that any reference to the sustainability characteristics of a product or service is indeed consistent with the sustainability characteristics of the product or service, and is fair, clear and not misleading. The general direction of travel is positive for the transition finance market. Products and tools, such as industry-produced principles are in place, and reporting and disclosure standards are evolving but there remains some road to travel in terms of implementing the various proposals put forwards by consultations and regulation to help establish transparent, consistent and reliable data to enable the creation and monitoring of effective transition plans that will help to drive confidence in the finance markets.
