The financial services industry faces a major hurdle in the race to net zero. There’s strong momentum behind investment in low-carbon technologies – but that’s only part of the solution to tackling climate change. To meet their net-zero targets, financial institutions – especially banks and asset managers – also need to finance the transition of carbon-intensive sectors and assets. That’s where the opportunities are, but where guidance is currently lacking.
High emitting sectors need to cut emissions by 8% a year to align with a 1.5°C rise in global temperatures. Such rapid decarbonisation requires an estimated $4.5 trillion in annual investment in decarbonisation. This creates enormous demand for transition finance, presenting a substantial opportunity for financial institutions to support the energy transition, while lowering transition risks associated with lending to hard-to-abate sectors and getting a head start on complying with incoming climate-related regulations.
There’s nothing off-the-shelf
So far, regulators and policymakers have prioritised establishing green taxonomies. Although these are useful for channelling investment into low-carbon technologies, they don’t support the far bigger job of transitioning existing portfolios.
In the absence of official guidance, several market actors have developed transition frameworks. However, in Baringa’s experience these suffer from practical challenges including being high-level in nature or targeting a narrow range of financial instruments and technologies. This means they are less useful in assessing emerging technologies, such as Direct Air Capture, or understanding sectoral and geographic nuances. As is to be expected in any emerging area, there is also widely differing terminology across frameworks.
Things are improving, but not fast enough. In response, financial institutions need to develop their own transition taxonomies and frameworks. These can act as an enabler of a range of outcomes, including:
- Driving closer collaboration between financial institutions and their clients or investees on transition planning and the financing of decarbonisation
- Encouraging the development and evolution of credible transition plans aligned with leading international standards
- Allowing identification of opportunities and risks arising from the transition to a low-carbon economy
- Informing engagement and expectation-setting with investees regarding rate and extent of decarbonisation
- Directing capital towards decarbonising hard-to-abate and high-emitting sectors, including:
- Decarbonising sectors with material scope 1 and 2 emissions where economic activity will likely remain stable or grow in a low-carbon economy, such as steel production where transition finance can be used to electrify production
- Accelerating the decarbonisation and phasing out of sectors with material scope 3 emissions that will face decreasing demand in a low-carbon economy, such as coal
- Financing activities such as sustainable finance instruments (Sustainability-Linked Loans, Sustainability-Linked Bonds) that will face increasing demand in a low-carbon economy and facilitate the transition of other sectors
- Ensuring robust, inclusive and transparent governance, with flexibility for continued evolution.
Financial institutions urgently need to focus on the enablers to transitioning their portfolios. They won’t be able to hit their net-zero targets if they wait for the current transition taxonomies and frameworks to mature; the UK Green Taxonomy Advisory Group has proposed the UK taxonomy remains ‘green only’ for at least three years by which point banks and investors will be locked into a glide path to their 2030 targets.
Act now, before it’s too late
Transition finance frameworks that align to financing plans and business strategies is a critical next step for the majority of organisations. Using these transition frameworks to assess and engage with portfolios at the entity, activity and asset level is key. By combining this work with existing green taxonomies that focus on specific assets, financial institutions can make real progress towards decarbonising their portfolios and meeting their net-zero intentions.
Starting now allows institutions to develop robust and tailored solutions that align to and reflect their business strategies while also preparing to align approaches when industry efforts coalesce and finalise standardised approaches.
So, what’s the best way to design and implement an effective transition finance framework? Here are some key learnings from our experience.
It’s crucial to strike the right balance between ensuring investments are genuinely transition-orientated and making a transition framework too prescriptive. If guidelines are too rigid, the flow of capital to transition-enabling activities may be severely reduced. However, guidelines that are too loose can increase the risk of greenwashing.
It’s also important to make transition frameworks dynamic by design, because technology and credible sectoral decarbonisation pathways are still evolving. This means that financial institutions need to allocate resources for periodically reviewing and updating their framework, especially as regulatory frameworks emerge.
Assess your clients
One of the most valuable exercises is ensuring that counterparties’ transition plans are assessed rigorously. This often reveals a significant gap between decarbonisation ambitions and the actual likelihood of realisation, affecting the future value of the company and its assets.
Assessments should look at the strength of the company’s decarbonisation pathway and publicly reported commitments, as well as proof of implementation, management incentives and levels of capital and operating expenditure committed. Although these assessments are sometimes done in-house, they’re usually carried out using a third-party solution and we have worked with many clients on this assessment using our own credible transition plan assessment tool.
Of course, successful portfolio transition requires access to comprehensive, reliable data on current emissions. This remains a significant challenge. However, the outlook is improving, thanks to initiatives such as the European Single Access Point, as well as plans for mandatory climate disclosures in Singapore and the US. Supporting this are qualitative inputs, such as disclosures aligned to the work of the Transition Plan Taskforce, who we were delighted to support with their recently published disclosure framework.
It’s also worth using transition frameworks to facilitate education and communication with internal stakeholders. For example, engaging investment teams and relationship managers to demonstrate how a transition framework can help front office teams pinpoint opportunities to generate alpha or deeper client relationships from transitioning assets.
When it comes to implementation challenges, securing the right resources is often high on the list. After all, building and maintaining transition models often requires technical data engineering capabilities as well as in-depth industry expertise. This heavy requirement for capability and capacity drives many financial institutions to integrate third-party transition models, which are less resource-intensive to design and maintain by integrating ongoing insights and industry developments.
As financial institutions take on the steps above, it’s important to keep a couple of principles in mind:
- Be transparent. Define your framework methodology and criteria clearly, anchoring on the scenario assumptions
- Focus on the business opportunities. Show how your framework aligns to the investment or financing strategy and supports identification of opportunities aligned to the transition
- Be relevant. Ensure that your framework is applicable across relevant sectors and regions for your business, using regional transition pathways where necessary.
To learn more about how we can help you decarbonise your portfolio, please get in touch with a member of the team below.
Reimagining the payments function
Right now, there’s a huge opportunity for banks to transform payments from a cost line item into a valuable new revenue stream. We explore what it will take for banks to tap into this revenue-generating opportunity and deliver sustained growth and long-term value creation.Read more
How should superannuation CROs respond to evolving climate change expectations?
For CROs in the superannuation sector, climate risk poses not only an additional complexity but also requires understanding new subject matter compared to traditional risks.Read more
Modernising your 3LOD and risk culture
Financial services' risk functions can’t continue to rely on the same old strategies and solutions. Here are three key questions FS firms should ask to make sure their organisational culture is prepared to meet volatility.Read more
The importance of culture for risk management
When we ask Chief Risk Officers (CROs) what they are worried about, they usually mention specifics like geopolitical risk, credit risk, and cybersecurity risk. But their biggest blind spot is often the most important factor that influences how these risks are managed: culture.Read more