Transition Finance: $4T by 2030, but only for financial institutions that are ready today
A Comprehensive Guide for Financial Institutions Navigating the Shift to a Low-Carbon Economy
The world is in the midst of a climate crisis, and the financial sector has a crucial role to play in driving the transition to a net-zero economy. This blog post delves into the future of transition finance, focusing on the role of financial institutions such as banks, asset managers, and brokerages. It draws insights from a recent report by Helix.Earth, on the subject and provides additional details on how the role of these institutions is expected to evolve over the next five years.
The Role of Financial Institutions in Transition Finance
Financial institutions are pivotal in providing transition finance through various instruments like sustainability-linked bonds/loans, transition bonds, project finance, and blended finance vehicles. They assess and finance credible corporate transition plans aligned with the goals of the Paris Agreement. Moreover, they ensure the transparency, consistency, and robustness of transition finance instruments.
Transition Finance Instruments
Transition finance instruments include sustainability-linked bonds/loans with variable returns tied to sustainability targets, transition bonds for financing emissions reduction projects, and asset-backed securities, investment funds, and equity investments for transition activities. Additionally, climate derivatives like weather, carbon, and catastrophe derivatives are also part of the mix.
Recommendations for Financial Institutions
We recommend that financial institutions should help polluters transition rather than just divesting. They should invest in credible, ambitious transition plans and activities across sectors and collaborate with companies to understand decarbonization needs and develop solutions. Prioritizing the transition of hard-to-abate sectors like energy, industry, and transport in the near term is also crucial. Furthermore, pushing for credible corporate climate transition plans as a basis for transition financing is recommended.
Opportunities and Risks in Transition Finance
The transition finance market was estimated at $400 billion in 2023 and is expected to grow to $4T, by 2030. Increased policy support and cost declines for low-carbon solutions are driving this growth. There is potential for competitive financial returns and positive environmental impact. However, there are also risks, including legal/regulatory risks around “transition washing” and transparency, market risks from technology, policy, and consumer preference changes, and climate transition risks - both physical and transition risks.
There are two competing priorities, which confuse the market, and have led to many financial institutions being blindsided. These are green finance, which serves to finance new/ additive capacity of green / renewable energy, and ESG, which is an investment criterion that focuses on traditionally low carbon business models. By taking the focus away, these have effectively kept financial institutions out of the Transition Finance market and have given the market away on a platter to a bouquet of transition focused funds.
The Current Role of Financial Institutions
Financial institutions currently serve as providers of transition finance capital, with banks providing sustainability-linked loans and transition bonds, asset managers offering transition-focused investment funds, and insurers investing in transition projects through blended finance vehicles.
They also structure transition finance products, with investment banks acting as underwriters for transition bonds and creating new asset-backed securities and derivatives for transition activities. Furthermore, they assess and align their portfolios, develop frameworks to evaluate the credibility of corporate transition plans and align lending/investment portfolios with net-zero pathways. They also offer advisory services, advising corporate clients on transition strategies and fundraising, and providing carbon risk assessment and mitigation advisory.
The Expected Evolution Over the Next Five Years
As regulatory frameworks solidify, e.g., the EU taxonomy, financial institutions are expected to significantly ramp up their transition finance activities across debt, equity, and advisory services. Assessment criteria for corporate transition plans will become more stringent, requiring robust methodologies, verification, and disclosure from financial institutions. New structured finance products tailored for transition needs of hard-to-abate sectors like shipping, steel, cement are likely to emerge.
Transition and physical climate risks will be deeply integrated into financial institutions’ risk management frameworks. Greater cross-border coordination among financial centers to harmonize standards and facilitate international transition finance flows is also expected. Investments in data management, analytics, and digital platforms to effectively track and monitor transition metrics will be crucial. Upskilling employees and establishing dedicated transition finance teams to build technical expertise will also be necessary. In the UK, Barclays has made investments in this space by establishing an Energy Transition Group within the Corporate & Institutional Business Unit, however given the size and scale of the business, they are likely to focus on just the large corporate space, leaving the mid-market effectively to boutique firms who are into deal making.
How Banks Can Leverage the Opportunities Presented by Transition Finance
To effectively leverage the opportunities presented by transition finance, banks will need to undergo several key changes. They must develop robust transition finance frameworks, build dedicated transition finance capabilities, integrate transition factors into core processes, develop innovative financing solutions, enable technology and data infrastructure, and update policies, governance, and incentives.
The Importance of Climate Risk and How Banks Are Building Expertise in This Area
Climate risk is a critical consideration for the transition finance market, and banks are enhancing their capabilities to effectively assess and manage these risks. Assessing climate risks is crucial for banks to make prudent financing decisions, manage exposures, and maintain financial stability. By integrating climate risk management capabilities, banks can make more informed decisions on transition finance, safeguard their portfolios against climate impacts, and position themselves as leaders in sustainable finance.
The Need for Enhanced Technology Capabilities
Financial institutions will need to enhance their technology capabilities to effectively leverage the transition finance market. This includes developing carbon accounting and emissions data management tools, climate scenario analysis and stress testing capabilities, climate risk analytics and scoring platforms, digital platforms for transition finance products, and alternative data and advanced AI/ML models.
The Current State of Technology Adoption and Significant Technology Gaps
Most large financial institutions have made initial investments in foundational capabilities. However, more advanced technology adoption is still in the early stages. To fully leverage transition finance, financial institutions need to enhance data and technology capabilities through dedicated climate risk technology platforms and solutions, integration of advanced AI/ML models and alternative data, cloud-based architecture for scalability and innovation, and collaboration with fintechs, big tech firms, and unified data ecosystems.
Transition Finance Products and Significant Technology Gaps
Financial institutions are leveraging several transition finance products, though significant technology gaps still exist in managing and scaling these offerings effectively. To bridge these gaps, financial institutions need comprehensive, integrated climate analytics and risk management platforms backed by robust data infrastructure and AI/ML models.
Leading Financial Institutions in Transition Finance
Several leading financial institutions are taking proactive steps to leverage the transition finance market opportunity. These include JPMorgan Chase, HSBC, BNP Paribas, and Standard Chartered among banks; BlackRock, PIMCO, and Amundi among asset managers; and AXA and Swiss Re among insurers. Even these have only scratched the surface in uncovering the immense potential of the Transition Finance market.
In conclusion, we would like to highlight the key role financial institutions can play in enabling and financing the transition to a net-zero economy across sectors through robust transition plans and innovative financing instruments and vehicles. By proactively evolving their strategies, governance, processes, and product offerings around the transition finance opportunity, financial institutions can position themselves as catalysts in the shift towards a low-carbon economy.