Transition finance key to address climate change


Transition finance, which provides financing to high carbon-emitting industries, should be part of a broad range of innovative financing options to address climate change. Addressing climate change and taking action to overcome its impacts and effects remain an urgent concern worldwide. There has been a consensus that the financial sector should go beyond supporting purely green activities to effectively transform the existing carbon emitters.

Realization of transition finance is crucial for combating climate change.

Transition finance is a concept which allows financial services to be provided for high carbon-emitting industries — such as coal-fired power generation, steel, cement, chemical, paper-making, aviation and construction — to fund the transition to decarbonization.

The concept emerged from the understanding that effective decarbonization of the entire global economy will require much more than green finance. Green finance and sustainable finance — as they are currently defined — focus largely on supporting activities that involve minimum pollution and carbon emissions. However, a much larger amount of financing is required in carbon-intensive sectors that need to decarbonize and eventually achieve net-zero emissions.

The key challenge to transition finance is the lack of private sector financing for decarbonization activities due to various barriers, including the lack of a clear definition of transition activities, which could cause investors to fear that their participation may be seen as "greenwashing" or claiming to invest in an eco-friendly business that isn't; the lack of disclosure that may encourage false transition activities; the lack of financial instruments that provide incentives for higher emissions reductions; and the lack of demonstration projects that show successful decarbonization is achievable in most of the high-emitting sectors.

To address these issues, and to effectively mobilize private investment in transition activities, a transition finance framework needs to be established. To make transition finance feasible, this policy framework should consider the following elements: identification of transition activities, disclosure and reporting, financing tools, incentives, and mitigating social impact.

First, there needs to be a credible approach to identifying and labeling transition activities. Any activity supporting credible transition toward netzero greenhouse gas emissions should be considered as transitional. One way to identify transition activities is to develop a "transition finance taxonomy" in which specific transition activities are presented with descriptions of technical pathways and emission reduction targets. This is being done in the European Union and some pilot regions in China, focusing on industries such as steel, cement, petrochemicals and agriculture.

The transition finance concept emerged from the understanding that effective decarbonization of the entire global economy will require much more than green finance. The identification approaches should be flexible and dynamic, and serve to reduce the cost of market participants and mitigate risks.

Second, good reporting practices are necessary to help prevent transition activities that convey a false impression or support an unsubstantiated claim on sustainability, where enterprises may claim to invest in emissions reduction activities but are in fact involved in projects that lock-in high carbon emissions — a behavior often termed as "greenwashing".

Third, a toolbox of financial instruments should be developed to support transition activities. This can include debt instruments such as transition and sustainability-linked loans and bonds. For example, if the fundraiser of a project can deliver stronger-than-expected emissions reduction performance, investors will charge a lower interest rate. The toolbox can also include equity-related instruments, such as the transition funds launched in Europe.

Additionally, existing instruments such as private equity, venture capital funds, buyout funds, and mezzanine financing facilities can be adopted to facilitate transition activities. And de-risking facilities should be developed to help lower the perceived risks of transition.

Fourth, fiscal subsidies, tax incentives, and green finance-related incentives such as central bank financing facilities should be considered to support transition finance and enhance the bankability of transition projects.

Fifth, socioeconomic costs, such as unemployment, energy shortages and inflation, need to be accounted for and disclosed when designing transition activities. To mitigate these costs, assessing employment implications thoroughly and including mitigation measures in transition plans, such as employee training and reskilling programs, are crucial to realize "just transition". Efforts should also be made to integrate such social elements (for example, employment performance) in the key performance indicator design of sustainability-linked products.

As for Asia and the Pacific, it should take the following steps to promote transition finance: To begin with, economies in the region should ensure regulators and financial institutions make clear the eligibility criteria for transition activities, which could be in the form of transition taxonomy, to lower the cost for banks and investors. This will guide companies to adopt the best technical pathways for transition.

Also, they should develop demonstration projects to highlight the feasibility of transition finance, which is new to most in the financial sector, and set concrete examples to counter the perception of high costs and risks. These could include transition projects in coal-fired power generation, steel, cement, and petrochemicals.

Furthermore, the Asia-Pacific region should consider launching its own transition funds. Transition funds can be launched by either governments or international organizations, such as multilateral development banks and other international financial institutions, or through international collaboration among different countries to reduce the funding costs and risks for these transactions, and help attract private sector investment.

In fact, a broad range of activities, with innovative financing options, are needed to address climate change, and transition finance is an important part of that equation.

Ma Jun is the president of the Beijing-based Institute of Finance and Sustainability; and Akiko Terada-Hagiwara is the principal country specialist, People's Republic of China Resident Mission, East Asia Department, Asian Development Bank.

The views expressed are those of the authors and do not necessarily reflect the views of China Daily or the Asian Development Bank.