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Defining Transition Finance: Exploring Its Purpose, Scope, and Credibility

We outline three key areas to address to find a common definition.

Transition finance is a key area of focus for the United Nations Climate Change Conference (COP28), with growing calls for consensus and clarity in this critical piece of the net-zero puzzle. COP28 will see public- and private-sector leaders convene in Dubai next week to, among other things, “endorse a roadmap for rapidly developing and implementing common definitions of the transition finance strategies needed to unlock global finance in support of net-zero commitments.” This could be an important step in the evolution of transition finance, as a lack of standardized definitions and approaches is often identified as a barrier to its deployment and credibility.

Transition finance is increasingly urgent. While green finance has increased over a hundredfold in the past decade, this momentum alone will not get us to net zero. Other critical parts of the economy — especially high emitting and hard to abate sectors — will require significant investment to support their transition. Such financing can be controversial, with accusations of greenwashing amid a lack of common standards and accountability mechanisms. To ensure finance flows at the speed and scale required for a just and orderly net zero transition, the global community must rapidly define, valorize, and deploy transition finance. As noted on the COP28 website, “Absent shared definitions of these strategies, in particular addressing strategies for high emitting sectors where transition finance is most urgently needed, progress towards collective climate goals will not be sufficiently rapid and globally equitable.”

Transition finance is a sensible area of focus for the host region, given its carbon-intensive economy and financial wealth. However, progress toward a common definition is an ambitious goal for the COP Presidency as questions of the purpose, scope, and credibility of transition finance remain hot topics of debate.

To support the clarification and mobilization of transition finance, RMI has partnered with UK Finance to convene monthly workshops with seven leading banks on this topic. We also brought together prominent NGOs in a global call to action on transition finance, published earlier today, which outlines a common vision for why transition finance is critical for the net zero transition and provides recommendations for finance, governments, issuers, and borrowers seeking to unlock transition capital.

To inform the COP dialogues and other related initiatives, this article outlines three key areas of debate that will need to be addressed to find a common definition. Based on our work, including analysis of 17 different transition finance frameworks (and consequently 17 different definitions!), we highlight where consensus is emerging as well as areas of continued ambiguity and tension. See the table below for the list of reviewed guidance.

What is the goal of transition finance?

The Glasgow Financial Alliance for Net Zero (GFANZ) has introduced an expansive definition of transition finance as “investment, financing, insurance, and related products and services that are necessary to support an orderly, real-economy transition to net zero.” However, many frameworks hone in on transition finance as finance that can enable the decarbonization of high-emitting entities and/or hard-to-abate sectors.

We think this is an important distinction. While markets and taxonomies already exist for those climate solutions that are eligible for green finance (solar panels, batteries, etc.), capital and investment is also needed to decarbonize the rest of the global economy. For example, Citigroup estimated that the cost of reaching net zero in aviation, shipping, road freight, steel, and cement is up to $1.6 trillion. We need financial markets that can support critical inflection points, build momentum for economy-wide change, and reduce emissions at their source. Transition finance can, if implemented credibly, deliver transition-enabling solutions for high-emitting counterparties and assets, which may otherwise not be eligible for green finance.

So how do you define which high-emitting and/or hard-to-abate counterparties should be eligible for transition finance? Many resources to date stipulate that transition finance should be made available for issuers and/or entities where a credible pathway to 1.5°C-aligned decarbonization exists. One major dilemma, however, is how to treat sectors, entities, and assets that lack credible 1.5°C pathways but whose decarbonization will still be critical to achieving climate goals (such as the elimination of flaring and the reduction of methane emissions from upstream gas production). Moreover, transition pathways also vary by sectoral and regional context, so attempts to create a global definition will need to reflect this reality, balancing equity and fair share concerns without jeopardizing the level of ambition.

Overall, it is critical that transition finance does just that — transitions the economy and avoids carbon lock-in, which can occur when carbon-intensive infrastructure, assets, or companies “perpetuate, delay, or prevent the transition to low-carbon alternatives.” Definitional discussions will therefore also need to consider the lifetime of the activities and time horizons in credible 1.5°C climate scenarios, as well as robust monitoring and ex-post verification, to ensure that transition finance is not business-as-usual financing. At the same time, it is important that definitions incorporate just transition guardrails for supporting affected workers and communities and mitigate negative impacts. Further clarity on what this looks like in practice will be critical to ensure that transition finance is “just transition finance.”

Who can access transition finance and on what terms?

Beyond the contentious scoping questions of qualifying activities, the resulting dilemma becomes: how should capital be made available? Should transition finance be limited to ring-fenced and use-of-proceeds activities? Or should issuers be eligible for transition finance as general-purpose financing?

Whereas dedicated financing can be directed and tracked to appropriate technologies and assets, general corporate purpose funding runs the risk of lacking assurances of transition impact due to fungibility of capital. However, given the scale of general-purpose financing, excluding it could drastically reduce the potential size and impact of transition finance markets (and, by extension, the speed of real economy decarbonization). Therefore, definitions should outline whether and how sufficient guardrails and monitoring of transition finance can be implemented to include general corporate purpose finance.

Further questions exist around the issuing or borrowing entity: can governments use transition finance to fund economic transformations in line with their nationally determined contributions, or should transition finance focus on corporate and/or project financing? Once eligibility is established, should finance be concessional and/or conditional, with incentives for achieving specific transition-related KPIs and penalties for missing them? For this to work, the transition finance market needs credible data and metrics and must avoid some of the pitfalls associated with the sustainability-linked market.

How can transition finance be deployed credibly?

In the absence of common definitions, clear standards, or necessary guardrails, some financial institutions are deploying transition capital on their own terms, which can lead to confusion in the market as well as accusations of greenwashing. In response, others are shying away from labeling transactions as transition finance but are still providing finance to decarbonize high-emitting companies and projects. As a result, not only do financial institutions face a stigma associated with staying invested in high-emitting companies, but there is uncertainty regarding the credibility and scale of the transition finance market.

So how can financial institutions deploy transition finance credibly? Existing definitions widely agree that transition finance should be predicated on the presence of a credible strategy for the issuer or borrower to decarbonize over time. However, the COP28 roadmap will need to examine what credibility means in this context, and how it can be robustly assessed.

One common criterion is the need for a transition plan. Although transition plans are subject to their own, related, definitional debates, the We Mean Business Coalition defined them as “a forward-looking list of actions taken in the near term to align internal strategies and external climate and energy policy advocacy to reduce GHG emissions in line with a 1.5°C pathway and achieve a just transition.”

In theory, if every company seeking transition finance had published a detailed, comparable transition plan, it would be easy to allocate finance to support implementation of those plans. However, reality is not so simple: in a survey of 18,600 companies, CDP found that fewer than 1 percent met all criteria for having a credible transition plan. As such, broader assessment principles for credible transition strategies are needed — at least in the short term — with financial institutions likely to rely on a mix of client engagement, disclosures, targets, and commitments to evaluate their clients.

Regardless, to ensure credibility and avoid greenwashing, transition finance should be tracked and reported by financial institutions. This is not a controversial statement, but the devil is in the details. What should be tracked? Where, when, and how should it be reported? Must it be independently assured and verified? As the COP28 Presidency notes: “Transition finance strategies will need to be accompanied by forward-looking metrics that measure the impact of finance on transition and decarbonization.” However, existing forward-looking approaches come with a host of challenges that will need to be quickly overcome to robustly deploy, measure, and report transition finance.

What would progress look like?

There are several potential avenues that the COP28 roadmap could take: a single taxonomy that categorizes and de-risks specific technologies, a credible label for transactions and funds, a reporting framework, or just a high-level definition and set of principles.

Whichever path is chosen, a clear definition must put robust guardrails around the what, who, and how of transition finance. This should help reduce confusion, stigma, and greenwashing, and consequently unlock more capital to support decarbonization, particularly in the hardest-to-abate and highest emitting portions of the economy. Without this, the most important question we face — whether we can reach 1.5°C in a just and equitable manner — will no longer be a debate.

The good news is that those meeting at COP28 do not need to start from scratch. Discussions of how to define and deploy credible transition finance are ongoing across the financial, nonprofit, and regulatory spheres, and the COP28 Presidency should ensure that these diverse, expert voices are invited to the table in Dubai.