Transition Finance 101: Five common questions about transition finance. Answered.

In late June, during this year’s London Climate Action Week, RMI launched the Transition Finance Resource Hub at the Climate Innovation Forum. The Transition Finance Resource Hub serves as a comprehensive resource for the financial sector and other stakeholders to learn about transition finance, featuring how-to guides, case studies, video content, a library of media and foundational resources from a variety of organizations, articles, and more. The Resource Hub is intended to be a live and growing repository for transition finance knowledge. As a primer for those less familiar with the concept, this article answers five key questions you might have on the topic before diving into the information and insights available on the Resource Hub. 

What is transition finance?  

RMI’s open letter, A Global Call to Action on Transition Finance at COP28, supported by 10 other NGOs, defines transition finance as enabling decarbonization of high-emitting entities and/or hard-to-abate sectors where a credible pathway to 1.5°C-aligned decarbonization exists. 

However, transition finance is an emerging concept with differing views on its precise scope, purpose, and credibility. Some see it as any financing that broadly supports the transition to net-zero emissions, while others define it with a specific focus on decarbonizing high-emitting sectors. However it is defined, transition finance is gaining momentum. Various organizations have put forth frameworks, such as the Glasgow Financial Alliance for Net Zero (GFANZ) and Climate Bonds Initiative (CBI), or taxonomies, including the Singapore-Asia Taxonomy and the ASEAN Taxonomy, to steer the market towards greater convergence.  

Why is transition finance important for limiting global warming to 1.5°C and reaching net-zero emissions? 

Reaching net-zero emissions by 2050 and keeping global average temperatures within 1.5ºC of pre-industrial levels are critical to avoiding the worst consequences of climate change. To achieve this, the global economy must undergo rapid transformation. Financial markets can play an important role in providing financial products and services that facilitate real economy emissions reductions and scale low-carbon solutions.   

The economy-wide climate transition will offer abundant financing and investment opportunities. The IEA estimates global clean energy investment must rise to about $4.5 trillion per year by 2030 to meet 1.5°C goals. Citi estimates decarbonization could require up to $1.6 trillion per year in the aviation, shipping, road freight, steel, and cement sectors.    

Providing transition finance is one way in which financial institutions can enable net zero, especially through the decarbonization of high-emitting counterparties and assets to align with a 1.5°C future. This type of financing and investment may be particularly important for supporting activities that may not otherwise be eligible for sustainable or green finance due to current high emissions. For example, the EU Taxonomy includes criteria related to system-level emissions thresholds for electricity transmission and distribution infrastructure. However, with the correct guardrails in place, transition finance has the potential to support a rapid and just transition. 

How can we ensure that transition finance is credible and not just greenwashing? 

Transition finance can raise concerns about the continued financing of high-emitting counterparties and activities due to its complex and forward-looking nature. Two related concepts include “greenwashing” — providing misleading information, labeling, or communication about the environmental benefits of an activity or company — and “transition-washing” — where transition finance is provided to activities that are misaligned with or entities that lack credible plans to align with decarbonization pathways required to achieve a global 1.5°C target.  

Robust guardrails, credibility assessments, and outcome tracking are needed to reduce these risks and ensure that capital is allocated in support of climate goals, without perpetuating business-as-usual activity. While the market is seeing growing momentum and convergence on transition finance, there is currently a lack of consensus on precisely what those guardrails, assessments, and measurements should entail. At a high level, however, a few suggested principles to support credibility, as outlined in RMI’s open letter, are listed below.    

Credible transition finance should be:   

• Predicated on the existence of a credible strategy for the counterparty to decarbonize over time, in line with relevant sector and regional science-based pathways, where available. This could be featured in a transition plan or demonstrated through engagement, disclosures, targets, capex plans, and commitments. The strategy should include credible plans and business strategy to phase out misaligned activities, as well as scaling up climate-aligned activities. 
• Tracked via annual monitoring and evaluation, with regular reporting of transition activities and outcomes from agreed baselines. This could include incentives or penalties if transition milestones and/or KPIs are met or missed, with transparency on expectations set out at initial 
• Designed to avoid carbon lock-in. Consideration should be given to the lifetime of the activities and time horizons to ensure that this is not business-as-usual financing that extends the lifetime of high-emitting assets and technologies beyond scenario time horizons or incentivizes new investment in misaligned technologies.  
• Allocated with attention to a just transition, which is critical to ensure that negative consequences of transitional activities are minimized and co-benefits are generated where possible. This should include consideration of social and economic equity and inclusion. 

What financial instruments should be in scope for transition finance? 

To date, transition finance has largely been issued in the form of debt financing; a report published in February 2024 by the International Capital Market Association (ICMA) estimates that $119 billion of green, sustainability, and sustainability-linked bonds have been allocated to transition finance in the hard-to-abate industries and fossil fuel sector.  

However, equity investments in transition-enabling counterparties will likely become more common as we navigate the crucial decade for climate action. Private equity, venture capital, and asset managers may see growing demand for transition finance. For example, funds from investors such as Brookfield and BlackRock have highlighted momentum for equity financing in support of the transition and emerging technologies.  

We also expect the adaptation of other financial instruments and asset classes, including insurance, real estate, infrastructure investments, and public equity products, such as transition-related ETFs and indices, to help scale transition finance. The unique attributes of each asset class can support transition in slightly different ways and for different purposes, while necessitating further, tailored guidance on how to ensure credibility for each.  

What are the challenges of measuring transition finance? 

Measuring the total volume of transition finance in the market  

It is difficult to accurately calculate the global volume of transition finance issuance in the market today, primarily due to the lack of standardized labeling for transition finance. While there is growing convergence in the space, some financial institutions are developing their own taxonomies to label and report on transition finance. These individual efforts could lead to accusations of greenwashing based on what activities are included and the sources or assumptions underpinning those decisions. Convergence on standards can help reduce this barrier to comparability, and a better understanding of current transition finance volume will help clarify the net-zero financing gap.

Measuring the emissions benefit attributable to transition finance  

The impact of transition finance is also difficult to quantify. By its nature, transition finance aims to support future decarbonization of companies or assets. As such, the emissions reductions are not necessarily known at the time of finance issuance and may be difficult to estimate. Ex-post quantification of emissions reductions is similarly difficult due to a lack of metrics. 

Financed emissions are a common and important metric used by financial institutions to quantify, report, and track the emissions associated with their lending and investment activity. However, they often fall short in the context of transition finance. Financed emissions metrics are backward-looking and therefore fail to contextualize future impact enabled by transition financing. Furthermore, transition finance may increase reported financed emissions in the near term, as financial institutions provide finance to decarbonize high-emitting companies and activities with credible transition strategies. As such, this measurement — and other similar backward-looking metrics such as green/fossil financing ratios — does not provide a sufficiently nuanced understanding of the potential impact of transition finance. Ongoing work to develop additional, complementary metrics, such as those based on forward-looking capex data and/or tailored to specific sectors, is crucial to accurately incentivize, assess, and account for transition finance. 

What’s next?  

Further information and resources on these questions, and much more, can be found on RMI’s Transition Finance Resource Hub. In this rapidly evolving space, open questions remain on transition finance and best practices to ensure its credibility:  

• How do we measure and monitor transition finance?
• How can financial institutions assess client transition activities to allocate transition finance where it is needed most?
• How do we understand and avoid carbon lock-in? 
• How are sector- and region-specific lenses applied to meet both climate and just transition objectives?

Check back often for new resources, examples, and guidance addressing some of these questions and more, or reach out to us at info@climatealignment.org for more information.