As COP29 approaches in a few weeks and with climate finance top of the agenda, discussions surrounding the Net Zero emissions transition and how to finance it have gained significant momentum. Negotiations will focus on finalising a New Collective Quantified Goal (NCQG) on climate finance before 2025, as was agreed in Paris in 2015 during COP21, where a $100 billion per year floor was set. With that in mind, ‘transition finance’ is a term that is raised in every one of these conversations and debates. It will play a critical role in addressing the climate crisis, accelerating the move towards a Net Zero emissions global economy, and aligning with the Paris Agreement’s 1.5C target.
It is now recognised that trillions of dollars of finance will be needed to address climate change, but despite its promise, transition finance remains a loosely defined concept. We look at how these debates on transition finance, while well-intentioned, risk stalling rapid and efficient capital deployment for the Net Zero transition. This can include financing national and/or corporate transition plans, scaling emerging clean technologies, the energy transition away from fossil fuels, or transitioning hard-to-abate or high emitting sectors – all of which highlights the breadth of what could be considered ‘transition’ activities.
Transition finance today
Mobilising private capital will be a critical component of the negotiations at COP29, the ‘Finance COP’, but the focus there will be on climate finance, both public and private, that seeks to support the mitigation and adaptation actions that address climate change, often in the form of energy transition actions. Even at its broadest, transition finance is different and can be understood as capital deployment financing the economy-wide transition towards a Net Zero by 2050 target. In practice, however, there is no consistent definition, as the examples below highlight:
- The OECD defines transition finance as ‘finance raised or deployed by corporates to implement their Net Zero transition’.
- The World Economic Forum’s transition finance initiative has the aim of mobilising capital to support the adoption and scaling of early-stage technologies key to unlocking the Net Zero transition of hard-to-abate sectors, such as steel, cement and aluminium.
- The International Capital Markets Association (ICMA) has published a ‘Climate Transition Finance Handbook’ as guidance for capital markets issuers. The handbook positions transition finance as a label applied to green, sustainable or sustainability-linked financing directed towards enabling an issuer’s greenhouse gas emissions reduction strategy in alignment with the goals of the Paris Agreement.
- The UK government, in its ‘Transition Finance Market Review’, refers to ‘the financial flows, products and services that facilitate an economy-wide transition to Net Zero consistent with the Paris Agreement’.
A key question is, which is it? Is transition finance a specific type of financing for hard-to-abate or high-emitting sectors? Is it for corporates only or are other issuers, borrowers and stakeholders included? Is transition finance even a distinct financing category, or is it a label as ICMA has positioned it? Does it need to be attached specifically to a pathway, strategy or transition plan? The only consistent elements of these definitions are the goal of Net Zero and 1.5C.
The financial sector likes definitions and mobilising finance depends, to an extent, on providing clarity to the market. The sector-wide ambiguity opens transition finance up to the risk of what Mark Carney, UN Special Envoy on Climate Action and Finance, has referred to as ‘50 shades of green’. The wide range of loosely defined or inconsistent interpretations of what qualifies as sustainable or transition investment also opens the door to transition washing where capital is deployed, often unintentionally, to activities that are less than impactful and, in some cases, actively damaging to the Net Zero trajectory.
These definitional debates also complicate efforts for market participants like lenders, investors, issuers and regulators, who struggle to understand how to clearly define the boundaries of transition financing activities and how these differ from already in place green and/or sustainable financing. Similarly, this uncertainty poses a significant challenge for lenders and investors who want to support the transition but are unsure how best to allocate their financing in a way which aligns with impactful sustainability goals.
Left unchecked, these ongoing discussions and debates on definitions and frameworks are becoming a significant barrier to the rapid and effective deployment of capital necessary for a Net Zero transition. While it is important to scrutinise the impact potential of financing activities, definitional debates should not become a roadblock to action.
At the most recent edition of Climate Week New York, convened in September 2024, financing the transition to a Net Zero future was a major focus, particularly in the context of the ongoing NCQG negotiations. Discussions served as a clear call to action to the global community, emphasising the urgent need for capital deployment to decarbonise hard-to-abate sectors. Particular attention was given to transition financing in emerging markets, where participants emphasised that an influx of capital alone is insufficient – what is needed is high-quality financing with clear and timely access for the real economy to achieve maximum climate impact. The overarching message was clear: immediate climate action is necessary and waiting for perfect definitional clarity on what constitutes transition finance is not an option.
A flexible understanding of transition would help catalyse climate action
The critical challenge for transition finance remains the lack of overarching, internationally accepted guidelines or standards that clearly lay out what transition is and what exactly constitutes legitimate transition activities in detail.
Unfortunately, the effects of this lack of an agreed definition are clear – a lack of capital deployment towards the transition, particularly in hard-to-abate sectors. Taking sustainable debt capital markets as a case study, as of 2023, the Climate Bonds Initiative had identified cumulative issuance volumes of $5.5 trillion, mainly green bonds but with significant growth in sustainability and sustainability-linked issuance. While volumes have stagnated somewhat in recent years, the first half of 2024 was on record pace with over $800 billion of issuance, with an expectation that this will be a record year for GSS+ bonds. Transition bonds, though, make up only a small proportion of that total at $15.5 billion, 90% dominated by Japan’s issuances under its ‘Climate Transition Bond Framework’.
However, definitional ambiguity should perhaps not be as problematic as we think. In fact, beyond a high-level definition, allowing for jurisdictional, sectoral, and case-by-case nuances in the definition of transition finance will be more catalytic to long-term efforts to finance the fight against climate change. Such flexibility enables adaptation to local contexts and promotes the development of tailored solutions. The ‘Transition Finance Market Review’ even warns that an overly rigid approach to defining transition finance, considering an evolving scientific and technological context, could limit market growth and stifle innovative solutions rather than facilitating them.
Building in flexibility and nuance will be particularly relevant for sectors, industries, or even countries with differing technological capabilities and economic circumstances. In the Global North, for example, transition finance may focus on decarbonising heavy industry through advanced renewable energy integration and electrification. This region may have the financial and technological infrastructure to implement ambitious carbon reduction technologies at speed, and transition financing mechanisms can support the scaling of innovations such as hydrogen production and carbon capture and storage (CCS).
By contrast, the Global South may require more gradual transition pathways to account for technological or financial restrictions. In these contexts, transition finance could focus on cleaner energy alternatives but across a gentler timeline to reflect market and contextual realities. Looking at coal power in the Global South as a case study, despite a concentration of technically abatable emissions, the possible transition pathway is constrained by the need to ensure that development outcomes do not regress. These factors include the need to provide stable electricity access, grid readiness for the integration of replacement renewables, and managing downstream socio-economic impacts. Technical assistance which supports EMDEs to navigate these constraints is a crucial element of support, and one which initiatives like the Coal Asset Transition Accelerator (CATA) seek to fill through their work globally. Ultimately, a flexible, adaptable definition of transition finance allows for solutions which balance both decarbonisation goals and the diverse needs of the country contexts.
Scaling transition finance through existing mechanisms and transition plans
Loans and debt capital markets have emerged as the vital arena for innovation in the broader sustainable finance ecosystem; whether green, sustainability-linked or transition. Market participants have convened and collaborated widely to develop and systemise credible and robust financing structures grounded in international standards and guidance.
While ’transition’ bonds, are seen as those most closely aligned with transition finance, ICMA has identified that these instruments only represent 0.4% of the market. Other thematic instruments, such as green, sustainable and sustainability-linked bonds (GSS+ bonds) present significant opportunities for supporting transition financing. Hard-to-abate industries (including chemicals, metals and mining, airlines, cement, steel and shipping) have issued $71 billion of GSS+ issuances to date, only 2% of the total deployed capital in the green and sustainability bond market. The proportion is larger for sustainability-linked bonds market at 20% but this only amounts to $38 billion of financing, far short of where the market needs to get to in order to reach the ambitions of the NCQG.
There is significant scope for further market development in the GSS+ bonds space for transition financing. While the sustainability-linked bond market seems more receptive to transition-themed issuances from high emitting or hard-to-abate sectors, this market would need to expand significantly beyond its current $246 billion level. This potential for growth remains considerable in the use of-proceeds bond markets as well, particularly due to the scale of investment needed to support decarbonisation efforts in these challenging industries and the ability to specifically tag transition assets as eligible.
One potential solution to increasing transition finance is to explicitly link it to robust transition planning. The standards and approaches for transition plans are already there. They provide a clear roadmap for stakeholders, including financiers and investors, to understand what they are deploying capital to, where and how.
Taking the work of the Transition Plan Taskforce, which has now been handed over to the IFRS Foundation in a positive development for consolidation of global standards and approaches, this also explicitly includes financial planning and the CAPEX and OPEX considerations that are required to transition business models. Robust transition plans, with the financial structures in place to enable them, are expected to have a catalytic effect in terms of building investor confidence and unblocking the current barriers holding transition finance back. Transition finance needs transition plans. Whether at the sovereign, entity or activity level, simply acknowledging the need to transition to Net Zero is not enough. There needs to be a plan addressing the how, when and why, with clear milestones and monitoring, evaluation and disclosure of progress.
What about stranded assets and the risk of carbon lock-in?
A question that keeps coming up in the definitional debates around transition finance is about stranded assets. If we take the definition of transition finance as supporting those high-emitting or hard-to-abate sectors that need a specific, right-sized approach, how does the financial sector ensure it is not exposed to unacceptable levels of risk, financial or emissions-related?
Perhaps the most poignant example of this dynamic is the coal transition. Transitioning coal-fired power generation to renewable alternatives is a pressing, high-impact intervention. Newer coal assets with long operational lifetimes left to run, and consequently often high debt burdens still to pay-down and locked-in power-purchase agreements (PPAs), require financing support to retire early. Across Asia, where 77% of global installed coal capacity is located, the average age of a coal plant is approximately 12 years (out of a rough total operational lifetime of 40-50 years) meaning there are hundreds of newer coal assets that require financing support to transition. However, the global push to align investments with sustainability criteria, metrics and taxonomies, which explicitly rule out brown assets, is creating some hesitancy amongst sustainable financial actors to engage in financing coal transition, despite the significant impact opportunity.
The reality is that financial institutions are already exposed to these risks. Exclusion policies on coal do not currently preclude any and all investments into coal. Regulatory capital requirements that push financial institutions to hold high quality liquid assets on their treasury books are a particular concern. This is particularly true in emerging markets with shallow capital markets – the trade-off of doing business is that there are limited high-quality liquid assets, mostly sovereign, other financial institutions or utilities. Those utility companies, as highlighted above, have a lot of coal assets, and in many cases coal assets that are relatively young and still have a long use life ahead of them. What, though, if there was another solution to support their transition? That is where transition finance can come in with catalytic impacts.
Under a clear and robust transition financing framework, with built-in contextual flexibility and safeguards, more financial institutions could carve out coal transition activities from their exclusion policies. Such financing lines would enable funding to flow where it is most needed, drive system-wide impact on global emissions and ensure that the utility sectors in EMDCs transition away from coal and are positioned resiliently for the economies of the future. While financed emissions would temporarily go up, it would be hard to argue that the opportunity benefit is not worth it. With appropriate disclosures and transparency, transition finance would position itself as an enabler over the medium- to long-term.
Looking ahead to COP29 and beyond
COP29 is being positioned as the ‘Finance COP’, and it has never been more urgent for a COP to place finance, public and private, at the heart of its agenda. The Carbon Trust’s expectations are that the negotiations, which are already ongoing, will focus on:
- Agreeing a new global climate finance target through the New Collective Quantified Goal (NCQG), outlining the scale, sources and distribution of finance that is needed to support climate mitigation and adaptation activities around the world from 2025 onwards.
- Finalising the architecture for international carbon markets following recent pre-COP negotiations in Baku, where key issues on carbon removals and credit mechanism methodologies were resolved after last year’s COP28 deadlock.
- Ensuring renewed ambition and technical assistance for revising Nationally Determined Contributions, which are due in February 2025, including a focus on addressing the financial and technical barriers which prevent developing countries from setting and achieving more ambitious climate targets.
Transition finance will play a critical role in empowering countries and companies globally to meet their climate commitments. Despite ongoing definitional debates, the public and private sectors must act now to harness the transformative potential of transition finance and direct it towards the urgency of addressing the climate crisis. The recommendations of the ‘Transition Finance Market Review’ come at a critical time and, while there may be some contextual bias towards the UK, they are a replicable example of practical thinking with rapid action in mind. It is now over to all relevant stakeholders – from governments and regulators to corporates via the finance sector – to take the urgent next step, leverage existing and innovative financial solutions, and accelerate the deployment of transition finance with appropriate contextual nuance not bogged down in debates looking for find a single, global definition.
