13 September 2019
In the second of this two-part series, Hervé P. Duteil explores the concept of Transition Finance and its limits, and proposes a non-prescriptive framework to start thinking about transition bonds (and loans)
In the previous article, we examined how the finance industry has started to expand its focus from climate change to biodiversity and inclusive growth, while looking at ways to extend additional financial and extra-financial benefits traditionally associated with a green use of proceeds to 'brown' sectors that have a key role to play in keeping global warming at less than 2°C above pre-industrial levels, or creating a climate-neutral, circular and resource-efficient economy. We shall now look more specifically at defining Transition Finance.
Defining Transition Finance
Let's be clear: Transition Finance is not about transitioning from 'brown' to 'green': that is Green Finance1. Transition Finance is about transitioning from brown to... brown; a lighter shade of brown, of course. Put simply, Transition Finance is for sectors that (1) are not green today; (2) cannot become green tomorrow; yet (3) can and need to get greener (by which we mean "less brown") faster; at a pace likely in line with recognised sustainable development scenarios; or at least within the scope of a disclosed comprehensive strategy roadmap that will get them back in line within an acceptable timeframe.
Let's take a look at each of these criteria:
- Sectors that are not green today
Here is a non-exhaustive list of the energy-intensive and hard-to-abate sectors (i.e. those with high costs and slow progress for emission-cutting) that emit the most greenhouse gases and particulates, yet that need to lead the world down a low-carbon pathway to meet the Paris Climate Agreement targets and 2050 climate-neutrality goals:
- Extractive industries
- Some segments of the fossil fuel industry
- Mining, especially of minerals critical for the low-carbon economy, such as lithium and cobalt
- Heavy industries
This criterion is very important. The key concept to understand is that these sectors will not be green in the short term because they simply do not have access to a green alternative that is reasonably economical.
Defining what is covered by this criterion can be tricky. For example, switching electricity production from coal to gas may not qualify if it is reasonably possible to build a wind farm nearby instead; however, if access to a renewable energy source is not possible due to a specific geographical context or particularly hard-to-change regulations, then it might qualify. In the upstream fossil fuel sector, rendering fossil fuel production more efficient through reduced greenhouse gas emissions may or may not qualify depending, for instance, on the relevance of such fuel within the energy mix required to achieve a two-degree-or-less pathway.
Here, again, the devil is in the details. This criterion is actually the hardest to assess and will often require the help of engineers and other expert groups. It could however be summarised as follows: how much improvement is enough? Should the pace be in line with the IEA's Sustainable Development Scenario (SDS), or even Beyond 2 Degree Scenario (B2DS) – i.e. a shift to a 2°C or less economy; or is a transition to a more sustainable business model – albeit not yet in line with IEA's SDS – adequate? At least, under what conditions would it be acceptable?
The good news is that we might not have to answer the question fully – just as the green bond market did not begin to settle the question of "what is green" for a good five years, providing for ad nauseam panel discussions around the world and delighting conference caterers. While the European Union – along with some other jurisdictions – has provided a green taxonomy, no one has really been able to answer a question that has no definitive answer. In fact, there are probably as many answers as there are green (or sustainable) investors. We should therefore not be surprised if the same holds true in the transition space.
Nonetheless, as in the green space, some form of common-sense guidance could be provided. For instance, to qualify, borrowers should probably achieve efficiency improvements that are in the top tier of what can be achieved reasonably economically with existing technologies. Should we say top quartile at the time the financing is closed? Or, along the lines of the European Union Taxonomy for Sustainable Activities, a performance that corresponds to the level achieved by the best 10% of installations in the world? Should we only consider scope 1 and scope 2 greenhouse gas emissions (primarily for practical reasons)? Or should we also take into account scope 3 and/or full cycle emissions? At least for some sectors?
Also, for any given sector, borrowers should disclose a comprehensive strategy roadmap that addresses the broad scope of sustainability challenges in their space, along with their targeted steady state and anticipated timeframe. If that steady state appears to be sustainable, then the financing of the first transformation step towards that ultimate goal could qualify for the transition label. To be sure, if that state were to be reached at or before the maturity of the contemplated borrowing, such financing should not be labelled Ttransition' but 'Sustainable'.
Where Transition stops
Just as we should not use the term 'green' to cover activities that are less brown than previously but still not green, we should not expand the definition of 'Transition' to cover activities that are still brown (albeit less than previously) but do have green alternatives, even on the basis that those alternatives could cause acute social damage (such as sending thousands of people out of work) or cause significant GDP deterioration.
This does not exclude the possibility of a societal – or even moral – justification to fund such activities. The question is more whether and how one should extend the Sustainable Finance tent (i.e. its capital flows, which come with added benefits) to include them. Again, we should let the sustainable investor decide.
Let's be clear: Transition Finance is not about transitioning from 'brown' to 'green': that is Green Finance. Transition Finance is about transitioning from brown to... brown; a lighter shade of brown, of course.
However, in order to not confuse investors, we need to use terms appropriately: 'Transition' is typically understood to refer to an environmental or energy transition and should be distinguished from the idea of a 'Just Transition'.
Firstly, if some sustainable investors refused to fund certain activities that they found questionable from an environmental perspective, this would not preclude such activities from being funded. Financing remains available – if not within the space of Sustainable Finance, then within the universe of regular or 'vanilla' finance. By the same token, some other sustainable investors might find it totally legitimate to direct their capital towards significant efficiency gains within these sectors on the basis of social considerations, especially if they consider that the public sector is adequately sharing the burden of gradually transitioning them. Such financing would then justifiably fall under the concept of a Just Transition.
Where the Just Transition starts
The concept of a Just Transition was written into the Paris Climate Agreement itself. However, it only received real attention at the latest United Nations Climate Change Conference last December in Katowice, Poland, when more than 100 investors representing over $5 trillion of assets signed a statement of commitment to support it, acknowledging that "there is an increasing recognition that the social dimension of the transition to a resilient and low-carbon economy has been given insufficient attention, notably in terms of the workplace and the wider community"2.
Where the Just Transition stops
However, the sole argument of avoiding stranded workers and/or communities along with stranded assets in high-carbon sectors that need to transform, shrink, or shut down, is likely insufficient to warrant the support of Transition Finance.
One could argue that Transition Finance requires a clear pathway leading to a new operating model that is fully sustainable by 2050, for example, with no disproportionate harm to a global transition scenario. For the most carbon-intensive sectors that are currently not considered viable in the longer run, it is hard to conceive how such pathways could be credible without the collaboration of policymakers – especially in stimulating large-scale action, establishing a level playing field and setting expectations as to how to achieve a low-carbon transition.
The (Just) Transition bond (or loan) process
To be clear, the above addresses the difficult question of what the Transition and Just Transition spaces consist of; in other words, what uses of proceeds could be considered as eligible. It does not address the definition of what constitutes a (Just) Transition bond (or loan), for one very simple reason: there is nothing that needs to be invented here. The Green Bond (and Loan) Principles exist, and nothing needs to be added, EXCEPT the clear qualification that the use of proceeds is NOT green in this case (and therefore a transition bond is simply not a green bond).
Growing the Sustainable Finance market
There is value in being rigorous and not cutting corners. We should not worry about capital markets drying up for activities that are not labelled 'Green' or 'Transition' – but we should worry about what would happen if investors feel that initiatives are being funded under category labels to which they do not belong.
Green-washing, transition-washing and any other forms of window-dressing could put an end to this worthy evolution of financial markets. Sustainable investors – along with regular ones – are certainly eager to be offered investment opportunities for 'Green', 'Social', 'Sustainable', 'Transition', and 'Just Transition' products – but they do not want to be misled.
This may be a new way of thinking in Sustainable Finance, the idea that we can expand the space not by financing more under the same label, but by using more and clearly differentiated labels. This might actually require a transition in mind-sets, after all.
Hervé P. Duteil is Chief Sustainability Officer for BNP Paribas in the Americas
2. These investors pledged in particular to draw on the recommendations in a guide for investor action on the Just Transition, written by the Grantham Research Institute on Climate Change and the Environment and the Initiative for Responsible Investment at the Harvard Kennedy School, with the support of the Principles for Responsible Investment (PRI) and the International Trade Union Confederation.
Read the first part of this article Sustainable finance: it's all about transition! Part one here