Transition finance: balancing global ambitions with local needs

The absence of an official definition of transition finance has led to a proliferation of different approaches to the topic at a regional level. Marie- Bénédicte Beaudoin, Adams Wong and Federico Pezzolato outline how ISS-Corporate is incorporating local developments into its assessments while continuing to support the global harmonisation of efforts to finance emissions reductions.

Environmental Finance: How has the topic of transition finance evolved for ISS-Corporate and driven the evolution of your offerings?

Marie-Bénédicte Beaudoin: A major challenge in the topic of transition finance is there is no official definition. Up to now, we have mostly followed guidance from the EU Taxonomy and Climate Bonds Initiative (CBI). Developments in the APAC region have been a huge driver as well, most notably with Japan, which has been one of the most active geographies in terms of transition-labelled bond issuances.

Japan's Ministry of Economy, Trade and Industry (METI) defines transition finance as: "a new financing approach that aims to support companies that are trying to steadily reduce GHG emissions in accordance with a long-term strategy to achieve a decarbonised society".¹

This definition covers many of the topics that we consider when we are working on transition-focused issuances and frameworks. As a second-party opinion (SPO) provider, ISS- Corporate follows the best market practices and guidance for transition.

We look at reduction of GHG emissions, the technologies used and the wider transition strategy of a business. Our analysis goes beyond just the technology that is deployed or developed by the issuer: it is essential to also assess the integration of the transition into their business model, the impact on the core business, and how the deployment of the strategy or technology goes beyond business as usual.

While frameworks that leverage the guidance from the International Capital Market Association (ICMA) Climate Transition Finance Handbook (CTFH) are heading in this direction, we are only seeing a marginal number of issuers using the CTFH, though this year may mark the turning point. We also track both global and regional developments to encompass them in our reviews.

EF: Why are so few issuers using the CTFH in their transition frameworks?

Adams Wong: It is early days, but I expect to see more momentum for issuers including the CTFH in their frameworks. We have noticed a growing trend of adoption among hard-to-abate sector players in APAC. As with the inclusion of more local taxonomies that encompass transition activities, banks play a significant role in driving corporates to implement the CTFH.

EF: How is the lack of definition of transition impacting issuance?

Federico Pezzolato: In the absence of a commonly accepted definition, we have observed a tension between the regionalisation or localisation of standards and the need to achieve the global target of a 1.5°C warming scenario, as set out by the Paris Agreement.

Clearly, there is a very strong rationale for issuers to be aligned with the Nationally Determined Contributions (NDCs) within the countries in which they operate. At the same time, there is a global need to reduce emissions in absolute terms, so we have seen a split in the conversation between the global context and the local one.

This is relevant not only for issuers but also for investors, who tend to have a more global perspective and would like to see comprehensively ambitious targets from investee companies.

As SPO providers, our methodology considers the global need to reduce emissions but, at the same time, we understand the need to consider the local context at the issuer level.

We have seen some attempts to provide some more clarity at the global level, and there are approaches – for instance, those developed by the CBI2 – that seek to give robust indications for how to identify a transition strategy, but it's still a work in progress.

Last but not least, the political debate in the US is another issue. There are very heated discussions over the pros and cons of transitioning in the US, and we expect this to continue for most of 2024. There will likely be a spillover to other countries and regions too. Until these disagreements are settled, the world will continue to have different points of view on the topic.

AW: There is also the question around whether corporations should align their transition strategies with the NDCs of their country to meet the goals of the Paris Agreement. The Intergovernmental Panel on Climate Change (IPCC) estimates that the projected global greenhouse gas (GHG) emissions from NDCs announced before COP26 would likely result in warming exceeding 1.5°C. This would require an acceleration of mitigation efforts after 2030 to limit warming to below 2°C.³

We believe issuers should constantly seek to adjust their targets and utilise the latest available data in their scenario analysis. Otherwise, targets will quickly become outdated. Issuers, underwriters and SPO providers should be mindful of this dynamic situation.

EF: COP28 in Dubai put the topic of transition at the centre of the debate. What were your takeaways from this conference?

FP: The transition away from fossil fuels was included in the final document, which is positive. We also saw progress on the idea of a just transition, which is just as important. The decision to fund a Loss and Damage Fund for economies impacted by climate change and the transition away from fossil fuels marks a growing recognition that the transition cannot be positive if it doesn't allow all countries to participate in global growth and continue to develop their economies. It's a step in the right direction, but we need to see some further concrete initiatives in this regard.

"We have always combined environmental and social elements in our analysis, and we look at sustainability from a holistic perspective" Federico Pezzolato

The concept of a just transition is very important and our methodological approach is aligned with it. At ISS-Corporate, we have always combined environmental and social elements in our analysis, and we look at sustainability from a holistic perspective. Also, for green or transition projects, we assess their social implications and not just the environmental elements.

MBB: The development of regional taxonomies allows for the just transition to be assessed according to the local perspective. However, there is still a need to drive the market discussion toward a common goal. For comparability reasons, we need to be able to apply the same methodology to an issuer based in Latin America, Europe, MENA, North America or APAC. As we work towards a global goal, we have to figure out how to weigh those local specificities in our universal approach to SPOs.

EF: Turning to APAC, how is the proliferation of taxonomies impacting issuers and investors seeking to fund the transition in the region?

AW: Many countries in the APAC region, including Hong Kong, Singapore, Thailand, ASEAN, China (via the Green Bond Endorsed Projects Catalogue), Indonesia, Australia, Sri Lanka, Bangladesh, Mongolia, and Malaysia, are developing their own taxonomies to support green and sustainable finance activities.

Overall, the development of taxonomies is a positive move to facilitate transition finance. Some APAC taxonomies have incorporated a traffic light system, classifying activities as green, amber, or red, and several provide thresholds or technical screening criteria for transition activities, along with a sunset timeline. This is helpful for identifying activities eligible for transition finance. Whereas if you look at the EU taxonomy, there are only two activities eligible for transition: gas and nuclear power.

While many of these countries have referenced or are aiming to align with the EU Taxonomy, the existence of numerous taxonomies in the market raises questions about their compatibility. For instance, Singapore, Thailand, and Malaysia are members of the ASEAN taxonomy board, but each has developed its own taxonomy. For European investors, understanding the alignment of APAC taxonomies with their EU counterparts poses a challenge.

EF: How is the topic of transition driving innovation in sustainable finance structures?

AW: Our clients in APAC are diverse, covering industries such as data centres, telecoms, financial institutions (banks and asset management), chemicals, materials, logistics, dairy, oil and gas, pharmaceuticals, interactive media and online consumer services, and various other businesses.

Generally, the majority of instruments have been in the form of loans, as opposed to the preference for bonds in Europe. However, we have observed a trend for asset managers issuing sustainability-linked instruments with Key Performance Indicators (KPIs) aimed at improving the ESG performance of their portfolio companies. We have also observed data centres issuing green use-of-proceeds and sustainability-linked instruments over the last two years, potentially associated with the development of artificial intelligence.

FP: We expect to see an increasing number of innovative transactions and new partnerships to finance the transition at the global level. As Adams mentions, we have already seen financial institutions come up with sustainability-linked loan structures that support the decarbonisation of their portfolios and their clients.

We also expect to see public-private partnerships and the combination of different forms of investments emerging. The transition will trigger a wave of innovation in financial instruments that will be created to support it.

EF: How has your methodology evolved in reaction to the drivers and challenges within this topic?

MBB: We need to be able to understand how the technologies that are presented to us are serving the transition. We also want to make sure that we cover the spectrum of what the transition means, not only at the asset level or the projects level, but also how this is reflected in the strategy of the issuer to prevent greenwashing. The development of sustainability-linked instruments has been hindered by such criticism and last year was not the most flourishing year for such instruments.

"A major challenge in the topic of transition finance is there is no official definition" Marie-Bénédicte Beaudoin

A lot of this is work in progress, but we are ready to tackle this topic in the first half of 2024.

FP: The challenge for the whole market, not just for us as an SPO provider, is the need to combine flexibility to address different economic contexts with the robustness and ambition of global targets. It's a very complicated task but we are confident that we can achieve these results with the support of all the players in the market.

Federico Pezzolato is associate director, sustainable finance business manager at ISS-Corporate, Marie-Bénédicte Beaudoin is associate director, head of sustainable finance research at ISS-Corporate and Adams Wong, associate vice president, is APAC team lead, sustainable finance research at ISS-Corporate.

To learn more about ISS-Corporate's Sustainable Finance Solutions, contact: SPOsales@iss-corporate.com