Transition Finance

Module 9: Transition Finance

The Challenge of Transition

Not every company can be "green" overnight. Heavy industries like steel, cement, chemicals, and aviation are essential to the economy but are also significant emitters. These sectors can't simply be excluded from financing—they need capital to transform.

Transition finance addresses this challenge by providing capital to help high-emitting companies and sectors shift toward sustainability. It's one of the most complex and contested areas of green finance.

Defining Transition Finance

Transition finance refers to financing that supports an organization's decarbonization strategy, even if the organization operates in a high-emitting sector or the activities being financed aren't yet "green."

Key Characteristics

• Supports movement from high to lower carbon intensity
• Addresses hard-to-abate sectors
• Requires credible transition plans
• Time-bound with measurable milestones

Distinction from Green Finance

Green Finance	Transition Finance
Funds already-green activities	Funds the journey to green
Clear taxonomy eligibility	May not meet taxonomy criteria
Less controversy	Significant debate about scope
Well-established standards	Standards still developing

Hard-to-Abate Sectors

Some sectors face particular challenges in decarbonizing:

Steel

• Responsible for ~7% of global emissions
• Traditional blast furnace process is carbon-intensive
• Alternatives: Electric arc furnaces, hydrogen-based reduction, carbon capture
• Transition requires massive capital investment

Cement

• Responsible for ~8% of global emissions
• Process emissions from limestone calcination are inherent
• Solutions: Alternative binders, carbon capture, efficiency
• Limited near-term alternatives for some applications

Chemicals

• Complex value chains with multiple emission sources
• Feedstock emissions (from fossil fuel inputs)
• Process emissions (from chemical reactions)
• Solutions: Green hydrogen, bio-based feedstocks, electrification

Aviation

• Growing demand, limited near-term alternatives
• Sustainable aviation fuels can reduce emissions
• Electric and hydrogen planes for short routes
• Efficiency improvements and offsets bridge the gap

Shipping

• International nature complicates regulation
• Alternative fuels: LNG, methanol, ammonia, hydrogen
• Efficiency improvements in fleet and operations

Credible Transition Plans

Transition finance depends on credible corporate transition plans:

Key Elements

Long-term Target: Net-zero commitment with specific date

Interim Milestones: 5-10 year targets with clear metrics

Strategy: How the company will achieve targets

• Technology changes
• Product mix shifts
• Efficiency improvements
• Capital allocation plans

Governance: Board oversight, management accountability, incentive alignment

Metrics and Reporting: Transparent tracking of progress

Capital Requirements: Investment needed and funding sources

Assessing Credibility

Questions to evaluate transition plans:

• Are targets science-aligned?
• Are interim milestones specific and ambitious?
• Does capital allocation support the strategy?
• Is governance robust?
• What happens if targets are missed?

Transition Finance Instruments

Sustainability-Linked Bonds (SLBs)

• General corporate purpose proceeds
• Coupon steps up if sustainability targets missed
• Well-suited to transition situations
• Targets should align with transition plan

Transition Bonds

• Use of proceeds format for transition activities
• Specific projects that reduce carbon intensity
• May not qualify as "green" but support transition
• Standards still developing

Sustainability-Linked Loans

• Flexible use of proceeds
• Margin tied to sustainability performance
• Common in bank lending to transitioning companies

Blended Finance for Transition

• Concessional capital to de-risk transition investments
• Particularly relevant for emerging market transitions
• Can catalyze private investment in new technologies

Taxonomy Treatment

How do green taxonomies treat transition activities?

EU Taxonomy Approach

• Includes "transitional activities" category
• Activities must meet technical screening criteria
• Must be best-in-class without low-carbon alternatives
• Time-limited as alternatives become available

Example: Certain gas power generation included as transitional, with conditions and time limits

Challenges

• Defining boundaries of acceptable transition
• Risk of locking in high-carbon infrastructure
• Different views on appropriate technologies

The Controversy

Transition finance is genuinely controversial:

Arguments For

• Real-world decarbonization requires transforming high-emitting sectors
• Exclusion doesn't reduce global emissions—may increase them if activities move to less regulated markets
• Companies need capital to make transitions
• Engagement is more effective than divestment

Arguments Against

• Risk of greenwashing, extending life of fossil fuel assets
• "Transition" label could legitimize insufficient action
• Difficult to verify credibility of transition plans
• Capital for "transition" may crowd out investment in truly green alternatives

Navigating the Debate

The key is rigorous standards that distinguish genuine transition from greenwashing:

• Science-aligned targets
• Credible decarbonization technology pathways
• Clear timelines and accountability
• Transparency about uncertainties

Fossil Fuel Finance

The most contentious area is fossil fuel financing:

Oil and Gas

• Some argue transition finance can support oil and gas decarbonization
• Others argue any fossil fuel financing undermines climate goals
• Key questions:
  • Can oil and gas companies credibly transition?
  • Does financing new fossil fuel supply align with transition?
  • How should legitimate transition activities be distinguished?

Coal

• Broader consensus that coal should be phased out
• Transition finance for coal typically means managed wind-down
• Just Transition considerations for workers and communities

Just Transition

Transition must be socially sustainable:

Principles

• Workers affected by transition should be supported
• Communities dependent on high-carbon industries need assistance
• Benefits of transition should be broadly shared
• Developing countries need support for their transitions

Financing Just Transition

• Social bonds funding worker retraining
• Transition bonds including just transition criteria
• Blended finance for affected communities
• Development finance for emerging market transitions

Case Study: Steel Sector Transition

The steel industry illustrates transition finance challenges:

Current State

• ~70% of global steel from blast furnaces
• 1.8 tonnes CO2 per tonne of steel (average)
• Growing demand, especially in developing markets

Transition Technologies

Electric Arc Furnaces (EAF): Use recycled scrap, powered by electricity

• Lower emissions with clean electricity
• Limited by scrap availability for primary steel

Hydrogen Direct Reduced Iron (H-DRI): Replace coal with green hydrogen

• Near-zero emissions potential
• Requires massive green hydrogen scale-up
• Higher cost currently

Carbon Capture: Capture CO2 from blast furnaces

• Can retrofit existing plants
• Questions about cost and effectiveness

Financing Needs

• $1.5+ trillion investment needed for steel transition
• New facilities require patient capital
• Operating cost premium until cost curves improve

What Transition Finance Looks Like

• Green bonds for EAF expansion
• Sustainability-linked loans tied to emission intensity
• Blended finance for pioneer H-DRI projects
• Equipment financing for efficiency improvements

Emerging Frameworks

Standards for transition finance are developing:

ICMA Climate Transition Finance Handbook

Guidance for issuers raising transition financing:

• Climate strategy with Paris-aligned targets
• Business model environmental materiality
• Science-based transition strategies
• Implementation transparency

Transition Pathway Initiative

Assesses companies' preparedness for low-carbon transition:

• Management quality
• Carbon performance
• Alignment with Paris Agreement benchmarks

Asia Transition Finance

Regional approaches recognizing different starting points:

• ASEAN Taxonomy includes transition categories
• Japan transition finance framework
• Recognition of emerging market contexts

Practical Considerations

For Companies

1. Develop credible, science-aligned transition plans
2. Set ambitious interim targets with accountability
3. Align capital allocation with strategy
4. Be transparent about challenges and uncertainties
5. Engage with investors on transition journey

For Investors

1. Evaluate transition plan credibility rigorously
2. Use engagement to improve plans
3. Monitor progress against targets
4. Be prepared to escalate if progress stalls
5. Recognize legitimate transition alongside greenwashing risk

For Financial Institutions

1. Develop clear criteria for transition financing
2. Require robust transition plans from borrowers
3. Include transition in net-zero strategies
4. Build expertise in sector decarbonization pathways
5. Balance supporting transition with avoiding lock-in

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Next, we'll explore the future of green finance—emerging trends and innovations shaping the field.