Here are 4 ways transition finance can pave the road to decarbonization

Can we break new ground accelerating the energy transition? Can the public and private sectors help depoliticize the issue, move beyond talk, and coalesce around concrete action? I would argue that the answers are a resounding “yes”. A critical path forward to achieve these goals is through transition finance.

Transitions, by definition, have a time period. The length of that period may be uncertain. During that transition, unanticipated events can occur, affecting the timing, pathway, and sequence of a transition. In the case of the energy transition, the Ukraine war represents a clear example of such an event that must be incorporated into replanning the energy transition.

Transition finance – new solutions to fund the energy transition to help remediate climate change – is something that all stakeholders can get behind. Done correctly, transition finance can potentially: a) enable a true shift toward decarbonization; b) enable the private sector to generate sufficient returns; c) support the public sector, which cannot fund this effort alone; and d) embrace, rather than ostracize, carbon-heavy industries and economies. In the case of the latter, this allows current high-emitters to participate and share much-needed institutional knowledge while decarbonizing their businesses and promoting economic growth and employment during the period of the transition. Let us examine each of those points in turn.

Research shows that the aggregate carbon intensity of institutional portfolios dropped by about a third from the beginning of 2019 to October 2021. Yet we know that actual carbon emissions did not drop by this amount during that period. So, while portfolio decarbonization may be a positive development, it depends on how the change happens and, critically, whether underlying portfolio companies become more carbon-efficient or if their institutional owners sold their holdings to other owners. Indeed, divesting a brown asset by itself does not check the box marked “climate change”.

Portfolio decarbonization and climate decarbonization are not synonymous. Divested holdings typically continue to operate under new owners and, if taken private, could pass beyond the scrutiny of public markets. Yet, many of the ways we currently keep score and measure progress on the carbon content of portfolios, be it an energy company’s assets or a mutual fund portfolio’s, incentivize meaningless portfolio decarbonization and disincentivize true transition finance. Atmospheric decarbonization requires a focus on measuring and scoring action.

The energy transition presents what is perhaps a once-in-a-century opportunity for companies and investors, with the World Economic Forum suggesting that transitioning to a nature-positive economy could generate over $10 trillion and create nearly 400 million jobs by 2030. Unlocking this potential, however, will not come cheap. According to a recent McKinsey & Company report, capital spending on physical assets across the energy and land-use systems needs to increase by more than $3 trillion annually for the next 30 years to reach net zero by 2050.

Every sector of the economy – energy, technology, transportation, manufacturing and agriculture – will need to be involved. Yet, while the private sector and institutional investors have the financial resources to support a sustainable transition, the required level of mobilization of capital has not yet occurred. Today, not enough investment opportunities exist at an appropriate scale for institutional investors. Moreover, solving atmospheric carbon levels requires both avoidance and reduction of carbon emissions in developing markets. Yet, private investors often see an unfavourable risk-return proposition and are deterred by the risks of investing in developing markets.

Blended finance – public-private investment partnerships – and collaboration between public and private sectors are key to mobilizing at-scale sustainable projects funding, particularly in developing countries. Public funding is insufficient to make the required investments. Private investment, while more than sufficient, often cannot invest on its own for risk, fiduciary or scale reasons. This is where blended finance steps in.

Multilateral development banks (MBDs) can collaborate more actively with the private and public sectors by designing blended-finance instruments in partnership with the private sector, leveraging their investment scale and expertise, which in turn creates an environment in which adequate capital can be brought to bear.

MBDs by themselves have far too little capital to solve the climate problem and, therefore, should focus on investing where and how private investment cannot, as well as providing complementary and additive financing. In addition, MDBs can also leverage their institutional knowledge, expertise and operating ability in developing economies to develop pipelines of projects in which to invest. By providing credit enhancements (such as first-loss guarantees and insurance against country and currency risks) and concessionary financing to developing countries (including grants and loans at below-market rate interest rates), MDBs with relatively little capital expenditure can incentivize the mobilization of capital towards decarbonizing developing economies.

A few (inconvenient) truths:

• Reducing carbon emissions requires focusing on and working with the highest-emitting industries.

• Some of the best know-how regarding emissions reduction exists within these high-emitting companies.

• These industries will require more investment – and certainly not disinvestment – to accelerate and achieve carbon reduction.

In addition, getting from high-carbon emissions to zero emissions may require passing through lower-carbon (but not zero) energy sources such as natural gas during the transition. That means that some ongoing investment is required in traditional fossil fuels. That is OK. It does require an empirical understanding of why and when investments in fossil fuels may be justified and being realistic about making investments in companies that have large legacy emissions and/or that make green products that produce significant emissions (e.g. solar panel companies). It is no accident that today in the US, the best carbon capture technology has been developed by traditional oil and gas companies. It would be foolish to exclude these actors from the table.

Given those opportunities and challenges, where do we go from here? The Sustainable Markets Initiative (SMI), launched by then Prince Charles at the World Economic Forum in 2020, has worked to provide recommendations to world leaders to drive the energy transition toward a more sustainable future.

The SMI and its members have collaborated on the development of a powerful transition finance framework to help investors and policy-makers. This set of recommendations serves as an actionable guide for all stakeholders to accelerate the flow of capital, at scale, toward viable and credible transition finance structures. The framework’s core pillars include:

The energy transition is a complicated journey that does not lend itself to simple solutions, nor naming and shaming. Multiple approaches – and a recognition that not all of the globe starts at the same point – will be required. Depoliticization of the issue is also needed; political rhetoric does little but send actors slumping into inaction. Serious thinking about the transition acknowledges its complexity, eschews purity tests and avoids simple thumbs up/thumbs down judgments.

The good news is that a historic opportunity exists for public and private, policy-makers and investors, to come together to support realistic action to address the signature challenge of our era. The path is clear, and the time is now.