What is climate transition finance and why bother?

The 2024 Robeco Global Climate Investing Survey of 300 institutional and wholesale investors provided fascinating insights into the state of play of climate investing. Some 62% of investors see climate change as being central to their investment policies, and 69% have a net-zero commitment, or are in the process of making one.

It means that investors’ commitments have held strong, in spite of a widespread realization that the policy momentum is weakening: 49% of investors think that the climate transition will be ‘too little, too late’, and 41% believe that the goals of the Paris agreement are no longer achievable.

This may appear as a contradiction, but when looking at investors’ plans for capital allocation, it starts to make more sense. Traditionally, allocations to low-carbon strategies and climate solutions have dominated the approach to climate investing. But there is a new kid on the block: 63% of investors are (or will be) allocating capital to transition strategies, focusing on high-emitting companies with credible plans to lower those emissions. This is shown in the chart below:

Transition investing targets companies who may be at the beginning of this journey to combat climate change. Historically, policies on transition financing differed from region to region, leading to inconsistent definitions and unclear labels for investments.

This meant that it was safest to focus on financed emissions as a core metric in portfolios, leading many institutional investors to steer away from carbon-intensive industries. This reduced accounted emissions in portfolios, but not necessarily real-world emissions.

And despite massive commitments to net zero from governments, industry and investors worldwide (equivalent to 92% of global GDP), real-world emissions have continued to rise. So while net zero continues to be the horizon, the immediate job at hand is to support and accelerate climate action by high-emitting companies. In other words: climate transition finance.

The need to define transition finance was addressed by a G20 report highlighting 22 high-level principles for transition finance.¹ The International Capital Market Association (ICMA) subsequently updated its Climate Transition Finance Handbook to include guidance for issuers in the ‘hard-to-abate’ sectors and extend the existing Green, Social and Sustainable (GSS) Bond Framework to facilitate transition financing.

This guidance is critical because transition finance comes with a significant risk of greenwashing. The guidance from authorities and market standards bodies emphasizes the need for robust measurement of the ambition, intentionality and credibility of company transition plans.

At Robeco, we have operationalized this in three measures which help to identify eligible investments supporting the concept. These are climate transition leaders, climate solutions providers, and GSS bonds. Let’s deal with each one in turn.

We identify these companies through our Climate Traffic Light assessment of their degree of alignment with the goals of the Paris Agreement, taking into consideration the common but differentiated responsibilities of different nations.

The degree of alignment is determined by assessing two questions. The first is to ask whether the company’s projected emissions are in line with its required sector decarbonization pathway under a well below 2 °C scenario, regionally adjusted where needed. The second is to find out if the company has verified credible targets for achieving its emission-reduction plans.

The chart below shows the traffic light distribution per sector based on its market weight in the MSCI World Index. From this perspective, a large part of the index appears to be well in line with the Paris Agreement – it’s largely green.

But what matters for the climate transition are the carbon-intensive sectors. So, the second chart shows the same numbers, but now weighted by their carbon footprints. This time it becomes very clear that misaligned and partially aligned companies are dominating the index in terms of climate impact. They are concentrated in the high-emission sectors, and so an increased effort should be made to bring these into alignment.

It’s a similar story in the bond market. The charts below show the traffic light distribution for the same sectors but compared with the Bloomberg Global Aggregate Bond Index. The first chart shows sector distribution by market weight and the second by carbon footprint.

These are companies providing solutions to enable climate change mitigation. They are often found in industrial sectors and therefore may have reasonably high-carbon-intensive processes. The Intergovernmental Panel on Climate Change (IPCC) and International Energy Agency (IEA) both provide lists of which technologies, activities and services can substantially contribute to mitigating climate change and thus constitute climate solutions.

Jurisdictions like the EU and the Monetary Authority of Singapore are establishing taxonomies to identify activities which they see as contributing significantly to climate change mitigation and adaptation, both of which can be considered climate solutions.

For fixed income investors, various instruments and types are available to help finance the transition. Our focus is on green bonds, where the proceeds will be exclusively applied to finance eligible climate projects. To combat greenwashing, Robeco has developed a proprietary five-step analysis to properly conduct selection and monitoring of GSS bonds.

The analysis is designed to ensure that only those GSS bonds that adhere to internationally accepted principles and which truly have an impact are eligible for the portfolio. The analysis is in line with the most recent regulatory developments on sustainable finance and applies to both corporate and government bonds.

So, where to look for opportunities? Many companies are taking steps to transition their business models toward low carbon, but may lack in ambition or in delivery, earning an amber traffic light. We believe that transition strategies should also selectively invest in these companies, combined with active engagement to accelerate and enhance the company’s transition plan.

Our stewardship strategy focuses on material sustainability issues, which provides additional insights for portfolio construction. It’s a win-win: aiding organizations in adopting good transition practices while deepening our understanding of each industry’s unique challenges and opportunities.

Engaging with public and private entities and with policymakers on their transition plans keeps us at the forefront of this changing landscape. This in turn provides us with information to refine our assessments and generate alpha. Our approach to transition brings insight and foresight; incorporating these into our portfolios should bring impact and returns.

This article is an excerpt of a special topic in our five-year outlook.

Footnote

¹ https://g20sfwg.org/wp-content/uploads/2022/10/2022-G20-Sustainable-Finance-Report-2.pdf