Why I’m a transition finance skeptic

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“Transition finance” is already a contender for this year’s hottest sustainability trend. Quite why is up for debate, but I have my suspicions that the ESG backlash and the wave of “greenhushing” it inspired played a role.  Moving the climate finance conversation away from the antagonistic “dirty vs green” framing to the less confrontational “transition” concept could be one way for financial institutions to get MAGA-addled conservatives off their backs. 

The problem is that transition finance is not just a less confrontational concept.  It’s a far woolier one, too.  Indeed, the dissensus over what it actually means could make climate finance even riskier for financial institutions, not less. Matt Levine made this point at the start of the year:

“A norm like ‘climate-focused investors should avoid coal companies’ is simple but possibly counterproductive. A norm like ‘climate-focused investors should buy coal companies and make them better’ is more nuanced but harder to police.”

Just how tough it is to police can be inferred from the messy debate over what’s in and what’s out of the definition. Climate finance think tank RMI found 17 different definitions of transition finance in a November analysis.  Meanwhile, the transition finance framework proposed by the Glasgow Financial Alliance for Net Zero (GFANZ) is so broad it could encompass pretty much anything. For example, it promotes “aligned and aligning” as a transition investment strategy. This permits investors to fund companies that have committed to transition in line with a 1.5 °C pathway, even if a plan for achieving this is yet to be implemented.  Presumably investments in ExxonMobil would qualify under this strategy.  After all, it has publicly stated its net zero goal.  Never mind it’s suing shareholders for daring to propose cuts to its scope 3 emissions.

This hypothetical exposes the first and most obvious risk that transition finance poses investors: reputational risk. Take HSBC’s recent net zero transition plan as an example.  It outlines the bank’s approach to ongoing financing of high-emitting sectors, including oil and gas and heavy industry.  There’s plenty in there about science-based pathways and the technologies needed for these sectors to decarbonize.  But strip all this away and what you’re left with are mealy-mouthed half-promises to cut exposures to companies that don’t align with its net zero ambition – at best! 

For example, in relation to cement producers, HSBC does not say it will sanction companies that fail to align with its 2030 financed emissions target.  As perennial troublemaker Ulf Erlandsson pointed out, this implies that a cement firm may continue to access financing from HSBC so long as it promises to cut emissions, even if its plan to do so relies on faith, trust, and pixie dust. 

HSBC gives itself plenty of flexibility as regards the oil and gas sector, too.  When it comes to hydrocarbon firms that do not align with their own net-zero targets, the bank says (my emphasis): “...we may need to consider whether to reduce our exposure. This choice will be informed by our policies and strategic portfolio considerations, including sustainability, credit and commercial alignment.”

More caveats than you could shake a stick at! 

I’d argue that HSBC is using the cover of “transition finance” to continue bankrolling high-emitting clients as it sees fit.  You can see how this will only add fuel to activist campaigns against the bank and further tarnish its already stained climate reputation.

Second, and perhaps less obviously, high-carbon companies supported under the guise of “transition finance” have the potential to become “zombie firms” – tying up capital that could be more productively deployed in truly “green” entities.   In addition, these high-carbon “zombies” may pose growing credit risks as net-zero policies tighten and technological pathways to a net-zero world come into focus. 

Think of a bank that bets on ammonia co-firing as a transition technology for coal-fired power plants.  What happens to these investments if the technology proves too costly to scale or governments back off from subsidizing it?  Far better (from a credit risk view) to have invested in a plain vanilla coal plant, or better yet to have avoided the sector entirely.

This gets to the heart of why I’m a transition finance scold.  A transition is the process of changing from one state or condition to another.  In climate world, we’re talking about changing from a fossil fuel economy to a net-zero economy.  We already have most of the building blocks for the latter.  Remember that around three-quarters of emissions are attributable to energy, and we have many of the technologies needed to replace fossil fuels used for this purpose.  What we need to do is scale them up.  So why create a permissions structure to divert finance from emerald green solutions to the murky, ambiguous, risky category of “transition”?

By skipping over “transition finance”, investors can avoid the hassle of heightened reputational and credit risk, and shortcut what promises to be a lengthy and exhaustive process to determine what counts as a transition investment.  (Of course, this may be part of the appeal to some unscrupulous actors, who may use the “transition finance definitions aren’t finalized yet” excuse as cover to continue investing in fossil fuels). 

Furthermore, stakeholders who want to understand investors’ alignment with the transition don’t need a new taxonomy or complex categorization framework to do so.  They can go by the ratio of “dirty” to “green” investments, something popularized by BloombergNEF.  It’s a crude measure, sure, but a decent gauge of how committed to the transition an investor is – and surely superior to the easily gamed financed emissions indicators used by HSBC and others.

And yes, I get all the arguments about most companies being a mix of ‘dirty’ and ‘green’ and how we want to appeal to the better angels of high-carbon company’ CEOs by offering them incentives to transition.  My counter is that a rigid focus on “green” vs “dirty” by investors may encourage the breakup of the largest high-carbon corporations into their “green” and “dirty” constituents, allowing investors to make their own choice.

I also get the point that “transition finance” as a concept isn’t going away anytime soon.  The institutional support behind it is building, because it serves climate finance advocates and financial institutions alike.  The former because it guarantees years of work (and funding) working out new financing frameworks and engagement strategies; the latter because it gives them space to invest however they choose while claiming the climate friendly mantle. 

But I maintain that transition finance injects unnecessary complexity into the climate finance debate, and will ultimately load additional risks onto investors while slowing our journey to net zero – an outcome we should all want to avoid.