Scaling Transition Finance with Lessons from Environmental Markets
Corinne Neale, Member of the Executive Team, Fiùtur
Andy Bose, SVP, Market Development and Policy, Fiùtur
Channelling trillions of dollars of “transition finance” towards cleaner energy, circular supply chains and more efficient infrastructure requires a rewiring of loan and risk management markets.
Many similar challenges have already been addressed in environmental markets, offering valuable lessons and advanced technology for the transition economy.
Transition Finance
Consensus is emerging on Transition Finance being defined as financing hard to abate sectors to meet the Paris Agreement temperature goal. The Glasgow Financial Alliance for Net Zero (GFANZ) characterises transition finance as enabling “an orderly reduction in emissions for carbon-intensive activities”.1
Many businesses in hard to abate sectors see benefits in preparing for a decarbonised economy due to stricter regulations, investor demands for greenhouse gas (GHG) disclosures and changing consumer preferences. Trade flows are being affected too; for example, manufacturers of carbon intensive goods entering the EU face new emission thresholds and direct tax via the Carbon Border Adjustment Mechanism (CBAM).
Missing these signals results in transition risks, and as recently highlighted by the European Central Bank, transition risks result in elevated credit and litigation risks for financial institutions. So transition finance can be seen as a way for all parties to mitigate risk. Reducing the cost of capital for a borrower when GHG emissions are reduced can improve the underlying performance by reducing exposure to transition risk (Tandon, 20212).
Although Transition Finance benefits are clear, its structure is still debated due to its complexity. Transitioning, by definition, implies supply chain asset-level changes, more amenable to lifecycle analysis than to the point in time proceeds or corporate level metrics used in sustainable finance. However, solutions are in sight, precipitated by the imminence of CBAM-style regulations affecting trade flows for specific commodities, and by environmental market experiences offering guidance.
“While there is no single definition of transition finance across the market, Standard Chartered has defined transition finance as any financial service provided to clients to support them in aligning their business or operations towards the 1.5 degree trajectory. Historically, one of the main challenges in this area has been that new-low carbon technologies are not sufficiently established in the market. But we’re starting to see the innovation needed across technology and digital to encourage the transition, and the development of the supporting transition finance structures required behind this.”
Nicolas Decaillet, Managing Director, Energy and Infrastructure at Standard Chartered Bank
1. https://www.gfanzero.com/publications
2. Tandon, A. (2021) Transition Finance: Investigating the State of Play: A Stocktake of Emerging Approaches and Financial Instruments, OECD Working Papers 179.
Insights from Environmental Markets
Environmental markets refer to both government-administered cap-and-trade “compliance” markets and voluntary markets. Initially focusing on SO2 and NOx emissions, these markets have evolved to address various challenges including land conservation, water quality, control of chlorofluorocarbon (CFC), and reducing GHG emissions.
- Like Environmental Markets, Transition Finance aims at aligning emissions to environmental targets;
- Both aim at the creation of premium products for the new economy;
- Both leverage a system of financial incentives and penalties;
- Both are subject to greenwashing scrutiny and encourage continuous digital innovations.
Most importantly the results are compelling. Environmental markets have reduced GHG emissions by c. 2 to 3% per year (Boning et al., 20233). This experience provides a template for the infrastructure, incentives and rigour required for financing the transition economy.
3. Boning, J., Di Nino, V. and T. Folger, (2023) Benefits and Costs of the ETS in the EU, a Lesson Learned for the CBAM Design, ECB Working Paper No. 2023/2764.
FinTech fit for Purpose
With increasing scrutiny on the integrity of environmental markets outcomes, several technical tools and advances in market governance have been introduced that can be applied in transition financing. Here are foundational Fintech building blocks:
- More precise and complete environmental and ecosystem monitoring via satellite imagery, drones, and other remote sensing technologies providing real-time, asset-level information;
- Vertically integrated systems to digitise the complete lifecycle of physical commodities with auditable information on origin, processing/refining, transmission, and relevant environmental attributes;
- Interoperable Digital Ledger Technology (DLT)-based infrastructure automated with “smart contracts" to connect multiple parties via secure platforms, and register environmental claims that eliminate risks of double-counting;
- New digital governance frameworks4 for delivery of high quality data and registering, transacting, reporting and retiring via standardised protocols.
See Fiùtur’s “Trust Infrastructure for the Transition Economy5 for more information on these areas.
Scaling Transition Finance
These advances enable lenders to reference verified outcomes for hard to abate products at asset level in supply chains. This is the domain of Trade Finance, Transaction Finance, Commodity Finance, Real Assets Finance and Exports and Import credits for transitioning assets. These advances extend asset lenders’ capabilities in three immediate ways in hard to abate sectors:
- Tracking emissions against targets for the specific asset to be financed with current data for valuation at the point of financing.
- Leveraging the higher market price paid for premium products with verified lower emission products.
- Leveraging market demand for Environmental Attribute Certificates (EACs) verifying emissions reductions. EACs create new revenue streams, e.g. the EU’s Upstream Emission Reduction (UER) scheme, California’s credits for low-carbon fuel, and Canada’s credits for low-emission gas are regulated ways to monetize emissions reduction certificates. This enables environmental outcomes to be authenticated and valued, harnessing market forces to fund the transition This practice has been acknowledged as essential for transition finance by industry groups6.
Transition Finance enhances traditional financing by referencing verified asset-level emission data to meet emission targets, measure transition risk and value transitioning assets. Better and higher frequency emission data at asset level will also enable lenders and their clients to build transition risk models. These models will foster innovation by isolating risks, analysing trends and pricing tailored transition risk mitigants. This virtuous loop will enable risk-sharing guarantees, and risk-sensitive collateral pools, covenants7 and insurance8. Asset-level risk mitigants will reduce the need for risk capital, freeing funding to further scale the energy transition.
The finance industry is actively engaging with economic stakeholders, and it is becoming increasingly obvious that no-one can transition alone. New business models call for mechanisms such as digital registries and environmental outcomes’ chains of custody for granular, verified, referenceable environmental information shared across parties. An illustration is provided in the graph below where producing assets’ environmental outcomes are:
- Captured alongside physical production,
- Verified according to accepted standards,
- Referenced in data registries,
- Passed down the supply chain,
- Shared with interested parties to support capital deployment, until retirement of environmental claims certificates.
As pressure builds up to deploy funding towards the new economy and to mitigate environmental and social impact, environmental markets bring much-needed experience and tangible technology solutions. We should focus on rewiring the loan and risk management markets with 21st century digital tools. This is “just finance” with the level of insights necessary to take action.
With our appreciation to Ken Abbott, ex IHC CRO at Barclays for his review.
6. See for example https://www.sustainable-markets.org/taskforces/agribusiness-task-force/ 7. https://www.moccae.gov.ae/en/media-center/news/4/12/2023/moccae-and-world-bank-treasury-partner-on-financing-the-future-of-food-f3-initiative-to-explore-innovative-bond-structures-for-projects-in-developing-countries.aspx#page=1 8. https://www.lloyds.com/news-and-insights/futureset/futureset-insights/risk-revealed-clean-technologies-and-hard-to-abate-sectors
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