Instead of divesting from high-emitting sectors and hoping they will one day decarbonise, investors should find ways to help these sectors transition to greener operations.
This is especially important in emerging markets, which depend heavily on emissions-intensive sectors for economic growth.
But this is easier said than done, with many companies in the hard-to-abate or “brown” sectors unsure of which operation areas to decarbonise, and, above all, lacking the funding to do so.
This type of funding, termed “transition finance”, remains severely inadequate, and is stifling decarbonisation progress within brown sectors.
Presently, hard-to-abate sectors such as cement, steel and glass manufacturing play a key role in developing economies. They represent a quarter of the world’s energy consumption and a fifth of global emissions. Without investments in fossil fuel abatement, their energy consumption and emissions are likely to increase in the coming decades, according to the International Renewable Energy Agency (IRENA).
As part of efforts to channel climate finance more effectively to developing countries, high-level representatives from various countries convened in late September for a dialogue on the New Collective Quantified Goal (NCQG), ahead of the COP29 climate talks in Baku, Azerbaijan.
The NCQG will succeed a previous goal from the Copenhagen Climate Summit, where developed countries committed to mobilising US$100 billion per year by 2020. Although this target has been met, climate investments continue to fall short of the war chest needed to reach net zero by mid-century.
Between US$1.6 trillion to US$3.8 trillion per year will be needed over the next three decades to meet the objectives of the Paris Agreement, despite a tripling in green finance investments since 2015, according to the United Nations Framework Convention on Climate Change (UNFCCC).
The UNFCCC also highlighted the slower pace at which transition finance has been mobilised compared to green finance, with the transition finance funding gap amounting to approximately US$125 trillion.
While green finance provides funds for technologies that produce near-zero emissions and are aligned with the Paris Agreement, transition finance allocates capital to companies and activities that are not yet considered “green” but are in the process of reducing emissions and “becoming green”, according to Delhi-based independent think tank Observer Research Foundation (ORF).
“The world cannot achieve net zero while allowing the economy to thrive on green projects and initiatives alone. We need carbon-intensive sectors producing essential goods and services, such as steel and cement, to find a way to decarbonise,” said Mervyn Tang, Schroders’ head of sustainability for the Asia-Pacific region, on the need for asset managers to invest in “brown-to-green” transition projects alongside “green” assets.
Tang added that for many economies in Asia trying to balance decarbonisation with economic and social development, investments in emerging market assets while steering these industries to decarbonise could lead to “better real-world outcomes”.
Differentiated approaches crucial for emerging markets
Despite growing recognition that addressing the climate challenge will require mobilising transition finance, access to capital has remained difficult for emerging markets and developing economies.
“Emerging markets have always struggled with getting enough financing, and this financing gap becomes even larger for green or sustainable finance,” said Liza Jansen, head of responsible investment at global Asia and Africa-focused life and health insurer Prudential plc.
Apart from the higher risks and interest rates associated with projects in emerging markets, Jansen highlighted another critical impediment: the focus on decarbonisation through global, sector-specific pathways, with little differentiation between developed and emerging economies.
“Many frameworks have only focused on the decarbonisation of portfolios, but this leads to the unintended consequence of investors shifting capital away from emerging markets to developed markets just to ensure they hit their decarbonisation targets. As a result, emerging markets are disadvantaged in securing crucial climate investments,” she said.
Jansen added that while the Paris Agreement has emphasised the idea of “common but differentiated responsibilities”, the concept has not been incorporated into existing responsible investment frameworks and standards – a challenge that Prudential’s ‘Financing the Transition Framework’ whitepaper aims to address.
Under the framework, launched in September this year and endorsed by Climate Bonds Initiative, investments are divided into five categories, ranging from “green” to “brown-to-green” projects. Climate Bonds Initiative is an international non-profit working to mobilise capital for climate action.
The framework captures five distinct categories under which investments can fall. It recognises the need for a more holistic approach since no single category can deliver the transition alone at the required speed and scale. Image: Prudential
A special category – “transitioning amidst growth” – is intended to provide flexibility with regards to emerging markets that are embarking on the green transition from a disadvantaged socio-economic development stage and therefore struggling to meet the high decarbonisation thresholds set by developed markets.
Companies in carbon-intensive sectors in these markets that can prove they have made quantifiable efforts to reduce their emissions intensity significantly can be classified in this category. However, these companies might not align to a net zero target by 2050, as their countries align to different net zero timelines.
“We recognise that country net zero targets can have different timeframes depending on the stage of economic development of the country. Regardless, we require investee companies to have ambitious transition plans with measurable progress,” noted Jansen, explaining that key criteria in this category include long-term net zero targets backed by interim and realistic targets and near-term commitments, leadership governance, and accountability.
“We do not expect this category to exist forever as we do not want to incentivise the status quo. Our framework is expected to become stricter over time with the expectations that companies in emerging markets move from transitioning amidst growth to aligning, and eventually, aligned.”
This flexibility allows Prudential to invest in projects transitioning from brown to green that would otherwise have been excluded under conventional investment frameworks without differentiated thresholds for emerging markets. Investments in such projects are desperately needed to achieve global net zero.
For instance, an Indian telecommunications service provider that has yet to commit to a 1.5-degree pathway – but has transitioned nearly all its rural sites to hybrid-solar power, in addition to committing to reach net zero by 2060 – would qualify for investments under the insurer’s “transitioning amidst growth” category.
“We can’t reach net zero without the emerging markets, and one of the best ways to do that is to allow for flexibility, in line with the Paris Agreement,” said Jansen.
The framework document also highlighted that this category is intended to be temporary; its primary objective is to help companies transition to the “aligning” and “aligned” categories, through targeted capital and stewardship efforts.
In line with the framework launch, Prudential announced an investment of US$200 million as a founding investor in asset management company Brookfield’s Catalytic Transition Fund, a blended finance vehicle to direct capital into clean energy and transition assets in emerging economies. Prudential has also committed up to US$150 million to a climate-focused strategy fund managed by global investment firm KKR. The fund will go towards infrastructure equity investments in Asia with a focus on the energy transition, including climate adaptation, climate mitigation and the brown-to-green transition.
Lack of a standardised definition for “transition finance”
While most investors acknowledge the concept of transition finance, there remains uncertainty over what qualifies as transition finance, noted Jansen. This, she added, is attributed to the lack of a standardised definition and methodology for assessing whether companies are making progress on decarbonisation.
Sean Kidney, chief executive officer of the Climate Bonds Initiative, shared the same sentiments: “Standards and guidelines help everyone from investors to issuers understand what needs to be done and what won’t quite meet the need.”
Prudential’s recent whitepaper aims to integrate the characteristics of emerging markets into a principles-based approach to decarbonisation, aligned with key regional initiatives like the Asean Taxonomy, to provide guidance from an asset owner perspective.
Because asset managers likely refer to different metrics when reviewing transition finance projects, Jansen said they should avoid being “too prescriptive” or rigid in how asset managers select for investee companies.
“A key challenge for asset managers is to find ways of assessing the quality and credibility of company transition plans. This alone requires a deep understanding of the underlying companies rather than just carbon metrics,” said Tang from Schroders.
“As an asset owner, we are instead doing due diligence on the asset manager, looking at how they determine a company is transitioning and whether we think it’s qualified as transition finance,” said Jansen.
She added that intentionality and measurability become essential to ensure credibility when no standardised definitions exist. These requirements will verify the commitment of the asset manager to finance the transition.
According to Prudential’s framework, asset managers should disclose the intentional allocation of funds into “green” and “brown-to-green” assets to demonstrate intentionality, and to report regularly on the milestones and outcomes of these investments. Similarly, measurability requires clearly defined data points to gauge progress.
“Asset managers need to be able to report something to us, even though we are not prescribing a specific type of data,” said Jansen.
She expressed hope for a more standardised definition of transition finance over time, adding that meanwhile, engagement and supporting “brown” companies will be crucial for a just energy decarbonisation.
“Part of the [Financing the Transition] Framework is that engagement is mandatory. It is rethinking engagement, speaking to the companies, and actively supporting them on how they can transition. That is going to be crucial in ensuring that emerging markets do not get left behind in the energy transition,” Jansen said.
