Transitioning to net-zero carbon emissions requires an economic overhaul. Since there is a sizable gap between where we are and where we hope to be to complete the green transformation, this will require fundamental change in four major ways.
First, the supply of renewable energy must be expanded. Second, electrification of energy use needs to become more widespread. Third, green hydrogen or ammonia should be deployed at scale to decarbonise transportation and industrial processes where electrification may not be feasible. And fourth, the remaining part of carbon usage – even after these possibilities and other carbon-free options are exhausted – must be offset by negative emissions.
The estimated amount of capital expenditure necessary to bridge the gap is considerable, but a framework for financing climate transition would enable financial institutions to effectively do this.
Transition finance is not a substandard category of green finance. Rather, it is finance intended for recognising the magnitude of necessary change, designing time-bound pathways for greening the transition and overcoming the hurdles to get there. One could argue that green finance is a subcategory of transition finance, not the other way around.
The Glasgow Financial Alliance for Net Zero categorises transition finance, or finance to support real-economy emissions reduction, in four groups: climate solutions, aligned, aligning and managed phaseout. The first two are typically known as green finance.
Following the similar concept, the Japanese government has established its own framework, underpinned by climate transition finance guidelines and decarbonisation roadmaps for 10 hard-to-abate sectors including steel, chemicals and cement. The guidelines illustrate the need for financiers and investors to assess borrowers’ and investees’ transition strategies – which must contain science-based and environmentally material carbon emissions reduction targets and pathways – together with their governance for monitoring the progress of their transition plan.
The sectoral roadmaps provide a reference for setting carbon emissions reduction targets and pathways. This is achieved by establishing a timeframe for the technological advance and adoption necessary for companies in hard-to-abate sectors to reduce carbon emissions over the next few decades to reach net zero by 2050. This framework does not rely on green taxonomies in ensuring the credibility of pathways because a threshold mechanism associated with taxonomies tends to make a judgement binary. A set of data on the potential for technologies to reduce carbon emissions can provide a more granular picture in designing pathways.
Transition finance is considered more vulnerable to greenwashing as it allows financing to not-yet-green but greening entities or activities. This is why a credible transition plan is important. That said, for certain hard-to-abate entities or activities, a transition plan is likely to contain untested but potentially impactful low-carbon or zero-carbon technologies to be developed in coming years.
This uncertainty is a concern. But Japan’s framework is not designed to deny such an uncertain prospect outright. To guardrail the path for future unproven and not-yet-commercialised technologies, the sectoral roadmaps outline a plan for research, development and commercialisation of decarbonisation technologies within certain timeframes.
Even technologies outside the roadmaps will be permitted in Japan’s transition finance framework as long as financiers or investors are convinced through dialogue with a borrower or investee. Levels of conviction may differ from one financier or investor to another, so imposing an identical action on each will be a mistake. The diversity of judgement must be retrained in the marketplace to chart the best course through uncertainty.
Satoshi Ikeda is Chief Sustainable Finance Officer at Financial Services Agency, Japan.