Why transition finance must go beyond energy
A coherent and coordinated approach is required to effect a sustainable transition, writes Marcus Pratsch, head of sustainable bonds and finance at DZ BANK AG.
There is no doubt that transition finance is essential for the successful implementation of the global sustainability agenda. A more sustainable world cannot be achieved by focusing on already highly sustainable economic activities. Instead, a greater positive impact can be made by helping to ensure that critical business activities become more sustainable over the long term.
Change, however, does not happen overnight. It is wishful thinking to expect that sustainable transition will occur quickly. Rather than being ‘one simple transaction’, it is an evolving process – especially when it involves sweeping structural changes for business infrastructure and the global economy. Transitioning is also a learning process. A coordinated and coherent approach must be developed, taking the specific needs of industries, sectors, geographies and cultures into consideration.
Sustainable transition should not be limited to the energy transition but should also include other environmental challenges, such as nature-related issues. According to the Intergovernmental Panel on Climate Change, agriculture, forestry and other land use contribute around 23% to global greenhouse gas emissions. Accounting for nature is therefore essential to achieving net-zero goals.
The need for a social aspect of transition
A successful and comprehensive sustainable transition can only work if it also has a social dimension.
Structural changes brought about by the sustainable transition can pose several socio-economic challenges. Moving to a more sustainable world creates multi-dimensional transition risks, such as disrupted supply or operations chains, reduced productivity or uneven market competitiveness. Transforming hard-to-abate industries could also lead to the displacement of workers, loss of income and marginalisation of regions.
The social implications of transition cannot be ignored and these challenges need to be financed in the context of the other dimensions of sustainability – economic, environmental and governance. If well managed and financed, the sustainable transition can be a powerful catalyst for job creation, job upgrading, social justice and poverty eradication.
However, the financing needs are huge and efforts need to pick up speed. Trillions need to be mobilised for the sustainable transformation of our economy and society. This cannot be financed solely by public money. Capital markets must be on board so that private capital can be allocated to transformational projects and business models. This capital is also needed to mitigate the social and economic risks of transition.
No need to reinvent the wheel
The financial sector can play an important role in accelerating the transition through capital and risk-mitigating mechanisms. We already have various instruments and the knowledge required to reflect comprehensive transition in capital markets. Take the fixed income market as an example. Transition bonds are a relatively new fixed income instrument that has joined the ranks of use-of-proceeds sustainable bonds. So far, they have been issued exclusively by the real economy.
However, a transition bond issued by a sovereign and tied to the Just Transition Principles would be an ideal instrument to simultaneously map and finance the environmental and social dimensions of transition. With the Green Bond Principles, the Social Bond Principles, the Sustainability Bond Guidelines and the Climate Transition Finance Handbook of the International Capital Market Association, various guidelines are already available on the market for structuring such a bond.
Many investors also see target-linked structures as a suitable instrument for just transition financing. Target-linked bonds are forward-looking and performance-orientated financial instruments in which issuers explicitly commit to future improvements in sustainability criteria within a predefined timeframe.
Sustainability development is measured using key performance indicators and evaluated against sustainability performance targets. The financing costs of target-linked bonds are linked to the (non-)achievement of these targets. If the issuer fails to meet them, financing becomes more expensive. In the case of a sovereign transition-linked bond, it would be conceivable, for example, to complement an environmental KPI like the reduction of GHG emissions with a social KPI like job generation.
Investor appetite to finance the transition is growing. In September last year, Ostrum Asset Management announced the launch of Ostrum Global Sustainable Transition Bonds, the first bond fund with a global investment universe devoted to the just transition. Two years ago, Union Investment launched the UniESG transformations rating – a proprietary forward-looking rating approach to identify corporates, which can benefit greatly from the transition. All relevant players in the capital market must work together to build a pathway to a successful sustainable transition.