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Transition Finance

The EU’s recommendation for Transition Finance for banks regarding ESG issues is part of the broader Sustainable Finance Package released on June 13, 2023. It is aimed at facilitating the transition to a sustainable economy by defining and articulating the needs for transition finance, and outlining ways to raise such finance. This initiative addresses the challenges companies, particularly those in high-carbon industries, face in transitioning to green and sustainable operations. The recommendation seeks to support activities and technologies that are not currently green but are essential for the transition towards sustainability.

Key aspects of the Transition Finance recommendation

Definition of Transition Finance: It is distinguished from sustainable finance (which funds activities already considered green or transitioning) and general finance (without sustainability objectives). Transition finance specifically targets the financing of activities that will become green in the future, emphasizing that short-term outcomes may not meet green performance targets, but must align with the EU’s climate and environmental objectives in the long term.

Articulating and Raising Transition Finance: The EU suggests using sustainable finance tools like the EU Taxonomy or climate benchmarks to define transition targets and needs. Transition finance can then be raised through instruments like green or sustainability-linked bonds, green loans, equity financing, or specialized lending.

EU Climate Benchmarks and Taxonomy: The EU climate benchmarks set criteria for portfolios aligning with a sustainable economy, requiring an annual reduction in greenhouse gas intensity. The EU Taxonomy offers a classification system to support the articulation of transition finance needs, providing a framework for investments across various timeframes and environmental impacts.

This recommendation aligns with the European Banking Authority (EBA)’s proposed guidelines for banks to manage ESG and climate transition risks. These guidelines include regular materiality assessments of ESG risks, integrating ESG risks into risk management frameworks, and developing transition plans addressing financial risks from ESG factors. The EU’s recommendations on Transition Finance are designed to make it easier for companies, especially those in high-carbon industries or those not currently aligned with green standards, to secure financing for their transition towards sustainability. By providing a clear framework and definitions for transition finance, the recommendations aim to:

Clarify the Landscape: They offer a structured approach to understanding what constitutes transition activities and the types of financial instruments that can support these activities. This clarity can encourage investors to fund projects that contribute to the transition to a greener economy.

Broaden the Scope of Finance: Transition finance includes not only activities already considered green but also those that are on a path to becoming green or sustainable in the future. This broadens the pool of potential projects and companies that can receive funding.

Support with Sustainable Finance Tools: The use of tools like the EU Taxonomy and climate benchmarks can help articulate transition finance needs more precisely. This could make it easier for companies to communicate their financing needs and for financiers to understand the impact of their investments, facilitating the matching of projects with capital.

Encourage Financial Innovation: The recommendations suggest various financial instruments for raising transition finance, including green or sustainability-linked bonds and loans, equity financing, and specialized lending. This diversity encourages innovation in financial products, potentially making financing more accessible.

Focus on Long-term Alignment: By emphasizing the need for transition finance initiatives to align with the EU’s long-term climate and environmental objectives, the recommendations assure investors of the commitment to sustainable development, potentially increasing their willingness to invest.

Mitigate Risks: The proposed guidelines by the European Banking Authority (EBA) for banks to manage ESG and climate transition risks alongside the EU’s recommendations can help financial institutions better assess and manage the risks associated with transition finance. This could lower the barriers to financing projects with higher perceived risks.

In essence, the EU’s recommendations on Transition Finance are expected to facilitate easier access to finance for companies by providing clear definitions, encouraging the development of new financial products, and aligning financial flows with the EU’s sustainability goals.

EU’s recommendation for Transition Finance

This Recommendation is addressed to undertakings that want to contribute to the transition to climate neutrality and environmental sustainability, while enhancing their competitiveness and are seeking finance for investments for this purpose. It aims to explain the use of sustainable finance tools for this purpose. Transition financing and green financing can be distinguished from general financing, which does not have sustainability objectives.

Transition means a transition from current climate and environmental performance levels towards a climate- neutral, climate-resilient and environmentally sustainable economy in a timeframe that allows reaching:

  • the objective of limiting the global temperature increase to 1,5 °C in line with the Paris Agreement and, for undertakings and activities within the Union, the objective of achieving climate neutrality by 2050 and a 55 % reduction in greenhouse gas emissions by 2030 as established in Regulation (EU) 2021/1119 of the European Parliament and of the Council;
  • the objective of climate change adaptation; and
  • other environmental objectives of the Union, as specified in Regulation (EU) 2020/852 as pollution prevention and control, protection and restoration of biodiversity and ecosystems, sustainable use and protection of marine and fresh-water resources, and the transition to a circular economy.

Transition finance means financing of investments compatible with and contributing to the transition, that avoids lock-ins, including:

  • investments in portfolios tracking EU climate transition benchmarks and EU Paris-aligned benchmarks (‘EU climate benchmarks’);
  • investments in Taxonomy-aligned economic activities, including:
  • transitional economic activities as defined by Article 10(2) of Regulation (EU) 2020/852 for the climate mitigation objective,
  • Taxonomy-eligible economic activities becoming Taxonomy-aligned in accordance with Article 1(2) of Commission Delegated Regulation (EU) 2021/2178 over a period of maximum 5 (exceptionally 10) years;
  • investments in undertakings or economic activities with a credible transition plan at the level of the undertaking or at activity level;
  • investments in undertakings or economic activities with credible science-based targets, where proportionate, that are supported by information ensuring integrity, transparency and accountability.

Transition plan means an aspect of the undertaking’s overall strategy that lays out the entity’s targets and actions for its transition towards a climate-neutral or sustainable economy, including actions, such as reducing its GHG emissions in line with the objective of limiting climate change to 1,5 °C.

Undertakings are encouraged to use one, or a combination of several, transition-related financing instruments to raise transition finance, such as specific loan types or capital market issuances with specific features.

  • Green or other sustainability loans
  • Green or other sustainability bonds
  • Equity financing and specialised lending

Aside from general lending and financing solutions, financial intermediaries can offer transition-specific financing solutions to undertakings or projects with significant transition finance needs. This includes, for example, offering loans or financing products that can help finance transition investments on the ground, such as those based on:

  • investments in alignment with Regulation (EU) 2020/852 that help increase the share of Taxonomy-aligned activities carried out by an undertaking in a meaningful way;
  • the EU climate benchmarks where they complement science-based scenarios or pathways;
  • credible entity or activity-level transition plans implementing science-based targets;
  • credible science-based targets, where proportionate, that are supported by information ensuring integrity, transparency and accountability;
  • the reduction of environmental footprints based on and aligned with EU strategic environmental Action Plans for Circular Economy(42), Biodiversity(43)and Zero Pollution(44);
  • a combination of the above, e.g. where transition plans integrate transition finance needs determined through the Taxonomy or the EU climate benchmarks.

Conclusion

Tough the Transition Finance recommendations are only recommendations, they can help to create awareness among market participants of the need to finance investments in the green transition. Banks will in the future have closer look at transition finance activities, which have a positive business outlook and are eligible for financing. The existing standards, principles and safeguards for banks – however – still need to be adapted in order to ensure the credibility and environmental integrity and the possibility to create new financing possibilities. Contact us to prepare your plan.

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Georg Tichy

Georg Tichy

Georg Tichy is a management consultant in Europe, focusing on top-management consultancy, projectmanagement, corporate reporting and fundingsupport. Dr. Georg Tichy is also trainer, lecturer at university and advisor on current economic issues. Contact me or Book a MeetingView Author posts