Mobilising transition finance will require credible corporate climate plans

Alexander Lehmann is a Non-Resident Fellow at Bruegel

One aim of sustainable finance regulation is to push companies towards activities that will be compatible with the target to limit global warming to 1.5 degrees Celsius above pre-industrial levels. This type of regulation – for example setting out classifications of what economic activities count as ‘green’1 – seeks to encourage financing for activities and technologies that are clearly carbon neutral.

But financial markets now increasingly focus on transition finance as a component of the broader sustainable finance asset class. Transition finance refers, for example, to financing for emission reductions and low-carbon technologies in industries such as cement or steel, where no purely green technologies are readily available. Transition financing is also needed for energy companies in the process of switching to renewables and phasing out their fossil-fuel assets.

From ‘cheap talk’ to credible climate plans

Some observers have argued that transition finance requires a new classification that would set out intermediate technologies and ‘shades of green’ deployed on the path to a net zero world – in other words, technologies that are not, in a strict sense, sustainable, but which are needed to get to sustainability.

Shipping, for instance, is a typically ‘hard-to-abate’ sector. Gas, rather than oil-powered, vessels may reduce emissions initially while not offering the ultimate net zero technology, such as green hydrogen. In the European Union, a technical expert group has proposed such a separate transition classification (Platform on Sustainable Finance 2022), but EU legislation on this right now does not seem likely.

That is no grave loss. A static classification of activities is neither sufficient nor necessary for transition finance to take off. Transition finance relies inherently on forward-looking climate commitments by companies.

Only on the basis of well-defined transition plans will investors be in a position to understand the residual climate risks to which companies are exposed, while bond and loan markets will increasingly feature contracts that link financial terms to the achievement of climate outcomes.

This central role of corporate climate plans has been recognised in templates for transition plans developed by, for example, the Organisation for Economic Co-operation and Development (OECD, 2022) and the G20 Sustainable Finance Working Group (2022).

The sheer number of net zero targets companies have announced would suggest that this concept is well-established. In fact, transition plans are a much more complex aspect of corporate disclosure and strategy. They should, for instance, explain how emissions in the upstream and downstream value chain are captured.

They should also explain the incentives management has to deliver on the plan, for instance, by setting internal carbon prices or linking executive pay to climate outcomes.

Some companies have already adopted this relatively comprehensive concept, in part based on templates that the Financial Stability Board’s Taskforce on Climate-Related Financial Disclosures (TCFD) first designed in 2016.

However, overall, the quality of corporate climate disclosures remains disappointing. In February 2023, the Climate Disclosure Project showed that only a small fraction of the 18,000 companies monitored globally met all key indicators of high-quality climate transition plans (CDP, 2023).

Only in a handful of EU countries do more than 10 percent of reporting companies define plans that meet most of the required indicators. According to the UK-based Transition Pathway Initiative, only one-quarter of about 400 large and listed global companies have made a strategic assessment of issues related to the climate transition. Major aspects of management quality were often inadequate2.

Only on the basis of well-defined transition plans will investors be in a position to understand the residual climate risks to which companies are exposed, while bond and loan markets will increasingly feature contracts that link financial terms to the achievement of climate outcomes

New regulatory standards

Against this backdrop, a number of regulatory initiatives will now likely bring more clarity on the elements corporate transition plans should include:

  • In the EU, the Corporate Sustainability Reporting Directive (CSRD, (EU) 2022/2464) will require roughly 50,000 companies to publish their climate transition plans, beginning in the 2024 accounting period. A 2022 European Commission proposal for a Corporate Due Diligence Directive3 remains under negotiation but is likely to raise standards further by requiring considerable detail in such plans, including how they would be in line with the 1.5 degree warming scenario. The European Financial Reporting Advisory Group, the EU’s accounting body, has published a draft standard that fleshes out these requirements (EFRAG, 2022).
  • In parallel, the International Sustainability Standards Board (ISSB) is developing new disclosure rules, with a climate standard to take effect from 2024 (ISSB, 2022). This also requires companies to publish transition plans.
  • Standards in the United Kingdom will also be important, given the close linkages to EU capital markets and London’s possible role as a green finance hub for emerging markets, as envisaged in the UK government’s 2023 green finance strategy (HM Government, 2023). Detailed standards for the transition plans of large or listed companies are expected in late 20234.
  • In addition, there are now various guidelines and regulations on transition finance and related corporate disclosures in Japan5 and other key Asian markets.

Much has been made of the EU’s greater ambition in disclosure. The EU’s ‘double materiality’ concept, which is embodied in the CSRD (reflecting sustainability risks to the firm as well as the firm’s impact on the planet) will go well beyond the equivalent ISSB standards6.

In terms of the format and content of corporate transition plans, the emerging EU, UK and international accounting standard templates are, in fact, very close. Unlike for green finance and the often-complex classifications of activities, regulatory equivalence, which could foster cross-border capital flows, seems a realistic prospect.

Fleshing out the fine print

Transition plans will quickly become an important tool in corporate strategy, and will be central to non-financial disclosures and reporting. But the high-level language in the EU directives and the new accounting standard will need to be fleshed out in further guidance and backed up in national legislation.

Three aspects should be addressed:

  • The EFRAG (2022) standard should be clearer on how the pathways for emission reductions will be set. This involves tricky judgements on how the finite remaining budget for global greenhouse gas emissions is allocated to industrial sectors, and how EU and national targets are translated to each company. There also needs to be clearer guidance on emissions arising further down the value chain (‘scope 3’ – indirect emissions) and whether targets are to be set in relative (intensity) or absolute terms. The sheer variety of methodologies invites arbitrage towards lower standards.
  • Sound transition plans will also need to be backed up by corporate governance and transparency rules. The EFRAG standard only requires companies to explain how the transition plan is embedded in the overall business strategy and that it has been approved by management bodies, which risks resulting in superficial language. An ongoing review of four related EU directives in this area (including the one on the harmonisation of transparency requirements)7 should therefore be accelerated and should support the ambition for better sustainability disclosures. Corporate governance rules are largely in the competence of EU countries and are defined in a patchwork of national legislation, securities regulations and non-binding codes or guidance from central banks. Climate-related aspects should become more central, for instance by requiring a climate strategy review in annual shareholder meetings.
  • Finally, investors’ assessments of corporate transition plans will rely on certification and verification by assurance providers and other private companies. This industry is set to expand, with the audit profession playing a more prominent role. Verification providers should be free of conflicts of interest and should deploy transparent models. The EU could design a relatively light-touch system of accreditation, as is already planned in support of the EU’s new green bond standard8.

The potential of the EU’s corporate bond market

If designed well, transition plans will underpin the further growth of green and transition finance. They will guide the design of bonds and loans that tie financial terms to climate outcomes.

In 2022, over 21 percent of European bond issuance was labelled as sustainable in some form. Within this total, sustainability-linked bonds, which reward issuers for achieving targets rather than spending on certain projects, have grown particularly strongly.

In 2022, about 200 EU companies issued such bonds for a total amount of €89 billion. Despite this rapid growth, the market for corporate bonds linked to climate outcomes is still quite immature. The European Securities and Markets Authority (ESMA, 2023) has shown that there has been a near-uniform bond contract structure and typically undemanding coupon step-up penalties, which were largely unrelated to the issuer’s credit risk.

Many of the performance targets set in corporate bond issues seem to have been unambitious, or have failed to capture relevant emissions. As it operates currently, the EU’s corporate bond market does not reward climate commitments sufficiently.

Once corporate transition plans become more transparent and credible, banks and bond investors will be in a position to fund companies that are committed to certain climate outcomes, and which can signal this commitment credibly.

This will not only channel additional finance to those companies fully engaged in the climate challenge, but will also exert a more meaningful discipline over the private-sector low-carbon transition than has been possible so far.

Endnotes

1. As in the European Union taxonomy for sustainable activities; see https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en

2. See https://www.transitionpathwayinitiative.org/

3. See https://commission.europa.eu/business-economy-euro/doing-business-eu/corporate-sustainability-due-diligence_en

4. See https://transitiontaskforce.net/workplan/

5. See https://www.meti.go.jp/english/press/2021/0507_001.html

6. For a discussion, see https://www.bruegel.org/event/corporate-disclosure-sustainability-risks-reconciling-international-and-eu-approaches

7. See https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/13128-Corporate-reporting-improving-its-quality-and-enforcement_en

8. See Council of the EU press release, ‘Sustainable finance: Provisional agreement reached on European green bonds’, 28 February 2023, https://www.consilium.europa.eu/en/press/press-releases/2023/02/28/sustainable-finance-provisional-agreement-reached-on-european-green-bonds/

References

CDP (2023) Are companies developing credible climate transition plans? CDP Worldwide.

EFRAG (2022) ESRS E1 Climate change, European Financial Reporting Advisory Group.

ESMA (2023) TRV Risk Monitor, ESMA Report on Trends, Risks and Vulnerabilities No. 1, 2023.

G20 Sustainable Finance Working Group (2022) 2022 G20 Sustainable finance report.

HM Government (2023) Mobilising Green Investment, 2023 Green Finance Strategy.

ISSB (2022) Exposure Draft, IFRS S2 Climate-related Disclosures, International Sustainability Standards Board.

OECD (2022) OECD Guidance on Transition Finance, Organisation for Economic Co-operation and Development.

Platform on Sustainable Finance (2022) The Extended Environmental Taxonomy.