How sustainable finance can help decarbonize the real economy

The consensus among academics, industry bodies, governmental advisory panels and climate finance initiatives is that detailed sectoral transition pathways will be needed to foster credible, achievable and orderly transitions to net zero for each area of the economy.

The need for FIs to carry out sectoral analysis of transition pathways is well established, but some leading FI industry bodies are recommending that FIs go deeper in their analysis with a more detailed entity or activity level focus.

At EY, we believe this extra layer of detail will be necessary for FIs to confidently and successfully finance transitioning companies and projects. Understanding how the transition will be carried out at a sub-sector level — or even on a case-by-case or project-by-project basis — will enable FIs to standardize their clients’ and investees’ emissions reductions performance more precisely. This detailed knowledge will help FIs to identify opportunities as well as mitigate risks. 

To achieve this position, FIs will need to deepen their understanding about the operations and supply chains of their clients and their investees — and their knowledge about how those businesses are set to transition. As EY ASEAN financial services partner Wolfram Hedrich explained: “To really make this work, to turn this into a real opportunity and a competitive advantage for financial services they need to become transition experts on a very granular sectoral level.”

Critical information to understand each transition pathway will include:

• The timeline for the transition
• The key emissions reductions goals for each pathway
• The business strategy and operational adaptations needed to meet those emissions reductions goals
• Where capital will be needed to enable transitions: (e.g., for project finance, machinery and equipment upgrades, building and property upgrades, research and development spending, technological development, and so on)

Assessing businesses and their activities through this detailed lens will help FIs understand which sectors and companies will need more support in establishing their pathways to transition, which activities will need to be phased out and where opportunities for investment in transition-enabling projects and technologies may lie.

Lenders, insurers and asset managers who move at pace to develop detailed sector-by-sector knowledge will be able to capitalize on the opportunities early and identify growth areas.

There will, of course, be great variety between sectors and businesses across geographies as different countries around the world have determined their own transition timelines. There will be variation in the transition-readiness of businesses between emerging markets and more developed countries as well — particularly as many EMs have so far lacked the capital needed to pursue the transition. This differentiation will have an impact for FIs analyzing transition financing opportunities, in addition to sectoral concerns.

Similarly, emerging changes in societal behavior, from buying local and transport sharing, to reducing shipping demands and working from home, will have a material effect on the transition timelines of different sectors and businesses. These changing societal norms, which may bring about a more circular economy and disruption to traditional supply chains should be factored into analysis of pathways in all economies.

Some emerging economies are more vulnerable to climate-related risks such as desertification and extreme weather — many nations are already experiencing these effects. There is a real and urgent need to accelerate the transition to net zero to mitigate these risks, but the transition should also be framed as an opportunity. Increasing the supply of renewable energy will provide EMs with a reliable and cheap power supply. Some nations also stand to benefit considerably from the demand for the raw materials needed to manufacture new technology and components for renewables (e.g., lithium, nickel, cobalt).

The transition will be paced differently across sectors and markets and FIs will need to develop their understanding of these dynamics if they are to successfully navigate these changes.

To begin implementing confident, successful transition financing plans, FIs will need to develop sub-sector transition pathway knowledge. In this regard, there are numerous practical points for FIs to reflect upon.

Leading FIs have four key areas to consider, covered in the following chapters:

• Chapter 2 - Tailoring finance for individual pathways
• Chapter 3 - Credible analysis for credible transitions
• Chapter 4 - Transition leadership for financial services
• Chapter 5 - Embrace dialogue and communication

To increase flows of finance toward transitioning sub-sectors, companies and projects, FIs need to innovate and design individually tailored products and services to facilitate that financing on a case-by-case basis. There will be unique transition pathways for each sector of the economy, so transition financing tools need to be adapted for every sub-sector, or, indeed, for every individual entity or project that is seeking financing.

Different personas across financial services including banks, insurers and asset managers will all face distinct concerns and differing practical challenges when it comes to financing transitioning projects and companies, but for all of them there are some common themes. Designing a well-structured product or service that can best facilitate and incentivize the transition means thinking across the lifecycle of an investment or loan, or underwriting process to identify where these incentivizing drivers can be inserted.

We have established a framework that delineates the different stages of an investment or loan at which FIs decision-making can drive transition incentives:

The below industry examples illustrate three major transition pathways:

1. Shipping
2. Renewables
3. Electric vehicles

In each example, we will examine the unique challenges faced by FIs when considering how to approach each transition pathway, as well as the innovative solutions finance providers are using to overcome them.

Shipping

Renewable energy

Electric vehicles

As the examples in the chapter above make clear, a granular understanding of transition pathways will be needed for transition financing to be implemented successfully but FIs do not yet have enough reliable and comparable data to establish what a “credible transition” looks like.

There will be some key questions for FIs to answer around both the quantitative and qualitative data that will help them to understand transitions, says EY FSO Consulting Partner and EY EMEIA Climate Change Risk Pillar Lead Max Weber: “Do we have the information, the data to assess the project we want to finance or the companies we want to finance? Where are they on their transition pathway? Do we have the right information to rely on so we really finance transition projects and transition portfolios?”

To begin addressing these questions, FIs need to conduct their own analysis to assess the transition potential of their portfolios on a sub-sector basis. The goal of this assessment will be to understand:

• Which sectors and businesses will already be transitioning without intervention due to sector-wide emissions reductions targets set by government, policy and regulators
• Which sectors and businesses have transition plans in place
• Which sectors will require further support to reach a credible transition pathway

Assessing their portfolios through this lens will enable FIs to better understand the transition readiness of assets across their portfolios. FIs can pursue a passive transition strategy for their own portfolios, choosing to focus on clients and counterparties who are already committed to decarbonization and have transition plans in place, while divesting from companies that are unable or unwilling to transition at pace. 

However, a passive strategy is unlikely to be sufficient either for FIs to achieve their own transition goals, or for net-zero targets to be achieved. FIs pursuing an active transition strategy will need to work with clients and counterparties to incentivize decarbonization through their financing decisions.

This type of transition financing is still a relatively new area for many FIs. Institutions are beginning to innovate and develop financing mechanisms that will encourage more ambitious transitions. But there remain significant challenges for FIs when it comes to financing transitions, not least the lack of data. The number of companies that have publicly announced their commitments to the net-zero transition is growing, but there are still too few concrete transition examples from which FIs can draw insights or longitudinal data. According to banking firms surveyed by the Annual IIF/EY Global Risk Management Survey (pdf), 54% have only a “preliminary understanding of their climate risk exposure”, the proportion of banks with a “somewhat complete” understanding stands at 28%.

Large, publicly listed companies are carrying out disclosures according to recommendations by the Task Force on Climate-related Financial Disclosures (TCFD), thereby creating a data set for FIs to base decisions on, but this kind of data is not available for many other parts of the economy as EY EMEIA Strategy and Transactions Innovation Leader Christopher Schmitz explains: “For other clients that are not publicly listed like SME mid caps – which make up for a large part of a bank's portfolio so the credit side – there are no publication standards as of now.”

This data gap will persist for a few years while FIs work out what kinds of disclosures they need from their clients and counterparties, but the imperative of acting to mitigate climate change means transitions require financing now and FIs need to follow this active pathway and work with clients and counterparties to facilitate their transitions.

In order to get comfortable with transition financing while this data gap remains, FIs will need to establish their own frameworks to delineate what a “credible” transition plan looks like (via EY.com UK) when considering their financed emissions. 

There are useful assessment structures emerging that FIs will be able to draw on when making these judgements: in October 2021 the TCFD published guidance (PDF) on the “characteristics of effective transition plans,” outlining seven key steps for evaluating the credibility of transition plans. According to this guidance a plan should:

1. Be aligned with the businesses’ strategy and their strategy for achieving emission reduction goals
2. Have measurable, quantitative climate-related targets grounded in science
3. Outline the responsibility and oversight of senior management over the achievement of targets
4. Detail the specific actions and business developments the organization will undertake to meet their transition goals
5. Contain information about the organization’s current transition capabilities and planning, as well as the challenges (e.g., does the company participate in activities that are hard to abate?)
6. Be updated at regular intervals (at least every five years) to continue aligning with emissions reduction goals and current business strategy
7. Report progress annually to relevant stakeholders, or to the public

FIs working closely with their clients and counterparties will be best placed to gather this kind of detailed information. In turn, those FIs will be able to operate more effectively to help realize the potential of the transition. 

The senior leadership of FIs will play an important role in establishing portfolio-wide transition ambitions and strategy. That’s the message from EY Associate Partner for Climate Change and Sustainability Loree Gourley: “[The responsibility for] financing the transition to facilitate climate change and climate action in response to the crisis I think sits with the business leaders in the financial community,” she says. The board of an FI sets the agenda when it comes to climate action, they are in charge of overall risk management, strategy and policy — they are in a position to choose where their organization focuses its efforts for financing and which sectors, if any, it will pull away from.

FI leaders have the tools available to incentivize transitions — and disincentivize the continuation of carbon intensive activities. For example:

• A bank’s risk committee has oversight of the organization’s risk management policies. They would be responsible for monitoring climate-related risks including litigation risk, reputational risk, transition risk and the physical risks associated with climate change. Their assessment of the risks of continuing to finance high-emissions activities — as opposed to the risks associated with financing new types of transitions — will influence the bank’s lending choices.
• For asset managers and institutional investors, investment committees have overall responsibility for setting the organization’s investment strategy and aligning it with longer-term objectives, including climate-related targets. Asset managers and institutional investors which have made climate or other sustainability pledges will need to navigate the implementation of these across the whole portfolio. Emissions reductions goals should factor into the investment mandates and policies these committees set.
• FI boards can make net-zero goals a priority for their own executives and employees by incorporating interim emission reductions targets as a factor for deciding remuneration, incentivizing FI employees to devote attention to these goals as well as year-on-year financial returns. 

Communication and dialogue with clients and counterparties will be of huge importance throughout the transition process. “I think there's a significant learning curve — as well as dialogue — that needs to take place across the industry, both for FIs to communicate to their clients what their net-zero commitments are, but also for FIs to understand what their clients’ commitments are,” says Ryan Bohn, an EY senior manager in Sustainability, Climate Change and Risk.

There are three main points where dialogue will be essential:

• FIs must clearly communicate their own transition ambitions to the market.
• FIs should be working closely with clients and counterparties to understand the specifics of their transition pathways and the new developments coming on line which will support the transition (e.g., new technologies).
• FIs should be assisting clients and counterparties by sharing their own transition expertise about the transition.

This type of close engagement is already happening in the investment space. “Investors are very much coming from the perspective of stewardship and engaging with companies on their transition plans,” says Emelia Holdaway, Policy Programme Director at Institutional Investors Group on Climate Change (IIGCC).

To facilitate positive and productive engagement, FIs will need to invest in their personnel to develop climate-related expertise and skills. A well-trained workforce will be able to speak authoritatively about sub-sector transition pathways with their clients and counterparties and guide them confidently through the transition process. “Having the right people in place, training people properly and really building up those skills to approach this credibly — that’s going to be really important,” says Ella Sexton, an EY manager in Sustainable Finance.

In some cases, the demand for climate-focused skills will be met by investments in recruitment — some FIs are hiring climate scientists and battery technology experts for example. But in other cases, it will mean training existing employees to deploy new, climate-specific knowledge tailored closely to sub-sector transition pathways.

However, FIs should not lose sight of the sector-specific knowledge many of their analysts and relationship managers already have. Employees with deep knowledge of specific sub-sectors, their operations and their supply chains will be well-placed to advise and support clients as they progress along their individual transition pathways.

Thank you to Jane C. Lin, Partner/Principal, Business Development, Ernst & Young LLP United States,  for her contribution to this article.