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FIs are working to develop approaches to transition finance that will allow them to support both new and existing clients’ transition journeys. However, FIs face their own internal obstacles, including:
- Operationalize the transition: pricing the transition into decision-making and incentive frameworks requires FIs to use multiple levers (including capital allocation, funds transfer pricing, emissions budgets and adjusted risk appetites) in order to develop a climate-adjusted view of economic profitability. However, this is a complex process given exposure to multiple sectors with differing transition pathways. Changes to internal incentive structures will be needed, requiring buy-in from the top and business unit heads.
- Engage with clients: FIs need to dial up engagement with their clients to assess their transition plans and provide tailored support where appropriate. Not only will this require significant investment and effort; firms may also need to make some difficult decisions over clients that are unable or unwilling to transition, despite support.
- Assess credibility: reviewing the alignment of their portfolios with 1.5°C pathways will be a key element of FIs’ net-zero journey. This is a challenging exercise, particularly when assessing the alignment of companies, or of assets that require managed phase-out. It’s made harder by the fact that many corporates haven’t yet disclosed their transition plans with sufficient transparency and detail.
- Consider suitable metrics: current metrics that focus on decreasing financed emissions to achieve portfolio decarbonization may not incentivize FIs to finance the transition of high-emitting entities or activities. However, it’s encouraging that portfolio alignment is considered as the leading indicator in the Science-Based Targets initiative’s (SBTi) latest guidance on the Financial Institutions Net-Zero (FINZ) Standard3 currently under development.
FIs also face many external challenges to engaging in the transition of capital and investment. This in turn, in many instances, has the effect of pushing up the cost of transition financing and depressing returns on investment. Key external challenges include:
- Political inertia: policymakers around the world are not generating the momentum required to unlock transition finance at the levels needed to make a 1.5˚C pathway attainable. This is illustrated by patchy national emissions targets, insufficient investment in accelerating technology development in certain sectors and the lack of mechanisms to generate a global carbon price.
- Framework limitations: inconsistent rules and standards contribute to the mispricing of climate risks and make it harder to intermediate supply and demand for transition finance. In addition, few current frameworks provide clear links between transition plans and taxonomies, mechanisms to prevent carbon lock-in, alignment with other sustainability goals, or proportionate treatment for small and medium-sized enterprises (SMEs) and companies operating in developing markets.4
- Investable pipeline: immature technologies and policies — and their impact on investment horizons and returns — impact FIs’ risk appetite and the availability of investable opportunities. For example, the long-term financing needs and uncertain returns associated with many early-stage low-carbon technologies may limit funding for areas with the most acute need of capital.
- Regional distortions: mobilizing finance in developing regions is often made hard by excessive costs of capital — even for green technologies like wind or solar that are more readily funded in mature markets. Political risks contribute, along with a lack of local financing capabilities — reducing investor appetite and creating a danger of continued fossil fuel dependency.