Why is it not enough just to promote already green activities?

Despite two weeks of tough negotiations, the final declaration of the last UN climate summit in Sharm El-Sheikh in November 2022 (COP 27) offered little in the way of concrete action to reduce greenhouse gas emissions. Although the states gathered there reaffirmed the 1.5-degree target of the Paris Climate Agreement, they are very likely to miss it. And not only that: according to calculations by the Climate Action Tracker research group, the average global temperature is likely to rise by 2.4 degrees Celsius by 2100 on the basis of current pledges.

Putting the brakes on climate change in line with the Paris Climate Agreement thus requires immediate action and, above all, enormous investment. At the EU level alone, the European Commission estimates the need for additional investments to turn the European economy towards less carbon at 390 billion euros per year. However, it will not be enough to promote only what is already green today. All sectors of the economy need to become greener. This is especially true for sectors such as steel, cement and aluminium. But here, process-related emissions are considered "hard to abate" because the companies there either do not (yet) have the appropriate technology or the costs are very high.

How can Transition Finance help us achieve our climate goals?

This is exactly the point where "transition finance" comes into play. Instead of selectively assessing what is already sustainable today, Transition Finance is about building momentum towards greater sustainability. "Transition Finance thus enables a comprehensive view of entire economic sectors. More importantly, it involves companies that emit a lot of CO2 today and supports them in the sustainable transformation of their business models; all this on the basis of specific and scientifically sound transition plans. In this sense, transition finance is an essential tool within a broader toolbox for sustainable finance. This tool can and should be used to align our economic activities with the temperature target of the Paris Climate Agreement.

What is still missing from Transition Finance? 

Since transition finance is a process, it is not as easy to list criteria as is sometimes done for dark green activities. The definition of what constitutes suitable transition finance to become climate neutral depends, among other things, on which company and which location is involved, how the national framework conditions are designed, which geographical conditions exist and also at what point in time financing is to be provided. 

The lack of clarity in the definition can lead to financial market actors being unsettled and hesitant to provide necessary transitional financing in the first place. It is then unclear, for example, how a bank can assess whether and that a company is credibly aligning itself to achieve the temperature target of the Paris Agreement. The OECD's 2022 Transition Finance Industry Survey bears out this uncertainty, with 62 per cent of financial actors surveyed saying they had such concerns. There is thus a quick risk that institutions will face "green washing" accusations. 

Another challenge of transition finance is to avoid so-called lock-in effects for carbon-intensive technologies. Lock-in effects can result from investments in new, but still carbon-intensive industrial plants with long lifetimes. This is when these emit slightly less CO2 than existing plants, but remain running for a long time after installation, making new investments in cleaner technologies unprofitable in the long run.

Can the EU taxonomy help to advance transition finance?

To meet these challenges, we need a clear framework for transition finance. With the EU taxonomy, there is already a classification system for environmentally sustainable economic activities at the European level. However, the EU's efforts have so far focused primarily on promoting investments in economic sectors that are already considered "dark green". In its current design, the EU taxonomy thus has precisely the above-described shortcomings of not sufficiently reflecting dynamic transformation processes, let alone promoting them. Moreover, the taxonomy so far only represents a part of the overall economy. According to the EU Commission, about 40 percent of listed companies are currently covered by the taxonomy.

The EU Commission has therefore commissioned the "Platform on Sustainable Finance" to deal with an extension of the taxonomy in order to better reflect "transition finance". The final report of the platform has been available since March 2022. The Bankers Association has welcomed this initiative, but we consider the current status to be far too complex for practicable implementation. In particular, the envisaged dynamic further development and tightening of so-called technical screening and do-no-significant-harm criteria to classify economic activities as sustainable / non-sustainable would cause great uncertainties and expenses due to permanent adjustments of the taxonomy. This could make it increasingly unpredictable in the medium to long term which investments are still opportune from a sustainability point of view: Then even activities of companies that are clearly pushing ahead with their climate protection efforts risk falling back into the red category.

How can these challenges be overcome?   

Since "transition finance" depends strongly on the respective circumstances, the dynamic process towards more sustainability - keyword: Greening the Economy - should not be steered by a multitude of highly complex technical evaluation criteria. A principle-based approach is much more effective. This means that the basis for "transition finance" should be, for example, credible transition plans of companies. This is also the approach advocated by the Organisation for Economic Co-operation and Development (OECD) in its October 2022 report "OECD Guidance on Transition Finance". 

Instead of introducing four additional categories as proposed by the EU Commission's platform, a simpler and more practicable approach can then be adopted. It would suffice to create a list of activities that lead to exclusion because they are not transformable, in addition to the already existing "dark green" taxonomy: i.e. an "Always-Significant-Harmful category" - ASH category for short. This creates legal certainty for all parties involved. For all other activities that can neither be considered "dark green" nor fall into the ASH category, there is then the possibility and also the necessity for transformation towards more climate protection. Transformation financing should be oriented towards transition plans of companies, which in turn should be oriented towards sector-based and scientifically sound transformation pathways.

Outlook

Since the presentation of the Platform Report, the topic of transition finance still seems to have moved down the priority list of the EU Commission. However, the central importance of transition finance and the closing window of opportunity to combat climate change underline the need for much more speed. The EU Commission should make the development of a clear and manageable framework for Transition Finance a priority. We will only achieve a "Green Economy" by "Greening the Economy".