Financing Net Zero: How to incentivise credible climate action through sustainability-linked and transition finance (2024)

Financing Net Zero

The critical role of finance inenabling the Net Zero transitionis now universally recognised. The creation at COP26 of theGlasgow Financial Alliance on Net Zero(GFANZ), put the role of private finance in accelerating decarbonisation of the economy under the global spotlight. A year later at COP27, the international community called for multilateral development banks to reform their practices and priorities to support the Net Zero transition. Despite the struggle of GFANZ, and other collaborative finance industry initiatives, to maintain a committed membership base, there has undoubtedly been a seismic shift in the understanding of what is needed to finance Net Zero.While early approaches focussed on mobilisation of capital flows towards low carbon technologies, it is now recognised that the entire global financial system needs to rethink its responsibilities and restructure its incentives if a Net Zero economy is to be delivered.

A vital element of this system-wide reform is the ability of transition financing mechanisms to incentivise credible climate action. Definitions abound on what exactly constitutes transition finance. The Carbon Trust takes the view thattransition finance can be broadly defined as financing mechanisms designed to support high-emitting companies or sectors to deliver on long-term strategies to reduce their emissions.Transition finance can be either a constituent part or an overlay to the more general sustainability-linked bond archetype. As governments, cities and businesses around the world set Net Zero targets, how can we ensure the public and private financial investment they receive pushes them to make progress towards these all-important climate targets?

The booming market for sustainability-linked bonds is overlooking emissions reductions

Bonds are one of the principal ways state and non-state actors can raise funds to support their Net Zero transition, and the market is booming. According to Bloomberg andWorld Economic Forum, the global market for sustainability-linked bonds totalled just over US$21 bn in 2021, a huge uptick from $9 bn in 2020. However, not all sustainability-linked bonds are made equal, and few on the market currently provide a compelling incentive to deliver reductions in emissions. The ability of the bond to incentivise urgent and credible climate action is tied directly to the strength of its key performance indicators (KPIs). Weak metrics and targets can lead to limited climate impact, bringing with it associated risks of greenwashing in the bond market and across transition financing mechanisms more broadly.

Despite these clear risks, it remains uncommon for sustainability-linked bonds to set clear KPIs for emissions reductions – a critical action required to link Paris-aligned emissions reduction pathways directly with a financial imperative to deliver on them.Transition finance definitions and frameworks lack detail on whether and how to include emissions reductions KPIs. The International Capital Market Association’s (ICMA)Transition Finance Handbooksets out the importance of bond issuers having Paris-aligned short, medium and long-term organisational emissions reduction targets, but only offers guidance for ensuring transition bonds lead to material progress on these targets.

Three challenges of incentivising emissions reductions through financing mechanisms

To bridge this gap, the Carbon Trust has advised a range of clients and partners, including through our involvement with ICMA, on how to effectively incentivise emissions reductions in financing frameworks. Our recent work advising a number of bond issuers has revealed three key challenges with the process:


1. ALIGNMENT OF EMISSIONS REDUCTION KPIS WITH AN ORGANISATION’S SCIENCE-BASED TARGET

It is not yet common practice to tie sustainability-linked bonds to the issuer’s science-based emissions reduction targets (SBTs). Instead, what often happens is a business or public entity sets a Net Zero target, validates it through, for example, theScience Based Targets Initiativebut then fails to marry its financial incentives to delivering on this target.

The result is a financial commitment that is misaligned with an issuer’s SBT, thereby reducing the validity of both. Issuers who publicly commit to externally validated targets should, in theory, be willing to commit financially to those targets. Deviation from those targets when it comes to financing raises questions about what the organisation’s priorities really are and their commitment over the long-term.

2. ENSURING THE CREDIBILITY OF EMISSIONS INTENSITY TARGETS

A hot topic across the sustainable finance ecosystem is the use of emissions intensity targets (i.e. emissions per unit of business activity). The Carbon Trust’s assessment is that emissions intensity targets are only as robust as their metric. Poorly constructed or weak metrics are vulnerable to what the Carbon Trust calls “technical greenwashing,” where the bond issuers absolute emissions go up, but they still hit their intensity target because of a relatively greater change in the unit that emissions are measured against.

For example, a bond issuer with a target focused on emissions per full time employee (FTE) will hit this target after recruiting many new employees, despite a rise in absolute emissions. To assess sustainability performance more accurately, it is crucial to look at the marginal increase in emissions associated with each additional FTE. If the marginal increase is lower than the baseline emissions per FTE then the result is promising. However, intensity metrics and targets still present a challenge for investors looking for impact.

A secondary challenge is that intensity metrics may not stand the test of time as the pace of technological change accelerates. Continuing with the emissions per FTE example, if an issuer finds that new technologies can allow them to grow without increasing FTE headcounts, their emissions intensity would increase. Any emissions intensity KPI must be very carefully constructed to avoid greenwashing and unintended consequences.

3. REPORTING TRANSPARENTLY AND ROBUSTLY ON TRANSITION PERFORMANCE

The final challenge is on the procedural side. More often than not, the early stages of the transaction process don’t sufficiently consider emissions reporting requirements. KPIs and targets are being set without enough consideration of data availability, quality or calculation methodologies.

The popularity and demand for sustainable products has, it seems, led to some corner cutting, resulting in the necessary questions of how issuers and borrowers will report to investors being left too late. This disconnect between what is acceptable in the market, and what incentivises real climate leadership must be corrected if Net Zero is to be reached.

Three steps towards credible transition financing mechanisms

One of the great ironies of the sustainable finance ecosystem is that its ultimate aim is redundancy: to become so ubiquitous as to just become “finance”.In order to get there, best practice when setting bond KPIs needs to prevail. The challenges outlined above point towards some critical areas of focus:

1. ISSUERS AND BORROWERS, AS WELL AS THEIR ADVISORS, NEED TO ENSURE THAT EMISSIONS KPIS ARE ALIGNED TO THEIR SCIENCE-BASED TARGETS.

It is important to signal financial commitment towards delivering on a science-based target. Without aligning the two, organisations will end up holding themselves accountable to different targets in different ways. Chiming with the message ofrecent scrutinyof the Science Based Targets initiative, targets alone are not enough to deliver climate action. Wholesale shifts in an organisation’s planning and financing are required to deliver progress against this target. For bonds, the practical solution here is straightforward: any organisation with a science-based target should account for this in their debt financing.

2. AN EMISSIONS INTENSITY TARGET MUST ALWAYS BE ACCOMPANIED BY AN ABSOLUTE EMISSIONS REDUCTION TARGET.

By combining the two, issuers and borrowers can evidence credible sustainability performance, reveal where emissions reductions have been delivered and ensure transparency. Returning to our earlier example, an issuer or borrower could easily have an emissions per FTE target while also committing to limit the increase in absolute emissions associated with company growth. This doesn’t preclude growth, rather it tackles technical greenwashing at its heart. If it isn’t possible to set a robust emissions intensity target, it should be omitted from the bond terms.

3. ISSUERS AND BORROWERS NEED TO CONSIDER EMISSIONS DATA COLLECTION AND REPORTING METHODOLOGIES AT THE OUTSET OF THE TRANSACTION PROCESS.

Too often, issuers and borrowers address impact assessments and reporting too late and without the data needed to accurately communicate sustainability performance. This creates structural weakness across the sustainable finance space, limiting its potential to accelerate progress towards Net Zero. Ensuring frameworks pay adequate attention to how impact will be measured and reported on is a simple step. Better still are pre-issuance impact assessments that take a future facing view of the potential impact of achieving targets. Issuers already doing this are in rarefied air, but a pre-issuance impact report sets the tone early, enhances transparency and provides investors with critical information.

If the challenge of linking financial investment to emissions reduction performance can be met, the sustainable finance eco-system can demonstrate true credibility and play a significant role in the transition of high-emitting companies and sectors to Net Zero.

Finance is one of the five key system-wide enabling conditions of Net Zero. Read more about the enabling conditionshere.

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Financing Net Zero and Transition Finance

The article "Financing Net Zero: The critical role of finance in enabling the Net Zero transition" discusses the crucial role of finance in facilitating the transition to a Net Zero economy. It emphasizes the need for the global financial system to rethink its responsibilities and restructure its incentives to support a Net Zero economy. The creation of the Glasgow Financial Alliance on Net Zero (GFANZ) at COP26 and the call for multilateral development banks to reform their practices at COP27 highlight the increasing recognition of the importance of private finance in accelerating decarbonization.

The article also delves into the concept of transition finance, which involves financing mechanisms designed to support high-emitting companies or sectors in delivering long-term strategies to reduce their emissions. It discusses the challenges and importance of incentivizing credible climate action through transition financing mechanisms, particularly in the context of sustainability-linked bonds. The booming market for sustainability-linked bonds is examined, along with the need for robust key performance indicators (KPIs) to incentivize urgent and credible climate action.

Furthermore, the article outlines three key challenges in incentivizing emissions reductions through financing mechanisms, including the alignment of emissions reduction KPIs with an organization's science-based targets, ensuring the credibility of emissions intensity targets, and reporting transparently and robustly on transition performance.

The article concludes by proposing three steps towards credible transition financing mechanisms, emphasizing the importance of aligning emissions KPIs with science-based targets, combining emissions intensity targets with absolute emissions reduction targets, and considering emissions data collection and reporting methodologies at the outset of the transaction process .

Overall, the article provides a comprehensive overview of the critical role of finance in enabling the Net Zero transition and highlights the challenges and steps towards credible transition financing mechanisms.

I hope this overview provides a clear understanding of the concepts discussed in the article. If you have any specific questions or would like to delve deeper into any of these concepts, feel free to ask!

Financing Net Zero: How to incentivise credible climate action through sustainability-linked and transition finance (2024)

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