2.WHAT CONSTITUTES THE TRANSITION FINANCE LANDSCAPE?

“Transition finance” intends to allocate capital to companies and economic activities that are “becoming green” instead of allocating capital to companies that are already sustainable at this point in time (OECD, 2021). In other words, transition finance lies at the interface of transition activities and sustainable finance (WWF, 2021)

Over the past years, a packed transition finance landscape has emerged, ranging from voluntary sustainability labels to mandatory disclosure frameworks, targeting both companies and financial institutions. Figure 13 below attempts to summarise these relationships in a simplified way: Non-financial corporates are in a phase of sustainability transition and publish forward-looking information about their progress. Financial institutions – or more broadly, “investor activity” including retail investors – can access the disclosed information and can support transitioning activities by the two main channels of investor impact, i.e., capital allocation and engagement. Both the financial sector and the real economy are encompassed by the policy framework and private sector initiatives supporting the interplay between financialsector andrealeconomy. We thereforeidentify three main buildingblocks ofthe transition finance landscape: corporates, investor activity, and the (evolving) policy and disclosure framework, all supported by private sector initiatives

Building Block I – Non- financial Corporates: How to set up a target and a transition pathway?

Thenumberofcompaniesmakingcommitmentsandannouncingtargets to reachcarbonneutralityby2050 is steadily growing. In 2022, 3,152 listed firms of the MSCI ACWI Investable Market index, comprising around 9,000companies, had somedecarbonisation commitment,butonly 41of these commitments werecredible net-zero targets4 (MSCI, 2022). Additionally, the target setting process is often opaque, and first actions following an emission pathway and a financing plan are often missing. With the aim of bringing more structure, ambition and clarity into this, several public and private organisations (e.g., IPSF, ISO, ICMA, or the five “Hallmarks” of CBI; also see Annex 3) have developed guidance and recommendations for companies willing to transform their business model to a more sustainable one. Steps to develop credible transition pathways include: (1) to set Paris-aligned targets for scope 1, 2, and 3 emissions with a realistic and credible baseline considering the most appropriate level (e.g., entity, portfolio, or asset level), (2) to create a mitigation plan based on accounting standards5 , (3) to monitor and measure all implemented actions, and (4) to internally and externally report the progress according to sustainability reporting standards and have it verified by a third-party (CBI, 2021; ISO, 2022b).

The go-to source for companies to manage their climate transition is the Science-based Target Initiative (SBTi). The private initiative provides companies with a clearly-defined pathway to reduce GHG emissions in line with the Paris Agreement and offers methodologies for target setting and validation. At the time of writingthisreport,morethan4,500companiesaroundtheworldareworkingwithSBTi(SBTi,2022). Building on the momentum of the SBTi, the Science-Based Target Network (SBTN) equips companies and cities to set science-based targets for climate and nature aspects (SBTN, 2022).

Building Block II – Investor activity and their contribution to the transition

There are two main mechanisms of investor impact: capital allocation and shareholder engagement (e.g., Fama and French, 2007; Brest and Born, 2013, Koelbel et al, 2020; see also Figure 1)6

• Capital allocation may affect corporate activity by changing its costs of capital, thereby creating incentives to change the quality or quantity of its activity (Koelbel et al., 2020) For this mechanism to work, one needs to assume that investors can influence the asset prices, and therefore costs of capital,byachangeindemand(thinkaboutasufficientnumberofinvestors investingproportionally more into “Paris-aligned” companies).

• Investor engagement and stewardship. Investors can influence the strategic development of their portfolio companies by using their voting rights or engaging in a direct dialogue. More capital from retail investors can increase their influence.

Investors have already joined forces to collectively change investment patterns. Initiatives such as Climate Action 100+, for example, are engaging companies to improve climate-related financial disclosures and reducing GHG emissions However, investors can currently not unleash their full potential. If transition aspects were accurately priced in, companies without any decarbonisation strategy would be exposed to transition risks (e.g., have higher costs of capital) which would incentivise firms to follow a transition plan to improve their access to capital(OECD, 2021). However, transition risks arenotwell(enough)reflected yet sincedataavailabilityonforward-lookingaspectsisoftenseenaslimited(Bocquetetal.,2021)whichmakes

4 Crediblein termsofSBTi approved.

5 Examplesare theGHGProtocolCorporateAccountingandReportingStandard,ISO 14064-1:2018,or standardsfromthe InternationalSustainability StandardsBoard(ISSB) it difficult to differentiate between entities with and without a credible transition pathway7. Transparency thus plays a crucial role.

6 In this report, we disregard other potential channels and indirect impacts Other channels include indirect impacts defined as impact mechanisms where investor activities influence a third party, which in turn affects company activities (Koelbel et al, 2020) Another channel refers to “Impact investing” where investors allocate capital based on a stated theory of change. The investment strategy is chosen to achieve a positive impact. The addressed markets are often underserved or are characterised by market failure. This has, for example, been highlighted as a third channel of investor impact in the draft UK label criteria (FCA, 2022).

Building Block III – Policy and Disclosure regulations: Transparency as the foundation

Disclosureregulationsplayanimportantrolebyenhancingtransparencyforfinancialmarketsand byraising corporate awareness for the required transition, among others. However, many disclosure requirements focus on backward-looking data, barely including transition aspects (IPSF, 2021). This is slowly changing with an increasing number of jurisdictions addressing the disclosure of transition plans, investments into sustainable activities, etc. The EU’s Corporate Sustainability Disclosure Regulation (CSRD), for example, targets around 50,000 companies in the EU. The disclosure requirements go beyond existing frameworks and also ask for transition plans (see Annex 3 for an overview on transition aspects in disclosure frameworks).

Going beyond disclosure, investors need to identify investments that contribute to the sustainability transformation. More and more jurisdictions are introducing sustainable finance taxonomies, which are classification systems, i.e., a “common language”, to facilitate the identification of sustainable economic activities.As of today,29 government-ledsustainablefinancetaxonomies havealreadybeen adoptedor are currently in a developing or initiating phase (WWF, 2022). Some taxonomies also aim to classify transitional activities andconsider the transition dimension,for instance througha traffic lightapproach Besides these governmental efforts to balance risks and facilitate investments into the transition, non-governmental and private sector initiatives have also been working on these issues. For instance, the Transition Pathway Initiative (TPI) provides sectoral decarbonisation pathways to facilitate the sustainability assessment of investors (TPI, 2022), and the World Benchmarking Alliance (WBA) offers a tool to measure corporate progress against the climate targets (WBA, 2022).

7 If acompanyhas,for example,avalidatedtargetbytheScience-BasedTargetNetwork(SBTN),thetransition plan isalreadymorecredibleasthetarget is alignedwithscienceandbestpractices.Gettingatargetvalidatedby theSBTNalso requiresacertain timecommitment. Attheother extremeare companiesthatdeclareagoalof,for example,carbon neutralityby2050withoutanyinterimstepsor detailedplanning.More informationontargetsetting can befoundinChapter 2