The Intergovernmental Panel on Climate Change’s (IPCC) sixth assessment report (AR6), the first section of which was published in August 2021, presents a sobering assessment of the lagging efforts the world has taken to reduce GHG emissions.[1] The AR6 emphasises what the IPCC and climate scientists have been saying for many years, but with a renewed and startling sense of urgency. GHG emissions must decline rapidly and substantially in the coming years and decades to keep warming within the ambitious targets set out by the 2015 Paris Agreement, with a 45% decline in GHG emissions from 2010 to 2030 needed to limit warming to 1.5C.[2] A rapid transition to net zero emissions is therefore needed across the entire economy, with the energy sectors at the centre of the action.

Given the unprecedented scale of this challenge and the need to allocate significant capital to facilitate transformations in technology, infrastructure and industrial processes, investors and the financial sector at large have a critical role to play. Transition finance addresses this challenge by targeting companies and entities which have aligned their pathways with those established by the scientific community to achieve the targets set out in the Paris Agreement. As such, while the financial sector has faced growing calls to clean up its act and be a proactive part of the solution, the momentum behind transition finance will create new opportunities to achieve impact at scale.

In part, the challenge for investors seeking to support the transition will be to expand their efforts to accelerate decarbonisation across the entire economy, including the ‘hard to abate’ industrial sectors. Investors should therefore not be afraid to look for opportunities within high GHG emitting activities and sectors if in doing so they can help drive forward the transition of these sectors, achieving critical emissions reductions through investment in capital intensive infrastructure, equipment and processes, as well as research and innovation.

Impact bonds, transition finance and net zero transition

The impact bond market has played a central role in the effort to finance the transition over the past decade. This is evidenced by the market‘s growth over this period. Including labelled green, social and sustainability use of proceeds bonds, and more recently sustainability-linked bonds (SLBs), cumulative impact bond issuance now stands at over US$ 2.1 trillion.[3] What began with pioneering but limited issuance of green bonds from large institutions such as the World Bank and the European Investment Bank has grown to include sovereigns and corporate issuers from a multitude of sectors and geographies. The increase of sovereign issuers, including recent issuance from countries such as Spain, France, Italy and the United Kingdom has provided the impact bond market with greater depth and liquidity.

These market developments have also been accompanied by growing attention among investors to issuers’ decarbonisation targets and transition strategies. An emphasis on forward-looking transition targets and alignment with global warming scenarios has brought attention to and created opportunities for issuers from a wider range of sectors to attract capital for the development of sustainable projects and the alignment of business models with the 2050 target of net zero GHG emissions.

At Affirmative Investment Management (AIM), we have been actively managing impact bond portfolios since 2016 and have been engaged with issuers throughout this time. Given our focus on forward-looking impact, we include transition strategies and targets as an important part of our issuer analysis. We know that while some targets are ambitious, others are weak; while some strategies are credible, others appear little more than exercises in greenwashing. Investors require dedicated expertise to assess the credibility and ambition of an issuer’s stated plan and must demand reporting and assurance on an ongoing basis. External initiatives to assess alignment with warming scenarios, such as the Science-Based Targets Initiative and the Transition Pathway Initiative, are critically important tools which can provide greater levels of assurance and clarity. However, given that the criteria for assessing transition plans are inherently forward-looking and specific to sector and geography, expertise, deep analysis and ongoing engagement are critical. In short, companies and governments are assessed on where they are going, rather than (or in addition to) where they have been. Transition finance should therefore be considered as part of a journey and a partnership.

Economy-wide transition

Importantly, the transition to a low carbon economy encompasses all countries and sectors. Tackling climate change will mean critical investments to support the rapid expansion of high-profile and established solutions such as renewable energy and sustainable transport, but it will also mean leveraging energy procurement policies, supply chains, product design and industrial processes from a wide array of sectors. Understanding the differing opportunities and challenges across sectors is key to assessing ambition and the relative contribution of a given company or country. Furthermore, policymakers, companies and investors need to ensure that the transition is a just transition. This will mean addressing and managing the social and economic impacts of the energy transition, to ensure that it is linked with growth, jobs and support for affected communities.

The energy sectors, in particular the production and expansion of electricity, is a core focus for transition finance, given that the production of energy accounts for the bulk of emissions and has downstream effects on the ability of other sectors to decarbonise. The energy system needs to decarbonise rapidly through expansion of renewable energy capacity and the simultaneous decommissioning of fossil fuel assets. At the same time, utilities and grid operators will face the significant task of maintaining baseload and grid reliability, a critical challenge as energy demand grows in the coming decades, particularly within emerging markets.

In addition to the electricity sector, a group of critical industries often classed as ‘hard to abate’ will require increased attention and support. These sectors account for a growing share of global GHG emissions, yet still face significant technological, material and economic challenges to decarbonisation. Attention to these hard to abate sectors, including steel, cement, shipping and aviation among others, will require concerted effort and close attention to detail. Steel, for example, currently accounts for some 7-8% of global GHG emissions, and is a critical input across the economy, including for activities and products vital to decarbonising the energy system. Despite this sizeable GHG footprint and its function in the global economy, the industrial processes needed to decarbonise steel production remain in early stages of development or are still not economically viable on a scale sufficient to meet global demand.

Furthermore, many activities and sectors perform an important enabling role to support the transition within energy systems and other hard to abate sectors. The transition to clean, reliable energy and electricity grids will require innovation and increased production and efficiency in a host of activities and products, including manufacturing of wind turbines, solar PV equipment, electric vehicle components, industrial scale energy storage solutions, and green building materials, to name a few. Additionally, a wide range of products, services and systems will be crucial to making decarbonisation possible, for example products which facilitate digitalisation and the internet of things, and more efficient, reliable and expanded electrical grids.

Finally, investors should identify and support companies and entities which have proactively sought to align their business models and strategies with science-based pathways, whether through large scale renewable energy procurement initiatives, rigorous supply chain controls and standards and emphasis on promoting sustainable products and the circular economy. Ultimately, the transition will require the participation of all sectors, and identifying leaders across the economy who have aligned their processes and strategies with the broader goal of the net zero transition can provide an expansive and holistic approach to tackling the problem.

Companies and other entities leading the transition will require capital and support to innovate and implement solutions at scale. The growing number of issuers setting credible, ambitious and science-based targets has created new opportunities for investors, including through the purchase of general corporate purpose bonds, which will be essential given that transition strategies are in most cases implemented across the business model and value chain, rather than linked to specific assets or projects. By harnessing the momentum and significant opportunity of transition finance, investors can achieve large-scale, forward-looking impact and tap into the industries, technologies, and companies of the future. By employing a strategy of positive selection of issuers based on forward looking analysis, we believe we can support the transition in a substantial and long-term way, delivering impact together with mainstream returns.

Daniel Kricheff, Partner Sustainability