1. What is Transition Finance?
There is currently no unified international definition of transition finance, but consensus has been reached on some basic elements. The Organisation for Economic Co-operation and Development (OECD) defines transition finance as "financial activities that provide financing to support economic entities in their transition towards sustainable development goals". The Group of Twenty (G20) defines it as "financial services that support the transition of the entire economy to low-carbon and net-zero emissions and climate resilience consistent with the goals of the Paris Agreement under the framework of sustainable development goals". The International Capital Market Association (ICMA) broadly defines transition finance as "financing programmes undertaken by issuers to support their climate change strategies".
2. Why is Transition Finance Needed?
The urgent need for transition finance stems from the challenges of global climate change. To achieve the goals of the Paris Agreement, the financial sector must fully support the low-carbon transition of high-emission industries; otherwise, the achievement of global climate goals may be jeopardized.
3. How Does Transition Finance Differ from Green Finance?
Green finance is mainly used to support investment and financing activities that already meet the defined standards of green finance, i.e., economic activities that are "purely green" or close to "purely green". In contrast, transition finance focuses more on providing financial support for the green and low-carbon transition of high-emission and high-pollution industries. In the medium to long term, the demand for financial services generated by low-carbon transition activities will exceed that for "purely green" financial services.
4. The G20 Transition Finance Framework
In November 2022, leaders of the Group of Twenty (G20) endorsed the 2022 G20 Sustainable Finance Report at the Bali Summit, which includes the G20 Transition Finance Framework. This framework marks the first time that the world’s major economies have reached international consensus on the development of transition finance, and it will guide regulatory authorities of all countries in formulating national policies on transition finance. The G20 Transition Finance Framework consists of five pillars: standards for defining transition activities and investments, information disclosure for transition activities and investments, transition finance instruments, incentive policies, and just transition.
5. The Five Pillars of the G20 Transition Finance Framework
Pillar 1: Definition Standards
The standards for defining transition activities and investments require clarifying what constitutes a transition activity to avoid "greenwashing in transition". There are two main approaches to defining transition activities: the classification catalogue approach and the guiding principles approach.
The classification catalogue approach is similar to green industry catalogues; for example, it lists ten high-carbon industries and their respective pathways to low-carbon and zero-carbon transition. China’s central bank is currently compiling transition catalogues for four sectors: coal-fired power, steel, building materials, and agriculture.
The guiding principles approach generally does not formulate specific lists of industrial transition pathways, but only sets out several basic conditions or principles that transition activities must meet. Activities that comply with these principles can be recognized as transition activities after assessment by third-party certification bodies.
Pillar 2: Information Disclosure
To ensure that the corporate entities or projects supported by transition finance continue to meet the requirements of carbon neutrality goals, achieve transition effects and preset transition targets, and prevent "greenwashing in transition", transition finance imposes scientific and relatively stringent information disclosure requirements on relevant financing entities. These requirements mainly include two aspects:
First, at the project level, transition finance should disclose the intended use and actual utilization of raised funds, as well as regularly disclose the transition (carbon emission reduction) benefits generated by the project and whether it meets the preset transition targets.
Second, at the corporate level, transition finance should disclose the enterprise’s transition targets (including quantitative short-, medium-, and long-term carbon emission targets) and plans (supporting policies), available historical carbon emission data of the enterprise, and regularly disclose the enterprise’s carbon emission performance and whether it has achieved the preset transition targets.
Pillar 3: Transition Finance Instruments
The biggest difference between transition finance products and traditional or green finance products is that transition finance products need to be designed with reward and penalty mechanisms linked to the transition performance of financing entities (enterprises or projects), thereby effectively incentivizing financing entities to meet or even exceed the agreed transition targets.
Since transition finance is still in its infancy, relevant products and instruments at home and abroad are not yet mature or scaled, mainly focusing on Sustainability-Linked Bonds (SLBs) and Sustainability-Linked Loans (SLLs). The 2022 G20 Sustainable Finance Report proposes that more types of financial instruments should be incorporated into transition finance in the future, especially equity-based, guarantee-based financing instruments and other risk mitigation tools.
Pillar 4: Incentive Policies
Many transition activities are characterized by high uncertainty and low or unstable expected returns, making it difficult to obtain sustained financing. Therefore, governments need to provide support at various levels.
In the financial field, support measures include drawing on the central bank’s current practice of providing low-cost funds to certain green industries through the Carbon Emission Reduction Support Tool, and local governments offering guarantees and interest subsidies for green projects.
In the non-financial field, measures include providing green electricity quotas for transitioning enterprises and land for constructing renewable energy facilities.
Pillar 5: Just Transition
The low-carbon transition to achieve carbon neutrality goals is a social transformation involving various stakeholders, with far-reaching impacts including employment in high-carbon industries, energy prices, inflation, income distribution, ecological environment, and biodiversity. Therefore, the transition finance system should incorporate mechanisms for assessing and addressing these potential impacts, minimize the negative effects of transition on other sustainable development goals, and realize a just transition for the whole society.
Specific measures may include: selecting key indicators related to just transition (most relevant to local conditions), such as the number of jobs affected, employee capacity-building activities, unemployment insurance, early retirement compensation, biodiversity assessment and protection, etc., incorporating these indicators into the information disclosure requirements for transition finance products, and linking them to reward and penalty mechanisms.
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