Climate change is a hard-hitting reality for all nations, irrespective of their development status, but it is hitting countries in the global south hardest. Developing countries must adapt to climate change while addressing negative social and economic externalities arising out of the energy transition.
Ceasing financing for carbon-intensive activities is critical to meeting net-zero targets but also risks impacting jobs and communities if it is not done with a systematic approach and careful planning. Adding to the Just Transition challenge, commercially viable low-carbon alternatives for hard-to-abate sectors are still not available globally.
As a result of this development and decarbonisation conundrum, transition finance has become an important aspect of sustainable finance discussions. Transition finance involves providing financial services and products to industries with high carbon emissions, such as steel, cement, chemicals and coal-fired power generation, to support their transition towards decarbonisation.
In the coming decades, developing economies are projected to lead global economic growth, with massive industrialisation in several high emission sectors. Investment in transitionary assets will help to ensure this growth is aligned with a low-carbon trajectory.
Transition finance in the G20
Transition finance has gained traction during recent G20 presidencies. The G20 Sustainable Finance Working Group’s (SFWG) roadmap on sustainable finance, which complements the international work on climate change, recognises the importance of integrating transition finance considerations in the overall sustainable finance strategy and approaches.
The Indonesian G20 presidency advanced this work by developing a set of 22 high-level principles for transition finance. The principles are divided among five pillars: identification of transition activities and investments, reporting, developing related finance instruments, designing policy measures and assessing and mitigating negative economic impact of transition activities and investments.
These pillars are intended as high-level guidance to help G20 countries tailor-make a specific transition finance framework within their jurisdictions and support a whole-of-economy transition. As a next step, developing countries need a practical and replicable framework that they can adopt as a starting point.
Extending the G20’s transition finance framework
India’s G20 presidency is an opportunity to assume a leading role in developing the transition finance framework, drawing on the SFWG's high-level principles and the experiences of other G20 nations.
To start with, the framework should have guidelines for issuance of transition finance instruments, such as sustainability linked bonds and transition bonds. For instance, Security and Exchange Board of India’s (SEBI) circular on green debt mentions that transition bond issuances should be aligned with India’s Nationally Determined Contributions (NDCs). However, there is also a need for a framework designed specifically for transition finance because of the inherent differences between green assets and those financed by transition debt.
The G20 could use the International Capital Market Association’s (ICMA) transition finance handbook as a guide. ICMA recommendations feature four key elements: climate transition strategy and governance, business model environmental materiality, science-based climate transition strategy, and implementation transparency. These elements are pivotal for developing a sound transition finance framework.
The transition finance framework should have detailed roadmaps of national-level transition pathways for all-hard-to-abate sectors, which are aligned with countries’ NDCs and net-zero ambitions. Japan's Basic Guidelines on Climate Transition Finance are an important development on this front. The guidelines include net-zero roadmaps for high-emitting sectors to help issuers prioritise projects for Japan's decarbonisation goals. The guidelines led to several issuances of transition bonds across sectors for the first time.
India is already developing an energy transition roadmap for the oil and gas sector, but the framework should also include other hard-to-abate sectors such as cement, steel and chemicals.
Additionally, the development of a carbon market regime linked to achievement of sectoral transition targets will clarify how such mechanisms can support energy transition across sectors. Carbon markets are in development in several G20 countries and are an essential tool for driving energy transition, especially in emerging markets.
In India, the Bureau of Energy Efficiency (BEE) has proposed a three-phase plan for its implementation of a carbon market. Linking implementation phases with achievement of sectoral transition targets will be useful.
The definition and verifiability of transition assets is another important aspect of SFWG's transition finance principles. The Indian G20 Presidency should seek guidance from the EU taxonomy’s transition activities definition in this regard.
The EU taxonomy outlines four conditions that need to be fulfilled before an asset can be considered environmentally sustainable under the taxonomy. The four conditions are that the asset’s emission reduction corresponds to best in the industry, does not hinder low-carbon development, prevents lock-in of carbon-intensive assets, and ensures credible pathways towards climate neutrality. This is an effective way to prevent greenwashing and could be an important guideline for a broad transition framework.
Lastly, highlighting how other developments align with the transition goals of a country will help provide a holistic picture to potential investors. From an Indian perspective, requiring business transition roadmaps as part of the business responsibility and sustainability reporting (BRSR) standards and aligning regulations for domestic financial institutions with the country’s energy transition goals are two examples.
Progress in all these areas will take longer than the duration of India's G20 presidency. However, India can establish a framework that outlines future advancements in all these areas and, more importantly, how they relate to one another in order to facilitate the flow of transition finance into the economy.
This article was first published in Outlook.