34 minute read 30 Nov 2021

How sustainable finance can help decarbonize the real economy

By Tom Groom

EY Global Client Service Partner

Corporate finance professional. Enjoys running. Father of three wonderful children.

34 minute read 30 Nov 2021

To fund the transition to a sustainable future, financial institutions need to deepen their knowledge of the businesses they finance.

In brief
  • Banks, asset managers and insurers have set out their net-zero goals. To meet them, FIs need to fund ambitious transition pathways.
  • FIs that develop granular knowledge of sub-sector transition pathways will be able to structure financing in ways that incentivize tangible climate action.
  • To position themselves successfully as transition finance providers, FIs will need to invest in a workforce skilled at analyzing sub-sector pathways.  

C OP26 will be remembered as the moment when finance moved to the forefront of the fight against climate change. Political surprises — ranging from the "phasing down" of coal to closer cooperation between the US and China — may have grabbed attention. But for the business community, it was finance that generated the headlines.

The global financial services industry has a critical role to play in achieving net zero targets by midcentury. Estimates for the investments required to transition the energy sector alone by 2050 range from between US$3.5 trillion (pdf) and US$5.8 trillion per year. At COP26, former Bank of England Governor Mark Carney announced that 450 major banks, asset managers and institutional investors representing up to US$130 trillion in assets have joined the Glasgow Financial Alliance for Net Zero (GFANZ), with a commitment to align their lending and investment portfolios to Paris Agreement climate goals.

Financial institutions (FIs) recognize that the transition to net zero will involve more than simply investments and underwriting for “green” assets and businesses such as renewables and electric vehicles. In order to achieve net zero across the whole economy, browner, more carbon intensive assets and companies will require financing to help them transition to green. For many businesses, the transition will mean a fundamental change to their operations — and to make those changes happen, they will need capital. Insurers, lenders and investors will play a crucial role in making that capital available and in incentivizing and supporting their clients and investees as they make their transitions.

As the IPCC’s sixth assessment report made abundantly clear earlier this year, rapid action is needed if we are to mitigate against the worst effects of climate change. The report reiterated the need to limit warming to below 1.5˚C and warned that despite these pledges, the IEA claimed that collectively they would only limit average temperature increases to 2.1˚C by the end of the century, which is not even in alignment with the lesser ambition of the Paris Agreement. The IEA’s estimates are optimistic. According to the UN’s latest annual Emissions Gap report, also published in October, climate commitments and plans from national governments are currently aligned with a 2.7˚C temperature increase.

New pledges made in Glasgow, if delivered, could take the world on a trajectory to 1.8˚C of warming at best. However, as stressed by the International Energy Agency (IEA) who analyzed the targets, implementing them will be key and is by no means a given. At a macro level, domestic implementation will mean increased disclosure and transparency requirements, greater scrutiny of targets and transition plans, and consolidation of sustainability reporting frameworks.

Risks and returns

The material risks of climate change — sea level rise, biodiversity loss, drought, wildfires, floods and loss of life — are themselves a compelling reason to act on the transition. To act on climate change is to act in the interests of people and the planet. But as well as their duties to society, FIs are ultimately structured around financial returns. They have a fiduciary duty to identify and protect their shareholders from foreseeable risks that might affect those returns. Failing to act on climate change would increase those risks substantially — and could reduce global annual economic output by $23 trillion by mid-century, according to research by SwissRe. As Emma Herd, EY Oceania Partner for Climate Change and Sustainability Services explains, “the core obligation [of financial services] is to respond to market information and to manage risk and to lean into economic trends, and climate change and sustainability is the biggest economic trend of this century.”

But the transition to net zero will not merely be about risk mitigation, it will also represent a tremendous opportunity for FIs. John Kerry, the U.S. Special Presidential Envoy for Climate, has called the energy transition “a vast commercial opportunity as well as a planetary imperative.” Furthermore, the transition to a low-carbon economy is projected to aid economic growth. A joint analysis by the International Energy Agency and the International Monetary Fund estimates investments in the clean energy transition will add an extra 0.4% to global GDP each year. Under a net-zero pathway, global GDP would be 4% higher by 2030 as compared to other models.

FIs acting early on the transition will be able to take advantage of this global economic opportunity first and they will be paving the way to a more profitable future. But to really grasp this transition opportunity with both hands, EY believes that FIs need to focus on a series of practical steps across the lifecycle of an investment, loan or underwriting process that will enable FIs to better evaluate transition plans at a sector and sub-sector level.

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Chapter 1

The approach

To advance net-zero goals, FIs need to develop a deeper understanding of sub-sector transition pathways.

The consensus among academics, industry bodies, governmental advisory panels and climate finance initiatives is that detailed sectoral transition pathways will be needed to foster credible, achievable and orderly transitions to net zero for each area of the economy.

  • Sectoral Decarbonization Approach (SDA)

    The Science Based Targets Initiative (SBTI), a coalition of CDP, the WWF and the World Resources Institute, developed the SDA (pdf) in 2015. The SBTI describes the approach as a “scientifically-informed method for companies to set GHG reduction targets” aimed at keeping temperature rise below 2˚C. The SDA encouraged the development of sectoral carbon budgets and greenhouse gas emission reduction pathways.

  • The EU taxonomy

    The European Commission’s taxonomy for sustainable activities outlines economic sectors and activities that are considered sustainable as well as prioritizing decarbonization for those sectors responsible for the majority of greenhouse gas emissions. The taxonomy attempts to define what counts as a “substantial contribution” to emissions reductions. In its 2021 report (pdf), the EU’s Platform for Sustainable Finance suggested evaluating economic activities in a focused way. The report recommended that those supporting transition financing should consider using the taxonomy’s evaluation criteria to establish transition pathways and to evaluate the environmental performance of “specific economic activities.” The report also discussed how companies can make use of sectoral decarbonization pathways “to clarify how their own transition is consistent with the transition required at sectoral level and demonstrate robustness.”

  • The Transition Pathway Initiative (TPI)

    The TPI’s benchmarking tool outlines sectoral carbon performance measures for 16 sectors of the economy, focusing on sectors with the highest global greenhouse gas emissions. In their latest report (pdf) on the State of the Transition, the TPI stated that: “We take a sector-by-sector approach, recognizing that different sectors of the economy face different challenges arising from the low-carbon transition, including where emissions are concentrated in the value chain and how costly it is to reduce emissions.”

  • The Climate Bonds Initiative

    A recent white paper on Financing Credible Transitions offers a framework to categorize transition pathways on an entity level (i.e., does the business as a whole have a credible transition plan?) and on an activity level (i.e., does a given activity by a business support the transition to net zero? Is there at present a credible path to reduce emissions for the activity? Could there be a path to reduce emissions in the future e.g., with investment in new technology?)

  • The UK’s Climate Change Committee (UKCCC)

    The Advisory Group on Finance for the UKCCC advises that (pdf) “clear pathways are needed for each sector of the economy with transparent expectations about policy, regulation and funding to provide investment clarity for companies and investors. A differentiated sectoral approach will also allow the identification of sector-specific barriers to the mobilization of capital, which can be overcome through financial innovation and policy.”

The need for FIs to carry out sectoral analysis of transition pathways is well established, but some leading FI industry bodies are recommending that FIs go deeper in their analysis with a more detailed entity or activity level focus.

At EY, we believe this extra layer of detail will be necessary for FIs to confidently and successfully finance transitioning companies and projects. Understanding how the transition will be carried out at a sub-sector level — or even on a case-by-case or project-by-project basis — will enable FIs to standardize their clients’ and investees’ emissions reductions performance more precisely. This detailed knowledge will help FIs to identify opportunities as well as mitigate risks. 

To achieve this position, FIs will need to deepen their understanding about the operations and supply chains of their clients and their investees — and their knowledge about how those businesses are set to transition. As EY ASEAN financial services partner Wolfram Hedrich explained: “To really make this work, to turn this into a real opportunity and a competitive advantage for financial services they need to become transition experts on a very granular sectoral level.”

Critical information to understand each transition pathway will include:

  • The timeline for the transition
  • The key emissions reductions goals for each pathway
  • The business strategy and operational adaptations needed to meet those emissions reductions goals
  • Where capital will be needed to enable transitions: (e.g., for project finance, machinery and equipment upgrades, building and property upgrades, research and development spending, technological development, and so on)

Assessing businesses and their activities through this detailed lens will help FIs understand which sectors and companies will need more support in establishing their pathways to transition, which activities will need to be phased out and where opportunities for investment in transition-enabling projects and technologies may lie.

Lenders, insurers and asset managers who move at pace to develop detailed sector-by-sector knowledge will be able to capitalize on the opportunities early and identify growth areas.

There will, of course, be great variety between sectors and businesses across geographies as different countries around the world have determined their own transition timelines. There will be variation in the transition-readiness of businesses between emerging markets and more developed countries as well — particularly as many EMs have so far lacked the capital needed to pursue the transition. This differentiation will have an impact for FIs analyzing transition financing opportunities, in addition to sectoral concerns.

Similarly, emerging changes in societal behavior, from buying local and transport sharing, to reducing shipping demands and working from home, will have a material effect on the transition timelines of different sectors and businesses. These changing societal norms, which may bring about a more circular economy and disruption to traditional supply chains should be factored into analysis of pathways in all economies.

Some emerging economies are more vulnerable to climate-related risks such as desertification and extreme weather — many nations are already experiencing these effects. There is a real and urgent need to accelerate the transition to net zero to mitigate these risks, but the transition should also be framed as an opportunity. Increasing the supply of renewable energy will provide EMs with a reliable and cheap power supply. Some nations also stand to benefit considerably from the demand for the raw materials needed to manufacture new technology and components for renewables (e.g., lithium, nickel, cobalt).

The transition will be paced differently across sectors and markets and FIs will need to develop their understanding of these dynamics if they are to successfully navigate these changes.

To begin implementing confident, successful transition financing plans, FIs will need to develop sub-sector transition pathway knowledge. In this regard, there are numerous practical points for FIs to reflect upon.

Leading FIs have four key areas to consider, covered in the following chapters:

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Chapter 2

Tailoring finance for individual pathways

With made-to-measure financing solutions, different sectors of the economy can achieve their transition goals.

To increase flows of finance toward transitioning sub-sectors, companies and projects, FIs need to innovate and design individually tailored products and services to facilitate that financing on a case-by-case basis. There will be unique transition pathways for each sector of the economy, so transition financing tools need to be adapted for every sub-sector, or, indeed, for every individual entity or project that is seeking financing.

Different personas across financial services including banks, insurers and asset managers will all face distinct concerns and differing practical challenges when it comes to financing transitioning projects and companies, but for all of them there are some common themes. Designing a well-structured product or service that can best facilitate and incentivize the transition means thinking across the lifecycle of an investment or loan, or underwriting process to identify where these incentivizing drivers can be inserted.

We have established a framework that delineates the different stages of an investment or loan at which FIs decision-making can drive transition incentives:

The below industry examples illustrate three major transition pathways:

  1. Shipping
  2. Renewables
  3. Electric vehicles

In each example, we will examine the unique challenges faced by FIs when considering how to approach each transition pathway, as well as the innovative solutions finance providers are using to overcome them.

Shipping

  • The pathway

    The sector-level transition pathway for shipping has been designed by the International Maritime Organization (IMO), a UN agency with responsibility for the safety and security of shipping and prevention of marine and atmospheric pollution by ships.

    The IMO first introduced measures to improve the energy efficiency and greenhouse gas emissions of ships in 2011 as part of the International Convention for the Prevention of Pollution from Ships. Since then the shipping industry’s transition pathway has developed in scope and ambition with initiatives to reduce the carbon intensity of new and existing vessels. 

    Important components of the transition pathway include:

    • Shipbuilding
      The Energy Efficiency Design Index (EEDI) was introduced in 2011. The regulation applied to new ships, requiring them to be 10% more efficient from 2015, 20% more efficient from 2020 and 30% more efficient from 2025. Since its introduction the EEDI has been developed to strengthen the requirements for certain types of ships as well as to better take vessel size into account.
    • Enhancement and modification
      The IMO’s Ship Energy Efficiency Management Plan (SEEMP) is an energy management plan that aims to optimize a ship or fleet’s operational and technical performance to best conserve energy for new and existing ships. It includes best practices for fuel efficient ship operation and improvements and modifications which will improve fuel efficiency (e.g. new propellers, incorporation of new technologies, introducing hybrid fuel approaches on existing vessels).
    • Use 
      In 2018 the IMO set its Greenhouse Gas Reduction Strategy with a goal to reduce the carbon intensity of shipping by 40% by 2030 compared to 2008 levels. The organization introduced a Carbon Intensity Indicator (CII) to rate ships against a 2019 reference line. A vessel is awarded a CII rating from A-E depending on how efficiently it transports goods or passengers and per nautical mile. Under IMO protocols established in 2021, ships scoring D for three years in a row or ships that score E will need to take actions to improve their energy efficiency performance.
      In the short to medium term, the shipping sector’s transition strategy is to reduce emissions using the measures above (better builds, modification of new and existing vessels and reductions in carbon intensity). New-build ships are beginning to use alternative fuels although this development is in its early stages. As of May 2021, only 12% of new builds on order are enabled for fuels other than diesel: 84% of them are still fossil fuels; either liquified natural gas or liquified petroleum gas. These fuels are viewed as a transition solution, other fuels will supersede these, over time.
      In the longer term, the industry’s net zero strategy relies on the use of alternative fuels, predominantly methanol and ammonia, as well as hydrogen, biodiesel and biogas. Battery technologies form part of the picture, particularly for short haul shipping, although batteries are unlikely to be suitable for deep sea shipping routes. 
  • The financing challenges

    For financial institutions, shipping’s transition pathway presents two major challenges:

    • Residual values
      Vessels prices have been, at the best of times, a relatively volatile asset class from a pricing perspective; the transition prices will add further factors into the mix when considering price, particularly residual values. The need for ships to meet energy efficiency measures will begin to have an impact on residual values, and as the next generations of ships come on line, there will be further changes. The nature of vessels coming through for secondary sale will change over time (in the immediate term, vessels modified for energy efficiency will be coming up for secondary sale, those will be superseded by EEDI defined vessels over the next 5-10 years, and then superseded by LNG.LPG vessels in 10-20 years times, with those ships being superseded by alternative fuel vessels thereafter).
      The problem
      During the transition period, there are projected to be numerous changes to vessel types in the shipping industry over a relatively short period of time. Those changes present a challenge for finance providers assessing the extent to which they will ascribe residual value for collateral purposes against loans. The uncertainty is also posing a risk appetite challenge for FIs, with those who have historically had an appetite to finance secondary purchases (a wider net of finance providers than those which fund new builds), distancing themselves even further from new build financing.
    • Structuring penalties and incentives
      The IMO’s Carbon Intensity Indicator (which reflects operational carbon emissions performance) provides a potentially useful metric against which to structure bond covenants or ratchets (with positive grading and preferential pricing for operating at an improved CII level or a penalty for failing to deliver CII improvement).
      The problem
      It appears that FIs and counterparties in the industry have so far been reluctant to innovate in this manner. As with any new development in financing, there are associated risks for finance providers. Industry participants seem to favor gathering data regarding carbon pricing (e.g., the price of offsetting different CII outcomes) before giving any specific CII based penalty or incentive.
  • How FIs can overcome these challenges

    • Collaboration
      Insurers and banks: While finance providers grapple with the pricing impact of operating vessels with different CII levels they could work with insurers to make CII compliant operations a prerequisite for underwriting and for financing — and thereby encourage more rapid improvements in CII levels.
    • Primary and secondary finance providers
      During the initial process of underwriting, primary and secondary finance providers could work together in order to give the primary finance provider a suitable "off-take" (a refinancing option from the secondary provider set out in indicative terms for a few years down the line) this would help to provide a refinancing, and with it a secondary ‘price floor’ thereby building confidence in the residual price of the asset.
    • Experimentation
      Start to set margin ratchet step-downs (even at modest basis points) based on the achievement of certain emissions-related KPIs or adherence to better performing CII levels — and margin ratchet increases if these KPIs are not met. Introducing new CII-based ratchets will help to incentivize positive performance by borrowers, although lenders will need to develop their knowledge about borrowers’ transition pathways and their skills to monitor and evaluate borrowers against these KPIs. Experimenting now with innovative financial instruments will help these structures become more of a market norm.

Renewable energy

  • The pathway

    The appetite for transition toward clean energy is huge — the IEA estimates $750 billion of investment in clean energy in 2021. Investments in renewables will need to increase substantially over time, the IEA’s 2021 global roadmap for Net Zero by 2050 estimates that investments in electricity generation and energy infrastructure will need to reach $2.5 trillion by 2030 to meet net-zero targets.

    Renewables projects requiring financing currently fall into three broad categories:

    1. Development — early stage formation of projects
    2. Traditional construction — typical risk factors include project risk and country risks as well as weather-related risks (i.e., evaluating wind speeds for wind farm projects and solar irradiation levels for solar power projects)
    3. Newer and innovative construction — for example, colocation of clean energy production and energy storage capabilities (i.e., battery storage) enabling a more consistent profile of energy sale even if the production is more volatile
  • The financing challenges

    • Power prices
      Typically, finance is structured around the cash flows associated with a project (e.g., the operations and maintenance contract, power purchase agreements and power prices in the open market). Outside of country risks, the main financing challenge relates to the fact that while a lot of costs are predictable, the income can be uncertain given the volatility of power prices.
      The following challenges emerge as a result of this volatility in liberalized power markets: i) forecasting power prices into the long term; ii) the impact of new construction (increasing supply) on power prices (“cannibalizing” existing pricing).
      Pricing uncertainty (“merchant risk”) is therefore factored in by lending banks. Typically FIs evaluating projects and companies in the renewables space will take a ‘baseline’ power price forecast and structure financing and underwriting based on low power price scenarios. Financial institutions have little incentive to consider/underwrite against other, more optimistic power price scenarios.
    • Resilience
      Any outage of a project clearly limits supply and revenues are also disrupted. The potential for outages further disturbs the certainty of cash flows. Climate change is increasing the likelihood and frequency of extreme weather events and therefore the potential for outages (e.g., extreme cold causing wind turbines to freeze, solar panels breaking with hail). A number of projects are looking to invest in resilience (giving a higher level of protection to their assets); however, this investment currently increases the cost profile and the benefit to cash flows is not necessarily seen commensurately by lending organizations to make this investment worthwhile.
    • Colocation
      Investing in energy storage colocation projects may help regulate the supply of clean energy, with the renewable power generation asset producing energy when the weather conditions prevail and storing that output to deploy when weather conditions are less favorable — but power is still in demand. Producers are also able to smooth pricing and sell stored energy onto the market at optimum points. These abilities will give renewables projects much higher certainty of cash flows — however, the nature of colocation projects presents some challenges for FIs. Many FIs will view a clean energy asset and a battery storage unit as two projects with separate risk profiles, each with their own uncertainty — rather than one set of complementary risks.
    • New technologies
      There are an increasing number of technologies emerging with high potential – including green hydrogen, green ammonia and others. However, technology risks and the lack of track record associated with new projects make securing finance a challenge for nascent technologies.
      The aggregation of risks (project, country, merchant, physical and technology risks) typically results in pricing of conventional bank funding that is beyond that which operators would commercially seek to secure, and the lack of viable finance inhibits new projects. 
  • How FIs can overcome these challenges

    A number of measures have already been taken to address the power price challenge – in particular to remove some of the pricing risk associated with power price fluctuations. These measures include entering into Contracts for Difference (CFDs) and engaging in longer term power purchase agreements with corporates (in turn, renewable providers are helping a range of corporations achieve RE100 status and with it their net zero or carbon neutrality aims). The lower pricing risk should help enable financing.

    A range of other innovations may also help provide cheaper financing:

    • Developing in-house power price view
      The discipline of power price forecasting is still improving and the data we have is from a relatively thin set of providers — establishing a broader panel of evidence, with a broader range of views will allow the responsible committees within FIs (e.g., credit committees) to better understand potential project outcomes and better discern whether to facilitate financing.
      FIs will also look to establish an in-house macro view on new power developments likely to impact power pricing forecasts (e.g., in the UK the time horizon for power production at Hinkley Point) as a basis for their decision-making.
    • Working across silos
      For colocation projects (see above), FIs that foster collaboration across teams will be better placed to assess aggregate risk and therefore enable financing for colocation projects.
    • Workforce skills
      FIs working with renewables providers should invest in talent and workforce skills across their relationship management and/or underwriting teams to ensure they have the capabilities needed to appropriately evaluate the merchant, physical and technology risks associated with renewables projects (as well as the project and country risks which have perhaps been the focus to date). 

Electric vehicles

  • The pathway

    Surface transport accounts for roughly 20% of global CO2 emissions. More than a dozen countries around the world have announced plans to phase out passenger vehicles powered by fossil fuels, some countries also have plans to ban the sale of new petrol and diesel HGVs. The electric vehicles (EV) market needs to develop in line with those transition goals, and producers of components for internal combustion engine (ICE) will need to plan for a future in which there is decreasing demand for their products.

    There are four key elements in the move to electrification:

    1. The battery ecosystem — Battery supply chains are becoming regionalized as EV battery manufacturing premises open in new jurisdictions. EV gigafactories will require upstream development of supply chains for the materials and minerals required for batteries and downstream development of recycling and reuse facilities.
    2. Fleet transition — Commercial and private vehicles fleets need to transition from conventionally fueled vehicles to EVs. Global initiatives such as the EV100, which seeks to encourage companies to transition their vehicle fleets and provide charging infrastructure for employees and customers will help to influence policy and increase demand for EVs, thereby accelerating change in the market.
    3. Infrastructure transition — Fleets transitioning to EV will need charging infrastructure available to them at sufficient scale and in the right locations.
    4. Supplier resilience through the transition — The move away from ICE vehicles presents risks for manufacturers across those supply chains. Those risks need to be managed to ensure that producers do not face “cliff edges” or risk becoming stranded assets. The requirements for components in EVs will remain the same for some suppliers (e.g., those making seats) but suppliers currently making components for ICE vehicles will need to pivot their production lines to make components suitable for EVs (e.g., different component shapes/sizes/purposes but same materials and processes). Some suppliers will no longer be relevant at all, particularly those making engine components (e.g., spark plug manufacturers). Only a small swing in demand from ICE to EVs will lead some traditional ICE suppliers to lose economic viability. Typical supplier production levels need to be 80%+ to break even meaning that we only need to observe a 20-30% swing toward EVs for some suppliers to go out of business (that swing is predicted to happen by 2024). 
  • The financing challenges

    • Residual values
      A secondary market for both EVs and the batteries inside them is not yet fully formed enough to give underwriters confidence — banks are therefore simply not willing to take on residual value risk. There are several factors that will determine residual value levels but the mechanisms through which these can be measured have not been determined. For example, the way a vehicle is used will have an impact on the life of the battery inside it, in particular the number of charges a battery undergoes, and the type of charge used (e.g., fast charge versus trickle charge) will influence battery life and therefore residual values.
    • Who owns the supplier resilience challenge?
      When suppliers fail in other industries OEMs may step in to rescue/finance them. However at the present time automotive OEMs are focusing their capital expenditure on the transition and do not have available funds to support failing suppliers. Governments may play a role in supporting suppliers; however, business failures may be seen as simply "the cost of transition." But ICE parts will still be needed until transitions are complete, so industry players will need some ICE suppliers to continue operating. FIs may be able to help ICE suppliers to consolidate to solve this challenge; however, consolidation efforts would require careful navigation from an antitrust perspective. Decommissioning finance is a tricky area for FIs, while an economic case can be made for it — especially as the “last man standing” in a given market can command higher prices during the wind down period — wind down risks are not easy for FIs to price attractively.
    • Reputation in sourcing and recycling
      Batteries require a range of minerals (e.g., nickel manganese cobalt, lithium) and the sourcing of those is a process that needs to be understood for it to be carried out safely and appropriately. The same goes for end-of-life recycling of batteries. Battery technology is changing all the time and keeping up with these shifts — and the impact new battery technologies have on recyclability — is difficult for finance providers to analyze. Understanding the evolution of raw materials pricing is also challenging for financing teams.
  • How FIs can overcome these challenges

    • Technology innovation to aid residual value (RV) assessments
      Telematics are already widely used in the insurance industry to understand use of vehicles. Telematics and internet of things (IOT) technologies could be deployed by finance providers to keep track of EV use and charging and to understand the impact of that use on the health of the battery. That data can be used to help structure covenants, or to underpin a guarantee around RV, or to underpin dynamic pricing.
    • Collaboration
      To solve the decommissioning and supplier resilience challenges noted above will require cooperation between big industry players, OEMs, governments and finance providers. FIs should seek to invest in their relationships with industry and with government to enable productive collaborations.
    • Workforce skills
      To keep abreast of the fast pace of change in the dynamic EV, battery and battery recycling landscape will require FIs to develop deep sector-specific knowledge among personnel who work on financing for the automotive industry.
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Chapter 3

Credible analysis for credible transitions

There’s a data gap when it comes to the transition. To overcome it, FIs need to be proactive.

As the examples in the chapter above make clear, a granular understanding of transition pathways will be needed for transition financing to be implemented successfully but FIs do not yet have enough reliable and comparable data to establish what a “credible transition” looks like.

There will be some key questions for FIs to answer around both the quantitative and qualitative data that will help them to understand transitions, says EY FSO Consulting Partner and EY EMEIA Climate Change Risk Pillar Lead Max Weber: “Do we have the information, the data to assess the project we want to finance or the companies we want to finance? Where are they on their transition pathway? Do we have the right information to rely on so we really finance transition projects and transition portfolios?”

To begin addressing these questions, FIs need to conduct their own analysis to assess the transition potential of their portfolios on a sub-sector basis. The goal of this assessment will be to understand:

  • Which sectors and businesses will already be transitioning without intervention due to sector-wide emissions reductions targets set by government, policy and regulators
  • Which sectors and businesses have transition plans in place
  • Which sectors will require further support to reach a credible transition pathway

Assessing their portfolios through this lens will enable FIs to better understand the transition readiness of assets across their portfolios. FIs can pursue a passive transition strategy for their own portfolios, choosing to focus on clients and counterparties who are already committed to decarbonization and have transition plans in place, while divesting from companies that are unable or unwilling to transition at pace. 

Understanding climate risk exposure

54%

of banking firms have only a “preliminary understanding"

28%

have a “somewhat complete” understanding

However, a passive strategy is unlikely to be sufficient either for FIs to achieve their own transition goals, or for net-zero targets to be achieved. FIs pursuing an active transition strategy will need to work with clients and counterparties to incentivize decarbonization through their financing decisions.

This type of transition financing is still a relatively new area for many FIs. Institutions are beginning to innovate and develop financing mechanisms that will encourage more ambitious transitions. But there remain significant challenges for FIs when it comes to financing transitions, not least the lack of data. The number of companies that have publicly announced their commitments to the net-zero transition is growing, but there are still too few concrete transition examples from which FIs can draw insights or longitudinal data. According to banking firms surveyed by the Annual IIF/EY Global Risk Management Survey (pdf), 54% have only a “preliminary understanding of their climate risk exposure”, the proportion of banks with a “somewhat complete” understanding stands at 28%.

Large, publicly listed companies are carrying out disclosures according to recommendations by the Task Force on Climate-related Financial Disclosures (TCFD), thereby creating a data set for FIs to base decisions on, but this kind of data is not available for many other parts of the economy as EY EMEIA Strategy and Transactions Innovation Leader Christopher Schmitz explains: “For other clients that are not publicly listed like SME mid caps – which make up for a large part of a bank's portfolio so the credit side – there are no publication standards as of now.”

This data gap will persist for a few years while FIs work out what kinds of disclosures they need from their clients and counterparties, but the imperative of acting to mitigate climate change means transitions require financing now and FIs need to follow this active pathway and work with clients and counterparties to facilitate their transitions.

In order to get comfortable with transition financing while this data gap remains, FIs will need to establish their own frameworks to delineate what a “credible” transition plan looks like (via EY.com UK) when considering their financed emissions. 

There are useful assessment structures emerging that FIs will be able to draw on when making these judgements: in October 2021 the TCFD published guidance (PDF) on the “characteristics of effective transition plans,” outlining seven key steps for evaluating the credibility of transition plans. According to this guidance a plan should:

  1. Be aligned with the businesses’ strategy and their strategy for achieving emission reduction goals
  2. Have measurable, quantitative climate-related targets grounded in science
  3. Outline the responsibility and oversight of senior management over the achievement of targets
  4. Detail the specific actions and business developments the organization will undertake to meet their transition goals
  5. Contain information about the organization’s current transition capabilities and planning, as well as the challenges (e.g., does the company participate in activities that are hard to abate?)
  6. Be updated at regular intervals (at least every five years) to continue aligning with emissions reduction goals and current business strategy
  7. Report progress annually to relevant stakeholders, or to the public

FIs working closely with their clients and counterparties will be best placed to gather this kind of detailed information. In turn, those FIs will be able to operate more effectively to help realize the potential of the transition. 

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Chapter 4

Transition leadership for financial services

C-suite executives and boards will determine FIs transition financing ambitions.

The senior leadership of FIs will play an important role in establishing portfolio-wide transition ambitions and strategy. That’s the message from EY Associate Partner for Climate Change and Sustainability Loree Gourley: “[The responsibility for] financing the transition to facilitate climate change and climate action in response to the crisis I think sits with the business leaders in the financial community,” she says. The board of an FI sets the agenda when it comes to climate action, they are in charge of overall risk management, strategy and policy — they are in a position to choose where their organization focuses its efforts for financing and which sectors, if any, it will pull away from.

FI leaders have the tools available to incentivize transitions — and disincentivize the continuation of carbon intensive activities. For example:

  • A bank’s risk committee has oversight of the organization’s risk management policies. They would be responsible for monitoring climate-related risks including litigation risk, reputational risk, transition risk and the physical risks associated with climate change. Their assessment of the risks of continuing to finance high-emissions activities — as opposed to the risks associated with financing new types of transitions — will influence the bank’s lending choices.
  • For asset managers and institutional investors, investment committees have overall responsibility for setting the organization’s investment strategy and aligning it with longer-term objectives, including climate-related targets. Asset managers and institutional investors which have made climate or other sustainability pledges will need to navigate the implementation of these across the whole portfolio. Emissions reductions goals should factor into the investment mandates and policies these committees set.
  • FI boards can make net-zero goals a priority for their own executives and employees by incorporating interim emission reductions targets as a factor for deciding remuneration, incentivizing FI employees to devote attention to these goals as well as year-on-year financial returns. 
Father and daughter hiking
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5

Chapter 5

Embrace dialogue and communication

Collaborative relationships will be critical to realizing the full potential of transition financing.

Communication and dialogue with clients and counterparties will be of huge importance throughout the transition process. “I think there's a significant learning curve — as well as dialogue — that needs to take place across the industry, both for FIs to communicate to their clients what their net-zero commitments are, but also for FIs to understand what their clients’ commitments are,” says Ryan Bohn, an EY senior manager in Sustainability, Climate Change and Risk.

There are three main points where dialogue will be essential:

  • FIs must clearly communicate their own transition ambitions to the market.
  • FIs should be working closely with clients and counterparties to understand the specifics of their transition pathways and the new developments coming on line which will support the transition (e.g., new technologies).
  • FIs should be assisting clients and counterparties by sharing their own transition expertise about the transition.

This type of close engagement is already happening in the investment space. “Investors are very much coming from the perspective of stewardship and engaging with companies on their transition plans,” says Emelia Holdaway, Policy Programme Director at Institutional Investors Group on Climate Change (IIGCC).

To facilitate positive and productive engagement, FIs will need to invest in their personnel to develop climate-related expertise and skills. A well-trained workforce will be able to speak authoritatively about sub-sector transition pathways with their clients and counterparties and guide them confidently through the transition process. “Having the right people in place, training people properly and really building up those skills to approach this credibly — that’s going to be really important,” says Ella Sexton, an EY manager in Sustainable Finance.

In some cases, the demand for climate-focused skills will be met by investments in recruitment — some FIs are hiring climate scientists and battery technology experts for example. But in other cases, it will mean training existing employees to deploy new, climate-specific knowledge tailored closely to sub-sector transition pathways.

However, FIs should not lose sight of the sector-specific knowledge many of their analysts and relationship managers already have. Employees with deep knowledge of specific sub-sectors, their operations and their supply chains will be well-placed to advise and support clients as they progress along their individual transition pathways.

Thank you to Jane C. Lin, Partner/Principal, Business Development, Ernst & Young LLP United States,  for her contribution to this article.

Summary

The COP26 process highlighted the need for action from finance providers, not only to decarbonize their own balance sheets but also to help businesses in the real economy decarbonize. The net-zero transition presents a challenge — it is a new area of financing for many banks, asset managers and insurers. But there are a series of steps finance providers can take to establish transition financing expertise — and identify opportunities. Developing deep sub-sector knowledge about transition pathways and investing in a transition-skilled workforce will be the key to success. 

About this article

By Tom Groom

EY Global Client Service Partner

Corporate finance professional. Enjoys running. Father of three wonderful children.