Transition finance, which used to facilitate the industrial transformation, now backs up the climate transition.
The article was originally published in chinese on July 26, 2021 in the PKU Financial Review
Author: WANG Yao
In September 2020, General Secretary Xi Jinping proposed the so-called “dual carbon” goal, which stipulates “China’s carbon dioxide emissions to peak by 2030 and for China to reach carbon neutrality by 2060” (often called also 3060 goals). Since then, authorities, enterprises and other parts of society have all embarked on a campaign to forge the path towards this goal. With it comes the rethinking of China’s economic development model in the new situation. Comparing to some developed countries who already achieved their carbon emissions peak, China is still at an early stage of its decarbonization process. The country’s social and economic development still largely relies on energy-intensive industries. To achieve green growth, more transformational efforts will be required in these sectors. However, some traditional carbon-intensive industries have faced difficulties during the green transformation and upgrading under the carbon neutrality goal. Those challenges, especially how related enterprises can get necessary financial support, deserve more thought, bringing transition finance on the agenda.
â… . The development of transition finance is of great significance under the “dual carbon” goal.
At the international level, the concept of Transition Finance has its broad and narrow definition. In 2019, Organization for Economic Cooperation and Development (OECD) put forward the general concept of “Transition Finance”, which refers to the financial activities that provide financing for economic agents and thus benefit their transition towards UN’s Sustainable Development Goals (SDGs). In a narrower sense, under the background of the global response to climate change, Transition Finance is defined as the financial support for the low-carbon transition of “brown industries” and carbon-intensive industries. In the Financing Credible Transition released in September 2020, Climate Bonds Initiative (CBI) emphasized that the concept of “transition” focuses on how to align the existing trajectory of greenhouse gas emissions with the goals and requirements of the Paris Agreement. and pointed out this is “climate mitigation transition”. The Climate Transition Finance Handbook published by International Capital Market Association (ICMA) in December 2020 is also concerned with “the climate-related transition”. The EU’s Platform on Sustainable Finance issued Transition Finance Report in March 2021, focusing on addressing climate change. In China, the People’s Bank of China is actively studying the relevant standards of transition finance to implement the 3060 goals better.. China accounts for about 28% of the world’s carbon emissions and faces considerable challenges in emission reduction work. However, the transition to low carbon is imperative, in which the transition finance plays a key role.
Transition finance provides financing channels for the realization of the “dual-carbon” goal.
The latest survey conducted by the International Institute of Green Finance (IIGF) shows that the financing needed to achieve China’s carbon peak by 2030 is significant. According to the conservative estimates, starting from 2021, the green investment demand in China will reach 14.2 trillion yuan.
Achieving the “dual-carbon” goal does not mean cutting the investment in carbon-intensive industries across the board.
On the one hand, green industries need a push to develop further; on the other hand, carbon-intensive industries require greater support for their low-carbon transition. The achievement of the “dual carbon” goal relies on the transformation and upgrading of industrial structures. The proposal of transition finance will help investors build a scientific understanding of this point and thus provide more sources of investment and financing for carbon-intensive industries, including coal, coal chemical industry, steel and cement.
Transition finance is a practical approach to support the greening of China’s energy structure. Carbon emission reduction and capture are two primary ways to realize the “dual carbon” goal, while the greening of industrial structure is the key to these two links. China has pledged to raise the proportion of its renewable energy in the primary energy consumption to 25% by 2025. By 2050 that figure is expected to rise to 75%. Today, however, the economy is still driven by the coal and coal power industry. In 2020, coal accounted for 56.8% of China’s domestic energy structure. In this context, it is not feasible to entirely abandon fossil fuels in one step.
Under current conditions, China needs a gradual energy transition through clean energy and green technologies. Transition finance will play a significant role in this process by guaranteeing the staged implementation of sustainable development and carbon reduction goals.
Transition finance is an essential supplement to the green financial system. Analysis of the progress and innovation aspects of the financial system shows the establishment of China’s green finance system provides a convenient channel for guiding funds towards green investments. However, the current system pays more attention to funding the “green” projects that meet the Green Industry Guidance Catalogue standards and other related catalogues. It has led to a lack of financial support to support the transformation of traditional carbon-intensive industries. Transition finance can channel funds to “brown” areas and high-carbon sectors such as coal, steel, and cement. On top of that, the implementation of transition finance puts forwards higher requirements on information disclosure and transition KPIs. Hence, it will guide and push the transformational development of “brown” areas and further accelerate realizing the “dual carbon” goal.
â…ˇ. Sustainability-Linked Bond is a typical practice of transition finance.
To strengthen the financial support for the low-carbon transition of traditional industries, on 28 April 2021, the National Association of Financial Market Institutional Investors (NAFMII) came out with the Sustainability-Linked Bond (SLB). Referring to the experience of The International Capital Market Association (ICMA), NAFMII successfully led market entities to issue the first SLB bonds.
SLB is one type of Bond that aims to support and encourage companies to contribute to sustainable development through debt financing. According to the definition by NAFMII, SLB is one type of debt financing instrument that provides financial support for enterprises through linking the bond terms to the issuer’s sustainable development goals. Unlike green bonds, SLB sets no limits on the use of proceeds. This feature effectively supports the sustainable transformation of carbon-intensive and high-pollution industries, such as coal power, steel, and cement. In this respect, it compensates for the limitation of green bonds to a certain extent.
Launching SLB has fully referenced and concluded Sustainability-Linked Bond Principles (SLBP) issued by ICMA. According to the SLBP model, the linked goal consists of two parts: including Key Performance Indicators (KPI) and Sustainability Performance Targets (SPT). The former indicates chosen goals, while the latter is the goal within a particular indicator (level of ambition). For instance, for an SLB, the KPI linked to the Bond could be “the scale of the new installed capacity”. And the SPT, which is used to measure the progress towards meeting the goal of this Bond, could be “the scale of the installed capacity will reach 400 MW by 2024”. If the bond issuer fails to meet any SPT of any KPI within the specified time, it will trigger adjustment of the bond terms. Since the linked goal is the key setting of SLB but the primary manifestation of the philosophy of transition finance, NAFMII also identifies the corresponding selection principles and basic requirements for formulating the linked goal.
SLB adopt strict information disclosure and third-party assessment requirements, which can strengthen the role of transition finance in target guidance. As an innovative step in promoting transition finance, NAFMII developed strict disclosure requirements for SLB issuers, requiring full disclosure of the bond-related information during the registration, issuance, and the duration of the Bond. Moreover, since issuers’ goal setting and performance need evaluation and verification from a third party, the disclosure also includes the rights, responsibilities, and obligations of both the issuer and the third party to safeguard the authenticity and validity of the information disclosed.
In addition, NAFMII has also imposed requirements on the third-party evaluation and verification content and on qualifications of the third-party evaluation agency to effectively constraint the bond issuers. In the pre-issuance evaluation and verification, the NAFMII requires an objective and fair selection of KPIs and SPTs, calculation methods and basis, baseline calculations, etc., to make the transition direction of enterprises correspond to the country’s development direction. It also asks the third party to evaluate and verify the SPT of bond issuers and issue a validation report at least once a year until the STP trigger event of the Bond has been reached. The effective participants and strict enforcement of the third party allow corresponding targets to be verified under more stringent technical norms and constraint frameworks. In the market-oriented promotion of transition finance, such a framework ensures its orderly and healthy development.
â…˘. Recommendations for the development of transition finance in China
1. Build and improve the standards of transition finance. SLB is China’s primary probe into transition finance. There will be more possibilities for the innovative development of transition finance in the financial field in the future. China can refer to EU’s practices and discussions in the transition finance and then formulate relevant standards. In the latest EU Taxonomy Climate Delegated Act, the reclassification of economic activities has been included in the mitigation category of the catalogue, ensuring the market’s support for transition activities when carrying out financial activities under the catalogue. People’s Bank of China is also actively studying the relevant standard of transition finance, recommending the formation of a scientific and clear support framework and providing the information disclosure requirement for standardized transition plans to ensure the effectiveness of transition finance standards contribute to China’s sustainable development.
2. Create diversified transition finance products. So far, SLB has been the most representative transition finance instrument. But other financial products, such as loans, funds, insurance and trust, can all support the development of transition finance. For example, a Sustainability-Linked Loan (SLL) is flexible in using funds and applicable to different industries. According to Bloomberg’s statistics, since the first SLL transaction was completed in 2017, its transaction volume has increased substantially, from the initial $5 billion to $140 billion in 2019. Although the volume was down in 2020, 41 SLL transactions have been completed globally in the first two months of 2021. In the past practices, GHG emissions, ESG evaluation, and energy use efficiency have all been used as the metrics for the sustainable development performance of borrowers. Not only does this provide opportunities for “brown” enterprises to get funds, but it also gives new impetus to the ESG governance and improved energy efficiency of energy.
3. Improve the market’s awareness and understanding of transition finance.
As the development of transition finance is not mature in China, enterprises and clients of the financial market entities still lack the understanding of this concept. Organizing influential courses, lectures, and symposiums to enhance the market’s knowledge of transition finance, support financial institutions to independently create asset portfolios for transition finance, and disclose the progress of current assets in climate transition to increase the market recognition of transition gradually. Aside from that, some market players believe that transition finance is designed to support “brown” assets. The emergence of such biased opinions means more publicity is needed to guide the market to correctly understand transition concepts and gradually form a consensus at home and abroad.
4. Ensure the information disclosure in transition finance and guarantee the responsible management of stakeholders.
Transition finance provides financial support for the low-carbon transition and sustainable development of enterprises. It is imperative to establish precise technical specifications, norms and constraint frameworks, such as low-carbon or sustainable development goals, the target realization path, examination, and evaluation indicators. Since products such as SLB only has constraints on the linked goals. Still, no special requirement on the use of funds, so it is essential to ensure the rational target setting and the accuracy and objectiveness of indicator calculation. As mentioned before, NAMFII has strictly requested information disclosure in the Bond’s registration, issuance, and duration. On this basis, it is advised to step up efforts in supervision to secure further the transparency and authenticity of the information provided. At the same time, there ought to be strict regulations regarding the external evaluation and verification work of bond issuance carried out by the third-party and certification agencies and relevant responsible personnel. Application of scientific accounting methods, accurate and transparent assessment process and precise responsibility-sharing mechanism can guarantee the credibility of the verification process.
5. Better reflect sustainable development goals in the design of transition finance products.
Green and low-carbon development has become a prior development direction in China, especially under the 3060 goals. ,. The launch of SLB develops new financing channels for the transformation and development of industries with high carbon intensity and significant environmental impacts, such as steel and coal. At the present stage, relevant subjects should actively use innovative tools, including SLB and SLL, and develop corresponding climate transition strategies for enterprises to support the realization of China’s carbon and overall environmental goals. In the future, with the increasing maturity of the market and financial products, other SDGs should be further included in the relevant targets to maximize the role of transition finance in promoting China’s sustainable development.
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