Abstract

We introduce a new definition of transition finance that overcomes the drawbacks of existing definitions and, with an emphasis on energy, we discuss the need for substitutability of investments in terms of GHG emissions. We also present worldwide statistics, an overview the types of investors and investees, and the cost of capital. The paper concludes with a taxonomy of investor engagement based on regulatory strength. In a nutshell, the stronger the regulation in terms of reporting, verification, and decarbonisation pathways, the lesser the engagement needed from private investors. We suggest using the EU Emission Trading System as a benchmark of good regulatory strength towards achieving the goals of the Paris Agreement.

Executive summary

As part of our commitment to advancing finance and sustainability, the Center for Sustainable Finance at Vlerick Business School has developed this white paper with the support of AG Insurance. This paper focuses on the critical role of transition finance in promoting the global shift to a low-carbon economy, particularly in the energy sector.

An estimated USD 9 to 10 trillion is required annually from now until 2050 for high-carbon sectors to achieve net-zero emissions and prevent economic and social losses projected to reach USD 1,266 trillion by the end of the century [1]. These figures underscore the high cost of inaction.

Transition finance will be a central topic at the upcoming COP29 in Baku, Azerbaijan, which highlights its crucial role in the global climate strategy. In 2022, for the first time since the 2014 report, the Intergovernmental Panel on Climate Change (IPCC) revisited investment and finance requirements to address climate change mitigation efforts, thus updating its perspectives and recommendations in its Sixth Assessment Report: Mitigation of Climate Change.

Key findings

We provide a new definition of transition finance, explain how it fits within the broader concept of sustainable finance, and distinguish it from green finance. We also explore the concepts of complementarity and substitutability and the need for credible decarbonisation plans to attract investment in a world with growing energy demands.

In addition, we highlight the opportunities and challenges of effectively mobilising capital towards low-carbon activities and the influence of policy and regulatory frameworks. We also analyse regional and sectoral differences in transition finance, distinguishing developed from emerging markets. The risk of greenwashing is addressed, emphasising the need for a just transition, and we examine the types of investors and investments required, along with their cost of capital.

Proposal

The role of institutional capital is underscored in steering the strategic direction of companies towards sustainable practices. Through investor engagement case studies, we showcase corporations leading in transition finance while also addressing the limitations of current approaches. We call for credible decarbonisation pathways, with deliverables and targets that are monitored, reported, and verified.

Finally, we develop a classification of investor engagement as a function of the regulatory strength towards the transition. We introduce the concepts of weak, semi-strong, and strong engagement, depending on whether regulations force investees to report and decarbonise according to Paris-aligned pathways. The EU Emission Trading System provides a good benchmark on robust regulatory strength and a roadmap for transition investments in weaker regulatory sectors and jurisdictions.

1.   Introduction

Transition finance is essential for shifting from high-carbon to low-carbon activities to achieve net-zero greenhouse gas emissions. Key organisations such as the OECD, the European Commission, and the UN Sustainable Finance Hub emphasise the importance of strategic investments and regulations to support this energy transition.

For high-carbon sectors to achieve the Paris Agreement’s goals requires around USD 9 trillion annually between now and 2030 and over USD 10 trillion per year from 2031 to 2050 [1]. These figures underscore the critical role of financial tools and instruments, as well as regulation, in creating a sustainable energy future.

While different institutions have their own definitions of transition finance, they agree on its crucial role in supporting global climate goals. There is consensus that inaction will increase the difficulty and cost of maintaining the 1.5°C temperature threshold. A cumulative investment of USD 266 trillion in climate finance from now until 2050 is essential to prevent economic and social losses estimated at USD 1,266 trillion by the century’s end under a business-as-usual scenario [1].

Transition finance includes financial products and services that help carbon-intensive industries reduce emissions, which involves investments in energy efficiency, renewable energy, and other innovative technologies. The International Energy Agency (IEA) estimates that about 70% of the global climate finance required will be sourced from the private sector, which focuses on improving efficiencies and implementing and expanding technological innovations.

This white paper seeks to shed light on transition finance. Sections 1 and 2 focus on what transition finance is and what it is not. Section 3 provides statistics on transition finance. Sections 4 and 5 explain the types of investors and investments needed for the transition, while section 6 provides an overview on their cost of capital. Section 7 analyses the limits of transition finance, and section 8 concludes with a proposal for institutional investors considering investments in transition finance in Europe.

2.   What is transition finance?

Transition finance is a pivotal concept in sustainable finance. It aims to facilitate the transition from high-carbon to low-carbon activities to achieve net-zero greenhouse gas emissions. Despite the lack of a common taxonomy, trusted sources highlight the importance of transition finance in tackling climate change, especially in supporting the shift to sustainable practices in the energy sector.

The European Commission acknowledges that transition finance is vital for ensuring financial flows that support climate resilience and sustainability; the EC also emphasises the need for clear guidelines and strong regulations to direct investments effectively [2]. Meanwhile, the UN Sustainable Finance Hub views transition finance as part of a broader effort to achieve Sustainable Development Goals (SDGs) and integrate environmental, social, and governance (ESG) factors into financial decisions [3].

The Financial Times, on the other hand, defines transition finance’s role more practically as an enabler of carbon-heavy sectors in cutting emissions and encouraging innovation in carbon reduction while allowing asset owners to participate in the world’s adaptation to net-zero profitably [4]. A recent publication underscores the fact that financial institutions are crucial in providing the necessary funds for the green transition. It claims that asset owners are in a unique position. They have the capital and influence to help the world transform. By allocating capital to the transition, they can help mitigate climate change while profitably participating in the adaptation of businesses and sectors on the path to net-zero [4].

Using various sources, we have built on the definition of the finance discipline to provide a clear understanding of transition finance for this white paper. Here, transition finance refers to the long-term management of money, credits, and investments by corporations and governments to phase out greenhouse gas (GHG) emissions in accordance with the Intergovernmental Panel on Climate Change (IPCC) conclusions.

The definition is divided into two parts: the first is about finance and the second is about transition. The first part expands upon the OECD’s focus on finance raised or used by corporations to meet net-zero goals by incorporating the role of governments. The second part is science-based, as it adheres to decarbonisation pathways outlined in the IPCC’s Sixth Assessment Report. This part emphasises that reductions of GHG emissions are absolute, as opposed to relative and/or netted. It also highlights that transition finance is long-term – and, therefore, it is particularly well suited for investors with a long horizon, as explained below in more detail.

Typically, transition finance targets high-emitting sectors (AFOLU[1], transport, industry and energy), aiding their shift to low-carbon technologies and sustainable practices. This approach leverages financial instruments to mobilise private sector investment, and it involves establishing regulatory frameworks to ensure that funds are allocated efficiently and transparently. Furthermore, it underscores the importance of policies that promote fairness and inclusion, aiming to achieve a just transition that supports all stakeholders.

Globally, various factors – such as Nationally Determined Contributions (NDCs) under the Paris Agreement, sectoral roadmaps, and guidelines from organisations like the International Capital Market Association (ICMA) and the Climate Bonds Initiative (CBI) – play a crucial role in enabling transition finance.

In Europe, the EU Green Deal is delivering a set of enablers through the EU Sustainable Finance Framework to pave the way for financing sustainable growth while transitioning to a climate-neutral and resource-efficient economy. The cornerstone of this framework is the EU taxonomy –a classification system that defines criteria for economic activities aligned with a net-zero trajectory by 2050. In line with the EU Taxonomy are the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD), which are aimed at helping investors and companies plan and report their sustainability efforts.

In addition, this framework includes tools – such as the EU Climate Benchmarks Regulation and the European Green Bond Standard (EuGB) – that enable companies and public entities to raise money for green investments in capital markets while meeting sustainability requirements, shifting to a low-carbon economy, and offering opportunities for innovation in finance.

Definitions of Transition Finance

Enablers of Transition Finance

3.   What does not qualify as transition finance?

In section 1, we discussed how transition finance fits within the broader concept of sustainable finance. In this section, we aim to provide further understanding of transition finance by distinguishing its investment rationale from other forms of environmental (green) finance. This understanding is made in the context of energy.

Transition finance targets the replacement of high carbon-emitting activities. In contrast, green finance prioritises investments in already environmentally-friendly activities, such as clean and renewable technologies, natural resource-based sustainable economies, and climate-smart blue economies [9].

Effective decarbonisation of the entire global economy will require much more than green finance [10]. Transition finance, therefore, addresses the investment gap created by green finance’s sole focus on purely environmentally-friendly activities, as it seeks to effectively transform existing high-carbon emitters, such as steel and cement, in their journey towards net-zero emissions [10] as the global energy demand continues to grow.

Furthermore, the International Energy Agency’s (IEA) Renewables 2023 report [11] highlights the roles of both renewable energy and fossil fuels in achieving net-zero emissions. While renewable energy is crucial for this goal, the transition must be managed carefully to ensure energy security and economic stability. Therefore, understanding how renewable energy and fossil fuels can work together – referred to as their complementarity and substitutability –  is crucial.

Complementarity: Renewable energy and fossil fuels can coexist during a transition period that is as short as possible, with renewable energy gradually taking a larger share of the energy mix. Transition finance plays a crucial role in supporting the scaling up of renewable energy projects, while also facilitating the reduction of fossil fuel emissions with technological updates.

Substitutability: As renewable technologies advance and become more cost-competitive, they will increasingly substitute for fossil fuels. Transition finance is critical in this phase, providing the necessary capital to decommission fossil fuel assets and invest in renewable infrastructure. Internal funding plays a pivotal role in facilitating the transition from high-carbon to low-carbon investments. For instance, revenue generated from high-carbon sources can be redirected to support investments in low-carbon stocks.

In addition to internal funding from net receipts of fossil fuels to finance substitutability that allows for future sustainable-steady income, several other options are available for attracting external funding for the transition, as explained in the following sections.

A Growing Demand for Energy

As mentioned above, a crucial point to emphasise is that transition finance in the energy sector should help replace high-carbon energy. Even though low-carbon energy adoption is growing at a faster pace, high-carbon energy use is also increasing. Therefore, in practice, low-carbon energy is simply adding to high-carbon energy and not replacing it – and this is the key problem to address in the path to achieving net-zero by 2050.

A recent report by the Energy Institute highlights this issue. In 2023, greenhouse gas emissions from energy reached a record high. Energy emissions increased by 2%, exceeding 40 gigatonnes of CO₂ for the first time​ [12]​. This increase was due to the ongoing high demand for fossil fuels, which still make up most of the global energy mix. Global energy use rose by 2% to 620 exajoules, with fossil fuels accounting for 81.5% of this total​ [12]​.

Based on information extracted from Our World in Data, the figures below confirm IEA’s report by showing the energy globally and for selected countries[3] in terms of primary energy consumption over time.

The figures also show the urgent need for transition finance to do more than support renewable energy growth. It must also reduce dependence on fossil fuels. Transition finance should fund the closure of fossil fuel plants and the build-up of renewable energy facilities in order to ensure that low-carbon energy truly replaces high-carbon energy.

An Effective Transition

Transition finance also needs to consider the dangers of speculation, greenwashing (especially in high carbon-emitting sectors), and an unjust transition:

Speculation: As mentioned in the previous section, transition finance is long-term. Therefore, speculative investments are not transition finance. Investments in transition finance in line with the IPCC conclusions require decarbonisation pathways that are achieved over the long-term.

Risk of Greenwashing: Transition finance provides a pathway for high-carbon emitting sectors to demonstrate their commitment to moving away from carbon-intensive practices, thereby enhancing their credibility and avoiding accusations of greenwashing [13]. An example of greenwashing would be Chevron’s 2021 plan to invest $750 million in renewables and offsets by 2028 and capture 5 million tonnes of CO₂ per year, which contrasts sharply with its $13.5 billion budget in 2020, of which 81% was spent on fossil fuel extraction and production [14] [15]. This disparity creates a perception of greenwashing, especially if the company’s transition plan lacks clear targets and milestones.

Just Transition Lens: Transition finance advocates for a just transition, integrating climate goals with human rights and social considerations when deciding on financial flows [16]. This approach ensures that the transition to a low-carbon economy is fair and inclusive. Lithium mining in the Uyuni salt flat in Bolivia is a case in point, illustrating the complex dynamics between local communities that depend on tourism and salt production, and Bolivia’s potential to emerge as a major player in the global lithium market [17]. With a poverty rate of 36.4% in 2021, Bolivia is tasked with finding a balance between environmental protection and economic development, as well as job creation in the electric vehicle industry [18].

4.   Statistics: investment opportunities and challenges

This section explores the current statistics of the global energy transition, focusing on the opportunities and challenges for capital providers. Understanding these factors is essential in identifying gaps, seizing opportunities, and planning effective investments in clean energy.

Regional View

The global energy transition presents various investment opportunities across different regions. As stated earlier in this paper, from now until 2050, USD 9 to 10 trillion is required annually for high-carbon sectors to achieve net-zero emissions. The G7 countries, with their robust financial markets and access to capital, will receive a significant portion of this investment, even though emerging markets and developing economies (EMDEs) collectively account for almost two-thirds of the world’s carbon emissions. As the world’s largest emitter, China alone produces more emissions than all of the G7 countries combined [19]. Despite their significant share of global emissions, EMDEs face substantial challenges in securing the necessary funds for the energy transition, in which transition finance is critically needed. According to the International Monetary Fund (IMF) in its Global Financial Stability Report of October 2023, climate mitigation investment needs in EMDEs are projected to increase to $2 trillion by 2030 and grow to about 40% of global mitigation investment needs [19].

Asia – particularly China and India – is expected to be a major player in the renewable energy sector. China alone is projected to account for nearly half of the global renewable capacity growth by 2030, while India aims to reach 450 GW of renewable capacity by the same year, offering significant investment opportunities [19].

Africa has vast potential for renewable energy, particularly solar power, but requires substantial infrastructure and grid development investments. The African Development Bank has identified $20 billion in investment opportunities through the Desert to Power initiative, which aims to harness solar energy across the Sahel region [19].

Latin America is emerging as a hub for renewable energy investments, with Brazil and Chile leading in solar and wind energy projects. The region’s abundant natural resources and favourable policy frameworks provide a supportive environment for clean energy investments. It is projected to account for nearly 40% of the USD 20 billion investment in biofuels and biogases by 2030, with Brazil being the second-largest market for transport biofuels globally after the US [19].

The Middle East is gradually shifting its focus towards green energy investments, which are projected to increase to account for around 15% of the region’s energy investments by 2024, and rising significantly by the end of the decade. The UAE and Oman have set ambitious targets to reach net-zero emissions by 2050, while Saudi Arabia is aiming to achieve this by 2060. Nonetheless, the Saudi Green Initiative is leading the way in the region. This initiative aims to develop substantial solar energy projects, targeting 50% of electricity production from renewables by 2030. Saudi Arabia plans to add 5 to 7 GW of solar capacity annually, including significant projects like the Sudair solar plant, which has a planned capacity of 1.5 GW [19].

Sectoral View/Energy

The IMF estimates that capital allocation to the energy sector for the transition will represent about 60% to 70% of total global transition investment needs. This institution also highlights the private sector’s importance and potential investment opportunities in focusing on energy investments in EMDEs, where the share of global emissions and the average cost of emissions avoidance are roughly half that of advanced economies. By 2030, it is estimated that private finance will need to cover about 80% of the climate mitigation investment needs in EMDEs. Excluding China, this share rises to about 90%.

According to the IEA, clean energy investments in EMDEs must increase from around USD 150 billion in 2020 to over USD 1 trillion annually by 2030 to meet climate goals [19]. Furthermore, the Energy Transitions Commission reports that energy companies are gradually reallocating capital towards low-carbon technologies, with oil and gas companies planning to increase their clean energy investments to 4-6% of their capital expenditures by 2025, which remains modest compared to the required scale of investments [20].

Sources of Financing

While corporations represent a critical source of available funding to decarbonise their operations and value chains, the primary sources of financing for the energy transition include institutional investors, governments, international development finance institutions, and private-sector investments.

In developed economies, institutional investors (such as pension funds, insurers, and sovereign wealth funds) are significant contributors due to regulatory pressures and increased awareness of climate risks. According to White & Case[4], 40% of energy companies expect to access private equity funding by 2024, 32% will use their existing balance sheets, 29% plan to raise new financing through equity capital markets, and 20% will utilise debt capital markets [21]. Additionally, green bond issuance surpassed USD 500 billion in 2021, which indicates substantial private-sector investment [21].

In emerging markets, international development institutions – such as multilateral development banks (MDBs) and development finance institutions (DFIs) – contribute about USD 20 billion annually to clean energy projects [19]. However, this amount needs significant scaling to bridge the investment gap. MDB commitments to clean energy projects have more than doubled recently, with nearly half going to transport and substantial amounts to renewables and energy efficiency. Despite this growth, current funding levels are insufficient to meet the broader financial needs required for a full transition to clean energy in these regions. Likewise, climate finance for developing economies grew to nearly USD 80 billion in 2018, yet this sum represents less than one-fifth of the clean energy investments that are required by 2030 [19].

Challenges

The transition to net-zero presents significant opportunities but also poses substantial challenges. On the one hand, capital providers aim to capitalise on the investment opportunities offered by the transition to net-zero by setting ambitious targets that align with global energy transition goals. For example, the Net-Zero Banking Alliance includes banks committed to aligning their lending and investment portfolios with net-zero emissions by 2050, with interim targets for 2030 and annual progress reports. This alliance represents over 40% of global banking assets, totalling USD 60 trillion [22].

Conversely, in developed economies, the energy transition sector faces several challenges in deal-making, including regulatory uncertainties, high upfront costs, and the perceived risks associated with new technologies. Regulatory instability creates uncertainty, making it difficult for investors to plan and commit funds. For example, in the United States, despite the optimism generated by the Inflation Reduction Act – which allocates over USD 300 billion to climate and energy – significant updates to existing regulations are needed to remove hurdles to investment [21]. Additionally, 39% of the respondents in a survey identified regulatory risk as a major barrier to their M&A strategies [21].

In emerging markets, for example, the high cost of capital associated with renewable energy projects can deter investment. According to the IEA, financing costs in emerging markets can be significantly higher, ranging up to 700-1500 basis points above the levels in advanced economies, and they can represent up to 20-30% of total project costs, making it crucial to develop innovative financing solutions to reduce these costs and attract more private capital [19].

The challenges vary significantly between developed countries and EMDEs. A more comprehensive list of challenges is provided in the following table, based on analyses from the IEA’s World Energy Outlook 2023, the IMF’s 2023 Global Financial Stability report, and the 2024 Geneva Association’s reports on climate technology:

In addition, the following table provides a summary of the key statistics of this section:

5.   Types of investors and investees

Public and Private Sector Collaboration

Three-quarters of global energy investments today are funded from private and commercial sources (private enterprises, households, and financial institutions), and therefore around 25% of investments come from public finances [23].

In developed economies, public-private collaboration is crucial for advancing energy transitions. For instance, in Germany, total energy investment in 2023 amounted to USD 60 billion. The private sector plays a significant role in financing this transition, with nearly 60% of investment growth attributed to household investments, driven by policies supporting rooftop solar, energy efficiency in buildings, and electric vehicles. The German government has also contributed through subsidies and tax incentives to encourage private investment​ [23].

Similarly, in the United States, investments in clean energy are estimated to exceed USD 300 billion in 2024, representing a 1.6-fold increase compared to 2020 levels. This substantial growth is driven by private and commercial sources, further supported by federal and state incentives [23].

In the EU, InvestEU is a European Union initiative that aims to drive sustainable development, job creation, and economic growth across Europe from 2021 to 2027. By providing an EU budget guarantee, it seeks to mobilise over EUR 372 billion in investments in both public and private investment, focusing on projects that align with EU policy priorities and facilitating Public-Private Partnerships (PPPs). The program focuses on areas such as innovation, renewable energy, sustainable food production, and digital transformation, supporting the European Green Deal and other strategic initiatives [24].

In emerging markets, governments are leading the transition to net-zero by providing long-term capital and encouraging innovation and new financing methods. For example, Chile issued the world’s first sovereign sustainability-linked bond in 2022. This bond is linked to specific sustainability goals in Chile’s NDCs and aims to reduce greenhouse gas emissions and increase electricity generation from Non-Conventional Renewable Energy (NCRE) sources [19]. At the sub-national level, initiatives in Gujarat, India, show how local governments can promote the adoption of clean energy. By simplifying processes, timely delivery of subsidies, and launching information campaigns, they offer a model for local governance to support transition finance [25].

However, attracting international investors in emerging market economies is challenging because many lack investment-grade credit ratings, which are often preferred by institutional investors like pension funds and insurance companies [19]. Additionally, few investors are willing to take on the higher risks in these countries, including political, social, economic, credit, and currency risks. Credit rating agencies play a significant role in determining the cost of capital for projects, which influences the success of transition initiatives [19].

EMDEs often borrow from local or foreign markets to finance clean energy initiatives, which was relatively easy until March 2022. Since then, the Federal Reserve Board (FED) raised interest rates quickly to combat inflation, which has been worsened by the Russian-Ukrainian war. Each rate hike by the FED has increased interest rates in emerging markets, raising the cost of servicing debt and putting pressure on their balance of payments. This situation weakens local currencies, increases taxes, and raises inflation rates, causing governments to prioritise spending and often neglect environmental transition initiatives [26].

Types of Investors and Investees

Effective financing for climate initiatives requires a diverse array of investors and investees. Private sector contributions are crucial in both developed economies and emerging markets, especially for the energy sector. In 2023, private finance sources accounted for 73% of total spending in developed economies [23]. Meanwhile, 80-90% of climate investment funding in emerging markets is expected to come from the private sector [19]. Multilateral Development Banks (MDBs) and public sector initiatives also play vital roles by mobilising funds and creating supportive environments for sustainable projects in EMDEs [19].

It is essential to point out that sovereign governments can act as both investors and investees in the context of financing clean energy transitions. As investors, they provide funding through public sources such as sovereign wealth funds and national development banks. These entities play crucial roles in mobilising capital for large-scale projects and ensuring financial stability in the energy sector [19]. As investees, governments can issue financial instruments like green bonds to attract investment for national sustainability projects​ [19].

The following is a non-exhaustive list of investors and investees for the IEA’s report on Financing Clean Energy Transitions 2021 [19].

Investors

1. Institutional Investors: These include pension funds, insurance companies, and sovereign wealth funds, among others. They manage large pools of capital and are increasingly aligning their investment strategies with ESG criteria.
2. Multilateral Development Banks (MDBs): Organisations like the World Bank and regional development banks like the European Investment Bank (EIB) offer financing and risk mitigation tools to support large-scale sustainable projects.
3. Corporate Investors: Many corporations invest in sustainability initiatives to align with their corporate social responsibility (CSR) goals and reduce their carbon footprints.
4. State-Owned Enterprises (SOEs): Particularly influential in emerging markets, SOEs drive national energy policies and are often leading investors in large-scale renewable energy projects.
5. Private Equity Funds: These funds invest in companies and projects with high growth potential, focusing on renewable energy and other sustainable technologies.
6. Commercial Banks: Banks provide project-level market rate lending and equity financing, particularly for large-scale projects and in collaboration with other financial entities.
7. Venture Capitalists: These entities invest in early-stage companies developing innovative climate solutions, providing essential funding for research and development​.
8. Development Finance Institutions (DFIs): These institutions provide funding and support for development projects, often focusing on sustainability and clean energy​.
9. Blended Finance Initiatives: By combining public and private funds, these initiatives play a critical role in de-risking investments in high-risk areas, enabling projects that might otherwise be financially unfeasible.
10. Philanthropic Organisations and Foundations: Although smaller in terms of financial scale, these entities play a pivotal role in funding research, pilot projects, and early-stage initiatives, particularly in underserved regions or sectors.
11. Local Financial Institutions: These institutions are important for financing SMEs and local projects, especially in developing regions where they better understand the local context and risks.

Investees

1. Large Energy Corporates and Oil Majors: These entities are transitioning to include more renewable energy in their portfolios, leveraging their scale and resources to impact global energy markets​.
2. Renewable Energy Companies: Firms that develop and operate wind, solar, and other renewable energy projects are primary recipients of climate finance.
3. Industrial Companies: These firms in sectors like steel, cement, and chemicals are major contributors to emissions. Investments aimed at improving their energy efficiency and reducing emissions have a significant impact on overall transition efforts.
4. Sustainable Infrastructure Projects: Large-scale projects, including green buildings and sustainable transportation systems, receive funding from institutional investors and MDBs.
5. Green Technology Startups: Companies focused on innovative solutions such as electric vehicle infrastructure, energy storage, and carbon capture technologies attract significant venture capital and private equity investments.
6. Energy Service Companies (ESCOs): Companies that provide energy solutions, particularly in energy efficiency and renewable energy integration, are critical investees in regions looking to modernise their energy infrastructure.
7. Off-Grid Energy Solutions Providers: Companies that offer decentralised energy solutions, such as solar home systems and mini-grids, are vital for extending access to energy in remote areas​.
8. Agricultural Enterprises: Businesses adopting sustainable farming practices or developing technologies to reduce agricultural emissions are increasingly targeted for investment.
9. Local Governments and Municipalities: These entities often receive funding for community-based sustainability projects, such as clean water initiatives and waste management systems.
10. Small and Medium Enterprises (SMEs): SMEs involved in green projects or technologies receive support from various financial institutions and initiatives.

6.   Types of investments

Transition finance encompasses various types of investments, each serving distinct purposes in facilitating the transition to a low-carbon economy. In addition to engagement, these include bonds, equity investments, and project financing.

Bonds

Green bonds and sustainability-linked bonds play a crucial role in raising capital for environmental projects. They offer fixed-income securities to finance both new and existing projects with environmental benefits. In 2022, the global volume of green and sustainability-linked bonds exceeded USD 650 billion [31]. However, the majority of these issuances occur in advanced economies. A few emerging markets – such as South Africa, Brazil, and the Philippines – make notable contributions but collectively account for only approximately 10% of the global issuance of clean energy-related sustainable debt [19].

A notable example in the green bond sector is South Africa, which is one of the leading emerging economies. This leadership is attributed to its developed financial markets, which see frequent bond issuances. South Africa was one of the first emerging economies to issue green bonds, initially issuing USD 143 million in 2014 to fund clean infrastructure projects in Johannesburg. By 2022, cumulative green bond issuance in South Africa had grown to USD 3 billion [31].

Equity Investments

Equity investments involve purchasing shares in companies actively engaged in transition-related activities. These investments provide capital for companies to innovate and scale up their operations, supporting their transition to more sustainable practices [19].

Project Financing

This type of financing is crucial for large-scale infrastructure projects, such as renewable energy plants, energy-efficient buildings, and sustainable transportation systems. Project financing often involves a mix of debt and equity, structured to mitigate risks and attract diverse investors [19]. Effective project financing structures, including blended finance mechanisms, can mobilise significant commercial capital by leveraging public funds. Currently, USD 1 of concessional capital can mobilise over USD 4 of commercial capital (leverage ratio), including nearly USD 2 from private investors (private capital mobilisation ratio) [31].

7.   Cost of capital of the investees and the transition projects

The cost of capital is important for evaluating the viability and attractiveness of transition finance projects. It includes the expenses related to raising funds for investment, such as debt and equity financing. Various factors affect the variability of the cost of capital, including the type of project, the perceived risk, and the specific technologies involved.

Components of the Cost of Capital

Debt Financing

Interest rates on loans and bonds play a significant role in determining the cost of capital. Projects with higher risk profiles may face elevated interest rates, reflecting the increased risk perceived by lenders. For instance, developing countries often face higher political and regulatory, off-taker, market liquidity, currency, and inflation risks, which can significantly impact financing costs​ [31]. Specifically, financing costs can account for about one-quarter of the levelized cost of electricity (LCOE) from solar power plants in advanced economies, but they account for about half of the LCOE in developing economies [31].

Interest rates have risen sharply in recent years, impacting the refinancing of renewable energy projects by increasing the costs associated with borrowing. This shift has prompted discussions about the role of central banks in promoting green investments through targeted monetary policies. An example of a policy proposal from Positive Money Europe and the Sustainable Finance Lab highlights the counter-productive nature of the ECB’s current targeted longer-term refinancing operations (TLTRO) funding for high-emission activities, which undermine the EU’s emission reduction targets. The proposal suggests that the ECB should offer favourable TLTRO rates for green activities instead (Green TLTRO). These activities could be identified using the existing EU taxonomy for sustainable activities and other EU ESG taxonomies, thereby aligning the funding with the EU’s climate and sustainability goals [34].

Equity Financing

The return expectations of equity investors are another critical component. Investors in high-risk sectors or innovative technologies demand higher returns, increasing the overall cost of capital. In the case of green hydrogen projects, private capital providers expect higher returns to compensate for the greater risk, which translates into a higher weighted average cost of capital (WACC), thereby raising overall project costs [31].

Risk Premiums

Transition projects often carry higher risk premiums due to potential regulatory changes, technological advancements, and market acceptance. These premiums can impact the cost of capital substantially. Risks associated with the local political environment and legal frameworks are key drivers of the cost of financing green hydrogen production projects​ [31]. For instance, the WACC for these projects in Southern Europe is 6%, while it is 11% for South Africa, which reflects these risks [31].

Another factor impacting risk premiums is the current inability of many renewable energy sources to provide consistent baseload power, making it necessary to use complementary solutions – such as batteries, hydrogen, or nuclear power – to ensure stable energy production. Additionally, electricity price volatility can significantly impact the cash flows of renewable projects, with prices being affected by factors such as excess supply and negative pricing scenarios. This volatility is evident in recent market developments, where Europe’s largest renewable power producer, Statkraft, has been forced to scale back its plans for new wind and solar installations due to these challenging market conditions [35].

Regulatory Environment

Favourable policies and incentives, such as tax breaks or subsidies, can lower the cost of capital by reducing financial burdens on investees. Conversely, regulatory hurdles can increase costs. For example, the EU Innovation Fund provides grants covering up to 60% of the capital costs of eligible projects, significantly lowering the average supply and financing costs [31].

Sector-Specific Costs

Non-Centralised Distributional Systems

These systems, such as decentralised energy grids, often have higher initial capital costs but can provide long-term savings and resilience. The need for advanced technology and infrastructure development may influence the cost of capital for these projects. Financial support mechanisms, such as guarantees or first-loss tranches, can help reduce project risk, and thus financing costs, making green projects more bankable [31]​.

Green Hydrogen

Green hydrogen production is capital-intensive, involving the use of renewable energy to electrolyse water. The cost of capital here is influenced by the high upfront investment in electrolysis technology and the infrastructure needed for production, storage, and distribution. Illiquid markets raise financing costs, which damages the economic prospects of capital-intensive green hydrogen [31]. Green hydrogen currently lacks a global and often local market, which creates substantial uncertainties for investors. In July 2023, the price of grey hydrogen in the US was below US$1/kgH2. In contrast, the cheapest US green hydrogen was priced at US$2.7/kgH2, mainly due to the absence of a well-established market and the higher financing costs associated with green hydrogen production [31].

Energy Storage (Batteries)

The cost of capital for battery storage projects depends on the technology (e.g., lithium-ion, solid-state), scale, and expected lifecycle. Innovations in battery technology can reduce costs, but high initial investments remain a barrier. Battery-electric vehicles can under-perform in extreme temperatures, making them less attractive in many developing countries [31].

Utility and Industrial Markets

Transition projects in these markets often involve retro-fitting existing infrastructure or developing new facilities to reduce emissions. The cost of capital is affected by the scale of the projects and the regulatory environment, especially uncertainty about regulation, which can either incentivise or hinder investment. Global demand for chemicals and steel is expected to increase by 30% and 12% by 2050, respectively, requiring significant investments in decarbonisation technologies [31]. ​Developing low-risk project environments and implementing and coordinating holistic energy transition policy frameworks at the regional and international levels can mitigate these risks and reduce financing costs [31].

8.   Where is the limit? When brown remains brown, or turns into black

The limit to transition finance lies in each company (and government) that wants to transition. The transition is not only a matter of communication and PR – it requires a strategic roadmap over the next 10 years, with clear deliverables and intermediate targets that can be monitored, reported, and verified.

Indeed, without strict oversight and clear transition plans, there is a risk that projects intended to reduce carbon emissions could fail or even increase emissions. This shows the need for strong monitoring and accountability to ensure transition finance achieves its goals.

A case in point is the big oil companies, which face significant challenges in the shift to green energy. They must reduce their environmental impact while still making a profit.

Big oil companies have faced significant scrutiny for not aligning their practices with their environmental commitments. ExxonMobil is a clear example of this disconnect, as it has faced considerable criticism for its minimal efforts towards reducing Scope 3 emissions, which constitute the bulk of its carbon footprint [36]. For more detailed information, see Box 3: ExxonMobil.

Another example is BP, which has been criticised for scaling back its climate targets while continuing to invest in fossil fuel exploration [37]​. For more detailed information, see Box 4: BP.

Similarly, Shell has been accused of greenwashing by setting carbon intensity targets rather than absolute emission reductions, allowing continued fossil fuel production under the guise of sustainability [36]​. Chevron and TotalEnergies have also faced criticism for their lack of substantial progress towards reducing overall emissions and for their continued investment in new fossil fuel projects [36] [38]​.

9.   Investor’s engagement vs. regulatory strength

Engagement refers to the active involvement of investors in the governance and strategic direction of companies. By exercising their voting rights and engaging in dialogues with company management, investors can influence companies to adopt more sustainable practices and improve their environmental performance [31]. In IEA climate-driven scenarios, private companies, including investors, will own over 70% of energy investments in clean sectors by 2030, which underlines their strategic influence [19]. Examples of collective engagement initiatives are Climate Action 100+ and the Net-Zero Asset Owner Alliance, which unite investors to pool resources and influence to substantially impact corporate behaviour and promote widespread adoption of sustainable practices.

Engagement is negatively correlated with the strength of the regulations towards a low-carbon economy. Generally speaking, the tighter the regulation, the lesser the need for engagement. In a jurisdiction where the transition is legally binding (typically with a mix of hard and soft law), there is less need for investors to engage with companies.

In this last section, we classify engagement according to three forms: weak, semi-strong, and strong. Each form depends on the strength of regulation, which boils down to the degree of mandatory reporting and decarbonisation pathways of the investees. A summary is presented in the table below:

The 3 recommendations of the European Commission

As stated above, the key components of transition finance are short-run complementarity and medium- and long-run substitutability of GHG activities towards zero-GHG activities.

Investors, therefore, need detailed and accurate corporate and government information, as well as credible and transparent transition plans. Regulations provide this information and plans: the Paris Agreement for governments (e.g., the NDCs) and country/jurisdiction-specific regulations for corporations.

A case in point is the European Union with its sustainable regulatory package, which includes reporting, due diligence, taxonomy, green bonds standard, and green claims. Building on this package, the June 2023 European Commission recommendations on “facilitating finance for the transition to a sustainable economy” [41] boil down transition investments to:

1. Transitional activities and CaPeX plans aligned with the Taxonomy
2. Financial products following either a Paris-aligned or an EU Climate Transition benchmark
3. Entities with credible transition plans aligned with 5°C

These recommendations emphasise the need for monitoring, reporting and verification (MRV) of the investments on an annual basis.

Yet, the recommendations fall short of their implementation and effectiveness. To that end, investors can draw lessons from one of the most – if not the most – successful climate tools of the European Union: The Emission Trading System (ETS).

The EU ETS

Since its creation in 2005, the ETS has targeted the high-emitting economic sectors, and it has been at the core of the GHG reductions in the EU. In other words, sectors under the ETS have invested in the transition – in fact, the ETS jargon does not refer to sectors or companies but rather installations and aircrafts.[5]

The investment in the transition is due to two facts. The first is its cap-and-trade design with a Paris-aligned cap of emissions that decreases over time. The second is the centralised and regulated nature of the ETS. Part of the regulation is the annual MRV that feeds the publicly available registry.

Relevant to this practical guide is the “benchmarking” embedded in the ETS and used for free allocations to sectors at risk of carbon leakage. Benchmarks are reference values for GHG emissions and are used to determine the level of free allocation. For the production of a given product or material, the benchmark is the average of the 10% most GHG-efficient installations [42]. In other words, for productions at the risk of carbon leakage, the best-in-class receive more free allocations than the worst-in-class. In addition, the benchmark decreases every year, reflecting the decrease in the cap.

Until recently, the EU ETS covered about 40% of the EU’s GHG emissions, including sectors like utilities, high-emitting industries (steel, cement, aluminium, etc.), and intra-EU aviation. The EU ETS is undergoing an expansion to cover other sectors (namely, maritime, road transport, and buildings) and essentially leaving out agriculture and waste. With the extension due in 2027, the EU ETS will cover about 80% of the EU’s GHG emissions.

Weak engagement

Because the EU ETS is compliant, credible, Paris-aligned, and transparent, it ticks the three above-mentioned recommendations of the European Commission.

Hence, investors that invest in ETS-compliant sectors have the regulatory certainty that companies decarbonise according to the pathway set by EU climate policy and report emissions that are publicly available in a registry.[6] As a consequence, investors need to spend less time and energy on engagement, and they do not need to be significant shareholders. This is the weak form of engagement.

Semi-strong engagement

But what if an investee does not fall under the EU ETS? If it falls within the CSRD, then it has to disclose a Paris-aligned transition plan (ESRS E1-1). CSRD exclusively deals with the R of MRV in the EU ETS. Monitoring is typically the task of investors and Verification is done by a third-party auditor.[7]  Unlike the EU ETS, MRV alone does not oblige an investee to reduce GHG emissions and engage in the transition.

An investee will reduce GHG emissions if there is a business case, if it is forced by consumers and investors, if there are changes in financial incentives (like taxes and subsidies), or because of technological developments. These causes are related. For instance, changes in subsidies and technology may create a business case for investments in decarbonisation.

Investors play a crucial role in engaging with investees on credible Paris-aligned decarbonisation pathways that require appropriate CaPeX plans. In addition, though many CSRD-compliant companies report SBTI-validated pathways, investors need to compare the pathway of the investee with the industry peers.

Drawing from benchmarking in the ETS, the investor can ask the company to speed up the transition and reach the best-in-class within the industry (the top 10%, say). This engagement is possible when the investor has a reasonably high share of the investee, or if investors participate in collective initiatives like the above-mentioned Climate Action 100+ and the Net-Zero Asset Owner Alliance.

All in all, this is the semi-strong form of engagement.

Strong engagement

Now, what if the investee is not subject to reporting of emissions or decarbonisation pathways? For the investor, this is the most challenging form of engagement, as it entails asking the investees to collect GHG information and to design a transition plan aligned with the Paris Agreement. Therefore, this is the strongest form of engagement.

These corporate strategic decisions entail a significant budget for the company, and a sine qua non condition is that investors become significant shareholders, are committed for the long haul, willing to assist the board and the top management, and act against the short-term pressures of speculative investors.[43]

Experienced institutional investors can provide knowledge on reporting and pathways by drawing lessons from the CSRD and the ETS, as explained above. That is, if an institutional investor uses weak and/or semi-strong engagement with other companies, this experience can be leveraged and used for strong engagement. In addition, investors can assist the investee in communication and stakeholder management, both internally and externally.[44]

However, the CSRD’s and ETS’s lengthy standards and complex methods likely do not fully apply, at least in the first years of strong engagement. A transparent conversation between the investor and investee is needed for setting clear reporting and a pathway that is adapted to the company and is financially viable.

10. References

[1] [Climate Policy Initiative] ( https://www.climatepolicyinitiative.org/publication/top-down-climate-finance-needs/)

[2] [EU Commission – Strategy on Sustainable Economy] (https://finance.ec.europa.eu/publications/strategy-financing-transition-sustainable-economy_en)

[3] [UN Sustainable Development Hub] (https://sdgfinance.undp.org/)

[4] [Financial Times – Content Article] ( https://www.ft.com/partnercontent/ninety-one/real-world-impact-the-rise-of-transition-finance.html)

[5] [OECD – Guidance on Transition Finance] (https://www.oecd.org/en/publications/oecd-guidance-on-transition-finance_7c68a1ee-en.html)

[6] [UN – Climate Change and NDCs] (https://www.un.org/en/climatechange/all-about-ndcs)

[7] [UNEP Finance Initiative – Just Transition Roadmap] (https://www.unepfi.org/industries/banking/first-roadmap-for-financiers-implementing-the-just-transition-launched-at-cop28/)

[8] [ICMA – Climate Transition Finance Handbook] (https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/Climate-Transition-Finance-Handbook-December-2020-091220.pdf)

[9] [Springer – Article on Transition Finance] (https://link.springer.com/article/10.1007/s44265-023-00026-x)

[10] [ADB – Critical Transition Finance] (https://blogs.adb.org/blog/transition-finance-critical-address-climate-change)

[11] [IEA – Renewables 2023 Report] (https://www.iea.org/reports/renewables-2023)

[12] [Financial Times – Fossil Fuel Transition] (https://www.ft.com/content/f0e1f4fa-bc5a-45e9-9257-871dae461e5d)

[13] [ClientEarth – Fossil Fuel Greenwashing] (https://www.clientearth.org/latest/news/revealed-9-examples-of-fossil-fuel-company-greenwashing/)

[14] [S&P Global – Chevron’s Emission Targets] (https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/chevron-unveils-new-upstream-emissions-intensity-reduction-targets-by-2028-63097372)

[15] [Chevron – Q4 2020 Earnings Press Release] (https://www.chevron.com/-/media/chevron/stories/documents/4Q20-earnings-press-release.pdf)

[16] [UNEP FI – Roadmap for Financiers on Just Transition] ( https://www.unepfi.org/industries/banking/first-roadmap-for-financiers-implementing-the-just-transition-launched-at-cop28/)

[17] [Mongabay – Future of Lithium Mining in Bolivia] ( https://news.mongabay.com/2022/12/five-pressing-questions-for-the-future-of-lithium-mining-in-bolivia/)

[18] [World Bank – Bolivia Poverty and Equity Report] ( https://databankfiles.worldbank.org/public/ddpext_download/poverty/987B9C90-CB9F-4D93-AE8C-750588BF00QA/current/Global_POVEQ_BOL.pdf)

[19] [IEA – Financing Clean Energy Transitions] (https://www.iea.org/reports/financing-clean-energy-transitions-in-emerging-and-developing-economies/executive-summary)

[20] [Energy Transitions Commission – Financing the Transition] (https://www.energy-transitions.org/keeping-1-5c-alive/financing-the-transition/)

[21] [White & Case – Scaling up the Energy Transition] (https://www.whitecase.com/sites/default/files/2022-11/Scaling_up_the_energy_transition.pdf)

[22] [UNEP FI] ( https://www.unepfi.org/net-zero-banking/members/)

[23] [IEA – World Energy Investment 2024] (https://iea.blob.core.windows.net/assets/60fcd1dd-d112-469b-87de-20d39227df3d/WorldEnergyInvestment2024.pdf)

[24] [Invest EU] ( https://investeu.europa.eu/index_en)

[25] [World Economic Forum – Financing Energy Transition] (https://www.weforum.org/agenda/2023/08/financing-energy-transition-developing-economies/)

[26] [IMF – Private Financing for Climate Transition] (https://www.imf.org/en/Blogs/Articles/2023/10/02/emerging-economies-need-much-more-private-financing-for-climate-transition)

[27] [ILO-UNEP – Just Transition Finance Pathway] (https://www.unepfi.org/wordpress/wp-content/uploads/2023/11/Just-transition-finance_Pathway-for-Banking-and-Insurance.pdf)

[28] [EY – Insurance Sector and Sustainable Finance] (https://www.ey.com/en_gl/insights/financial-services/emeia/how-the-insurance-sector-can-drive-sustainable-finance)

[29] [McKinsey – Climate Opportunity in Insurance] (https://www.mckinsey.com/industries/financial-services/our-insights/capturing-the-climate-opportunity-in-insurance)

[30] [Geneva Association – Climate Tech] (https://www.genevaassociation.org/sites/default/files/2024-01/climate_tech_full_report.pdf)

[31] [Deloitte – Financing the Green Energy Transition] (https://www.deloitte.com/content/dam/assets-shared/docs/collections/2023/deloitte-financing-the-green-energy-transition-report-2023.pdf)

[32] [Ørsted – Annual Report 2023] (https://orsted.com/en/who-we-are/sustainability/sustainability-report)

[33] [Fluxys – Annual Report] (https://www.fluxys.com/en/about-us/fluxys-group/annual-report)

[34] [Green Central Banking – Green TLTRO] (https://greencentralbanking.com/research/targeting-a-sustainable-recovery-with-green-tltros/)

[35] [Financial Times – EU Renewables] (https://www.ft.com/content/f4086927-ebf2-414c-849d-9da36e757b30)

[36] [Grist – Big Oil’s Emissions Footprint] (https://grist.org/energy/big-oil-is-finally-talking-about-the-elephant-in-the-room-the-emissions-footprint-of-its-products/)

[37] [US Senate – Climate Denial Report] (https://www.budget.senate.gov/chairman/newsroom/press/new-joint-bicameral-staff-report-reveals-big-oils-campaign-of-climate-denial-disinformation-and-doublespeak/)

[38] [DW – Shell and BP Renewable Energy Investment] (https://www.dw.com/en/shell-bp-boost-profit-sink-investment-in-renewable-energy/a-64656800)

[39] [Client Earth – ExxonMobil Greenwashing] (https://www.clientearth.org/projects/the-greenwashing-files/exxonmobil/)

[40] [Financial Times – Energy and Transition Article] (https://www.ft.com/content/38d03e16-6954-4589-aae1-94af7fbef23f)

[41] [Commission recommendation (EU) 2023/1425 on facilitating finance for the transition to a sustainable economy] (https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32023H1425)

[42] [EU ETS Phase 4: Benchmark Updates and Free Allocation Policy (2021-2025)] (https://climate.ec.europa.eu/document/download/fd041819-e22e-4e77-a267-6ab4405328aa_en?filename=policy_ets_allowances_bm_curve_factsheets_en.pdf)

[43] [Harvard Business Review 2021 – Engaging with your investors](https://hbr.org/2021/07/engaging-with-your-investors)

[44][PRI – How ESG engagement creates value for investors and companies]( https://www.unpri.org/download?ac=4637)

[1] AFOLU: Agriculture, Forestry, & Other Land Use

[2] The Oxford English Dictionary defines greenwashing as the creation or propagation of an unfounded or misleading environmentalist image.

[3] Data source is Our World in Data. Left vertical axis shows the consumption of primary low-carbon and fossil fuel sources. Fossil fuels are coal, oil, and gas. Low-carbon sources are wind, solar, nuclear, hydro, biofuels, and geothermal. Right vertical axis shows the proportion of low-carbon sources of primary energy.

[4] White & Case is a global law firm based in New York that provides legal services across various industries and practice areas, including mergers and acquisitions, finance, and regulatory matters.

[5] That said, the evolution of the allowance price has been a bumpy road, with periods of very low prices and very high prices. However, the cap of allowances in line with the Kyoto Protocol and the Paris Agreement is the main reason for the ETS’s success.

[6] Strictly speaking, an installation in the ETS may not decarbonize according to the Paris alignment and, instead, may opt to buy allowances. However, sooner or later, the installation will have to either invest in low-carbon technology or close, as the cap reduces over time.

[7] A repository of CSRD reports is expected in the forthcoming European Single Access Point.