Transition Finance

What Is Transition Finance and How Does it Differ from Green Finance?

In a world racing to net-zero, high-emitting and/or hard-to-abate sectors are at an inflection point. On the one hand, they represent a significant proportion of total GHG emissions, and therefore, are critical for Canada to achieve the “net-zero emissions by 2050” commitment. For example, heavy industry alone accounted for 11% (77 Mt CO2 eq) of Canada’s total GHG emissions in 2021, ranking fourth among all sectors.¹ On the other hand, these carbon-intensive sectors (while playing a crucial role in economic stability and job creation) are struggling to access affordable financing in support of their decarbonization progress due to the fear of stranded asset risks.

The G20 Sustainable Finance Working Group defines transition finance as: “financial services supporting the whole-of-economy transition, in the context of the Sustainable Development Goals (SDGs), towards lower and net-zero emissions and climate resilience, in a way aligned with the goals of the Paris Agreement.”²

In practice, how does transition finance differ from green finance? Green finance encompasses capital allocation in eligible green projects which contribute towards environmental objectives such as climate mitigation, climate adaptation, pollution prevention and control, and biodiversity conservation. On the path towards greater global interoperability,³ financial regulators and market participants worldwide are in search of a transparent and science-based definition of “green” through taxonomies and classifications. Green bonds/loans⁴ are use-of-proceeds⁵ financial instruments designed to channel capital towards eligible green projects.

In contrast, transition finance enables capital to flow towards decarbonizing emission-intensive yet socio-economically critical entities and activities. It fills in the void by supporting decarbonization efforts in high-emitting and/or hard-to-abate sectors such as heavy industry and manufacturing which are otherwise excluded in the mainstream green finance market. Despite growing regulator- and market-led efforts across the globe, it remains a common challenge to define credible criteria and tailored thresholds to avoid “transition washing”. In terms of financial instruments, transition bonds/loans, sustainability-linked bonds/loans⁶ can be structured to fit for transition financing purposes.

Table 1: Comparison between Green and Transition Finance

When is a transition label appropriate?

In the context of climate mitigation, green finance is necessarily limited to financing low-carbon activities. Therefore, entities in emissions-intensive sectors are largely unable to credibly finance their transitions using green-labelled financial instruments.

Transition financing helps to address this gap by offering a credible avenue for high GHG-emitting entities to finance their transitions and play their necessary role in the transformation of our economy.

Importantly, the transition concept is intended to facilitate financing that supports ambitious transitions. It is not a catch-all label for anything that doesn’t qualify as green, or represents only a slight change from business-as-usual. The success and credibility of the transition label will depend on robust definitions and principles that instill market confidence and safeguard against “transition-washing.” As an example, the Climate Bonds Initiative (CBI) has proposed five principles for credible transitions of entities, activities and projects:

1. Goals and pathways in line with limiting global warming to below 1.5C, net zero by 2050, and halving emissions by 2030.
2. Goals and pathways that are established by science.
3. Goals and pathways that do not count offsets and do count upstream scope 3 emissions.
4. Technological viability trumps economic competitiveness when determining the decarbonization pathway.
5. Action not pledges – the transition plan is backed by operating metrics, not a pledge to transition along a pathway in the future.⁷

Six Pillars Underpinning a Credible and Inclusive Transition

Six pillars underpin a credible transition finance policy framework (examined in more detail below):

• a transition taxonomy,
• disclosure frameworks,
• transition-related risk management,
• fit-for-purpose financial instruments,
• policy incentives, and
• a “just transition” mechanism.

Taxonomies⁸ provide common definitions that foster an improved understanding of the activities and projects that credibly constitute “transition”. Within transition finance, they have several use cases. For instance, investors may use taxonomies as an input to investment selection, improving their ability to assess and identify credible opportunities and mitigate “transition washing” risks. At the same time, real economy actors can use taxonomies to support their corporate transition planning by identifying activities and projects for funding that will help meet emissions reduction targets. As of early 2023, many existing taxonomies are green-only classifications that may incorporate limited transitional elements. However, several ongoing efforts, including in Canada, Singapore, ASEAN, and Australia have indicated plans to cover both green and transition activities.

To assess whether the transition claim or plan is science-based and Paris-aligned, consistent disclosures on transition activities should be embedded at the company, portfolio, and project levels. These assessments should follow internationally comparable frameworks and be verified by independent third parties. For example, the His Majesty’s Treasury (HM Treasury) has launched the Transition Plan Taskforce (TPT) to develop a gold-standard for the UK’s private sector transition plans. At a global scale, the International Sustainability Standards Board (ISSB) is setting out an international baseline of sustainability (including transition-related) disclosures to further enhance interoperability.

While climate-related transition risks quickly manifest, financial institutions and regulators should stay alert and prudential in adapting their risk management strategies. For example, at a micro-level, long-term, capital-intensive natural gas infrastructure built today may incur “locked-in” emissions for decades to come. These assets running on higher operating expenses (OPEX) because of an increasing carbon price risk being economically unviable, hence, becoming stranded in the near future. At a macro-level, a disorderly transition will disrupt financial stability when hard-to-abate and critical economic sectors are unable to fund their transition. Financial institutions should proactively assess and adjust these risk exposures in different climate scenarios and timeframes. Central banks and other financial regulators should leverage their macro-prudential tools to guide and support effective risk management.

Fit-for-purpose financial instruments including both use-of-proceeds and general-purpose instruments can be designed to raise affordable capital towards financing transition plans of carbon-intensive sectors. Unlike green bonds/loans, transition bonds/loans and some Sustainability-Linked bonds/loans can be more suitable for a broader set of entities and activities (beyond “pure green”). They can facilitate a credible whole-economy transition if accompanied with clear identification and labelling standards and measurement, reporting, and verification (MRV) best practices. However, the transition bond market is still in a nascent stage with a mere $3.5 billion US issuance in 2022, compared to $487.1 billion in green bonds.⁹

Policy incentives such as preferential tax treatment, subsidies and public funding can help mobilize private capital to accelerate the decarbonization pace of high-emitting sectors. These measures also extend to central banks and other financial regulators’ monetary and macroprudential policy tools, for example, the adjustment of the collateral framework to allow eligible sustainability-linked bonds.

Critically, a “just transition” mechanism needs to be in place to make sure transitioning towards a low-carbon economy is not at the cost of heavy industry workers’, especially marginalized groups’ livelihoods. A well-designed “just transition” mechanism should guarantee equity-deserving groups — Indigenous communities, youth, racialized individuals — have equal access to the new jobs and opportunities brought by the transition.

State of Play and Outlook for Canada

There are multiple initiatives underway in Canada that represent a step forward in supporting a low-carbon transition.

In March 2023, Canada’s Sustainable Finance Action Council (SFAC) released its Taxonomy Roadmap Report. The Report includes 10 recommendations for the design and development of a Canadian green and transition finance taxonomy. Once developed, the taxonomy will identify activities under separate green and transition categories. The introduction of a taxonomy is a foundational step that will create greater clarity around what can credibly be considered a transition activity. When used to support transition-labelled bond issuance, this improved understanding will help to reduce information asymmetries and mitigate “transition washing” risks.

In the same month, the Office of the Superintendent of Financial Institutions (OSFI) issued Guideline B-15: Climate Risk Management, described as the “first prudential framework that is climate sensitive, and recognizes the impact of climate change on managing risk in Canada’s financial system.”¹⁰ As part of its governance and risk management expectations, the Guideline sets out that financial institutions should implement a climate-related transition plan and directs organizations to refer to the Task Force on Climate-Related Financial Disclosures’ (TCFD) transition planning guidance. OSFI has not yet specified a specific timeline for when this expectation must be implemented.

The Federal Government has also recently released the interim Sustainable Jobs Plan, identifying 10 key actions to spur sustainable jobs creation and support workers. The interim plan is a precursor to a more comprehensive Sustainable Jobs Action plan that will be released every five years starting in 2025.

• ¹Environment and Climate Change Canada, “National Inventory Report 1990-2021: Greenhouse Gas Sources and Sinks in Canada,” 2023.
• ²G20 Sustainable Finance Working Group, G20 Sustainable Finance Report, 2022.
• ³The term ‘interoperability’ was first applied in information technology to refer to the ability of two or more systems to exchange and use information. In the context of sustainable finance taxonomies, interoperability relates to taxonomy design – where the use of shared design principles and common metrics promotes alignment between national and regional taxonomies.
• ⁴In this primer, we discuss bonds and bank loans together, which are both debt financing sources. However, we acknowledge the differences in their structures, costs of capital and restrictions.
• ⁵Use-of-proceeds instruments exclusively reserve their proceeds for specific projects. For example, the proceeds raised from a use-of-proceeds green bond are earmarked specifically for green projects.
• ⁶They are performance-based bond or loan instruments whose coupon rates or interest rates are structurally linked to issuers or borrowers’ ability to meet their predefined sustainability targets. The progress towards meeting those targets is (i) measured through predefined Key Performance Indicators (KPIs) and (ii) assessed against predefined Sustainability Performance Targets (SPTs). For example, most Sustainability-Linked bond issuers will be penalized for not meeting the targets by a step-up of the bond’s coupon rate.
• ⁷Climate Bonds Initiative, Financing Credible Transition – How to Ensure the Transition Label Has Impact, September 2020.
• ⁸For more information on taxonomies, see ISF’s Taxonomies Primer or, for a more in-depth overview, ISF’s Taxonomies Briefing Note.
• ⁹Climate Bonds Initiative, “2022 Market Snapshot: And 5 Big Directions for Sustainable Finance in 2023,” January 2023.
• ¹⁰Office of the Superintendent of Financial Institutions, OSFI issues new Guideline on Climate Risk Management, March 2023.