Transition finance: navigating complexity

As the world grapples with the urgent need to address climate change, finding a smart way to align financial flows with emissions reduction is more important than ever and could be a key unlocker. However, financing the energy transition is a complex task, fraught with diverse views on how to execute it credibly.

 

 

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There is widespread desire to avoid further carbon lock-in and accelerate sustainability measures through the development and financing of breakthrough technologies. But many breakthrough innovations are not yet economically viable, and from an investment standpoint, it is unrealistic to expect a significant number of investors to contribute purely for altruistic reasons; performance cannot be compromised. At Vontobel, we have long recognized this global necessity with longstanding impact expertise.

Another approach considers leveraging the resources and expertise of existing high-emitting companies in hard-to-abate industries, which are committed to the transition to support substantial emissions reductions. Some examples of these are green steel or carbon-capturing asphalt. Providing funding to these companies for transition investments towards clean technology could facilitate a less disruptive and more reliable shift to a lower-carbon world. Indeed, a balanced approach that considers the transformation potential of existing companies and the importance of bold new technological solutions is likely to offer the most effective path forward.

Investment firms have an important role to play

In Europe, private infrastructure investors are seeking to facilitate carbon neutrality, backed by the comprehensive directives established by the European Union. Infrastructure managers who invest in companies and projects related to renewable energy, the energy transition, and decarbonization can direct significant funds in a manner that can deliver a large environmental impact if the right return frameworks are in place.

In the public markets, transition bonds are an example of how capital can be allocated to shift to a low-carbon economy. These bonds are commonly issued by companies in hard-to-abate industries, such as steel, cement, chemicals, and shipping, which account for a significant share of global carbon dioxide (CO2) emissions. As Sarah Murray’s article highlights, the cost – $13.5 trillion – required to decarbonize these industries is astronomical. Transition bonds can generate the funding required to develop and deploy innovative technologies like carbon capture, utilization, storage, and clean hydrogen or ammonia-based processes. Yet, since they emerged in the late 2010s, transition bonds have accounted for only a small fraction of the global bond market, and unlike green bonds, they have so far failed to take off. This might be partly explained by the fact that investors price in climate-related risks, causing companies in these hard-to-abate industries to face higher borrowing costs due to their higher carbon emissions. Research by the European Central Bank (ECB) found that companies with the highest emissions paid interest rates approximately 0.14 percentage points higher than those with the lowest emissions.¹ Nonetheless, the market has recently gained some traction. In 2024, Japan issued JPY 1.6 trillion (USD 10.7 billion) in climate transition bonds, a move that could herald a trend in the bond market.

Due to their specific use of proceeds, transition bonds address a prominent criticism towards Sustainability-Linked Bonds (SLBs), where a company faces penalties, such as higher interest rates, if it misses its sustainability targets, but where the proceeds can be used for general corporate purposes, prompting skepticism about the actual environmental impact.

To ensure investor confidence and accelerate adoption, companies that issue transition bonds will need to provide evidence that carbon lock-in is minimized, thereby demonstrating a genuine shift towards a low-carbon approach without perpetuating reliance on fossil fuels.

Comprehensive reporting, disclosures, and transparency on transition projects are also crucial for compliance and, more importantly, genuine effectiveness. A company serious about transition must have a clear plan, a method to execute it, and a system to measure its progress – it is only logical to establish these evaluation criteria. Rating agencies could help in assessing transition “credentials” and provide initial oversight. Active managers then have the key disciplining role to play in conducting rigorous analysis on these projects. In situations where costs are too high and companies or private investors are unable to commit, government intervention becomes necessary. In such cases, blended finance can offer a promising solution.

Building a better future

The pace of progress has been slow even though the importance of the energy transition is widely accepted. The cost and complexity of decarbonization have prompted many governments and companies to pause or reconsider their commitments. At Vontobel, we recognize that we must play a responsible and active role in the sustainable transformation of our society and economy as a corporate citizen.

As a fiduciary, we recognize that we are acting on behalf of our clients, who entrust us with their capital. We strongly support the transition from a value and necessity perspective. However, this cannot and does not come at the expense of our financial fiduciary duties.

We seek to provide the knowledge, tools, and investment options that empower investors to consider sustainability in their financial strategies. We believe it is critical to remain steadfast in overcoming prevailing challenges and designing economically viable solutions to rapidly build the foundation for a cleaner and better future.