At this momentous juncture, for the first time in the conference’s 28 years of history, COP members passed a deal calling for the “transitioning away from fossil fuels in energy systems, in a just, orderly and equitable manner … so as to achieve net zero by 2050 in keeping with the science.” The tide seems to be finally moving in the right direction.

Despite this milestone, the hard work towards averting climate disaster wages on. Massive pools of long-term, risk-taking capital are essential to reach net zero. According to the International Energy Agency, an estimated $4 trillion in clean energy investment is required annually until 2030 to reach net-zero emissions by 2050. Citigroup has also estimated that the cost of reaching net zero in aviation, shipping, road freight, steel, and cement – hard-to-abate, carbon-intensive industries – may hover around $1.6 trillion. With these tremendous figures in the backdrop, transition finance is emerging as a promising instrument to convert today’s carbon-reliant industries to tomorrow’s carbon-free champions.

The Promise of Transition Finance in Combating Climate Change
The Glasgow Financial Alliance for Net Zero (GFANZ) adopts an expansive definition of transition finance: “investment, financing, insurance, and related products and services necessary to support an orderly, real-economy transition to net zero.” The EU Taxonomy adopted by the European Commission provides additional pragmatic context. It acknowledges that sustainable finance is not the exclusive domain of businesses with the highest sustainability credentials. It also acknowledges that such capital is essential for those organizations with “different starting points” but nevertheless have clear sustainability targets and paths to net zero, especially in hard-to-abate sectors. As such, transition finance is a critical enabler that converts environmental and climate ambitions into actions through the availability of bespoke capital.

Transition finance is a central instrument in the fight against climate change. Transition finance is not exclusively for the “cleanest” and “greenest” businesses of today but includes those on a committed journey to net zero in the future. Thus, it meets companies where they are now and coalesces climate outcome-driven stakeholder groups together rather than create a divide between the “clean” and the “dirty.” For instance, oil and gas companies are increasingly raising and seeking to deploy capital towards hydrogen, carbon capture, biofuels, wind, solar, and other cleaner forms of energy in an attempt to diversify their future business. Given their outsized contributions to global emissions, transition finance is tailored to support such carbon-intensive industries that nevertheless have credible ambitions to become a part of the future net-zero economy.

Moreover, transition finance offers new opportunities to mobilize public and private finance creatively. Research shows that investors now demand more than traditional financing options and are increasingly seeking transition financing structures such as green bonds, social impact bonds, and sustainability bonds. Green tax incentives (exemptions, credits, cash grants) have spurred a generation of socially conscious capital providers looking to support environmental outcomes while generating profit. Ambitious, country-level initiatives in specific markets also exist to assist in the large-scale systematic transition away from fossil fuels, most well-exemplified by the so-called Just Energy Transition Partnerships (JETPs). Launched at COP 26, JETPs were created to help finance the retirement of carbon-emitting power plants and aid in developing renewable energy and efficient transmission systems while providing an alternate livelihood for jobs displaced through the transition process (i.e., the “just” element in JETPs). Donors and investors have pledged over $46 billion for implementation, demonstrating a new high-impact, large-scale blended finance model to fund the energy transition. The momentum for transition finance is rolling full steam ahead.

Key Legal Risks
Transition finance has been the target of several legal challenges, primarily across regulatory, reputational, and litigation risks. At its core, transition finance hinges on a detailed and testable long-term transition plan that credibly demonstrates that financed activities are meaningfully contributing to a net-zero target. The We Mean Business Coalition defines transition plans as “a forward-looking list of actions taken in the near term to align internal strategies and external climate and energy policy advocacy to reduce GHG emissions in line with a 1.5°C pathway and achieve a just transition.” In other words, transition plans set out (1) high-level targets that organizations are using to mitigate climate risk, (2) interim milestones, and (3) actionable steps the organization intends to take to achieve those targets and milestones. However, transition plans are complex, and as surveys have shown, only a handful of companies have met all criteria for having a credible transition plan, according to the Carbon Disclosure Project (CDP). This creates reputational and legal risks (e.g., greenwashing and false marketing allegations) for the finance provider as without the requisite capacity and know-how, they are unable to diligence the robustness and comprehensiveness of a transitioning company’s transition plan.

Jurisdictions also vary in the importance of credible transition plans for issuing transition finance products. In the EU, for instance, transition plans remain voluntary. By contrast, as of November 2021, the United Kingdom now requires listed companies and large regulated asset owners and asset managers to disclose transition plans and set out in detail how they plan to adapt and decarbonize in line with the country’s 2050 net zero target. As the demand for transition finance increases in momentum, similar regulations will appear among other jurisdictions to govern the market appropriately. However, uncoordinated transition finance-related regulation can create high barriers to cross-border investment and finance as it increases the cost of compliance. Understanding these risks, organizations have recently called for more coherent and interoperable international rules to promote a sustainable transition, which has manifested in global initiatives such as the OECD guidance and the US Treasury Department’s Principles for Net-Zero Financing & Investment.

Relatedly, the lack of common definitions and standards can lead to confusion in the transition finance market as well as give rise to greenwashing allegations, which represent a growing category in climate litigation but one that is generally not factored in investment decisions. In a pending case, Notre Affaire à Tous Les Amis de la Terre, and Oxfam France v. BNP Paribas (2023), French environmental NGOs Notre Affaire à Tous, Les Amis de la Terre, and Oxfam France brought claim that BNP Paribas violated the French “law on the duty of vigilance” which provides that specific French companies of a certain size must establish a plan to prevent environmental damage in the course of their business. Contrasting BNP’s “unilateral commitment of will” to limit and combat climate change, the plaintiffs argue, in part, that the organization’s plans did not sufficiently clarify climate risks, disclosure, reporting, and investment flows associated with its financing and investments in the fossil fuel sector, which is necessary to comply with the law on the duty of vigilance. In response to litigation cases like this, there has been market hesitance from finance providers to label their investments as transition finance while still de facto funding the decarbonization of high-emitting companies and projects. Here, transition finance providers face a dual challenge: the stigma associated with staying invested in high-emitting companies and uncertainty regarding the credibility and scale of the transition finance market, given evolving regulations, standards, and legal risks therein.

Making Transition Finance “Work”
The establishment of a strategy to address climate change-related issues is a crucial prerequisite to issuing transition finance instruments. A transitioning company must demonstrate a credible transition plan underpinned by a detailed emissions reduction strategy, commitments, milestones, and actions. Further, the company must reflect not only its ability to identify eligible climate-related expenditures and/or key performance indicators (KPIs) in the short term but also a broader strategic approach to address climate change risks and opportunities in the medium and long term. Climate change scenario analysis – either through engaging providers in the market or doing so in-house – can be incorporated to inform a more credible strategy design. Above all, a climate transition strategy must be science-based, guided by the objective of limiting average global temperature increases ideally to 1.5°C. Incorporating and implementing credible transition plans can also serve as the first-line defense against potential greenwashing allegations and legal claims.

On the regulatory side, international cooperation continues with the development of detailed transition plan regulatory recommendations, including the UK’s Transition Plan Taskforce, GFANZ, and the International Sustainability Standards Board (ISSB). Many jurisdictions are likely to follow the ISSB’s sustainability-related reporting standards (published in June 2023), which is widely viewed as serving as a global baseline. Transition plans should be iterative, and transitioning companies should seek to incorporate the latest best practices and regulatory requirements as this dynamic field continues to unfold.

To mitigate potential legal and reputational risks from vigilant regulatory bodies, advocacy groups, and consumers alike – while also staying competitive in the energy transition – transitioning companies will have to not only build internal capacity to design and implement transition strategies but further diversify their pool of partners. Joint ventures and multi-stakeholder projects can help mitigate risk and leverage expertise and bespoke capital when structuring transition finance-backed projects or transactions. For instance, carbon-intensive companies (e.g., oil and gas, manufacturing) are increasingly forming commercial partnerships and joint ventures with financing sponsors (e.g., private equity firms, asset managers) to apply their respective financing, accounting, reporting, regulatory, and compliance expertise in transition finance, often assisted by law firms with specialized experience in sustainability-focused investments and climate finance. Diverse, broad-based partnerships can also enable transitioning companies to strategically consider the timing of when to divest their fossil fuel-based assets: doing such can help influence the pace of transition and leverage profitable opportunities of decarbonization while minimizing the risk of carbon taxes and regulatory compliance, and potential litigation. For investors and financial institutions, broader assessment principles for credible transition strategies are needed (in the absence of standardized jurisdictional guidelines and mandatory regulation), which will rely on a variegated mix of client engagement, disclosures, targets, and commitments to comprehensively evaluate their clients’ transition journeys.

Conclusion
The path to net zero is long, circuitous, and full of pitfalls if not done right; however, it is a path that must nevertheless be taken to avert the worst consequences of climate change. COP 28 has vividly demonstrated humanity’s demand that the status quo of a fossil fuel-driven global economy can no longer be a viable option. Transition finance will be a critical tool in the fight against climate change to inclusively engage a broad audience of low and high-emitters alike and support their transition journeys. The legal challenges of the transition finance market, however, will continue to persist as long as regulations remain in flux, definitions and standards are loose, and the cost of compliance is high. Policymakers must continue to collaborate to formulate regulatory standards adopting science-driven practices governing transition plans to broadly apply across different jurisdictions. In tandem, transition finance seekers and providers must require and commit to transition plans that target milestones and actions in both the short and long-term time horizons. They must collaborate intentionally with a wide swath of stakeholders and partners to build capacity, leverage broad expertise, and strategically deploy transition finance that maximizes environmental outcomes while also generating profit. Only then can the potential of transition finance be unlocked to move towards a net zero future and a livable planet for all.

 

[1] Daniel Kim is an evening J.D. candidate, Business Law Scholar, and Fellow at the Center for Transactional Business and the Law. Concurrently, Daniel serves as the Senior Partnerships Manager for the USAID Climate Finance for Development Accelerator, where he designs, manages, and implements global climate mitigation and adaptation projects in emerging economies.