The regulatory environment and investor expectations surrounding sustainability are evolving rapidly. Investors face the challenge of balancing stewardship, risk management and risk-adjusted returns when considering transition finance, and there is a strong desire to manage short- and long-term economic risks through a sustainability lens.
OMFIF has created the Transition Finance Working Group to explore these concerns and priorities. Over the past few months, global asset owners and investors, which include EY, have convened to discuss the status of transition finance and share insights on the environmental, social and governance landscape. Market participants understand they have an important role to play in what comes next.
At the same time, the market remains incomplete and significant risks still require management to evolve into an effective tool of transition. Three such risks are worth highlighting.
Significant risks require management
First, political-economic behaviour risk is apparent to many investors and continues to lead to inconsistency and uncertainty. There is evidence of this in the way policy is set within and across countries, and how regulatory structures are designed and enforced. These inconsistencies are the main reason consumer demand does not (yet) match required shifts in consumption behaviour for climate impact mitigation at a scale necessary to fundamentally alter investment. Some working group participants suggested policy and regulation is going backwards, even while the daily cost of climate impact is worsening and our lived experiences of climate events are increasing.
Second, transition finance markets are quite thin. This is a function of the underlying policy, regulatory and behavioural dimensions of markets that show a deficit of investable projects tied to credible impact abatement strategies. Investors suggested that much of the ‘low hanging fruit’ has been harvested and what remains is projects with uncertain financial and climate impact, including in circumstances where capacity for action is not yet ready for market investment. The risk that capital goes unallocated against science-based abatement and transition targets remains very real.
Third, portfolio risk is critical where the primary driver for mandated investment is financial return (i.e. fiduciary responsibility) and the secondary driver is climate impact. At a project level, matching investment to impact over time is crucial to success and includes significant play in so-called ‘grey’ projects, where decarbonisation is a longer-term result. Some working group members indicated that they are making investments where the short-term impact on the portfolio carbon balance sheet might actually be negative, as abatement-driven investments in necessary capital/operating transformation only takes hold over time. In this context, forecasts matter.
Encouragingly, the discussions also offered insights into the opportunities to manage such risks and secure greater short- and long-term development of sustainable finance markets.
Compatibility and consistency
We have a particular interest in the still-emerging role that standardisation of investment-grade financial information and associated transparency and reporting requirements can play in decreasing the cost of information, and making that information more widely available to policy-makers, regulators, investors and consumers.
The framework advanced by the International Sustainability Standards Board in 2023 is beginning to find its way into regulation. This is a vital first step that, potentially, will be extended to the public sector through a similar framework expected from the International Public Sector Accounting Standards Board in October 2024.
Discussions with transition financiers make it clear that these frameworks are critical. They must be adopted as the standard across jurisdictions to enhance comparability and consistency. This not only reduces the cost of compliance, but importantly increases standardisation of the global investment market. Over time, this will reduce investment-to-impact uncertainty and help lay bare a new wave of investable decarbonisation transition projects.
Just as importantly, the requirement to forecast climate impact and associated financial performance is inherent in the new reporting frameworks. It should become an important tool to help inform necessary shifts in political-economic behaviour. Achieving sustainable outcomes requires that policy-makers, regulators, investors, managers and consumers must work off the same scope of information about how public and private economic action plays out in financial, fiscal and climate impact terms. The economic competitiveness of jurisdictions depends on it, particularly as the real financial and economic costs of climate adaptation and mitigation continue to rise.
The information distilled from the roundtables has been informative, consistent and often inspiring. We strongly support the need to further examine the results secured to date and renew commitment to developing the necessary capacity and market conditions that OMFIF is promoting. At EY, we share this vision and are ‘all in’ to support.
Heather Taylor is Partner, Climate Change and Sustainability Services Practice, and Mark MacDonald is Global Public Finance Management Leader at EY.
OMFIF has collated and analysed the outcomes of the working group discussions in a report, publishing on 13 November at COP29 in Baku. Register to attend the launch here.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organisation or its member firms.