Trust in Transition
There are now over 100 transition-labelled funds, but investors can’t yet be sure they will keep their promises.
Over the last few years, we have seen a global shift by leading corporates, from net zero target-setting to also formulating the plans and strategies necessary to achieve these goals.
With trillions of dollars needed to finance the move to a low-carbon future, there has been an explosion of transition-focused funds.
According to research published by MSCI, there are 139 investment vehicles managing collective assets of just over US$50 billion, with 70% launched within the last four years.
“One key benefit of transition funds is that they have huge flexibility and a wide variety of approaches, allowing for diverse strategies that target different sectors, regions or stages of the decarbonisation journey,” Rumi Mahmood, Research Director at the MSCI Sustainability Institute, tells ESG Investor.
Several of these funds also tackle broader social and environmental themes alongside the energy transition, which has led to inconsistent definitions and approaches across strategies. Fund composition and portfolio size vary, ranging from high-conviction strategies with fewer than 50 holdings, to globally diversified portfolios with more than 1,000.
Nearly 80% of transition funds are aligned with an implied temperature rise of less than 2.5°C, but just under a third are on track for 1.5°C, the MSCI report said.
“We find that transition-labelled funds fall into three categories: those focused on portfolio-level decarbonisation, such as by tracking Paris-aligned benchmarks; broader funds targeting real-world sustainable action; and vehicles investing in solutions-oriented products,” says Rob Edwards, Global Director of ESG Product Management at Morningstar Indexes.
It’s unsurprising to see such variety: transition finance is still an emerging concept, with differing views on its purpose, credibility and scope.
But this does pose a problem for investors. How are they supposed to know whether their investment really is turning an asset from brown to green? How can they best measure and compare the degree of progress being made? The answer depends on the fund, the region, the sector, and the company.
In a market that expanded before firm regulatory guardrails were put in place, there is very valid concern that some transition-labelled funds may be perpetuating greenwashing by investing in companies misaligned with credible decarbonisation pathways.
More recently, guidelines and regulations have sought to better account for transition finance, attempting to strike a balance between setting a floor and enabling innovation.
Adopting wider lens
The first regulatory initiatives focused on sustainable finance looked to define what is sustainable – led by the EU taxonomy. But governments and regulators are now playing catch-up with fund managers as they expand their focus to transition finance.
“These early regulatory frameworks stifled transition finance by only looking at what is sustainable today, thereby reducing incentives to provide capital to sectors and companies that are critical to the transition,” says Elizabeth Lance, Assistant Chief Counsel at the Investment Company Institute (ICI) Global.
But much of the existing regulatory architecture can and is being leveraged to channel transition finance.
With companies required to disclose their degree of alignment with the EU taxonomy’s list of sustainable economic activities since 2022, the EU’s Platform on Sustainable Finance is now in the process of honing application – including defining transition-related economic activities.
“Taxonomies like the EU [iteration] already provide forward-looking metrics for assessing transition through taxonomy-aligned capital expenditure, which underpins wider entity-level transition plan disclosures, providing clarity at the economic activity level,” says Leo Donnachie, Senior Policy Manager for Sustainable Finance at the Institutional Investors Group on Climate Change (IIGCC), noting that this can inform the development of criteria that would qualify a fund for a transition label.
The European Commission has also issued guidance designed to increase the flow of transition finance, outlining practical examples of how existing regulations such as the EU Green Bond Standard can be used by investors to channel capital and manage transition risks effectively.
Pierre Garrault, Senior Policy Adviser at the European Sustainable Investment Forum (Eurosif), points to fund names rules published by the European Securities and Markets Authority (ESMA) – which will come into effect from 21 November. These include thresholds for funds with transition-related terms in their name.
“ESMA’s [criteria] outlines minimum exclusions for these funds,” he says, noting that their investments must be on a “clear and measurable path” to social or environmental transition.
Pending a review of the Sustainable Finance Disclosure Regulation (SFDR), a more formal transition label could well be on the cards for EU-domiciled funds, aligning with the UK’s Sustainability Improvers label under its Sustainability Disclosure Requirements (SDR).
“We really appreciated the more principles-based approach of the UK SDR [transition label], as it allows the fund manager to set its own KPIs in terms of what its strategy is trying to achieve, leaving room for different ways of approaching transition,” says ICI Global’s Lance.
Plan of action
Further insight into transition-labelled funds can be provided by credible and robust climate transition plans implemented by portfolio holdings.
The UK’s Transition Plan Taskforce (TPT) has made up a lot of ground formulating the ‘gold standard’ transition plan for both companies and financial institutions. It published its final set of resources in April, including deep-dive guidelines for asset owners and managers, as well as high-level guidance for 30 sectors.
“Globalised standards are going to drive cohesion and change,” says Morningstar Indexes’ Edwards.
He also points to the unifying role the International Sustainability Standards Board (ISSB) has already played in the development of its climate and sustainability reporting standards – supported by governments around the world.
Its influence is set to extend to transition plans, following an announcement by Chair Emmanuel Faber earlier this year that the ISSB would be taking over the transition plan disclosure resources developed by the TPT, in a bid to consolidate frameworks and standards.
Credible transition plans are one thing, credible transition funds are quite another, says Ella Sexton, the IIGCC’s Senior Investor Strategies Programme Manager, noting also the need for transition guidance across asset classes beyond equities, such as sovereign bonds, real estate and infrastructure investments.
“Identifying robust transition funds is currently more challenging, as what they can and can’t contain is not well-standardised, so it can be time- and labour-intensive for institutional investors to systematically compare and contrast what each fund is delivering in terms of its impact on the transition,” she says.
“This is a space where policymakers can make real strides to develop a definition and bake it into fund-labelling regimes, which would allow the industry to work around some commonly agreed principles, while still allowing for the flexibility of diverse approaches.”
The UK’s recent publication of its Transition Finance Market Review (TFMR) outlined a framework to scale the market for transition finance nationally and globally.
Beyond calling for mandatory transition plans, the review recommended the adoption of a transition finance classification system with clear metrics developed by bodies including the Bank of England and Financial Conduct Authority (FCA), drawing on the existing work of the ISSB, TPT, Transition Pathway Initiative, Climate Action 100+ and others.
“Flexibility may also be needed in the application of various metrics and frameworks and how they are utilised to support investment decision-making,” the review said.
Separately, this week the Taskforce on Nature-related Financial Guidance (TNFD) and Glasgow Financial Alliance for Net Zero (GFANZ) published individual consultations for nature-focused transition plans for companies and financial institutions.
“Building the plane while flying it”
Given industry calls for both flexibility and standardisation, policymakers have a tough job ahead striking the right balance between encouraging innovation and reducing greenwashing risk.
“We have to acknowledge that the gradation of transition funds reflects gradations in investor preference,” says MSCI’s Mahmood.
If the transition fund universe is so condensed by standards and regulation that only the best-performing or most ambitious companies receive capital, then the fund manager may well end up with a narrow portfolio of Paris-aligned stocks, which doesn’t meet client demand for a globally diversified portfolio. Nor will the fund channel transition capital to where it’s most needed – such as emerging markets firms.
Too broad a definition also poses risks, according to IIGCC’s Sexton.
“High-emitting assets that are not transitioning – and where there is no intention from the asset to transition, or the investor to influence it to do so – also should not fall into the [transition] mix,” she says.
“Without clear definition and classification of what transition funds can and cannot contain, and what they need to demonstrate in terms of accountability, investors could still be vulnerable to unintended greenwashing risk.”
An assessment of 430 passive funds with sustainable labels – including a variety of transition-labelled funds – found that 70% were exposed to companies developing new fossil fuel projects. This doesn’t align with what should be a transition fund’s core goal of moving away from unsustainable business operations.
The report noted that the BlackRock ACS World ESG Equity Tracker Fund holds US$499 million in fossil fuel developers – including ExxonMobil, which has made headlines this year for its legal threats against shareholders calling for increased climate ambition.
Nonetheless, Dr Rory Sullivan, CEO of global advisory firm Chronos Sustainability, says existing work from policymakers and industry suggests transition finance’s teething troubles will resolve themselves in the near-term.
“We have made huge progress in defining what Paris-aligned looks like from an investment perspective and in determining how that is measured,” he tells ESG Investor.
“This has been a necessary iteration 1.0 of developing a coherent approach to transition finance.”
He acknowledges that tools like the Paris-aligned benchmarks have had the negative effect of steering investors away from the sectors in most need, such as brown building stock.
The next step is to evolve market understanding of Paris-alignment to ensure all entities and sectors that need to transition or that enable transition can be included in transition-focused funds that investors can trust.
“The key barrier is investors with commitments to net zero – they need to demonstrate that they are willing to support transition finance, put capital into companies that may not currently be green (or aligned) and use their influence to encourage and enable the transition,” Sullivan says.
“While there is clearly a long way to go before global capital flows are aligned with net zero, we need to acknowledge that we’ve been building the plane while flying it.”
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