The Investor’s Guide to Transition Finance: Transforming the Grey into Green
Transition finance is emerging as a crucial tool in the shift toward a sustainable economy, creating an opportunity for investors to engage with industries that are in the process of becoming more environmentally responsible – but aren’t there yet. This approach is especially important as it targets sectors traditionally seen as high-emission. By providing the necessary financial support, transition finance enables these companies to adopt greener practices, playing a critical role in mitigating climate change. Understanding how to implement this type of financing into an investment strategy is essential for investors seeking to contribute to meaningful change while navigating the complexities of the evolving regulatory (and societal) landscape.
What is Transition Finance?
Transition finance represents a critical and emerging component of sustainable investing. Unlike traditional sustainability strategies that focus exclusively on green assets, transition finance offers a pathway for investors to support companies that are on their journey towards sustainability, but are not yet fully “green.” This approach allows investors to fund traditionally “grey” sectors, while helping them move toward more sustainable practices.
Such financial support is crucial for sectors such as chemicals, construction, marine, and aviation—often called “hard-to-abate” sectors. These industries face significant challenges in reducing their carbon emissions due to the energy-intensive nature of their processes. Without this type of targeted investment, the shift towards a more sustainable economy would be nearly impossible.
And not only is this relevant for the large corporations dominating these sectors, but also for small and medium-sized enterprises (SMEs) that also need to take part in this transformation— despite having fewer resources. This type of financing can open up the possibilities for such companies, accelerating the transition.
The Evolution of Transition Finance in European regulation
In 2021, the European Union introduced a comprehensive strategy for financing the transition to a sustainable economy. This initiative aims to mobilise capital to help heavy industries reduce emissions and align with the EU’s environmental objectives. Additionally, the European Securities and Markets Authority (ESMA) is expected to propose new guidelines on transition finance, creating more clarity on the way investors can take action to support companies in these efforts.
The UK has also already embodied transition finance in their Sustainable Disclosure Regulation. The label for “Sustainability Improvers” allows for investments in assets with the potential to improve sustainability over time, rather than investing solely in already sustainable assets.
Despite this strong institutional support from the standard setters, the flow of capital into transition finance has not been as fluid as expected. Several risks, including reputational risks and the need for long-term gains, have slowed progress. And confusion remains about what transition finance truly entails.
How is Transition Finance Different from Sustainable Finance?
The key distinction between transition finance and sustainable finance lies in the principle of “Do No Significant Harm” (DNSH). For an investment to be considered ‘sustainable’, it must have a positive impact on society without causing significant harm elsewhere.
Many companies in the transition phase cannot yet make this commitment, however. These “grey” companies may still release significant emissions, despite their attempts to reduce them. Although they are not fully sustainable, they are transitioning toward sustainability.
Transition finance, therefore, occupies a unique space between traditional grey assets and fully green or impact investments. It can be attractive for investors who are mindful of ESG risks but are not ready or able to commit fully to a sustainable fund. This raises critical questions for investors: How can they use their resources to support companies in transition, without getting berated for investing in grey companies?
The Investor Perspective
Private Equity and Venture Capital Opportunities
Private Equity and Venture Capital Firms can leverage the foundations of transition finance to justify investments in companies that are not yet sustainable but have the potential to make significant environmental improvements. Private equity firms in particular may see opportunities in acquiring companies that are early in their transition process and guiding them towards greener practices, adding value over the investment period to achieve their desired return rate.
Impact Investing in Transition Finance
Impact Investors who prioritise social and environmental outcomes alongside financial returns may also find transition finance particularly relevant. While these investors traditionally focus on ‘green’ investments, such as clean energy, transition finance offers a way to generate perhaps even greater positive impact. Rather than excluding these companies from their mandates, they can instead invest in very clear and tangible plans to make these companies greener.
For transition finance to work effectively, both investors and companies must have robust, credible transition plans. These plans involve setting clear targets and using established tools and frameworks to assess transition finance needs of portfolio companies. Investor engagement is critical to ensure that capital is allocated responsibly and achieves meaningful results.
The Case of the Real Estate Sector
If you consider the Real Estate sector, funds classified under Article 8 of the Sustainable Finance Disclosure Regulation (SFDR) can use transition finance to improve the energy efficiency of buildings, moving energy performance certificate (EPC) ratings from C to A. This approach can turn a transition fund into a green fund over time, allowing for re-categorisation as an Article 8+ or even Article 9 fund. For a deeper understanding of real estate financing, refer to our expert guide.
The Company Perspective
For companies in traditionally grey industries, transition finance offers a lifeline. Consider a company performing well but facing sustainability challenges, such as energy sources, supply chain issues, or inefficient material usage. Receiving finance to improve the impact of these key business elements is also likely to bring cost reductions and efficiency enhancements, and reduce the possibilities of non-compliance or reputational consequences.
It is the responsibility of the company to have a detailed and credible transition plan. A gap analysis can help identify and address the most material aspects of their business, creating targeted solutions that lead to the greatest impact. By doing so, companies can attract investment from those seeking to avoid ESG risks—whether from a sustainability, reputational, regulatory, or financial return perspective.
Challenges in Transition Finance
Transitioning toward sustainability is both costly and complex. It requires upfront investment and a long-term perspective. However, many companies face obstacles, such as:
- A lack of well-developed and scalable technologies
- Insufficient infrastructure
- Uncertainty around financial incentives for pursuing transition finance
Banks may find regulatory and reputational benefits in transition finance, but other investors might hesitate due to concerns about immediate returns. Reputational risks are also a concern, as some investors might be accused of “greenwashing” if their investments in heavy industry are not perceived as genuinely contributing to their transition.
Despite these challenges, companies engaged in transition finance can gain recognition for their efforts, even if they are still considered grey or brown. Access to finance, partnerships, and fundraising opportunities improve as they progress on their sustainability journey.
Conclusion: The Future of Transition Finance
Transition finance is expected to evolve into green finance as more companies complete their sustainability journeys. Achieving global sustainability goals requires more than just investing in new green technologies—we must also focus on greening what is not yet green.
As the world continues to tackle climate change and environmental degradation, transition finance will become increasingly indispensable in our collective effort to create a sustainable future. It provides the necessary bridge for investors to support critical sectors that need to transform, helping to secure both environmental progress and long-term financial returns.
By embracing transition finance, investors can play a critical role in driving meaningful environmental change—turning the grey into green.
Any Questions?
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