UK takes a lead with mandatory carbon transition plans

Sustainable finance experts were delighted this week by the UK’s announcement that the country's financial institutions and listed companies will have to publish transition plans showing how they intend to cope as the economy moves towards net zero greenhouse gas emissions. The measure will take time to be implemented, but could cut out much of the uncertainty and unclear communication that now clouds this issue.

The planned legislation for this could also kick-start a new burst of evaluation services to assess how robust each transition plan is.

“For major corporates, we do need to drive them to change, and from an investor perspective the disclosure part is fantastic,” said Sean Kidney, chief executive of the Climate Bonds Initiative and a member of the EU’s advisory Platform on Sustainable Finance. “I’m going to be saying in Brussels — look at this: the British have finally come up with a good idea. The question is whether the US regulators go this far, because they are considering a whole raft of changes.”

Spain became the first country to require corporate transition plans in its Climate Change and Energy Transition Law, passed in May. Companies there will have to submit climate action plans, saying how they will reduce emissions over five year periods.

That the UK was considering following suit had been flagged in its Green Finance Roadmap, but this week, at COP26, Rishi Sunak, the chancellor of the exchequer, went further, making it clear that the plans would be mandatory from 2023.

Firms’ plans will not have to indicate a path to net zero but they will have to set out how the company intends to reduce its emissions, and adapt in other ways to an economy that is heading for carbon neutrality.

A new Transition Plan Taskforce will be formed to draw up a science-based ‘gold standard’. It will include representatives from industry, academia, regulators and civil society.

The secretariat will be provided by E3G, the climate change think tank, and the Centre for Greening Finance and Investment. Bizarrely, funding will be provided by philanthropists.

The Taskforce will report by the end of 2022. As standards for transition plans are formed, they will be incorporated into the UK’s Sustainability Disclosure Requirements.

“I think the intention is that other countries might follow,” said Kate Levick, associate director for sustainable finance at E3G in London. “The EU has had it under discussion. The UK as G7 president [for 2021] has really showed leadership in putting forward this idea of a net zero financial system.”

The G7 had accepted that broad idea, she said.

Asked whether there had been opposition in any quarter to the idea of mandatory corporate transition plans, Levick said: “There has been a lot of discussion about whether the market is ready, and whether we know what a good transition plan looks like.”

Up to now, investors and banks have been using a variety of standards and methods to evaluate whether companies’ transition plans are fast enough to be consistent with a climate-safe future.

Science-Based Targets, which started in 2015, is the most widely adopted scheme; in the past year it has become increasingly well recognised in corporate debt markets, including as a way to evaluate the robustness of green and sustainability-linked bonds.

There is also the Transition Pathway Initiative, and the Climate Bonds Initiative is soon to announce a new service for assessing transition plans.

“We have been talking to TPI and SBTi about the apparatus of recognition,” said Kidney. “It is going to develop quickly.”

Asked whether this could be an opportunity for firms such as S&P Global, Moody’s and MSCI to offer new services evaluating transition plans, Kidney said: “It is an opportunity. I think you will see them stepping up quickly.”

Levick said SBTs had “really helped to set the tone for what has now happened”. But she pointed out that they specifically referred to the pace of reducing carbon emissions.

“Transition plans will address broader issues,” she said. “They will need interim targets, and, very crucially, they will be about how you change your whole business strategy and model. You are reducing emissions, but what are you scaling up? It’s about how ultimately you plan to make your business viable in future.”

Although being obliged to publish a transition plan may initially feel like a burden for companies — and even more for investment firms and banks, whose portfolios of activities are far more complicated — they may soon welcome the government’s involvement.

“At Deutsche Bank we have put the transition dialogue at the centre of our sustainability strategy, so this is a helpful development,” said Jörg Eigendorf, head of sustainability at Deutsche Bank in Frankfurt. “What the UK is doing puts the issue in the centre. We are all well advised to put a lot of time into this transition question.”

Banks like Deutsche, which are members — as nearly all large banks now are — of the Net Zero Banking Alliance, will have to report from 18 months after joining the alliance on the Scope 3 emissions in their loan portfolios, and publish plans on how to reduce these.

Banks say they find it difficult to gather the metrics required to do this.

Since carbon emissions are highly concentrated in certain industrial sectors, the easy way to make reductions would be to pull out of financing those. But banks do not want to do that — partly because it would involve loss of revenue and market share, especially in investment banking, where league tables are very important. They also argue there are genuine economic and governance reasons why divestment is not the right answer.

“There is pressure on banks to exit certain activities, but in many cases this should eventually be a government and societal decision,” said Eigendorf. “Yes, we should not finance new coal mines or Arctic oil fields. But in other areas we have to manage carbon emissions down gradually. I’m not aligned with the radical approach of just stopping things.”

The alternative is to stay invested, but support companies to reduce their emissions. That involves potentially very awkward discussions with hundreds of clients. Either companies themselves get on a pathway towards net zero emissions, including reasonably rapid actions in the next few years, or banks may have to stop financing them.

Banks find it difficult to have those conversations, and even to work out whether each company’s decarbonisation efforts are sufficient, or need to be improved.

“You need to enter into dialogue with clients — on carbon, but soon also on biodiversity and other issues,” said Eigendorf. “So we need to agree with the client metrics, and financing will be conditional on our own ESG rules. If a client has Science-Based Targets, is that enough? Do we need other defined sectoral pathways?”

Legislation and official guidance in this area, such as the UK is proposing, could be just what banks and investors need.

“It would be good to see transition guidelines integrated into the EU Taxonomy,” said Eigendorf.

In the meantime, banks that advise companies on how to craft their ESG strategies — a huge growth activity at present — are wrestling every day with their clients over what constitutes a robust or credible transition plan, and what investors will think of it.

“Excitement by investors over companies’ net zero targets is pretty short-lived,” said Farnam Bidgoli, head of ESG advisory EMEA at HSBC in London. “They are increasingly looking for medium-term and short-term targets, to demonstrate that the company is taking action now. Companies are under constant pressure to be transparent about implementation pathways and transition trajectories, and face scrutiny over whether or not the pace of change is fast enough.”

She pointed to six oil and gas majors, including Repsol, BP and Shell, having not only set climate targets but then returned to them soon after and accelerated them.

Despite the overwhelming sense in financial markets that ESG is top of the agenda for investors, there are signs that investors, too, can sometimes be disengaged or even uninterested.

“The other challenge today is that companies that are transitioning are not necessarily being rewarded for it in equity markets,” said Bidgoli. “For example, many traditional automotive [manufacturers] are setting ambitious targets around transitioning to electric, but we don’t see evidence of a green halo like Tesla. So there are mixed signals from investors on how much they are willing to support traditional companies in their transitions.”

Investors, too, may therefore benefit from greater clarity on companies’ transition plans, and from these being presented in a more regular and standardised way.

CDP, the non-profit organisation through which more than 8,000 companies report their carbon emissions and climate-related financial disclosures, published a quick recommendation on Thursday of five steps organisations should take when building a transition plan.

First, set a net zero-aligned business strategy; then set a Science-Based Target to reduce all greenhouse gas emissions, with five and 10 year targets as well as an ultimate net zero endpoint; third, ensure financial planning such as capital expenditure supports the target.

The last two steps are to make sure lobbying on public policy is aligned with the strategy, and to report regularly to stakeholders and listen to their feedback.

Levick said a number of leading companies had already come out with transition plans, “but it’s an area where best practice is still emerging. That’s part of the reason the government has formed a new Taskforce.” It would help define best practice, she said.

The treasurer of a German energy company that has published a low carbon transition plan said the requirement would not be difficult for his firm, and its plan was already evaluated by nine or 10 sustainability rating companies and by investors.

But he said: “I fully agree that for the overall economy, transition plans are very important, because many companies still have a very long way to go.”

So far, bond bankers are not sure whether the changes will mean much for their business. “It’s too early to tell,” said a syndicate official in Germany. “Without seeing the details, it is just hot air at the minute.”

Competitors agreed that more details need to be firmed up before they could work out how issuers might react.

However, they do expect a pick-up in sustainability-linked bond issuance to result.

“Sterling is a great market for use of proceeds [sustainable] bonds,” said a London syndicate official. “There is lots of demand, and hardly any supply. I was speaking to an investor just today who was trying to work out whether there might be more sustainability-linked bonds next year. They want to see them.”

He pointed to UK supermarket chain Tesco’s £400m seven year SLB, priced last month, as an example of the appetite in sterling. It attracted £1.8bn of demand.

Tesco used the same KPI in its sterling deal — cutting greenhouse gasses by 60% from a 2015-16 baseline by 2025 — as it had on its debut €750m SLB in January.

“Once a company ascertains its KPIs,” said the London syndicate banker, “it all falls into place. It’s the KPIs that often prove to be a sticking point.”

The UK government’s insistence that big firms present their plans for net zero means these companies will have to establish the sort of metrics that will be easy to turn into KPIs for capital market issuance.

Sustainable finance bankers have said in recent weeks that they expect more sectors to turn to ESG finance in the UK, especially leasing companies, car parts makers and property companies outside social housing, which is already “about 90% green supply this year”, according to one sustainability banker.

With such a focus on transition from governments, it seems logical that the more rarely seen transition bond might also be in line for a resurgence of popularity.

The structure, championed by gas transmission companies Snam of Italy and Cadent of the UK, has struggled to gain a wider foothold, in part because gas so far falls outside the EU Taxonomy of Sustainable Activities and in part because SLBs do a similar job and have proved more popular with issuers and investors.

“Transition bonds definitely still have a place,” said the syndicate banker in Germany, “though we will not be seeing them as often as SLBs.”  

When Snam brought its last transition bond in the summer, a €500m 10 year bond that got a tepid response, several investors said they wanted to see only green, social and sustainability-linked bonds presented to them.