Transition finance needs to reach beyond the boundaries of Europe

Capital is a prerequisite for decarbonizing our economy and so is policy. Nowhere is this more evident than in the European Union, where policy and capital are together driving progress. Emissions from electricity generation in the EU are set to fall by far more than any other region.[1] Earth’s climate, however, is global, and progress remains uneven.

A greening EU in a brown world

Companies in the EU outperform the rest of the world in their decarbonization journey. Our data shows that 14% of EU-domiciled companies are “aligned to a net-zero pathway” (as defined by the Paris Aligned Investment Initiative’s Net Zero Investment framework), compared with 3% of companies outside the EU. While a majority (58%) of companies in the EU are still “not aligned” with a net-zero pathway, that compares favorably with 88% of listed companies elsewhere.

This success, however, means EU companies now represent a dwindling share of the world’s emissions. Global emissions are increasingly fueled by the Asia-Pacific region, which accounts for more than three-quarters (78%) of global coal-power generation capacity.[2] Hence, stemming climate change depends on investors’ willingness to transition emissions-heavy assets in jurisdictions that may be far from their own.

The unevenness of the transition should be instructive for decision-makers in finance and policy alike, as climate finance evolves from aligning portfolios with climate ambitions toward achieving decarbonization in the real economy. Transition finance marks this shift and should be guided by data showing where we are making progress and where we are not.

The data shows two growing chasms for transition finance to bridge: one between European companies and the rest of the world, and another between the emissions associated with financial institutions’ portfolios and the physical emissions of the economy.

Financial portfolios’ emissions diverge from the real economy

Financial institutions are reducing the emissions they finance, as many have reported.[3] Yet overall company greenhouse gas emissions in the economy remain near record highs.[4] How can this be?

The seeming contradiction stems in part from climate-focused capital chasing a dwindling number of fast-decarbonizing companies. These companies represent a smaller fraction of global greenhouse gas emissions, while more and more companies join the ranks of those on a less ambitious path. As one example, an investment strategy designed to track a Paris-aligned benchmark must, by EU regulation, reduce average emissions by at least 7% annually.[5] That means today, only about one-third (32%) of the original global investment universe of global companies are eligible to be included in such a strategy; and for emerging markets, only 28%. While a higher proportion of companies in Europe (62%) meet the eligibility criteria than in other regions, companies excluded continue to emit at a high rate.

Data suggests that such strategies have had limited impact on economy-wide decarbonization so far. In fact, the total Scope 1 emissions of listed companies globally has remained roughly flat over the past three years, at 11 gigatons of CO2e, according to the MSCI Net-Zero Tracker .?Further, an investment portfolio or lending book that decarbonizes much faster than the real economy risks becoming concentrated and less diversified over time, an outcome at odds with financial stability.

Transition finance needs to go where the emissions are, and that’s increasingly beyond the EU’s borders

The movement to define and measure transition now sits at the crossroad of two camps. One takes a broad, inclusive view that every company should produce a transition plan. Transition capital flows to those with better plans. But the history of tying capital flows to better corporate disclosures and sustainability performance suggests that this will favor large companies in the EU, U.K., and U.S.

More than 90% of large listed companies in developed markets have disclosed their Scope 1 and 2 emissions, compared with 65% of their peers in emerging markets. About half of smaller listed companies have done the same. Without levers to even the playing field, smaller companies and those based in emerging markets, which need transition finance the most, will miss out.

Another camp would double down on financing only those assets that are most difficult to decarbonize. The simple math shows no path to net-zero can bypass phasing out coal-fired power plants in emerging markets or transitioning companies in emission-heavy industries such as energy, transportation, steel and cement.[6]

From our experience in helping financial institutions align investments with sustainability, we see financial, regulatory, and reputational roadblocks to financing these high-emission assets. Overcoming these hurdles is essential for attracting private finance, which seeks high risk-adjusted returns while satisfying activists and regulatory green finance ratios.

We support the many collaborative efforts to remove the roadblocks, including levers for retiring high-emitting assets in the Asia-Pacific region; initiatives to build confidence in the voluntary carbon market; development of definitions, taxonomies and financing instruments targeting transition assets; and quantifying emissions reduced or avoided.

Halting climate change demands speed and scale. That’s why we need to experiment, learn quickly and concentrate the confluence of policy and capital on decarbonizing the most impactful assets, which increasingly lie beyond the EU’s borders.

_____

[1] "Electricity Mid-Year Update,” International Energy Agency, July 2024

[2] “Simulating a Managed Phaseout of Coal-Fired Power Plants in the Asia-Pacific Region,” MSCI Sustainability Institute, November 2023

[3] Combined absolute financed emissions for members of the U.N.-convened Net-Zero Asset Owner Alliance, for example, fell to 213.4 megatons of carbon dioxide-equivalent (tCO2e) as of December 2022 from 221.2 tCO2e a year earlier. See “The third progress report of the Net-Zero Asset Owner Alliance,” U.N.-convened Net-Zero Asset Owner Alliance, October 2023.

[4] “The MSCI Net-Zero Tracker,” MSCI Sustainability Institute, July 2024

[5] “Commission Delegated Regulation (EU) 2020/1818,” July 17, 2020

[6] See “CO? emissions by sector, World,” Our World in Data,” Oct. 31, 2023. See also “Concrete steps for speeding the decarbonization of cement,” MSCI Sustainability Institute, 2023.