Islamic finance could provide a way to make transition finance adaptable as economies transform

Many companies are responding to the urgency of transitioning their business but are running into challenges. One barrier they face is that it can be harder or more costly to access finance if they are penalised for using debt-based finance for transition-related investments.

Transition finance is a critical part of the global transition that will be needed to meet the requirements of the Paris Agreement and the global push towards Net Zero by 2050. Despite the big financing opportunity that the climate transition represents, debt-based financial markets are still approaching this with a short-term mindset that can impose barriers to transition finance.

These barriers, which are present across financial markets, are driven by features in our economic models that determine what is valued and how costs and benefits of the transition are calculated. The most common way to work around the limitations of the current economic model is to combine debt-based finance with concessional capital, but the structures that result can be complex, they can take a long time to negotiate, and they have been criticised for delivering only limited additionality.

To take just one example, there has been substantial effort by companies, governments and multilateral development banks to support the energy transition from coal in Indonesia, and this has run into many of these barriers.  Indonesia’s Just Energy Transition Partnership (JETP) was signed in 2022, and the first early retirement to be replaced with renewables occurred three years later, with the announcement in February by Indonesia’s Minister of Energy and Mineral Resources that the Cirebon-1 power plant would be retired in 2035, seven years earlier than scheduled.

Replacing power generation assets is complex in any case, and there has been a lot of focus put on the Cirebon coal phase-out financing because it is a novel transaction, and is hoped to pave the way for other transactions to follow. The impact of follow-on transition finance transactions will be greatest if the learning process in each transaction speeds up the process and makes it easier for companies in the value chain to use the experience to shape their own transition plans.

Yet, during the structuring phase of the coal phase-out transaction, Kelvin Wong, global head of energy, renewables and infrastructure at DBS, one of the structuring banks, acknowledged that “with the difficulties we have gone through in the last 30 months, I’m more circumspect about the viability of the project”. He added, “Had we known the costs that we know now, it is debatable whether the Indonesian authorities would still have wanted to undertake this same exercise”.

Part of the challenge was due to slow and uneven follow-through on the JETP, which had the result of shifting costs onto the utility and electricity consumers. The United States, which was a co-lead along with Japan, subsequently withdrew from the JETP, highlighting the issue of reliability of concessional capital sources.

Beyond the political risks and limited accessibility of international climate finance, the rigidities in debt-based finance can make it difficult to make it resilient and adaptable enough to withstand future economic volatility related to the climate transition. Within transition projects specifically, higher debt needs mean the challenges are even greater. There needs to be sufficient funds raised to refinance debt already borrowed for existing unsustainable assets, while also investing in new physical assets (renewable energy in the case of the coal phase-out projects).

The role of concessional capital in transition finance is to provide a buffer, whether through lower-yielding debt or first-loss capital, in order to hold down the interest rate on the commercial finance mobilised at a level where the project economics work for all financial stakeholders. Projects involving the phase-out and replacement of unsustainable with sustainable assets also have to navigate a process to find an outcome that is just for all stakeholders, including affected workers and local communities. 

This is a sizeable challenge for individual transition projects, which can seem easier to manage with debt-based and concessional capital, but this structure can introduce rigidities beyond the project. It can affect the way that companies upstream in the value chain respond to transition investments. 

For example, coal phase-out projects should be designed in a way that rewards value chain participants who anticipate and mitigate their own transition risks even before the coal phase-out projects close.  Sometimes, the economics of transition work against this objective by adding additional costs for transitioning companies that don’t impact companies that ignore transition risks.

A case study covered by Climate & Capital describes the transition investments of an Indonesian coal miner that took a strategic decision to use the recent profitability in its coal business to help fund its efforts to reach 50% of non-coal revenue by 2028 through investment in renewable energy and gold mining. 

Over the short term, as it scaled up investments in its transition projects, the miner needed substantial finance, which it raised through borrowing. However, the reliance on debt for its new investments led to a cut in its credit rating because it became more highly indebted (and viewed as more of a financial risk by creditors) compared to peers who didn’t pursue transition-related investments, even though its transition investments can make it more resilient as utilities phase out coal and demand wanes. 

This is indicative of the ‘tragedy of the horizon’ that then-Bank of England governor Mark Carney warned about almost 10 years ago.  In his speech, Carney warned that the problem was that the “catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix”. 

The increase in climate disasters is showing the cost that current and future generations already have to bear. However, we still see that for many transition-related investments, not only is there not a direct incentive to fix the issues, but the financial incentives in debt-based finance work against companies making the transition investments they need to make.

A decade ago, Carney highlighted the cost of a delayed energy transition because “earlier action will mean less costly adjustment” and can contribute to fewer companies seeing “jump-to-distress pricing because of shifts in environmental policy or performance”.  

The transition risks that Carney highlighted still exist, but many companies are disincentivised from taking the necessary action because debt-based financial markets and credit ratings on which many investors and financial institutions rely are short-sighted. They undervalue the future credit risk associated with inaction on transition risk relative to the credit risk associated with the transition investments they take.

If credit ratings disincentivise transition investments, fewer companies will pursue these investments.  For an industry in transition, delaying transition investments increases the risk of cliff-edge events when transition risk is recognised suddenly with ‘jump-to-distress pricing’ that factors in risks only after they materialise.

For coal, the transition risk is both foreseeable and well defined. IEA’s global Net Zero by 2050 roadmap expects “low-emissions electricity [to rise] so rapidly that no new unabated coal plants [that were not under construction at the beginning of 2023] are built”. This impacts coal-fired power plants and their value chain.

The risk to coal miners from the scenario in the IEA’s Net Zero by 2050 roadmap is that demand falls rapidly as power generation shifts to renewable sources. This shift has been underway for years, and in some emerging markets like Pakistan and countries across Africa, the change in demand has begun to sharply accelerate.

Companies that diversify their revenue to other sources are likely to be far better positioned than those which do not, but financial incentives in debt markets through credit ratings counteract and could lead to companies increasing their risk through inaction in pursuit of short-term gains.

Companies need time to pivot their business strategies towards less transition-exposed sources of revenue and should not be penalised for making long-term investments that reduce their transition risk. Investors and banks, as well as other stakeholders, including workers and local communities, will pay the price if credit ratings provide the wrong financial incentives related to transition risk.   

In addition to financial losses for creditors, the employees of impacted companies will face job losses, electricity consumers will face disruption and higher costs if the transition proceeds in a less orderly way, and communities will be exposed to pollution from coal-fired power plants for longer.

Making progress at restructuring the debt-based financing for one link in the value chain can help to address the economic, environmental and social costs from continuing the status quo towards a disorderly transition. However, the rigidities introduced by debt-based finance may not fully alleviate risks and could just shift the risk onto another part of the value chain.

At each stage of the value chain, the transition risk is concentrated by debt, which moves the claims of some stakeholders’ interests ahead of others.  The inequity is greatest where the financial decision-making of those providing debt finance does not fully capture transition risk.

Improving consideration of transition risk can improve the situation if it adequately rewards companies for mitigating transition risk or penalises those that ignore the risk. However, since the speed of the climate transition is uncertain and can impact the intensity of transition risk exposures, debt-based finance is likely to be too inflexible to adjust to a changing reality and thus may not be the most effective way to finance the transition.

Alternative approaches that link financing returns to their success in supporting the transition can help to remove the rigidity of debt and the potentially counter-productive incentives that are created for companies. Financing the transition with instruments other than debt, including through Islamic finance, can offer more flexibility to adapt to changes in the global transition, although it may introduce other challenges in today’s debt-based financial system.

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