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.

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.   

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.

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.