Sustainable finance is not only about financing activities and investments that are already compatible with a low-carbon, climate resilient future, considered "green," and aligned with the Paris Agreement. It is also about financing activities and investments that are not yet compatible with a low-carbon, climate resilient future but contribute to a reduction of greenhouse gas emissions.

There are various interpretations of what constitutes transition financing. Broadly speaking, this refers to the financing of activities and investments supporting the shift away from carbon-intensive operations to those more closely aligned with a low-carbon climate resilient future. This is particularly relevant for hard-to-abate sectors, which are some of the most challenging to decarbonize because of combined technological and financial barriers. However, companies in such sectors often face challenges in obtaining transition financing.

Low transition financing implies a significant drag on progress toward meeting the Paris Agreement's goal of limiting the rise in the average global temperature to well below 2 degrees Celsius above the pre-industrial levels. Here, S&P Global Ratings answers questions from market participants on how it views green and transition financing, as shown through its second party opinions (SPOs), research, and other market coverage and capabilities. We use the hard-to-abate chemicals, cement, and metals sectors for illustration purposes.

Frequently Asked Questions

How visible is transition financing in the overall sustainable finance space?

Governments and market actors around the globe have been developing transition taxonomies, pathways, and roadmaps to accelerate transition financing. However, it has proven challenging for companies in high-emitting and hard-to-abate sectors--such as cement, chemicals, steel, and long-haul transportation--to raise sustainable finance.

According to the International Capital Market Association (ICMA), only 3.6% of green, sustainability, and sustainability-linked bond issuance through January 2024 has been from issuers in those sectors. Sustainability-linked bond issuance, once viewed as a promising structure for high-emitting and hard-to-abate sectors to access sustainable financing, is at a crossroads following two consecutive years of annual issuance decline. And the transition-labeled debt market, while likely seeing some momentum this year, has constituted a tiny fraction of the sustainable finance market, accounting for a mere 0.3% of use-of-proceeds sustainable bond issuance in 2023 (see chart 1), according to data from Environmental Finance and S&P Global Ratings.

The financing of activities and investments that reduce greenhouse gas emissions may still happen without being labelled as transition financing. But this creates a lack of transparency regarding the environmental credibility of such investments, which can lead to uncertainty and confusion in the market.

Chart 1

What has stymied the growth of transition finance in hard-to-abate sectors, and what could this mean for meeting Paris Agreement goals?

The low level of transition financing is noteworthy because hard-to-abate sectors contribute more than 30% of global energy and process-related greenhouse gas emissions, according to the International Energy Agency; these sectors are steel (7%-8% of global greenhouse gas emissions), cement (7%-8%), chemicals (5%-6%), long-haul transportation including shipping (2%-3%), aviation (2%-3%), and heavy-duty vehicles (about 6%). The products and services these sectors deliver are essential to modern life but currently lack commercially viable and scalable solutions to fully decarbonize.

We believe part of the reason for low transition financing to date is that issuers and investors may be wary about potential accusations of overstating their green credentials, referred to in the market as "greenwashing." Added to this are concerns in the market about whether transition plans and activities aimed at decarbonizing over time are credible.

Meeting the goals of the Paris Agreement implies a significant amount of mitigation financing for hard-to-abate sectors. The Intergovernmental Panel on Climate Change found that current climate financing flows, across all sectors, need to increase by 3x-6x by 2030 to meet mitigation goals. The ability to give financial market participants confidence that a transition activity or investment is backed by a decarbonization plan that is robust, and appropriately ambitious in the sectoral and regional context, will play an important role in increasing financing for transition initiatives.

How do you distinguish between green activities and transition activities in your SPOs and other sustainable finance assessments?

Our principles-based Shades of Green approach, which is integrated into our SPOs, has long acknowledged the importance of both green and transition activities in achieving Paris Agreement goals, as does the Company Assessment product offered by Shades of Green. We distinguish between green and transition activities using our Shades of Green scale. Within the green spectrum of our Shades of Green scale, we assess activities or investments as:

• Dark green, if they correspond to the long-term vision of a low-carbon climate resilient future. For a company in a hard-to-abate sector, this might include investing in projects supporting green hydrogen production, where other environmental risks (such as potential hydrogen leakage, water usage, and end use of products) are well managed and monitored.
• Medium green, if they represent significant steps toward a low-carbon climate resilient future but will require further improvements to be solutions for the long term. For a company in the hard-to-abate chemicals sector, this may include substituting carbon-based feedstocks with bio-based ones from forestry waste, where emissions are lower but perhaps environmental impacts from direct and indirect land use change associated with the inputs are not yet fully addressed.
• Light green, if they represent transition steps in the near term that avoid emissions lock-in, but are not long-term low-carbon climate resilient solutions. Activities in our chemicals sector example may include a new waste heat recovery facility, where the source of waste heat is fossil based currently but could also be compatible with lower-emission sources as they become available. This would reduce the risk of emissions lock-in and, in the meantime, use energy that would otherwise be unused.

All three green shades signify important steps along the transition pathway toward the Paris Agreement's goals.

Three non-green shades further illuminate the spectrum of transition activities: Yellow, Orange, and Red (see chart 2).

Chart 2

To illustrate how we may differentiate between these non-green shades, we again turn to the chemicals sector for an example.  If activities or investments are associated with conventional fertilizers, we may assign a Yellow shade to reflect significant emissions but also benefits such as higher crop yields and more efficient use of land. If activities or investments are associated with a traditional petrochemicals facility that makes little use of renewable inputs, we may assign an Orange shade. Refining of oil and gas may be assigned a Red shade.

An important aspect is that our approach to assigning a shade considers the regional development contexts in which activities and investments take place.   For instance, we recognize that a substantial portion of manufacturing processes in hard-to-abate sectors is concentrated in lower- to upper-middle income countries, particularly in Asia. We consider the impacts of emissions from activities and investments but also the relevance to economic development and the region's distinct transition starting point.

How relevant is transition risk in hard-to-abate sectors from the credit perspective?

We've found that factors driving transition risk may become financially material and relevant to credit quality in hard-to-abate sectors. Transition risks may relate to disruptions from mounting regulatory pressure to decarbonize, rising carbon costs, and potential rejection of carbon-intensive products.

We have published in-depth research on decarbonization in several hard-to-abate sectors, including chemicals, cement, and metals (steel and aluminum), which are all significant contributors to global greenhouse gas emissions. These sectors require substantial amounts of energy to run their high heat-intensive operations (for example, steam cracking and reforming in the chemicals sector, kilns used in the cement sector, and furnaces used in the steel sector). They also use carbon-based feedstocks that release greenhouse gases when processed. For example, crude oil, coal-based, and natural gas feedstocks emit carbon dioxide (CO2) when transformed into chemicals; the calcination of limestone to create clinker for cement directly emits CO2; as does the reduction of iron ore into molten iron for steel (typically done using coke or natural gas).

We have found that most policy and private-sector decarbonization targets, out to 2030, appear manageable from a credit and operational perspective. Rated companies in these sectors, in our view, could feasibly achieve their interim decarbonization targets without material disruptions, using existing technologies.

Decarbonization beyond 2030, however, relies heavily on the scalability of technologies that are still immature, may require specific infrastructure development, and will need significant new green energy generation (see chart 3). We are mindful that regulatory pressure is increasing, and this could weigh on companies' credit quality beyond 2030, when we expect decarbonization policies and regulations, particularly in the EU, to become stricter.

Chart 3

Are there decarbonization solutions that potentially apply to all hard-to-abate sectors?

Continuing with our examples of chemicals, cement, and metals, we see that these sectors have similar technical challenges and potential solutions. However, important differences complicate the decarbonization process, leading to diverging abatement options (see table).

The chemicals sector has a much broader range of products, each of which requires tailored decarbonization solutions, while cement and metals products are relatively more homogenous. The chemicals and metals sectors may also be more exposed than the cement sector to the challenge of sourcing affordable green hydrogen. This is because hydrogen is a crucial raw material in the production of chemicals, such as ammonia, which consumes about 50% of the hydrogen availably globally. In addition, hydrogen plays an essential role as a reducing agent in the hydrogen-based direct reduced iron process, which is critical to decarbonizing steel production. Increasing the scale of green hydrogen also faces many hurdles, including how to establish environmental credibility to facilitate much-needed sustainable financing.

The cement sector could also benefit from green hydrogen as an alternative fuel for firing kilns, if available in large enough quantities. However, the bigger challenge for the sector, at this stage, could be lack of a viable, low-carbon alternative to clinker. Although the clinker ratio in cement can be lowered, it cannot yet be fully replaced and still meet safety and quality standards. This highlights the need for a scale-up of carbon capture and storage capabilities. In sum, these decarbonization technologies and their supply chains will require far more research, development, and investment to scale, with likely disruption of these sectors' cost structures and business models.

What progress have you observed on decarbonization in the chemicals and cement sectors?

We see that companies we rate in these sectors are beginning to invest, in preparation for more stringent decarbonization policies and regulations. However, significant investment in new, more structurally important projects is being prudently deployed and remains marginal overall. This is often because disruptive technologies are still at a nascent stage, costly, and lack the infrastructure or end market to support scaling.

In the cement sector, we see the emergence of pilot projects in carbon capture technologies. We also see some cement companies updating their commercial strategies to include targeting a larger share of products made with low-carbon feedstocks. This is especially the case for cement companies in the EU, where the price of carbon is generally higher than in other regions.

Chemicals companies are taking on projects to reduce steam-cracking emissions and incorporate more bio-based feedstocks and fuels in the manufacturing process. Yara, the world's largest nitrogen fertilizer producer and fertilizer distributor, is one such example (see the credit rating analysis on RatingsDirect, as well as our Company Assessment and SPO). Yara has several pilots and partnerships in place to facilitate its transition to using blue and green hydrogen as feedstocks in ammonia production.

Metals companies are starting to test hydrogen-based production processes as well as making efforts to develop more renewable power solutions. Norsk Hydro, the world's 10th largest primary aluminum producer is one such example (see the credit rating analysis and SPO), operating hydroelectric assets to power its aluminum production. Some steel companies also have plans to increase the use of electric arc furnaces (typically first with scrap, due to the high price of green hydrogen-based direct reduced iron).

The costs associated with these newer and more structural decarbonization strategies are high, underscoring the need for significant investment and financing to decarbonize these sectors. But early adopters are likely to be better positioned for the medium to long term.

Note: The SPOs on Yara and Norsk Hydro were completed using Shades of Green methodology before its integration with S&P Global Ratings' SPO methodology and the publication of the updated Analytical Approach: Second Party Opinions: Use Of Proceeds, on July 27, 2023.

What is S&P Global Ratings' role in transition finance?

We support the transparency and credibility of transition financing through the assessments in our sustainable finance products (such as use-of-proceeds SPOs) and research on climate transition topics, such as decarbonizing hard-to-abate sectors. We also provide insight on how climate transition risk may, in some cases, materially influence creditworthiness. Transition financing is a crucial element in meeting the aims of the Paris Agreement, especially for high-emitting and hard-to-abate sectors.

Using our Shades of Green methodology, we examine financing frameworks and transactions and share our view on the "greenness" of financing through our SPOs. Activities that we would typically assess as Medium green or Dark green in our SPOs, such as renewable energy or electrified transport, are usually targeted for financing. Since the launch of our updated use-of-proceeds SPO product in July 2023, about 80% of the project categories to be financed were assigned Medium to Dark green shades. However, financing of activities at a relatively early stage of the transition, typically assigned a Light green shade, is also important for achieving the Paris Agreement targets.

Chart 4

The agreement to transition away from fossil fuels in energy systems at COP28, potential momentum regarding the transition label, and various regulatory initiatives around the globe mandating the disclosure of credible transition plans, all signal that we may be nearing a turning point for transition finance.

Related Research

• Decarbonizing Hard-To-Abate Sectors: Credit Quality Implications And Six Key Observations, June 25, 2024
• Decarbonizing Metals Part One: A Pressing Issue With Uncertain Fixes, June 3, 2024
• Decarbonizing Metals Part Two: Financial Strength Mitigates Rising Credit Risk, June 3, 2024
• White Paper: Assessing How Megatrends May Influence Credit Ratings, April 18, 2024
• SPO Spotlight: Second Party Opinions – March 2024, March 28, 2024
• Look Forward: Multidimensional Transition, March 13, 2024, on spglobal.com
• Sustainable Bond Issuance To Approach $1 Trillion In 2024, Feb. 13, 2024
• Full Analysis: Yara International ASA, Dec. 5, 2023
• Full Analysis: Norsk Hydro ASA, Nov. 17, 2023
• Decarbonizing Chemicals Part One: Sectorwide Challenges Will Intensify Beyond 2030, Sept. 5, 2023
• Decarbonizing Chemicals Part Two: The Credit Risks And Mitigants, Sept. 5, 2023
• Analytical Approach: Shades Of Green Assessments, July 27, 2023
• Analytical Approach: Second Party Opinions: Use Of Proceeds, July 27, 2023
• Yara Shades of Green Company Assessment Update (Methodology of Shades of Green, formerly part of CICERO), March 31, 2023, on spglobal.com
• Decarbonizing Cement Part One: How EU Cement Makers Are Reducing Emissions While Building Business Resilience, Oct. 27, 2022
• Decarbonizing Cement Part Two: Companies Could See Pressure On Ratings As The EU Firms Up Carbon Rules, Oct. 27, 2022
• Norsk Hydro ASA Green Financing and Sustainability-Linked Financing Second Opinion (Methodology of Shades of Green, formerly part of CICERO), July 18, 2022 (on spglobal.com)
• Yara Green Financing Second Opinion, July 12, 2022

External Research

• Transition Finance in the Debt Capital Market, International Capital Market Association (ICMA), Feb. 14, 2024
• IPCC, 223: 2.3.3. Lack of Finance as a Barrier to Climate Action. In: Climate Change 2023: Synthesis Report. Contribution of Working Groups I, II and III to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, H. Lee and J. Romero (eds.)]. IPCC, Geneva, Switzerland, pp. 35-115, doi: 10.59327/IPCC/AR6-9789291691647

Editor: Bernadette Stroeder

Digital design: Joe Carrick-Varty