Transition finance is becoming one of the next frontiers in sustainable investing. Private markets have a distinctive role to play as focus shifts to enabling value creation and delivering real-world outcomes – by Holly Turner, climate  specialist, Schroders Capital

Transition finance continues to gain real momentum, but at the same time remains clouded with uncertainty.  

Over the past 18 months, discussions around the political reality of decarbonising economies across all sectors has highlighted both the challenge and complexity. At the same time, the conflict in the Middle East and related energy price shock has put the spotlight once again on the importance of energy security. In many regions, this directly supports the case for accelerating the energy transition to reduce reliance on imported fossil fuels.  

As such, transition finance is rapidly becoming one of the next frontiers to sustainable investing.  

What is ‘transition finance’? 

The terminology of ‘transition’ has traditionally been focused on climate and decarbonisation – and that is where this article concentrates. But the same principle can apply across sustainable transition more broadly, focusing on wider environmental or social objectives.  

Put simply, it implies a transformation of a business, with value created through the likes of margin resilience, lowered risk or operational improvement.  

In the context of climate, transition finance therefore refers to the financing of companies, activities or projects that are not yet low-carbon, with a focus on enabling their decarbonisation progression. This applies most notably in traditionally hard-to-abate industries, such as transportation or heavy industry.  

Policy backdrop and regional disparities 

Sustainable finance policy shows a clear interest in defining transition activities and ensuring credibility – although the approach varies considerably across jurisdictions, with implications for how this manifests in investment priorities and opportunities.  

The UK is advancing through its Transition Finance Guidelines and is likely to introduce mandatory transition plan disclosures, aligned with the International Sustainability Standards Board and Transition Plan Taskforce, alongside FCA implementation of the ‘sustainability improvers’ label within Sustainability Disclosure Requirements (SDR).  

Meanwhile, the EU remains more rules-based but is recalibrating through its updates to the Sustainability Finance Disclosure Regulations (SFDR), introducing clearer product categories, with the inclusion of a transition focused category. This transition or improvement assessment is currently proposed as a minimum 70% of portfolio with a transition-related objective. Demonstrating transition is expected to rely on a range of indicators, including transition plans and targets, or capex alignment to EU Taxonomy.  

The EU and other government taxonomies clearly remain central to how transition finance is defined and operationalised, but the treatment of ‘transition’ remains nuanced among them. The EU Taxonomy, for example, classifies a set of activities as ‘transitional’ if they meet a set of technical screening criteria and DNSH (do no significant harm) tests. At heart it is a classification system, not a transition framework. The criteria are stringent, designed to recognize activities that are already operating at, or very close to, a low-carbon performance level – and they reflect end-state criteria rather than capturing those earlier in their transition journey. 

By contrast, jurisdictions such as ASEAN and Singapore have developed more flexible and tiered “traffic-light” taxonomies that capture a broader range of transition activities, coupled with step-change transition criteria, rather than anchoring to an end-state “green” transition.  

Defining ‘transition’: one concept, many interpretations  

The industry has in turn developed a range of frameworks that define transition in different ways.   

One approach, building on government taxonomies, identifies a set of activities or sectors that qualify under a definition of transition to mark out a ring-fenced investible universe. An example of this is the Climate Bonds Initiative. Government and classification taxonomies are used to highlight activities across geographies that are most critical to transition – generally those considered to be high-emitting with no low-carbon alternatives.  

Of course, differences across these taxonomies give rise to regional differences in transition requirements and priority sectors. Our own Climate Solutions Identification tool assists with this, cross-comparing different external classifications of climate solutions (across low carbon, enablers and transitional activities) to understand ‘market agreement’ of definition, whilst contextualising each activity.  

The second definition assumes that all activities can transition in some way, provided they set credible targets and transition plans. This can be seen across both regulatory frameworks (SDR/SFDR), as well as industry frameworks such the Net Zero Investment Framework by IIGCC (Institutional Investors Group on Climate Change) or the Climate Transition Finance Handbook from ICMA (International Capital Market Association).  

These frameworks largely focus on the alignment of commitments to science-based pathways, factoring in whether commitments are credible – or in other words, based on current economic and technological conditions and company actions, if the committed transition is feasible.  

A more expansive definition focuses not only on the transition of a company’s own operations and supply chain, but also on its contribution to the broader economy-wide transition towards 1.3C alignment. In our definition, this economy-wide transition is more closely aligned with ‘climate solutions’ (explored in more detail here). 

Regional differences will always remain, given economies start from very different points, including varying energy mixes, manufacturing vs service-based economies, and overall level of development. Limited flexibility will lead to stricter definitions that exclude regions or sectors from access to transition finance, ultimately requiring a balance between credibility and inclusivity. 

Assessing credibility: from ambition to execution 

Over the past decade capital has largely flowed towards explicitly ‘green’ or low-carbon solutions, which can easily qualify under ‘climate solutions’ through frameworks and taxonomies. Examples would be renewables and clean technologies. However, the realities of economy-wide decarbonisation have brought into focus sectors that cannot simply be replaced.  

In contrast, the concept of transition is a blurred zone – and there exists a tension between the transition journey itself, and its completed end state. The question of overall ‘credibility’ is central to the test of transition finance, given it relies on forward-looking claims vs backward-looking outcomes. It demands a capital allocation based on forward-looking assumptions and pathways that contain uncertainties from technological, economical and policy perspectives. 

Assessing credibility therefore involves evaluating both the ambition of targets and the execution of those commitments. Our internal Net Zero Alignment Framework, covering all private market asset classes, covers just that – the ambition and science-alignment of commitments, whilst checking for continued progress and execution.  

Credibility, in this context, is determined by whether targets are linked to science-based decarbonisation pathways and supported by actions across governance, risk management and strategy. However, what this framework does not fully capture is transition capacity within the system and its connection to investment outcomes. This is our current area of focus, both across public and private markets.  

The above has already highlighted two components of our decarbonisation framework – our Net Zero Alignment Framework and Climate Solutions Identification Tool. The final component for private markets is the ‘ability to decarbonise’. This assessment aims to determine the feasibility to decarbonise based on: 

• whether the technology pathway exists
• whether the company being proposed for investment can execute financially and operationally; and, lastly
• whether country context is supportive from a policy perspective. 

Driving transition: The role of active ownership 

Transition is fundamentally for active managers; it shifts the narrative from not just lowering financed emissions within a portfolio, but actual decarbonisation in the real world.  

Taking an active approach enables numerous levers to be operationalised to achieve transition: the direct management of assets, engagement with investees on their transition plans, and linking financing terms to transition outcomes. 

Crucially, transition outcomes can be linked to value creation within asset classes – and indeed, as we have discussed previously, this is becoming central to the sustainable investment case. But investments will also need to accept a level of complexity and uncertainty in their assessment.  

Directly linking where value is created for an investment with transition outcomes achieved will assist in removing some of this uncertainty, as we show in the table below.  

The road ahead: from frameworks to outcomes 

Increasingly, transition finance is shifting its focus towards execution and value creation, but its success will depend on resolving interconnected challenges: defining transition, assessing credibility and delivering real-world outcomes. No single definition is likely to prevail, given regions and framework differences, with credibility becoming the critical filter that links ambition with feasibility.  

Transition will only be effective where capital is deployed to enable measurable and economically viable decarbonisation – and private markets have a distinctive role to play. Through management, long-term capital and active ownership, they are uniquely positioned to drive transition value creation across asset classes.

Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

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