How investors are approaching the decarbonization of hard-to-abate sectors
Many carbon-intensive industries lack the resources or technologies needed to transition to a net zero future. Climate-conscious investors are increasingly focused on making a positive impact by supporting the development of viable transition pathways.
Hard-to-abate sectors collectively account for about a third of global greenhouse gas emissions and present a formidable obstacle to greening the economy. These include heavy industries like steel, cement, aluminum, basic chemicals and petrochemicals, as well as heavy-duty transportation such as aviation, shipping and trucking.
What separates hard-to-abate sectors from other emissions-intensive sectors is the lack of a low-carbon alternative that is credible or technologically or economically viable, explained Sayuri Shirai, Advisor for Sustainable Policies at the Asian Development Bank Institute.
Demand for hard-to-abate sectors is also set to expand over the coming years and decades as populations grow, incomes rise and affluence spreads – especially in fast-growing regions of the world such as Asia.
“Products from hard-to-abate sectors are essential for economic and social development,” said Shirai. “Given the projected increase in demand for these products, it is important to scale up transition finance targeting hard-to-abate sectors.”
For investors, however, the uncertainty around the transition pathway for these sectors is a major hurdle. Broadly, investors looking to align their portfolios with the net zero transition can approach carbon-intensive sectors in one of two ways. They can divest them from their portfolios, or they can work with businesses to encourage them to take action.
“There is an acknowledgement on the part of responsible investors that divestment is just transferring emissions,” said Sonia Gandhi, Senior Director, Education at CFA Institute. “Wherever possible, we believe that engagement is perhaps one of the sharpest of the financial industry’s arsenal of tools to help reduce real-world emissions.”
More broadly, simply shuttering hard-to-abate sectors or forcing them to adopt prohibitively expensive technologies to cut their emissions could lead to widespread industrial disruption, job losses and consumers being unable to afford many of the goods and services they have come to rely on, from plastic bicycle helmets to convenient international travel.
Furthermore, hard-to-abate sectors are necessary for decarbonization. Without steel, for example, there would be no wind turbines. Concerns have already been raised that shortages of steel could threaten wind energy projects, not to mention production of electric vehicles.
Falling short
Transition finance, which refers broadly to funding directed towards emissions reduction, can be a powerful tool for carbon-intensive businesses. While green finance – which is restricted to projects that are already climate-friendly – has more than tripled since the adoption of the Paris Agreement in 2015, investments required to decarbonize hard-to-abate industries are falling short.
A big part of the problem is the difficulty of coming up with valid transition plans for investors to support. Based on a 2023 survey, the majority of firms in hard-to-abate sectors have yet to lay out a clear climate target, owing in large part to the technological uncertainty involved (see Figure 1).
Hurdles to transition finance include the lack of a standardized definition of eligible activities, the absence of instruments endorsed by international organizations, and the uncertainty about whether and when it will be technically feasible to cost-effectively decarbonize hard-to-abate sectors. The confusion and complexity around these issues increase the risk of transition finance being associated with greenwashing, said Shirai.
“I am sure many investors wish to contribute to decarbonization of the economy by providing finance to address the hard-to-abate sectors,” she said. “It is therefore essential to encourage discussions among governments, financial regulators, and investors to share information and experiences to foster convergence by establishing minimum standards and criteria or promoting interoperability among these approaches.”
There are several factors that make hard-to-abate sectors especially difficult to deal with, including:
- High-temperature production processes. Cement production, for instance, is carried out at around 1,400°C, which can only be done cost-effectively using fossil fuels
- Non-energy emissions. Ammonia, for example, is typically produced from fossil fuels in a process that generates carbon dioxide as a byproduct
- High-density energy requirements. Space and weight are major constraints to long-distance travel. For example, replacing fuel tanks on a commercial aircraft with current battery technology would exceed the maximum takeoff weight many times over
- Highly integrated and complex processes. This makes finding new low-carbon approaches complicated and expensive
- Significant capital investments. Owners may be reluctant to write down their sunk costs in current technology. This is exemplified by the slow adoption of electric arc furnaces among steelmakers
Governments are looking to help by establishing pathways for specific sectors. Japan’s Ministry of Economy, Trade and Industry, for example, has laid out a three-stage pathway for the iron and steel sector until 2050 (see Figure 2), beginning with energy efficiency, then incorporating hydrogen in the second stage, and finally focusing on CCUS and expanding usage of arc furnaces.
Measuring the impact
Shirai also explained that additional information disclosure by companies beyond their net zero targets and associated decarbonization pathways could help enhance transparency and credibility among investors.
“Companies experimenting with new technology using hydrogen fuels and investing in CCS or CCUS facilities also need to provide convincing evidence over time to demonstrate whether these technologies they are experimenting with can really become commercially viable and put them on a 1.5°C pathway,” she said.
Another issue hindering transition finance is that the main metric used by financial institutions to signal their climate commitment is financed emissions, a measure of the emissions they finance in the real economy. If a bank chooses to finance the ambitious transition plan of a company in a hard-to-abate sector, in the short- to medium-term at least, the bank’s financed emissions would increase, even though it might support real-world decarbonization in the long-term.
To address this issue, fund managers looking to establish funds focused on driving real-world emissions reductions have looked to quantify the positive impact by calculating avoided emissions, also referred to as Scope 4 emissions. This approach, however, also currently lacks a clear and standardized methodology.
What remains is for investors to assess the credibility of individual firms’ transition plans. Several organizations, including CDP (formerly known as the Carbon Disclosure Project), and the Network for Greening the Financial System, offer guidance on the key elements credible transition plans should include.
Outperformance potential
By identifying companies that have developed better transition plans than others in their sector, investors can potentially generate alpha.
“Right now, perhaps a company is unloved and seen as high-risk, and its share price has taken a battering,” said Michael Lebbon, Founder & CEO at EMMI, which helps financial institutions analyze climate risks.
But if an investor assesses that the same company is well placed to transition successfully, it might offer a good investment opportunity, according to Lebbon, who was speaking on CFA Institute’s Climate is Collective Webinar about Transition Plans and Transition Planning.
Such companies stand a good chance of outperforming their less prepared peers, “who won't get as much access to capital, won't be able to compete as much and may face regulatory issues.”
“There is definite benefit in doing this properly. And more and more investors are now starting to really think about transition plans. But it's still very much in its infancy,” he added.
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