Transition planning: credibility is in the eye of the shareholder

Recently, particularly in the US, there has been a rising legal and policy backlash against investors using environmental, social and governance (ESG) factors as the basis for investment decisions. 

This backlash stems from a perception that investors are placing their values above financial returns and breaching fiduciary duties. However, climate risk is now seen as a credit risk by many investors and is being incorporated into credit risk assessments. This means that the wave of ‘anti-woke’ legal cases and proposed bills will not stop the assessment of climate risk in financial decisions.

In practice, we are witnessing the continued integration of climate risk with financial decision making, which aligns with legal opinions for investors in many jurisdictions. For example, in 2021, The Aotearoa Circle sought legal advice regarding the duties of New Zealand trustees to manage climate change-related risks to trust investments. This is crucial when company directors are determining how to respond to climate change.

The corporate response is generally organised in what is termed a “transition plan”. The New Zealand Climate Standard (NZCS) requires captured organisations to disclose a corporate transition plan starting from FY25. But what does this mean in practice? In terms of compliance, it actually doesn’t mean much. The NZCS does not require a certain level of action or ambition to address climate change (such as a 1.5-degree-aligned transition plan); it merely requires disclosure of what actions are being taken. This means that “compliance” could involve having no greenhouse gas (GHG) emissions reduction targets in place and therefore disclosing a transition plan that contains no specific actions beyond business as usual.

However, the more critical judges of the “required” level of action or ambition of a transition plan are the debt and equity providers, who have a duty to act in the best interests of their beneficiaries. Global banks and institutional investors are developing their own standards for what can be deemed a “credible” transition plan from a credit risk perspective, and they are already voting with their money. 

A relevant example of this is the Commonwealth Bank of Australia’s (CBA) recent announcement in their 2024 Climate Report (pages 58-59) to stop new financing for companies that derive 15% or more of their revenue from certain higher-risk fossil fuels (including oil and gas) or generate 25% or more of their electricity from coal, unless they have a transition plan that has been independently assessed as meeting CBA's definition of credible by 2025. This announcement has been welcomed by investors in CBA, with some stating that this policy is the reason they added CBA to their investment universe. Other major banks are now facing shareholder resolutions to take similar actions.

So, for a New Zealand climate reporting entity (CRE) embarking on its journey to develop or refresh its transition plan, what does credibility mean in the eyes of these large capital providers? Investor considerations for credible transition plans generally consist of the following elements:

• Emissions coverage of GHG reduction targets: Most definitions of credible plans require that GHG reduction targets include a majority of scope 1 and 2 emissions and, in most cases, also material “scope 3” or “value-chain” emissions sources, particularly if they are necessary for revenue generation.
• Timing of GHG emissions reduction targets: A short-term target is useful for integrating into business planning cycles, but a medium- or long-term target is also generally expected to demonstrate the overall level of ambition and alignment with the Paris Agreement.
• Ambition of GHG reduction targets (the tricky bit): Setting a target that aligns with a “well below 2 degrees” future or the “Paris Agreement” is a key requirement of many definitions of credibility. What this means in practice is somewhat subjective, as there are differing views on what an equitable pathway to a “well below” 2-degree future looks like. For most definitions of “credible,” this can range from achieving net zero (all GHGs) by 2050 (or sooner for some energy-related sectors) to setting a verified target using the Science-Based Target Initiative’s (SBTi) sectoral approach or developing a regional sector target based on locally recognised bottom-up analysis of what is feasible (in New Zealand, this is likely to be the work of the Climate Change Commission).
• Developing the supporting decarbonisation plan: For a transition plan to be credible, it needs to outline the key actions that will allow the organisation to meet its target. These decarbonisation plans are generally developed using a range of tools, from energy efficiency assessments to marginal abatement cost curve analysis, and may involve more wholesale business model or supplier changes. Most definitions of credibility will also provide a cap on the level and quality of any offsetting allowed within this plan.
• Capital allocation approval: The decarbonisation plan generally needs to be costed to a level of accuracy that is feasible (noting that long-term actions generally rely on a level of technology improvement, meaning cost estimates and ranges are required). It is also expected that these capital allocation plans are approved by the appropriate level of governance, and shorter-term actions are contained within normal business budget approval processes.
• Level of governance: Some definitions of credibility (such as CBA’s) also set out a minimum level of governance expected to accompany the transition plan and the broader assessment of risk and mitigation. Usually, these require a level of board oversight and approval.

There are many international frameworks that set out criteria for credible transition plans, such as CA100+ or the UK’s Transition Plan Taskforce. These frameworks are generally used by international and Oceania capital providers to develop their definitions of credibility. Most of these frameworks focus on decarbonisation rather than also considering a business’s response to the physical risks presented by climate change.

For companies with significant anticipated impacts from physical changes to the climate, the scope of their transition plan will likely need to incorporate their strategic response to these risks as well, to alleviate investor concerns about other unmanaged credit risks. If the anti-ESG movement leads to a rollback of global decarbonisation targets, these physical risks will increasingly become a greater focus for investors.

Note: The views expressed in this article are the views of the author, not Ernst & Young. This article provides general information, does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Liability limited by a scheme approved under Professional Standards Legislation.