Regulations surrounding the European sustainable finance package seem to have entered somewhat calmer waters for now. Nevertheless, the topic of ‘transition financing’ and ‘transition investing’ remains relevant, especially as there is a need for clear frameworks and definitions.
The concept of transition financing and transition investing can be described as financing or investing in projects and economic activities that support the transition to a more sustainable economy. This is also the primary goal of the European sustainable finance package, launched in 2018. It involves financing and investing in sectors transitioning to lower carbon emissions, increased energy efficiency, and improved climate and environmental outcomes. In short, sectors working towards achieving the climate goals of the Paris Agreement.
The European taxonomy, the classification system for sustainable economic activities as outlined in the European Taxonomy Regulation, plays a key role in promoting transition financing. However, unlike investments that comply with the European taxonomy and sustainable investments under the Sustainable Finance Disclosure Regulation (SFDR), the current framework does not provide a clear definition for transition investments.
Frameworks for transition investing
The European Commission, in its explanation of investing in transition, distinguishes between financing or investing in companies that are already sustainable and those that will meet certain sustainable performance levels in the future. The latter category refers to companies that are ‘in transition’.
In its recommendations of 27 June 2023, the European Commission described what it understands by ‘transition’ and ‘transition financing’. These descriptions were linked to, among others, investments that follow the EU climate-, transition-, and EU Paris benchmarks, activities that align with the taxonomy, and investments in companies with a credible action plan to meet the Paris Agreement’s goals.
These recommendations aimed to provide the financial sector with guidance on how to approach transition financing. However, they are not legal definitions. The SFDR also refers to transition activities in its information templates and provides a description. But within the SFDR framework, transition investments do not play a central role and are not legally defined.
The role of regulators
Dutch financial markets supervisor AFM has also noted the lack of clarity around transition investing. In its position paper of November 2023, it advocated for a specific label for transition investments, including requirements these products must meet. The European Securities and Markets Authority (Esma) also addressed this in its “Guidelines on fund names using ESG or sustainability-related terms” of 21 August.
Esma mandates that if you—as a fund manager—use transition-related terms in your fund name, you must meet certain criteria. For example, at least 80 percent of the fund’s investments must align with the intended sustainable, binding investment strategy, and the fund must not invest in companies involved in activities related to controversial weapons or the cultivation and production of tobacco. Despite the absence of a legal definition, Esma seems to be further defining what constitutes a transition investment.
Nevertheless, Esma advocates for a legal definition of transition investing, as evidenced by its opinion “Sustainable investments: Facilitating the investor journey – A holistic vision for the long term”, published on 24 July. A legal definition within the framework provides legal certainty and supports the development of transition-related products, according to Esma.
What next?
The call for further clarification and positioning of transition investing is justified. Investing in transition is often seen as the driving force towards a more sustainable society. It therefore deserves a much clearer and more prominent place in the current regulatory framework.
However, a key element is missing from the criteria outlined by AFM and Esma. The essence of a company in transition is that the company is not yet sustainable, but is becoming increasingly sustainable. An important element of the definition should be that transition investments must demonstrate continuous progress. This can be tracked using predefined KPIs, as a transition without measurable progress is essentially not a true transition.
Randy Pattiselanno is a legal and regulatory consultant at the Projective Group.
