Charting a Pathway for Transition Finance – Challenges and Opportunities in the EU Framework

By Frédéric Ducoulombier, CAIA, Director, EDHEC-Risk Climate Impact Institute

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This article by Frederic Ducoulombier, Director of EDHEC-Risk Climate, has been originally published in the December 2024 newsletter of the Institute. To subscribe to this complimentary newsletter, please contact: [email protected].

 

Transition finance is increasingly recognised as a critical tool for meeting net-zero targets. Broadly defined, it encompasses extending financial support to high-emission sectors to transition toward sustainability by decarbonising their operations, adopting cleaner technologies, or decommissioning outdated facilities.

The magnitude of green and transition investments has increased over the last decade but remains insufficient to deliver the emissions mitigation required to meet the goals of the Paris Agreement. According to the Intergovernmental Panel on Climate Change, mitigation investments for this decade have to grow from three- to six-fold from current levels in scenarios that limit warming to 2°C or 1.5°C.[1] Scaling up transition finance is a pressing imperative for this decade and, in the words of the IPCC, calls for “clear signalling and support by governments.”

However, there is no globally accepted definition of transition finance, and few major regulatory frameworks have provided a proper treatment of this critical area. This lack of clarity hinders the necessary alignment of fund flows towards the investments needed for transition, as consistent with State commitments under the Paris Agreement.[2] 

Surprisingly, even the European Union (EU), often heralded as a pioneer in establishing a comprehensive framework for sustainable finance, faces gaps and inconsistencies in its approach to transition finance, which create significant challenges for its effective deployment.

In this article, we first discuss the definitional challenge of transition finance and how it is addressed in different jurisdictions, then review the current challenges faced by transition finance in the EU Sustainable Finance Framework. We then explore the role of private-sector initiatives in providing practical tools and frameworks to guide transition finance. Finally, the article highlights key policy recommendations and examines their potential implications for the integration of transition finance into sustainable finance frameworks.

 

The Contextual Nature of Transition Finance

Pathways to net-zero, as described in IPCC work, require a comprehensive approach combining investments in climate solutions, transition activities, and carbon sinks, which may be defined as follows:

  • Climate solutions investments, i.e., investments in activities that are central to a net-zero economy and have or allow high performance in terms of emissions: low-emissions energy; clean transportation; energy efficiency; waste management and recycling, etc.
  • Transition investments, i.e., investments supporting the decarbonisation of high-emission sectors where no readily implementable low-emission substitutes exist, yet which remain essential in a net-zero economy. These investments may include retrofitting industrial facilities, switching to low-carbon and/or high-efficiency systems or processes, especially in reputedly hard-to-abate sectors like steel or cement making. They may also include decommissioning assets such fossil fuel power plants or other carbon-intensive facilities that cannot align with net-zero goals.
  • Carbon sink investments, i.e, investments aimed at offsetting unavoidable emissions through nature-based or technological solutions. Examples include restoring forests, peatlands, wetlands, or mangroves, making land-use changes to develop these ecosystems, enhancing soil carbon sequestration and ocean carbon absorption, and implementing advanced carbon capture and storage technologies.   

 

When one sets aside power generation and household use of fossil fuels, the bulk of greenhouse gas emissions are produced by sectors like industry, transportation, commercial buildings, and agriculture. Achieving substantial emission reductions in these areas necessitates considerable investments, particularly when less capital-intensive solutions—such as curbing conspicuous consumption and high-emissions lifestyles, starting with the most affluent strata of the global population, and shifts towards plant-based diets—are not pursued due to socioeconomic or cultural factors. In this context, transition finance plays a pivotal role in bridging the emissions gap for high-emission sectors that cannot immediately align with net-zero targets but remain integral to the global economy. By facilitating decarbonisation through electrification, retrofitting, innovation, and the gradual phase-out of carbon-intensive infrastructure, transition finance complements climate solutions investments and helps mitigate risks like economic disruption[3] and stranded assets.

Global climate governance recognises that states have “common but differentiated responsibilities and respective capabilities” in addressing climate change.[4]  It is thus accepted that the diversity of national circumstances shapes the needs and capacities for achieving a sustainable transition. As a result, activities and sectors deemed critical to the transition vary widely between countries and evolve over time. This inherent variability makes it challenging to establish a global, precise definition for transition-related activities and finance, as their scope must accommodate these contextual differences.

Indeed, there are no globally accepted definitions or prescriptions for transition-related finance.

National and regional authorities have produced tools to assist in the qualification of transition investments at activity and/or entity level. Besides the Nationally Determined Contributions (NDCs) required under the Paris Agreement, these tools have included regional/national and sectoral ambitions and/or pathways, taxonomies, and guidelines that differ in their degree of specificity.

The European Union regulation on the establishment of a framework to facilitate sustainable investment (hereafter Taxonomy Regulation), sits at one extreme of the spectrum as it provides highly granular activity “Technical Screening Criteria” (TSC) and mostly quantitative thresholds to determine which assets are eligible, in the sense of being regarded as making a substantial contribution to at least one of six sustainability objectives, and potentially aligned, in the sense of not significantly harming the other objectives. Qualification of eligible investments as aligned under this EU Taxonomy also requires entity-level compliance with social and governance standards.

At the other end of the spectrum of detail, the Malaysian Sustainable and Responsible Investment Taxonomy uses six principles to guide sustainable investments in a way that flexibly accommodates varying levels of readiness. It incorporates both asset-level considerations, by providing guidance on classifying specific activities as sustainable, and entity-level considerations, by encouraging organisations to adopt broader social and governance commitments in line with national sustainability objectives.

The criteria or principles of these taxonomies allow certain investments by entities operating in sectors that need to be phased out as part of the global transition to qualify as transition aligned. As such, critics argue that taxonomies could inadvertently abet greenwashing if financing is not tied to robust, entity-specific decarbonisation pathways.[5][6]  Authorities are increasingly emphasising the importance of robust transition plans, providing detailed guidance on, and requiring disclosure of, corporate transition plans, and in rare cases, mandating that they be aligned with decarbonisation goals.

Building on the global context of transition-related finance explored above, we turn to what is often described as the world's most comprehensive regulatory effort to support sustainable investment: the EU Sustainable Finance Framework. Despite its ambition, we explore how its design leaves critical gaps, allowing transition finance to fall through the cracks.

 

Transition Finance in the EU Sustainable Finance Framework

On the heels of the European Union’s international sustainability commitments, the European Commission convened the High-Level Expert Group on Sustainable Finance (HLEG) in 2016 to provide strategic guidance on aligning the bloc’s financial system with sustainability goals, beginning with climate commitments. The group’s 2018 report proposed a comprehensive framework, including a tricolour taxonomy to classify economic activities (into sustainable, enabling/transitional, and unsustainable), phased sustainability disclosures starting with corporates and followed by financial market participants, and incentives to channel investments into green and transitional activities.

While the EU Sustainable Finance Package drew heavily on the recommendations of the HLEG, it diverged significantly from the group’s thought-through planning and holistic vision. This is evident in the prioritisation of certain regulations, such as the 2020 climate-themed update of the Benchmark Regulation, and the delayed or partial implementation of key recommendations, shaping its current structure and impact.

To understand how transition finance fits within the framework as implemented, it is essential to first explore its key elements, i.e., the Taxonomy Regulation, the Sustainable Finance Disclosure Regulation (SFDR), and the Regulation pertaining to the EU Paris-aligned and Climate-transition Benchmarks (PAB/CTB, hereafter referred to as EU Climate Benchmarks):

 

  • The Taxonomy Regulation establishes a comprehensive framework for classifying sustainable activities, starting with climate change mitigation and adaptation and four other environmental objectives.  Detailed TSC identify activities making a substantial contribution one or several of these six sustainability objectives while avoiding significant harm to others consistent with the Do No Significant Harm (DNSH) principle.  Taxonomy eligible investments are qualified as aligned if the entity making these investments respects “Minimum Safeguards”, i.e., it complies with internationally recognised norms for responsible business and human rights while also addressing the bloc's specific social and governance standards.  The EU Green Bond Standard requires that funds raised through green bonds be used for Taxonomy-aligned investments. However, this standard remains voluntary, and the financial incentives recommended by the HLEG, such as lower capital requirements for sustainable investments, have yet to materialise.

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  • The Sustainable Finance Disclosure Regulation (SFDR) imposes transparency requirements on financial market participants regarding sustainability risks, principal adverse impacts (PAIs), and sustainability policies at the entity level, as well as sustainability objectives and processes at the product level.  In a cart-before-the wheel manner, the 2019 Regulation on sustainability‐related disclosures in the financial services sector introduced granular disclosure requirements on a host of (often ill-defined) sustainability areas for which there were no readily available and standardised corporate disclosures. The Corporate Sustainability Reporting Directive (CSRD) was meant to belatedly address the data gaps while also encouraging companies to integrate sustainability considerations into their strategic planning and operations, and thus ensure better access to capital. However, successful interest group pushback has diluted[7] and delayed corporate disclosure obligations, perpetuating the consequences of this illogical sequencing.[8]

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  • The Regulation establishing EU Climate Benchmarks meant to provide investors with tools to align investment strategies with the net-zero transition by setting uniform portfolio construction requirements for indices claiming the PAB/CTB labels, with a view to increasing comparability and mitigating the risks of greenwashing. However, the regulator’s decision to ignore industry feedback at the design stage has produced regulation that does not allow for meaningful product-level comparisons and institutionalises greenwashing by giving the stamp of regulatory approval to strategies that do little to channel funds towards key transition sectors and issuers delivering real-world decarbonisation.[9]

Together, these three texts establish a framework to classify, disclose, and incentivise sustainable activities. Yet, the role of transition finance—a critical lever for decarbonising high-emission sectors—remains unevenly integrated within these regulations. Exploring each text in detail sheds light on how transition finance is addressed and highlights areas where gaps exist.

 

  • Transition Finance in the Taxonomy Regulation

While the TR provides detailed criteria for identifying environmentally sustainable activities, its primary focus on already aligned ‘green’ activities fundamentally limits its ability to support the full spectrum of activities necessary for transition. This contrasts with a traffic light taxonomy, such as the one recommended by the HLEG, which could classify activities across a broader range of sustainability performance, including unsustainable practices requiring urgent transition or decommissioning.

In addition to green activities that 'contribute substantially' to one or more of the Taxonomy’s environmental objectives, the framework recognises 'enabling activities' that facilitate such contributions and narrowly defined 'transitional activities.'

These transitional activities are high-emission operations without feasible low-carbon substitutes, provided they achieve 'best-in-class' performance aligned with pathways limiting global warming to 1.5°C.  The TSC for qualifying transitional activities are particularly stringent, excluding many bona fide investments aimed at decarbonising transitioning activities. Even when such activities meet the TSC bar, the DNSH principle adds another layer of restriction, disqualifying those that cause significant harm to other environmental objectives. Furthermore, the framework does not address the retirement of unsustainable infrastructure.

The TR includes a forward-looking provision that allows companies to classify investments in currently non-sustainable activities as Taxonomy-aligned, provided they are part of a clear plan to transition these activities towards sustainability. This plan must be approved by the company's management and should outline the steps to achieve alignment within five years, or up to ten years in exceptional cases. Additionally, companies are required to annually disclose the proportion of total capital expenditures associated with this transition to ensure transparency and accountability. However, this provision is constrained by the same stringent TSC and DNSH criteria that apply to already aligned activities. Furthermore, the medium-term timeframe reduces its practicality for high-emission sectors that require phased decarbonisation over longer horizons.

These four distinct limitations—the stringency of the TSC, the rigid application of DNSH, the omission of decommissioning efforts, and the restricted scope of the CapEx exemption—severely constrain the Taxonomy’s ability to support the breadth of transition finance initiatives necessary to achieve climate goals.

 

  • Transition Finance in the Sustainable Finance Disclosure Regulation

While the SFDR is primarily a disclosure regulation, it is also designed to support the allocation of capital toward investments needed for the transition to a sustainable economy. Its definitions, categories, and requirements indirectly shape how capital is mobilised and deployed—often leading to unintended consequences for transition finance.

Under Article 2(17) of the SFDR, a sustainable investment is defined as an investment in an economic activity that "contributes" to an environmental or social objective, provided that such investment does not significantly harm any of those objectives and is carried out by an investee company that follows “good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance”.  However, the term "contribute" is not defined in the SFDR, nor is it linked to the substantial contribution and related TSC of the TR. This lack of definition allows for a wide range of interpretations by FMPs. While this flexibility can support transition finance by accommodating investments in activities that are not Taxonomy-aligned but may nevertheless be considered as contributing to the transition, it also introduces significant risks. The absence of standardised criteria undermines comparability across investments and increases the potential for greenwashing, where investments are marketed as sustainable without rigorous substantiation. A similar ambiguity applies to the DNSH and governance screens, which need to be defined by each FMP (DNSH assessments are tied to PAIs, and safeguards to global norms, but without a prescriptive approach or thresholds). Importantly, these negative screens apply not at activity level, as in the case of the TR, but at the level of the investee company, which is inherently more exclusory (since it disqualifies any investment in a company that fails any of the screens).

The definition of sustainable investment matters for funds promoting sustainability in the sense of the Regulation.  SFDR imposes disclosure at entity level for FMPs and a tripartition of disclosure requirements on financial products, distinguishing between Article 6, Article 8, and Article 9 funds. 

•     Article 9 funds are those that have sustainable investment as their objective. They must explain how this objective is to be attained and disclose the proportion of taxonomy-aligned investments when pursuing environmental objectives.

•     Article 8 funds are those that ‘promote’ environmental or social characteristics alongside other financial characteristics. These funds must disclose how they promote these sustainability characteristics, the share of their investments classified as sustainable investments, and, when promoting environmental objectives, the proportion of taxonomy-aligned investments.

•     Article 6 funds include all other funds. They are required to disclose how they integrate sustainability risks into their decision-making or explain why they consider these risks irrelevant.

It follows that Article 9 funds can include transition finance investments, but only if they qualify as sustainable investments under Article 2(17). However, negative screening creates significant hurdles for bona fide transition investments, particularly for companies associated with significant adverse impacts, such as high emissions. These issues are not present for Article 8 funds promoting transition along other characteristics.  This plasticity, however, comes at a high cost since it allows for a wide variety of custom approaches of varying ambition and effectiveness to market themselves as transition investments. The lack of established standards to objectively label or rate these offerings also hinders the development of a cohesive market for transition finance-oriented funds. 

One can also remark that the requirement to disclose the proportion of Taxonomy-aligned investments may disincentivise the use of definitional flexibility that could otherwise allow for the inclusion of transition projects that fail to meet the Taxonomy’s strict criteria. Likewise, the disclosure of PAI – which is mandated at entity level and is also needed for products that market themselves as considering them – may disincentivise transition investments into activities associated activities with short-term adverse impacts even though these investments may be key to supporting the transition (and possibly contribute to mitigating adverse impacts at longer horizons).

 

  • Transition Finance in the EU Climate Benchmark Regulation

The EU Climate Benchmarks are intended to support the European Green Deal by offering investors clear, long-term signals to reallocate funds towards sustainable activities and improve the climate impact of investments year after year.

The minimum standards for these so-called Paris-Aligned Benchmarks and Climate Transition Benchmarks require a reduction in the weighted average carbon intensity of portfolios by 50% and 30%, respectively, relative to the relevant market benchmark right from onset. Additionally, an absolute year-on-year contraction of 7% in carbon intensity is required to align with a rigorous global 1.5°C pathway. The approach, however, is short-term and backward-looking, as it relies on selecting and weighting assets based on their absolute intensities and year-on-year changes in intensities to achieve the required portfolio decarbonisation. It allows only minimal consideration of corporate commitments or adherence to differentiated transition pathways reflective of sector and country responsibilities and capabilities.

PAB standards further mandate the exclusion of companies with material involvement in fossil fuels and medium to high carbon intensity power generation. As such, they at best channel investments towards green energy—they are not designed to support the transition of the power generation sector required for rapid electrification.  The requirement to halve relative average carbon intensity right from onset also does little to maintain exposure to the assets contributing most significantly to emissions, thereby missing the opportunity to accompany these assets in their transition. The regulation’s crude sectoral controls—partitioning assets into high- and low-emission sectors while merely requiring that cumulative exposure to high-emission sectors remains aligned to market benchmark weights—enable portfolio decarbonisation primarily through reallocation across and within (high-impact) sectors.

While the lower market-relative intensity reduction for CTBs does not automatically disqualify high-intensity sectors that need to transition, at least at onset, the lack of granularity in the framework still promotes divestment from key transition sectors and heavy emitters. Furthermore, the chosen intensity metric, which emphasises price momentum in capital markets over real-world emissions mitigations, disincentivises honest transition finance approaches and undermines the benchmarks' potential to drive meaningful change—this is compounded by the requirement to incorporate unreliable value chain emissions data into measurement. These issues, which the author pointed out at the design stage (Amenc and Ducoulombier, 2019; Ducoulombier, 2020) and later documented in peer-reviewed publications (Ducoulombier, 2021; Ducoulombier and Liu, 2021), are now widely accepted, and net-zero investor coalitions have set forth recommendations for the design of transition benchmarks that can better promote decarbonisation in the real economy (UN NZAOA, 2022; IIGCC, 2023).

Despite the EU's ambition to lead in sustainable finance, a clear definition of transition finance is conspicuously absent from its key regulatory texts. The approach to transition finance across the Taxonomy Regulation, SFDR, and Climate Benchmark Regulation is fragmented and weak, failing to provide the necessary incentives or frameworks to support high-emission sectors in their transformation. Worse, the interactions between these texts create negative synergies, where the total effect is less than the sum of the parts. Rather than facilitating a cohesive and effective pathway for transition finance, the current framework risks undermining the very systemic changes it seeks to promote.

 

Private-sector initiatives providing transition finance guidance

Finance industry initiatives have significantly contributed to defining and operationalising transition finance, producing guidelines and frameworks that operate at both the instrument and issuer levels and provide valuable insights for refining regulatory approaches to sustainable finance. 

The birth of transition finance dates back to the second half of the 2000s with the first issuances of climate and green bonds by Multilateral Development Banks (MDBs) in a period of renewed thrust by many nations to tackle climate challenges.[10] Following these groundbreaking issuances and in response to the growing appetite for climate finance, the Climate Bond Initiative (CBI) was launched at end 2009 to develop standards to promote high integrity in the nascent market and support low carbon investment.  At end 2011, the not-for-profit organisation finalised its first Climate Bond Standards, covering wind energy and announced a certification scheme.  Coverage rapidly extended to other renewables and energy efficiency projects while the Certification Scheme developed to ensure that bonds would meet strict climate-aligned criteria through pre- and post-issuance verification. Eligible projects and criteria were formalised in the CBI Taxonomy, first released in 2013, which categorised sectors and activities aligned with a low-carbon economy.

The CBI Taxonomy has been periodically updated to extend coverage and reflect advancements in climate science and evolving international commitments, including the temperature goals of the Paris Agreement. From 2020, it began expanding to address the decarbonisation challenges of high-emission sectors by introducing criteria for transition-aligned projects. In 2024, the Climate Bond Standards were revised to include a 5% flexibility pocket for use-of-proceeds and expand the certification coverage to general-purpose instruments, assets and entities. The latter further facilitated transition finance by allowing the funding of more incremental, entity-wide investments, while preventing greenwashing by insisting on issuer-level alignment with, or transition towards, science-based transition pathways. 

A similar evolution is visible in the work of the International Capital Market Association (ICMA). In 2014, the industry association launched the Green Bond Principles (GBP) to support broader development of the sustainable bond market than allowed by the CBI. Whereas the CBI initially focused on climate change mitigation, the GBP recognised a wider array of “green” projects. And while the CBI laid out prescriptive science-based criteria, the GBP adopted principles-based guidance: whereas issuers had to respect strict guidelines for the use of proceeds, they enjoyed flexibility in defining sustainability objectives, with ICMA relying on transparency and external reviews to promote market integrity.[11] As the urgency of the transition and the challenges faced by high-emission sectors became better understood, ICMA too recognised the need for a broader approach. In 2020, it introduced the Sustainability-Linked Bond Principles (SLBP) and the Climate Transition Finance Handbook (CTFH). Relative to the GBP, the SLBP shift the focus from project-specific financing to issuer-level performance, offering flexibility in the use of proceeds while requiring that Sustainability Performance Targets (SPTs) be met lest the issuer face a penalty such as a stepped-up coupon or the requirement to purchase offsets to make up for the sustainability performance gap. Meanwhile, the CTFH emphasises the necessity for issuers to articulate credible transition strategies, addressing greenwashing risks from the strategic issuance of green or sustainability-linked instruments. 

The financial sector's engagement with transition finance aptly began with debt instruments, which dominate the primary market and enable the direction of capital toward urgent, on-the-ground decarbonisation investments by corporates and administrations. Over time, buy-side institutions expanded this effort, exploring the potential to incorporate sustainability considerations more broadly across asset classes and both primary and secondary markets. Broader buy-side engagement in transition finance began to gain momentum in the mid-2010s, aligning with the preparation and subsequent implementation of Paris Agreement commitments.

Notable initiatives, such as the Montréal Carbon Pledge and the Portfolio Decarbonisation Coalition demonstrated investor interest in addressing climate change and sought to foster a supportive atmosphere for the negotiations leading to the Paris Agreement. These early initiatives emphasised measuring, disclosing, and reducing portfolio carbon footprints by reallocating capital from carbon-intensive to green activities and encouraging issuers to cut emissions and support the transition. Though limited in scope, they laid the groundwork and built networks for more comprehensive transition finance frameworks and actions.

As understanding of the urgency of comprehensive climate action progressed following the Paris Agreement, buy-side institutions elevated their ambitions from climate-conscious to net-zero investment. In 2019, the Paris Aligned Investment Initiative (PAII) and the Net-Zero Asset Owner Alliance (NZAOA) were launched, aiming to provide detailed guidelines for aligning portfolios with the Agreement's long-term goals. In 2021, the first version of the Net Zero Investment Framework (PAII, 2021) and the inaugural Target Setting Protocol (NZAOA, 2021) were released. While there was not a single mention of “transition finance” in these early frameworks, they were designed from the outset to extend beyond mere portfolio decarbonisation by incentivising real-world decarbonisation through capital allocation strategies and issuer engagement (Ducoulombier, 2021b). Critically, both frameworks have provided valuable insights for the transition of high-emission sectors since inception. The Net Zero Investment Framework introduced a bucketing approach, underpinned by analysis of key backward- and forward-looking criteria, to classify assets by their alignment with net-zero performance and goals. This approach captures not only green assets operating at net-zero performance but also those aligned with or transitioning toward a net-zero pathway, as well as those committed to aligning and the non-aligned. Meanwhile, the Target Setting Protocol emphasised the importance of setting science-based sector targets, starting with key transition sectors, to link portfolio decarbonisation with real-world progress.  While key transition sectors were already subjected to stricter scrutiny than other sectors in the initial Net Zero Investment Framework, the 2024 revision insists on the use of relevant science-based pathways and strengthens the oversight of transition plans, including through enhanced evidencing of capital and operational expenditures supporting target delivery. Additionally, transition finance is explicitly identified as an advocacy priority, emphasising the importance of creating enabling environments and regulatory frameworks to support decarbonisation in high-emission sectors (PAII, 2024). The treatment of transition finance within the Target-Setting Protocol has remained largely consistent since its inception. However, the NZAOA (2023) report on developing credible transition plans provides valuable guidance on evaluating the credibility and effectiveness of such plans, offering an opportunity to enhance the application of the protocol.  This guidance draws on insights from reports by various industry associations, supranational organisations, and on the transition plan disclosure framework of the CSRD.

While asset-owner-driven initiatives blazed the trail of net-zero alignment frameworks, other financial sector stakeholders—including asset managers, banks, and insurers—have increasingly stepped forward with their own commitments and frameworks. Recognising the need for greater coordination and consistency across the financial ecosystem, the Glasgow Financial Alliance for Net Zero (GFANZ) was established ahead of COP26 in 2021. In recent work, GFANZ (2023) introduced a taxonomy of transition finance that highlights four critical dimensions: scaling climate solutions, financing assets or companies already aligned with net-zero pathways, supporting high-emission assets and companies transitioning toward net-zero, and responsibly phasing out carbon-intensive assets. The inclusion of this final dimension—managed phaseout—represents a critical yet underdeveloped area in transition finance, requiring further attention to ensure a just and orderly transition. 

 

Advancing Transition Finance in the EU: From Guidance to Reform

Active dialogue among stakeholders, regulators, and supervisors has fostered a growing recognition of the EU Sustainable Finance framework’s initial inadequacies in addressing transition finance. Recent work by the European Commission (EC) and the European Supervisory Authorities—most notably the European Securities and Markets Authority (ESMA)—provides guidance on navigating the current framework while charting a course to enhance the regulatory architecture to support transition activities effectively.

 

Working Around the Gaps: The EC Communication on Transition Finance

The European Commission's June 2023 Recommendation on facilitating finance for the transition to a sustainable economy builds on earlier work[12] acknowledging the critical role of mobilising private funding alongside public investments to achieve the EU's climate neutrality and sustainability objectives and the importance of developing tools and frameworks to facilitate the transition for high-emission sectors.  The 2023 Recommendation is intended as guidance for market participants that wish to obtain or provide transition finance as well as for Member States and supervisors acting as facilitators.  Crucially, it defines "transition finance," a term absent from the EU legal framework, and situates it within the EU’s climate and sustainability goals.[13]  

The Communication defines transition finance broadly to mean financing of investments compatible with, and contributing to, the transition, that avoids lock-ins[14] and include:

(a) investments in Taxonomy-aligned transitional economic activities and Taxonomy-eligible economic activities becoming Taxonomy-aligned;
(b) investments in undertakings or economic activities with a credible transition plan at the relevant level;
(c) investments in undertakings or economic activities with credible science-based targets, where proportionate, that are supported by information ensuring integrity, transparency and accountability;
(d) EU climate benchmarks tracking investments.

The flexibility this inclusive approach provides allows to acknowledge that entities with transition finance needs have varying starting points and constraints.  However, it also warrants careful evaluation.

For instance, extending beyond sustainable investment in the sense of the Taxonomy to include entities with credible transition plans offers a pragmatic approach to overcoming the limitations of the Taxonomy’s timelines and strict environmental and social safeguards.[15]  

The wisdom of considering science-based targets in lieu of transition plans may not be immediately clear. While there is growing industry consensus around the importance of credible and effective transition plans, there remain well-placed concerns about target setting stringency and limited enforcement and accountability in the market’s preferred framework for recognising science-based targets – the Science Based Target Initiative. However, the language of the Communication indicates clearly that this should be a fallback approach that could be appropriate when “proportionate to the complexity, size and impacts of the undertaking” and should be subjected to integrity and accountability safeguards.

The unconditional inclusion of investments tracking EU Climate Benchmarks in the topline definition of transition finance instruments and approaches poses significant challenges. The minimum standards for these benchmarks are poorly suited to transition investments, incorporating substantial design flaws that discourage genuine transition finance practices. However, the section of the communication addressing the use of benchmarks takes a more cautious and conditional tone, suggesting that EU climate benchmark methodologies may, where appropriate, complement science-based scenarios or pathways and help mitigate the risk of asset stranding. 

Ultimately, the Communication underscores the importance of using reliable tools to enhance transparency and integrity in transition finance markets while minimising greenwashing risks. Its emphasis on linking use-of-proceeds financing to Taxonomy-anchored transition targets and tying sustainability targets for broader financing to science-based criteria reflects a balanced, if imperfect, framework for advancing transition finance.

 

Pushing the Boundaries: The ESMA Opinion on Sustainable Investments

While the European Commission's June 2023 Recommendation seeks to provide guidance on transition finance within and besides the existing sustainable finance framework, the July 2024 ESMA Opinion titled “Sustainable investments: Facilitating the investor journey” ambitions to provide “A holistic vision for the long term” and acknowledges the need for material amendments and enhancements to the framework itself, aiming to make it fit for purpose in supporting transition finance.

The ESMA Opinion outlines the securities markets regulator’s vision for a trustworthy and competitive sustainable finance framework.  The end goal is to ensure good market conduct and provide investors with adequate tools and information to make informed decisions and support the bloc’s sustainability and transition goals while enhancing the competitiveness of its capital markets.

The ESMA makes key recommendations in seven areas, three of which dealing specifically with transition finance:

 

1. Anchoring sustainability assessment in the EU Taxonomy

  • Extend the Taxonomy to include all activities that can contribute to sustainability, including activities that can transition or need decommissioning. 
  • Phase out the SFDR’s flexible definition of sustainable investments, first making it more prescriptive and then replacing it with a Taxonomy-based approach.

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2. Strengthening tools for transition finance

  • Introduce a legal definition of transition investments to facilitate transition-related financial products.
  • Complement disclosures to cover revenues and CapEx linked to harmful activities undergoing transition or decommissioning.
  • Ensure consistency in transition planning disclosures across all regulations and levels (activity, project, company, and product).
  • Raise the ambitions of the EU Climate Benchmarks (e.g., set sectoral allocation constraints to promote real-world decarbonisation) and develop dedicated transition benchmarks (e.g., benchmarks requiring year-on-year increase in share of investments aligned with the taxonomy);
  • Develop high-quality standards for transition/sustainability-linked bonds. 

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3. Establishing a Product Categorisation System including categories for sustainable and transition investments

  • Design (retail-investor focused) categories in reference to investor preferences and targeted outcomes,
  • Ensure categorisation follows clear, science-based, binding, and measurable eligibility criteria and impose transparency on the outcomes achieved to allow for evaluation of ambition and progress (for transition investments).
  • Require full DNSH compliance for sustainable (i.e., Taxonomy-aligned) investments; for transition investments make room for harmful activities on a transitioning trajectory or being decommissioned, subject to safeguards.
  • Promote integrity through state-level supervision.

 

Other recommendations include: introducing consumer and industry testing of policy solutions;  imposing minimum sustainability disclosures for all financial products; improving the quality of ESG data underlying SFDR disclosures; and promoting high standards of conduct across the investment value chain.

These recommendations aim to address critical gaps in transition finance by enhancing regulatory clarity, aligning efforts with market needs, and fostering a more effective sustainable finance framework.

 

Transition Finance: Charting a Pathway for Global Ambition

Transition finance is essential for addressing the global climate challenge, enabling high-emission sectors to align with net-zero objectives through adopting higher-efficiency processes, retrofitting infrastructure, and phasing out unsustainable assets. While sustainable investments play a crucial role in funding activities already aligned with sustainability goals, transition finance focuses on bridging the gap for sectors and activities that require transformation to meet net-zero targets. Together, they form complementary pillars of a comprehensive strategy for systemic change.

As this article has outlined, the contextual nature of transition finance is critical to its effectiveness. Transition pathways—high-level roadmaps for decarbonisation—differ widely across countries and sectors due to variations in responsibilities, capabilities, and circumstances. These differences also extend to individual entities and activities, where the feasibility and timing of decarbonisation efforts can vary significantly and require tailored transition plans. A one-size-fits-all approach is inadequate; instead, tailored frameworks are necessary to support global decarbonisation while respecting regional, sectoral, and operational differences.

While transition finance is globally recognised as essential for achieving net-zero goals, jurisdictions have adopted varying approaches, ranging from principle-based to highly prescriptive. The European Union’s Sustainable Finance Framework is often regarded as both highly prescriptive and the most advanced regulatory effort in the sustainable finance space. However, despite its high ambitions and comprehensive scope, the framework remains incomplete and incoherent in addressing the specific needs of transition finance. Predominantly geared toward sustainable investment, it lacks a robust framework to support the broader spectrum of transition activities essential for decarbonising high-emission sectors.

This article has highlighted critical gaps in the trilogy of texts that form the foundation of the EU Sustainable Finance Framework. The Taxonomy Regulation is largely a sustainable investment taxonomy, with stringent technical criteria and safeguards that exclude the bulk of transitional activities. The environmental and social safeguards of the Sustainable Finance Disclosure Regulation (SFDR) place urgent and bona fide transition investments beyond the scope of sustainable investment ('deep green') funds reporting under Article 9, which may still be prioritised by investors for their stricter sustainability criteria. Effectively differentiating the value of transition investment strategies reporting under the catch-all, sustainability-promoting Article 8 remains challenging, particularly for retail investors. Moreover, the interpretative leeway afforded to providers under SFDR renders comparisons across investment options difficult, creating risks of greenwashing and mis-selling. Finally, the deeply flawed Benchmark Regulation disincentivises transition investments through the imposition of steep market-relative decarbonisation requirements (combined with lax sectoral constraints), reliance on backward-looking metrics dominated by capital market momentum, and half-thought through exclusions. These three pieces of legislation also integrate inconsistencies and incompatibilities that create negative synergies, further undermining the effective deployment of transition finance at scale.

Private-sector initiatives have significantly contributed to defining and operationalising transition finance, providing actionable frameworks and standards that have considerable informational value for regulatory approaches. Early efforts focused on the sell-side, establishing guidelines for use-of-proceeds instruments and later advancing sustainability-linked debt frameworks suitable for entity-level transition financing. On the investor side, net-zero asset owner alliances have set a new benchmark for credibility and ambition. By emphasising rigorous target setting anchored in science-based sectoral pathways, developing alignment criteria based on current performance and forward-looking metrics, and insisting on credible transition plans and accountability for real-world decarbonisation, these initiatives have raised the bar for transition finance. Together, these efforts have driven the evolution of sustainable finance from the funding of isolated ‘green’ projects to comprehensive, entity-wide transition strategies, while increasingly addressing critical frontiers of early-stage climate solutions and decommissioning.

Recent guidance from the European Commission (EC) and the European Securities and Markets Authority (ESMA) marks an important step toward in recognising the significance of transition finance and outlining a pathway to fully integrate it into the EU Sustainable Finance Framework. The EC Communication of June 2023 offers a foundational definition of transition finance, emphasising its role in supporting diverse decarbonisation pathways across countries, sectors, and entities. It proposes linking financing mechanisms to credible transition plans and science-based criteria, while introducing safeguards to enhance integrity and minimise greenwashing risks. Building on this, ESMA’s Opinion of July 2024 takes a more reformative stance, recommending the development of a tricolour taxonomy to classify sustainable, transitional, and unsustainable activities. It also calls for strengthened transition planning disclosures, ensuring consistency across all levels—activity, project, company, and product—and complementing these disclosures with links between revenues, capital expenditures, and harmful activities undergoing transition or decommissioning. The Opinion further advocates for robust disclosure systems to ensure transparency and comparability, alongside the introduction of clear, science-based standards for sustainable and transitional product categories, as well as stricter requirements for labels.

Looking ahead, the EU has an opportunity to lead by example, creating a sustainable finance framework that balances ambition with practicality. By integrating transition finance into its broader strategy and leveraging science-based tools, robust reporting systems, and clearly defined product categories and labels, the EU can set a global standard for channelling financial flows toward systemic decarbonisation. Achieving this will not only support the bloc’s climate goals but also provide a blueprint for global action against climate change.

For jurisdictions favouring principle-based approaches, the EU framework offers important lessons. Granting excessive leeway to product providers can undermine transparency and effectiveness. And while granular criteria bring clarity and accountability, they require extensive taxonomy work with lead times that may delay urgent climate action. Principle-based frameworks, by contrast, can foster flexibility and innovation, enabling firms to tailor their strategies to local and sectoral contexts while reducing compliance burdens. However, this flexibility must be paired with robust governance and accountability mechanisms to mitigate greenwashing risks and ensure alignment with sustainability goals. By fostering public-private collaboration, embracing evidence-based classification of transition activities and investments, and promoting transparent reporting of decision-relevant metrics, all jurisdictions can design effective frameworks that support investor choice and direct financial flows toward the transition at scale.

 

Footnotes

[1] The Synthesis Report of the Sixth Assessment Report (AR6) of the Intergovernmental Panel on Climate Change (IPCC, 2023) reads: “Average annual modelled mitigation investment requirements for 2020 to 2030 in scenarios that limit warming to 2°C or 1.5°C are a factor of three to six greater than current levels (…) Even if extensive global mitigation efforts are implemented, there will be a need for financial, technical, and human resources for adaptation”.

[2] Article 2.1(c) of the Paris Agreement defines “Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development” as one of the means to strengthen the global response to the threat of climate change.

[3] While the prioritisation of current socio-economic structures contributes to perpetuating systemic inequities or sidelining the needs of less affluent or vulnerable communities, the avoidance of economic dislocation aligns with the imperatives of a just transition of the workforce as mentioned in the Paris Agreement.

[4] The principle (“CBDR–RC”) is enshrined in the 1992 United Nations Framework Convention on Climate Change (UNFCCC) treaty.

[5] A review of transition finance approaches by Tandon (2021) suggests that transition finance is, and should remain, investee-specific, as it must depend on the unique characteristics, needs, and decarbonisation pathways of the entity or sector in question. In this principles-based approach, defining criteria include alignment with relevant sectoral, national, and global decarbonisation pathways; the absence of viable low-emission alternatives; and the avoidance of lock-in of carbon-intensive technologies. While not prescriptive with respect to entity-level transition plans, taxonomies typically require the absence of viable low-emissions alternatives and may include very clear safeguards against the risks of lock-in, as in the case of the EU Taxonomy.

[6] A recent survey (OECD, 2022) identified the Climate Bonds Initiative (CBI) frameworks and the International Capital Market Association (ICMA) principles and handbooks as two of the most widely used tools for transition finance alongside the EU Taxonomy. The CBI frameworks focus on project-level criteria, offering rigorous science-based standards to ensure alignment of specific investments with decarbonisation pathways. In contrast, the ICMA principles adopt an entity-level approach, focusing on aligning the issuer's overarching strategy with long-term decarbonisation goals and providing the flexibility needed for issuing instruments like sustainability-linked bonds to finance broader transition plans (aside use-of-proceeds instruments such as green or sustainability bonds). Using these tools in tandem could enable transition finance to achieve both project-level rigour through CBI's science-based standards and entity-level strategic alignment with credible decarbonisation pathways, as emphasised by ICMA..

[7] In July 2023, the European Commission adopted the European Sustainability Reporting Standards (ESRS) under the CSRD. The ESRS subject the disclosure of key indicators to materiality assessments (except for 'General Disclosures') and render certain key indicators voluntary. This approach diverges from expert group recommendations, which emphasised the necessity of mandatory disclosure of specific sustainability indicators to ensure transparency, comparability across companies, and the provision of data required by Financial Market Participants for compliance with existing regulations.

[8] Granular CSRD data will first become available in 2025 for large companies previously subject to the Non-Financial Reporting Directive (NFRD). Availability will expand throughout the decade as other large companies, listed SMEs, and non-EU entities with significant EU presence are progressively required to report.

[9] The author provided extensive feedback on design flaws to the European Commission and its expert group, both formally and informally, privately and publicly, before and after the drafting of the regulation (see Amenc and Ducoulombier, 2019, 2020a, 2020b and Ducoulombier, 2020). Central design issues were later detailed in two peer-reviewed publications (see Ducoulombier and Liu, 2021 and Ducoulombier, 2021). These concerns are now widely echoed by market participants, and the European Securities and Markets Authority (ESMA, 2024) acknowledges in its recent opinion on the regulation of sustainable finance the need to 'raise the ambition of the EU Climate Benchmarks,' for instance, by introducing additional sectoral allocation constraints to 'ensure that the decarbonisation of the benchmarks relies on a minimum amount of actual GHG emissions reduction by the constituents over a given time period.'

[10] The Kyoto Protocol operationalises the United Nations Framework Convention on Climate Change (UNFCCC) by committing industrialised countries and economies in transition to legally binding greenhouse gas emission limitation and reduction targets. Signed in December 1997, it faced significant ratification challenges—not least the withdrawal of U.S. support in 2001—and only entered into force in February 2005 after ratification by Russia. The adoption of the Bali Action Plan at the 13th UNFCCC Conference of the Parties (COP13) in 2007 set the stage for negotiating a successor framework to the Kyoto Protocol, which would eventually be agreed in Paris in 2015. Key aims included bringing major developing economies into the global response to climate change, promoting international cooperation for funding adaptation and technology transfer, and mobilising financial resources through innovative mechanisms and public-private partnerships to support climate action in developing countries. Concurrently, the IPCC Fourth Assessment Report (2007) provided unequivocal scientific evidence of the anthropogenic nature of climate change, reinforcing public and political support for urgent action. Against this backdrop, the European Investment Bank (EIB) issued the first Climate Awareness Bond in 2007, followed by the World Bank’s first Green Bond in 2008. These innovative financial instruments mobilised private capital for climate mitigation and adaptation projects, complementing public funding for climate action—a key theme of the Bali Action Plan

[11] In 2018, ICMA supported the launch of the Green Loan Principles (GLP), which build on and refer to the GBP. The GLP's reference to the GBP and its project categories promotes a consistent approach across segments of the fixed income market.

[12] Including the 2021 Communication titled “Strategy for Financing the Transition to a Sustainable Economy”.

[13] Transition refers to transitioning from current performance levels to a climate-neutral, climate-resilient and sustainable economy in a time frame consistent with: (a) the highest ambition of the Paris Agreement and, for undertakings and activities within the Union, the objective of achieving a 55% reduction in emissions by 2030 and neutrality by 2050; (b) the objective of climate change adaptation; (c) the other environmental objectives of the TR.

[14] Long-term locking-in of significant harmful activities or assets, considering their lifetime.

[15] The Communication does not call for an extension of the Taxonomy: it puts forwards alternative tools to address gaps in the Taxonomy's coverage and suggests anchoring transition investments in the existing Taxonomy when possible, e.g., to define goals of transition plans in relation to the Taxonomy and capture incremental alignment with the Taxonomy.

 

References