Charting a pathway for transition finance: Lessons from the EU framework

• Transition finance is essential for decarbonising high-emission sectors, enabling the adoption of low-carbon technologies, retrofitting facilities, and phasing out unsustainable infrastructure.
• The EU Sustainable Finance Framework falls short in integrating transition finance due to the Taxonomy Regulation’s strict screening criteria, which disqualify many investments under its narrow definition of transitional activities; the SFDR, which disincentivises transition finance products and starves investors of actionable information by granting excessive leeway to providers; and flawed, backward-looking climate benchmarks that punish allocation to high-emission transition sectors.
• Science-based criteria, pathways and robust transition plans are essential for channelling investments toward the decarbonisation of key sectors, as demonstrated by private-sector initiatives.
• An extended taxonomy that classifies sustainable, transitional, and unsustainable activities, along with improved transition planning disclosures, is critical to scaling transition finance –complemented by clear product classifications and updates to benchmark regulation. Collaboration between public and private sectors, evidence-based classification of transition activities, and transparent reporting of decisionrelevant metrics are vital to supporting investor choice and directing financial flows toward the transition at scale.

Transition finance is essential for decarbonising high-emission sectors through cleaner technologies, operational retrofits and decommissioning outdated facilities. Despite increased investments over the last decade, funding remains far below the levels needed to meet Paris Agreement goals. According to the Intergovernmental Panel on Climate Change (IPCC [2023]), mitigation investments must grow three- to six-fold this decade to limit warming to 2°C or 1.5°C, underscoring the urgent need for clear governmental support and signalling.

However, the absence of a globally accepted definition of transition finance, coupled with inconsistent regulatory frameworks, hampers the alignment of financial flows with Paris Agreement commitments. Surprisingly, even the European Union (EU), often seen as a leader in sustainable finance, struggles with gaps and inconsistencies in addressing transition finance, limiting its effectiveness.

This article examines the definitional challenges of transition finance, the obstacles within the EU Sustainable Finance Framework, and the role of private-sector initiatives in advancing practical solutions.

It concludes with key policy recommendations for integrating transition finance into sustainable finance frameworks.

The contextual nature of transition finance

Achieving net-zero requires three types of investments:

• Climate solutions: Investments in activities central to a net-zero economy, including low-emissions energy, clean transportation, energy efficiency and waste management.
• Transition investments: Support for decarbonising high-emission sectors lacking low-emission substitutes, such as adopting low-carbon processes, retrofitting industrial facilities in hard-to-abate sectors like steel and cement, or decommissioning unsustainable fossil fuel power plants and other carbon-intensive facilities.
• Carbon sinks: Investments to offset unavoidable emissions through naturebased or technological solutions, such as restoring ecosystems, enhancing soil and ocean carbon absorption, and advancing carbon capture technologies.

When excluding power generation and household fossil fuel use, the bulk of greenhouse gas emissions arise from industry, transportation, commercial buildings and agriculture. Reducing these emissions requires significant investment, particularly when behaviour-based solutions, such as curbing high-emissions lifestyles or adopting plant-based diets, face socioeconomic and cultural barriers. Transition finance bridges the emissions gap for high-emission sectors that cannot immediately align with net-zero targets but remain integral to the global economy. It complements climate solutions investments and helps mitigate risks such as economic disruption[1] and stranded assets.

Global climate governance acknowledges the principle of “common but differentiated responsibilities”[2], reflecting the diverse circumstances shaping transition needs and capacities across countries. This variability complicates efforts to define transition-related activities and finance globally, as their scope must adapt to national and sectoral contexts.

In response, national and regional authorities have developed tools to qualify 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 (OECD [2022]).

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 employs principles-based guidance to balance flexibility with sustainability objectives, accommodating 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.

Both taxonomies allow certain investments by entities in sectors requiring phase-out during the global transition to qualify as transition aligned. Critics warn, however, that this could inadvertently enable greenwashing if financing is not tied to robust, entityspecific decarbonisation pathways.[3]

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 this global context, we turn to the EU Sustainable Finance Framework, often regarded as the world’s most comprehensive regulatory effort to support sustainable investment. Despite its ambition, the framework has critical gaps that allow transition finance to fall through the cracks.

Transition finance in the EU Sustainable Finance Framework

In 2016, the European Commission (EC) established the High-Level Expert Group on Sustainable Finance (HLEG) to provide strategic guidance on aligning the bloc’s financial system with its climate and sustainability objectives. The group’s 2018 report proposed a comprehensive framework, including a tricolour taxonomy (green, amber and red) to classify economic activities (into sustainable, enabling/transitional and unsustainable), phased sustainability disclosures starting with corporates and followed by financial market participants (FMPs), and incentives to channel investments into sustainable and transitional activities.

Although the EU sustainable finance package drew heavily from HLEG recommendations, it diverged significantly from the group’s holistic vision. Key regulations were prioritised inconsistently, such as the 2020 update to the Benchmark Regulation, while some recommendations faced delays or incomplete implementation, shaping the framework’s current gaps.

To understand how transition finance fits within this framework, its three key elements must be examined: 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 (TR) establishes a comprehensive framework for classifying sustainable activities, initially focusing on climate change mitigation and adaptation, and later expanding to another four environmental objectives. Detailed TSC identify activities making a substantial contribution to one or several of these sustainability objectives while avoiding significant harm to others, in line with the do no significant harm (DNSH) principle. For investments to be taxonomy-aligned, entities must also comply with ‘minimum safeguards’, ie, they must comply with internationally recognised norms for responsible business and human rights and with the bloc’s specific social and governance standards. The voluntary EU Green Bond Standard requires funds raised through green bonds to be used for taxonomy-aligned activities, but financial incentives such as lower capital requirements, recommended by HLEG, have not been implemented.
• The Sustainable Finance Disclosure Regulation (SFDR) imposes transparency requirements on FMPs 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-horse manner, the 2019 regulation on sustainabilityrelated 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[4] and delayed corporate disclosure obligations, perpetuating the consequences of this illogical sequencing.
• The regulation establishing EU Climate Benchmarks (BMR) was meant to provide investors with tools to align investment strategies with net-zero goals 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 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.[5]

   

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, leaving significant gaps. Exploring each text in detail sheds light on how transition finance is addressed and highlights areas for improvement.

Transition finance in the Taxonomy Regulation

The TR provides detailed criteria for identifying environmentally sustainable activities but focuses primarily on already aligned ‘green’ activities, limiting its support for broader transition needs. In contrast, a traffic light taxonomy could classify activities across a wider spectrum, 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” – high-emission operations without feasible low-carbon substitutes, provided they achieve ‘best-in-class’ performance aligned with 1.5°C pathways. However, the related TSCs are particularly stringent, excluding many bona fide investments aimed at decarbonising these activities. Even when such activities meet the TSC requirements, the DNSH principle imposes an additional restrictive layer, disqualifying those that significantly harm 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 transition plan. This plan must be approved by the company’s management and should outline the steps to achieve alignment within five years, or up to 10 years in exceptional cases. Companies are also required to disclose annually the proportion of total capital expenditures (capex) allocated to this transition to ensure transparency and accountability. However, this provision remains constrained by the TSC and DNSH criteria that apply to already aligned activities. Additionally, the medium-term timeframe limits its practicality for high-emission sectors requiring phased decarbonisation over longer horizons.

These limitations – the stringency of the TSC, rigid DNSH application, omission of decommissioning efforts, and narrow capex exemption – significantly constrain the taxonomy’s capacity to support the breadth of transition finance initiatives needed to meet climate goals.

Transition finance in the Sustainable Finance Disclosure Regulation

Primarily a disclosure regulation, the SFDR also shapes capital allocation by defining, categorising and imposing requirements that influence how investments are mobilised – often with unintended consequences for transition finance.

Under Article 2(17), a sustainable investment is defined as one that “contributes” to an environmental or social objective without significantly harming other such objectives and is carried out by investee companies following “good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance”. However, “contribute” is undefined, nor is it linked to the substantial contribution and TSC of the TR. This ambiguity allows flexibility for transition investments not aligned with the taxonomy but increases risks of greenwashing and undermines comparability. Similar ambiguities apply to DNSH and governance screens, which lack prescriptive criteria and thresholds, further complicating standardisation. These screens are also applied at the company level, making them inherently more exclusory than the activity-level criteria of the TR.

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 with sustainable investment as their objective. They must explain how this is to be attained and disclose the proportion of taxonomyaligned investments for environmental objectives.
• Article 8 funds “promote” environmental or social characteristics alongside other financial characteristics. They must disclose how they promote these characteristics, the share of their investments classified as sustainable investments, and, where relevant, the proportion of taxonomy-aligned investments.
• Article 6 funds are 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.

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 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 with 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 financeoriented funds.

Finally, the requirement to disclose the proportion of taxonomy-aligned investments may discourage definitional flexibility, while PAI disclosures may deter transition investments in activities with short-term adverse impacts, even when such investments are vital for the transition.

Transition finance in the EU Climate Benchmark Regulation

The EU climate benchmarks aim to support the European Green Deal by guiding investors to reallocate funds toward sustainable activities and improve the climate impact of investments over time.

Minimum standards for PABs and CTBs require a reduction in the weighted average carbon intensity of portfolios by 50% and 30%, respectively, relative to the relevant market benchmark, and an absolute contraction of 7% pa to align with a rigorous global 1.5°C pathway. The approach, however, is myopic and backward-oriented, relying on selecting and weighting assets based on their cross-sectional intensities to achieve the required portfolio decarbonisation. It offers only minimal consideration of corporate commitments or differentiated transition pathways reflecting sectoral and national contexts.

PAB standards also exclude companies with material involvement in fossil fuels and those with majority revenues from power generation activities exceeding an ambitious carbon intensity threshold. 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 from the onset further limits exposure to major emitters, missing opportunities to support their decarbonisation efforts. The regulation’s crude sectoral controls – partitioning assets into high and low-emission sectors while merely requiring that cumulative exposure to high-emission sectors remain aligned to market benchmark weights – enable portfolio decarbonisation to proceed 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, 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, 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 have prompted net-zero investor coalitions to advocate for redesigned transition benchmarks that can drive genuine decarbonisation in the real economy (NZAOA [2022]; IIGCC [2023]).

Despite its ambition, the EU Sustainable Finance Framework lacks a cohesive approach to transition finance. The fragmented and misaligned design of the Taxonomy Regulation, SFDR and Climate Benchmark Regulation creates negative synergies, failing to incentivise the systemic transformation needed to meet climate goals.

Private-sector initiatives providing transition finance guidance

The finance industry has played a pivotal role in defining and operationalising transition finance, developing guidelines and frameworks at both instrument and issuer levels to refine sustainable finance approaches.

Transition finance originated in the late 2000s with climate and green bond issuances by multilateral development banks (MDBs).[6] In response to the growing appetite for climate finance, the Climate Bond Initiative (CBI) was launched at the end of 2009 to develop standards to promote high integrity in the nascent market. At the end of 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. 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. Relative to the CBI, the GBP recognised a wider array of ‘green’ projects and adopted principles-based guidance. Issuers enjoyed flexibility in defining sustainability objectives, with ICMA relying on transparency and external reviews to promote market integrity. 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). 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. The CTFH further highlighted the need for credible transition strategies, addressing greenwashing risks associated with 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, like the Montréal Carbon Pledge and Portfolio Decarbonisation Coalition, highlighted investor interest in climate action and supported the Paris Agreement negotiations. These efforts focused on measuring, disclosing, and reducing portfolio carbon footprints by reallocating capital from carbon-intensive to green activities and encouraging issuers to cut emissions. Though limited in scope, they laid the foundation for more comprehensive transition finance frameworks.

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 Net-Zero Asset Owner Alliance (NZAOA) were launched to provide guidelines for aligning portfolios with long-term climate goals. Their early frameworks, released in 2021, focused on incentivising real-world decarbonisation through capital allocation and issuer engagement, even without explicit reference to “transition finance” (Ducoulombier [2021b, 2022]). Critically, both frameworks have provided valuable transition insights since inception. The PAII Net Zero Investment Framework (NZIF) introduced a bucketing approach to classify assets by net-zero alignment, capturing green assets, those transitioning or aligned with net-zero pathways, and the non-aligned (PAII [2021]). The NZAOA Target Setting Protocol (TSP) linked portfolio decarbonisation to science-based sector targets, starting with key transition sectors (NZAOA [2021]). While key transition sectors were already subjected to stricter scrutiny than other sectors in the initial NZIF, its 2024 revision insisted on the use of relevant science-based pathways and strengthened the oversight of transition plans, including through enhanced evidencing of capex and operational expenditures (opex) supporting target delivery alongside board-level accountability (PAII [2024]). While the treatment of transition finance within the TSP has remained largely consistent since its inception (NZAOA [2021 and 2024]), the NZAOA report on developing credible transition plans provided valuable guidance on evaluating the credibility and effectiveness of such plans (NZAOA [2023]).

While asset owner-driven initiatives paved the way for net-zero alignment frameworks, other financial stakeholders – including asset managers, banks and insurers – have introduced their own commitments. To enhance coordination across the financial ecosystem, the Glasgow Financial Alliance for Net Zero (GFANZ) was established ahead of COP26 in 2021. GFANZ’s 2023 taxonomy of transition finance identifies four key dimensions: scaling climate solutions, financing net-zero-aligned assets, supporting high-emission sectors in transition and responsibly phasing out carbon-intensive assets. The latter highlights a critical but underdeveloped area, 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 highlighted the EU Sustainable Finance framework’s shortcomings in addressing transition finance. Recent initiatives by the EC and European supervisory authorities, particularly the European Securities and Markets Authority (ESMA), provide guidance on navigating the current framework while charting a course to enhance the regulatory architecture.

Working around the gaps: the EC recommendation on transition finance

The recommendation on facilitating finance for the transition to a sustainable economy (EC [2023]) builds on earlier work acknowledging the need to mobilise private funding for the EU’s climate and sustainability goals. It defines “transition finance” for the first time, offering guidance for market participants, member states and supervisors.

Transition finance is broadly defined as financing investments compatible with and contributing to the transition while avoiding lock-ins of significant harmful activities or assets. It includes investments:

• In taxonomy-aligned transitional economic activities and taxonomy-eligible economic activities becoming taxonomy-aligned.
• In undertakings or economic activities with a credible transition plan.
• In undertakings or economic activities with credible science-based targets, where proportionate, supported by information ensuring integrity and accountability.
• Tracking EU climate benchmarks. This inclusive approach acknowledges the diverse starting points and constraints of entities requiring transition finance but warrants careful evaluation.

Extending beyond taxonomy-defined sustainable investments to include entities with credible transition plans is a pragmatic solution to limitations in the taxonomy’s timelines and stringent safeguards.[7] However, relying on sciencebased targets instead of detailed transition plans raises concerns about enforcement and accountability in the market’s preferred framework, ie, the Science Based Target Initiative (SBTi). The recommendation however suggests this should be a fallback option, subject to proportionality and robust safeguards.

The unconditional inclusion of investments tracking EU climate benchmarks in the topline definition of transition finance is puzzling as their design flaws discourage genuine transition practices. However, the section of the recommendation addressing the use of benchmarks takes a more cautious and conditional tone, suggesting that their methodologies may 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 sciencebased criteria reflects a balanced, if imperfect, framework for advancing transition finance.

Pushing the boundaries: the ESMA opinion on sustainable investments

While the EC recommendation offers guidance on transition finance within the existing framework, the July 2024 ESMA opinion, Sustainable investments: Facilitating the investor journey, outlines a long-term, holistic vision and calls for significant reforms to make the framework more effective in supporting transition finance. The goal is to ensure good market conduct, equip investors with effective tools and information, and support the EU’s sustainability and transition goals while enhancing its capital markets’ competitiveness.

ESMA (2024) makes key recommendations in seven areas, three of which focus specifically on transition finance:

Anchoring sustainability assessment in the EU Taxonomy

• Expand 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 taxonomybased approach.

Strengthening tools for transition finance

• Legally define transition investments to facilitate transition-related financial products.
• Expand disclosures to include 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, eg, by setting sectoral allocation constraints to promote real-world decarbonisation, and develop dedicated transition benchmarks, eg, benchmarks requiring year-on-year increase in share of investments aligned with the taxonomy.
• Develop high-quality standards for transition/sustainability-linked bonds.

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 DNSH compliance for sustainable investments; allow harmful activities on a transitioning trajectory or being decommissioned, subject to safeguards.
• Promote integrity through state-level supervision.

These recommendations address key 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 critical to addressing the climate challenge, enabling highemission sectors to align with net-zero goals through higher-efficiency processes, retrofitting and phasing out unsustainable assets. While sustainable investments fund activities already aligned with sustainability goals, transition finance bridges the gap for sectors requiring transformation, forming complementary pillars for systemic change.

Transition finance’s contextual nature is key to its effectiveness. Decarbonisation pathways differ across regions, sectors, and entities due to varying responsibilities and capabilities, necessitating tailored frameworks rather than one-size-fits-all solutions.

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, it 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 SFDR place urgent and bona fide transition investments beyond the scope of sustainable investment 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 and creates 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 halfthought-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. 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 underpinned by appropriate capex and opex schedules and supported by robust governance and accountability, these initiatives have raised the bar for transition finance and real-world decarbonisation. 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 EC and ESMA marks an important step. The EC recommendation of June 2023 offers a foundational definition of transition finance, emphasising its role in supporting diverse decarbonisation pathways. It proposes linking financing mechanisms to science-based criteria and credible transition plans, while introducing safeguards to enhance integrity and minimise greenwashing risks. The ESMA opinion of July 2024 takes a more reformative stance, recommending the development of a tricolour taxonomy to classify sustainable, transitional and unsustainable activities. It calls for strengthened transition planning disclosures, ensuring consistency across all levels. It advocates for sustainable and transitional product categories anchored in science-based criteria and differentiated expectations in respect of harmful activities.

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 sciencebased 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 principlebased 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 insist on science-based pathways, criteria and metrics, and 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] 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.

[2] The principle is enshrined in the 1992 United Nations Framework Convention on Climate Change (UNFCCC) treaty.

[3] Tandon (2021) argues 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.

[4] In July 2023, the EC 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 for mandatory disclosure of specific sustainability indicators to ensure transparency, comparability across companies and the provision of data required by FMPs for compliance with existing regulations.

[5] The author provided extensive feedback on design flaws to the EC 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 and 2020b]; Ducoulombier [2020]). Central design issues were later detailed in two peerreviewed publications (Ducoulombier and Liu [2021]; Ducoulombier [2021a]).

[6] 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 instruments mobilised private capital for climate projects, complementing public funding – a central theme of the 2007 Bali Action Plan, which set the stage for the Paris Agreement. The Bali Action Plan aimed to advance a successor to the 1997 Kyoto Protocol, which committed industrialised countries to binding emission reduction targets but only entered into force in 2005 after Russia’s ratification, following the withdrawal of US support in 2001. Concurrently, the IPCC Fourth Assessment Report provided compelling scientific evidence of anthropogenic climate change, reinforcing the urgency of global action.

[7] The recommendation does not call for an extension of the taxonomy but puts forward tools to address gaps in its coverage. It also suggests anchoring transition investments in the TR when possible, eg, to define goals of transition plans in relation and capture incremental alignment.

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• Institutional Investors Group on Climate Change (IIGCC – 2023). Enhancing the Quality of Net Zero Benchmarks. https://www.iigcc.org/resources/enhancing-the-quality-ofnet-zero-benchmarks
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