A transition category is set to transform how fund managers use the EU Sustainable Finance Disclosure Regulation, but the finer details are yet to be ironed out. Michael Hurley writes
The EU has for years been criticised for failing to encourage financial institutions to invest more in companies that need to 'transition', from high-emitting processes to those that will still be needed in a net-zero world.
This criticism has included that its EU Sustainable Finance Disclosure Regulation (SFDR) lacked a distinct bucket to identify a strategy targeting such investments.
Instead, these were largely held either in funds that managers self-categorised as 'Article 8' – the least ambitious of the current categories to denote funds that 'promote' sustainability – or 'Article 6' funds that made no sustainability claims.
The European Commission last month proposed a major overhaul of the SFDR – including the creation of a dedicated category for 'transition' investment funds, under a new 'Article 7'.
Supporting investment in the transition of high-emitting industry is essential if the EU is to meet its climate targets.
Between 2030 and 2050, about €650 billion ($765 billion) will have to be allocated yearly to the transition of the energy system alone across a variety of scenarios, according to analyses by the Commission.
Transition is "the most important" of the three categories the Commission proposed, because of its potential for transformative impact, says Stephan Kippe, head of ESG research at Commerzbank.
"But if asset managers don't have regulatory cover, they don't have an incentive to create transition funds and the space will not grow," he tells Environmental Finance, suggesting that when the Commission draws up more detailed criteria next year it will face a tough balancing act of ensuring credibility while also making sure criteria are not so stringent they limit uptake.
"Creating the transition category can help, but to achieve the EU's climate goals transition finance needs to raise its market share to 30% or more from the current low single digits," he adds.
What qualifies for inclusion?
To help investors identify products 'with a high level of transition ambition', the Commission proposed that fund managers be required to ensure at least 70% of their portfolio 'is coherent with the transition-related objective of the products'.
It suggested this could be demonstrated by linking the investments with companies that have a Paris-aligned climate transition plan, or Science-Based Targets, or showing that the fund has a portfolio-level, transition-related target such as to reduced financed emissions.
Alternatively, the fund could use alignment with the criteria of the EU Paris-Aligned Benchmarks or Climate-Transition Benchmarks rules to demonstrate conformity.
Another option is to demonstrate investment in companies that can demonstrate at least 15% of their capital expenditures are line with the EU Taxonomy.
This category should also exclude companies developing new projects 'linked to oil or gaseous fuels, and companies developing new projects, or without a plan to phase-out from, hard coal or lignite for power generation'.
Generating momentum
The proposal was generally warmly received by asset managers, many of whom previously called for a transition label.
"I don't think it is a coincidence that one of the [other proposed] categories is called 'ESG basics'," says Commerzbank's Kippe. "Transition is a much more attractive category name, also as a marketing tool, as it is the topic du jour in sustainable finance."
The lack of regulatory requirements for industrial transition had deterred asset managers from creating related financial products, mainly to avoid legal and financial exposure that could result from creating labelled funds consisting of investments in high-polluting companies, he suggests.
However, most companies were lagging their climate commitments and misaligned with a Paris Agreement transition pathway, which would limit the amount of assets that could qualify under the proposed framework, he says.
Kippe estimated that only about 13% of the funds currently categorised under one of the three existing SFDR categories – including funds categorised as Article 6 and that do not claim to target sustainability objectives, as well as Articles 8 and 9 – would use the transition category.
Estimates by Morningstar Sustainalytics are even more conservative, suggesting that 'the Transition (Article 7) category will likely represent a niche segment of the EU fund market, with a share estimated between 1.6% and 3%'.
Morningstar previously argued that limited uptake of a similar, 'Improvers' category in the UK's Sustainability Disclosure Requirements regulation illustrates why a transition category in SFDR may face similar problems.
Commentary on the transition category has also focused on what types of investments these funds might contain.
Kippe suggests that managers who choose to demonstrate compliance by selecting investments linked to companies with at least 15% of capex in alignment with the EU taxonomy "could have an overweight in classic industrial sectors, which are exhibiting an above-average percentage of taxonomy alignment", with utilities and real estate companies likely to dominate.
Silvia Merler, head of responsible investment & policy research at Algebris Investments, tells Environmental Finance that "backsliding" on net zero targets by corporate and financial institutions could impede uptake of the category.
Meanwhile, there have been calls for the Commission to clarify where sovereign bonds fit within the overhauled SFDR.
"The treatment of sovereign exposures is too limited", argues Anyve Arakelijan, senior regulatory policy advisor at the European Fund and Asset Management Association.
"General-purpose government bonds are confined to the 'ESG basics' category, while only narrowly defined use-of-proceeds instruments may qualify for the 'transition' or 'sustainable' categories," she says.
The realm of uncertainty
The Commission's 62-page proposal must still be fleshed out with more detailed technical criteria, which it can only finalise after political agreement has been reached between the European Parliament, Council and Commission next year.
The tribulations of the first Omnibus package to 'simplify' EU corporate sustainability reporting and due diligence rules have put some on guard for similar cuts to the SFDR proposals.
The clause that would see companies with plans for new fossil fuel production excluded from the SFDR transition category could be a "problem" that would be difficult to square with the EU's ambition to massively ramp up transition finance, says Commerzbank's Kippe.
"If we want to stabilise grids to enable a further increase of the renewable energy share, there is still a need to invest in gas infrastructure as long as sufficient battery capacity is not yet available," he says.
However, the clause could be a key flashpoint for the political negotiations, Kippe suggests.
"The fossil fuel exclusion could be an area where the European Parliament, which is much more regulation-sceptic than it used to be, could have a less rigid view than the commission," he argues, hinting at the outsized influence of centre-right and far-right political parties in the Parliament that was influential in securing greater cuts in the Omnibus process.
Consultants at KPMG suggested that the fossil fuel exclusions could "cause issues for sponsors that fundraise from US investors, particularly investors from states that have anti-ESG legislation on the books".
This raises the prospect of lobbying by US financial services firms to dilute the proposal, as with the first Omnibus package.
"This [SFDR review] is one of the most thought-through proposals I've seen in financial services regulation," a head of EU public policy at a large European asset manager tells Environmental Finance.
"The downside is the risk that, with the political context, the co-legislators opt against keeping the spirit of the text, and instead tear it apart, and then what comes out of the 'sausage machine' [of EU policymaking] is not good anymore," they add.