EU Member States Propose Dropping Exclusion of Fossil Fuel Companies from New SFDR Transition Fund Category

The European Council announced an agreement by EU member states on its negotiating position on proposed changes to the Sustainable Finance Disclosure Regulation (SFDR), the EU’s key legislation setting out how financial market participants have to disclose sustainability information, and aimed at helping investors to more easily identify and compare sustainability-focused investment products and invest in line with their sustainability preferences.

One of the key changes included in the Council position is the elimination of a proposed exclusion of companies developing new fossil fuel projects from a new “transition” investment category, replacing it instead with requirements for a proportion of the companies’ capex to be in line with the EU Taxonomy, and to set a strategy to reduce operational greenhouse gas emissions.

The Sustainable Finance Disclosure Regulation, in application since 2021, sets out how financial market participants, such as asset managers, have to communicate sustainability information to investors, regarding the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products. The goals underlying the introduction of the regulation included helping to attract private funding to facilitate the transition towards greater sustainability, and helping companies pursue transition-related opportunities.

A 2023 review of the SFDR framework by the European Commission revealed that the current requirements of the regulation include disclosures that are too long and complex, making it difficult for investors to understand and compare the environmental or social characteristics of financial products. Among the key concerns noted by the Commission was the apparent mis-use of the regulation’s Article 8 and Article 9 disclosure regime as de-facto sustainability labels, which it said may have lead investors to believe that Article 9 funds are necessarily fully sustainable and that Article 8 funds strongly integrate ESG factors, even though this is not necessarily the case, increasing the risk of greenwashing.

To address these concerns, the Commission proposed introducing a new simplified categorization system for financial products making ESG claims, based on three recommended categories, including “Sustainable,” for products contributing to sustainability goals, such as climate, environment or social goals, that already meet high sustainability standards; “Transition,” for products investing in companies and projects that are not yet sustainable, but that are on a credible transition path, or contribute toward improvements in areas such as climate, environment or social areas, and; “ESG Basics,” for products that do not meet the Sustainable or Transition criteria, but integrate ESG investment approaches, such as those focused on best-in-class performers on a given ESG metric, or those excluding the worst ESG performers.

The Commission’s proposal set out a series criteria for each category including exclusions, or industries and activities in which the product would not be able to invest, and positive contribution, with a requirement for at least 70% of the portfolio to follow an ESG strategy that matches product’s category.

Under the Commission’s proposal, both the Sustainable and Transition categories would exclude companies expanding their fossil fuel activities, while the Sustainable category would also exclude companies active in fossil fuels or high-emitting energy activities, and the Transition category would have a less restrictive exclusion of companies generating significant revenues from coal.

Under the Council’s position, however, the Transition categories’ exclusion of companies expanding fossil fuel activities would be replaced with a requirement for companies active in the fossil fuel sector to allocate 20% of their capital expenditure to economic activities aligned with EU taxonomy, and to have a clear, time-bound strategy to reduce Scope 1 and 2 greenhouse gas emissions. Notably,  the significant majority of most fossil fuel companies’ GHG footprint comes from their Scope 3 emissions related to the use of their products.

Environmental and sustainable investing groups sharply criticized the Council’s position, with Thibault Girardot, Sustainable Finance Policy Officer at WWF European Policy Office, noting that “governments have twisted a regulation meant to distinguish genuine sustainability and transition efforts from greenwashing.”

Thibault added:

“The Council’s approach risks actively deceiving investors by selling the illusion that their money supports the sustainable transition, when, in reality, it may end up funding the climate crisis.”

Lara Cuvelier, Sustainable Investments Campaigner at climate finance-focused NGO Reclaim Finance said:

“As parts of Europe swelter under a heatwave exacerbated by climate change, it is outrageous that the Council has chosen to listen to the oil and gas lobby and not exclude companies developing oil and gas from the transition label. MEPs face a simple choice – vote to support a fossil fuel future, or vote to protect the wellbeing of European citizens.”

Another significant change proposed by the Council is the elimination of an exclusion of general purpose issuances by EU-based public sector bodies from the transition category, under certain conditions, with the Council noting that the established framework of climate and sustainability commitments at EU level make it possible to assess their compatibility with sustainability objectives, and the inclusion of these securities would significantly expand the ability of insurance and pension fund investors to invest in transition category funds.

The Council’s proposal will form its position on the Commission’s proposed changes to the SFDR regulation in upcoming negotiations with the European Parliament. Parliament is expected to vote on its negotiating position in mid-July.

Click here to access the EU Council’s position.